This is an exclusive guest post by Alastair Mundy, Portfolio Manager of the Investec Cautious Managed Fund.
A colleague of mine is convinced that, at some stage, many of us will be travelling around in flying cars.
He believes that human achievement has continued to surprise over time and, arguably, is happening at an increasingly quicker pace. He claims he is simply extrapolating this progress.
Certainly, while he is not the first to express a belief in new transport methods, what this thinking does is differentiate him from the mainstream by putting a tick in the box marked ‘imaginative’.
Imagination is an appealing characteristic – but does it have a place in investment management or is it just a more acceptable term than guesswork?
One way to utilise this imagination, which has been recommended by various academics, is to conduct premortems – a strategy in which a manager imagines (in this case an investment decision) has failed and then works backwards to determine what could lead to this failure.
However, the human mind is, simply, incapable of assessing all future possibilities. Rather than putting poor thinking down to investors, it is a reflection on the bizarre world we live in.
For example, anyone accurately forecasting the deterioration in UK government services company, Serco’s profitability in the past few years would have predicted — to quote from the Financial Times — “a Serious Fraud Office investigation into an offender tagging contract, a City of London police investigation into a prison vans contract, a shortfall on a detention centre contract in Australia (and) a temporary ban on bidding for UK government work”.
That would have undoubtedly pushed all investors to their imaginative limits.
In its simplest form, stock analysis can be perhaps boiled down to four main areas – where has a company been, where is it now, where is it going and how much are we paying to go there?
To answer these questions, we need to look at a company’s historic performance, its current performance (in cashflow terms, balance sheet strength as well as profitability), and its future performance.
Undoubtedly, the fun part of analysis is working out where we are going. This, depending on the investor, includes meeting senior management, ‘hobnobbing’ with industry experts and building detailed models of the future. It tends to involve less rigour, number crunching and boredom than studying and analysing the past, but in investment bank reports it often generates far more words and spreadsheets.
As we all like fun, there is a good chance excessive time is wasted on the ‘where is it going’ phase relative to the other three areas.
Having committed so much time to that phase, it is difficult for an analyst to be anything other than confident that their time has been well spent – that their imagination is accurate.
What Serco and the many other stocks that throw up surprises actually teach us, is that the future is far more uncertain than we realise. Value investors’ decision-making process is greatly assisted by valuations.
Moreover, a low rating provides great protection against our imagination overcooking (by not paying much for extremely bullish thoughts) or undercooking things (paying insufficient attention to threats), while a high valuation tells us the imaginers have already pushed the price up to levels where their new age vision of the future must be reasonably accurate to justify the price.
When panic is rife, investors are usually insufficiently imaginative. At these times, it really pays to analyse say, the benefits of a merger between two parties, the potential to cut costs significantly or when it comes to profitability, just a reversion to mean.
Additionally, when times are good, the stress-testing of a balance sheet or concerns about future actions of a company’s board of directors with a dubious past seem more worthy of an imaginary focus rather than estimates of new product development over the next 10 or 15 years.
While hoping to avoid too tortuous an analogy, it may be useful to compare our actions with that of a chess player. In essence, we are looking more than one or two moves ahead.
However, as all players will be doing the same and therefore, there is little value we can add, we will also seek to avoid analysis of 12 move combinations, as there are simply too many variables to suggest that our results will be anything other than wildly inaccurate.
Instead we are searching for opportunities in the imaginative middle ground; three or four move combinations and taking a bit of thought, but not totally reliant on randomness for a positive outcome.
IMPORTANT INFORMATION
Past performance should not be taken as a guide to future returns. The value of investments can go down as well as up you could end up with less than you invested.
All the information contained in this communication is believed to be reliable but may be inaccurate or incomplete. Any opinions stated are honestly held but are not guaranteed and should not be relied upon. This is not a buy, sell or hold recommendation for any particular security.
This communication is provided for general information only. It is not an invitation to make an investment nor does it constitute an offer for sale. The full documentation that should be considered before making an investment, including the prospectus and Key Information Documents, which set out the fund specific risks, is available from Investec Asset Management.
