A common trait of successful investors is that they tend to understand their own strengths and limitations. They are cognisant of their circle of competence and continuously focus on playing to their strengths, ultimately improving the odds of success. In other words, they understand what gives them an edge. Portfolio managers who consistently exploit their edge over time are those who generate market-beating returns, or alpha, for their investors. At Denker Capital, we continuously look for ways in which we can improve our edge so that our investors can enjoy the rewards.
Outperforming the market starts with understanding the potential sources of returns.
At Denker Capital, to generate market-beating returns for our investors, we continuously look at how we can improve our edge by gaining a better understanding of past sources of alpha.
The foundation or framework we follow to achieve this involves understanding the three potential sources of return available to investors:
1. The starting valuation, represented by a rating metric
This refers to the price at which you are able to invest in the company in relation to its value. The starting valuation is often represented as a pricing or rating metric, i.e. the price to earnings (PE) ratio, price to book (PB) ratio, or dividend yield.
2. Growth in earnings or dividends
3. A change in the rating metric
This could come about as a result of a change in valuations across the market, or a relative change in the rating of the company compared to the market.
So, what does this mean in practice? Let’s look at an example¹.
• If you buy a company at a starting dividend yield of 5% and there is no growth in earnings, then your return will simply be 5% plus or minus any change in the yield. If the yield remains flat, you will only earn 5% return.
• However, if the profits of the company grow and dividends increase by 10% each year, then your return will be 15% per year (5% starting yield and the 10% growth in dividends) plus any change in the yield.
• If the price increases to such an extent that the dividend yield reduces by 20%, from 5% to 4%, you can add a further 20% capital appreciation to your total return.
The key is to maximise risk-adjusted returns from all three sources of return, instead of focusing on only one source.
Traditional value investors focus mostly on rating changes as the major source of excess returns, while growth investors tend to hone in on the potential growth in profits. At Denker Capital, we look for opportunities where we can potentially maximise risk-adjusted returns from all three sources of return by matching these to our skills and where we believe we have an edge. By gaining a better understanding of our competitive edge, we hope to consistently improve our clients’ investment outcomes.
Considering the impact of time on the potential sources of return is equally important.
Time plays a very important role, but it applies differently to the different sources of returns. Let’s consider growth in earnings as an example. The longer a business can grow its profits above the average company (assuming it is earning a good return on the capital required to generate those profits), the stronger the effect of compounding will be and the higher your total return is likely to be. This shows that both growth in earnings and the investment time horizon are critical to understanding the return potential of a business.
When it comes to a change in the rating, many investors are fixated on its short-term impact on potential returns. In the above example, if the 20% change in rating happens over the course of just one year, it makes for an attractive addition to your total returns. However, unlike the contribution from earnings growth, where time is your friend, when it comes to rating change, time is in fact your enemy. The longer it takes for the rating to change, the lower the annualised return contribution will be. This contribution to return is finite and a once-off occurrence.
To make the most of the different return sources requires identifying and understanding your edge.
For companies that are not growing and pay no dividends, the only source of return will be a change in the PE ratio. Buying stocks at a low PE ratio is a great idea if you can successfully predict both what will trigger a rating change and how quickly this rating change will take place. This is where it’s important for portfolio managers to understand their edge. The likelihood of consistently predicting the timing, magnitude and cause of a change in a company’s rating correctly is low, making this source of potential return more a function of luck than skill. Adding to the complexity and reducing the odds even further is that, to outperform the market, you not only have to predict the change in the company’s rating in absolute terms, but also relative to the market. It’s no good if you think the company’s PE ratio will go from 10x to 11x (an increase of 10%), but the market PE ratio increases from 10x to 12x over the same period (an increase of 20%). While rating changes may be an attractive source of return, this often tends to disappoint, especially in the absence of growing profits or when combined with elevated company-specific risks.
Michael Mauboussin identified four sources of edge in his paper Who is on the other side?
1. Informational edge
An informational edge refers to acquiring information that translates into a differentiated insight before it is reflected in the price of a stock. This is becoming increasingly difficult, since information has become much easier and more affordable to obtain. New approaches to an informational edge are being explored, such as capturing several weak signals that together generate a stronger signal using big data, artificial intelligence and the process of machine learning. However, the sustainability of this as an informational edge has not been conclusively tested. One area we have identified as a marginal informational edge is being effective at capturing new information that may affect the investment case. Sometimes it takes time for new information to be reflected in share prices, and this could create an opportunity. For example, it took over a year from when the first murmurings of corruption at EOH were leaked before it was fully reflected in the share price.
2. Analytical edge
An analytical edge is about figuring out what matters most and being skilled at analysing the information of a specific stock or industry. Understanding where you have an analytical edge (and where you don’t) is key to long-term investment success.
3. Technical edge
A technical advantage is normally a unique or specific event that results in a temporary disconnect between the price and the intrinsic value of an investment. A great example of this is the recent unbundling of MultiChoice by Naspers. Most investors in Naspers were left with a small and insignificant holding in MultiChoice in their portfolios, with many choosing to sell out. This resulted in the MultiChoice share price temporarily trading well below our assessment of intrinsic value as everyone rushed to exit at the same time. Our clients benefitted handsomely from this technical inefficiency, as we were able to buy Multichoice shares at a significant discount, locking in long-term value.
4. Behavioural edge
A behavioural edge is the most persistent but also the most difficult to capture. In the short term, most share price changes are outside of management’s control and may have very little to do with long-term fundamentals. We tend to look for breakdowns in the diversity of opinions on a stock, which may indicate a potential disconnect between intrinsic value and the share price, and therefore an opportunity to lock in attractive long-term returns. Our investment process includes various tools that are designed to encourage us to analyse all sides of a transaction and to avoid heuristic biases. The construct of the investment team is also an important factor in seeking out diverse views. Thanks to some valuable insights from Guy Spier², we have developed a checklist that incorporates all the things that have caused us and our investors pain in the past so that we may avoid the same pitfalls in future.
Putting the theory into practice is hard, but critical to favourable long-term outcomes.
While the above theory may sound simple, it’s much harder in practice. We are continuously learning and looking for ways in which we can gain a small edge that translates into better risk-adjusted returns for our clients in the long term. This starts with understanding our edge and continuously looking for opportunities to exploit this over time.
¹ We owe some credit to well-known investment writer Vitaliy Katsenelson who has shared some of his views on the sources of returns and risks that come with each.
² We met with Guy Spier in Switzerland earlier in the year. His book, The Education of a Value Investor, makes reference to the value of checklists in the investment process.
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