Are you sitting comfortably? Ian Lance and Nick Purves, co-Heads of the UK Value & Income Team at Redwheel and co-fund managers of Temple Bar Investment Trust, share a tale of the parable of the four fund managers at Global Megabucks Asset Management: Danny Defensive, Ivor Income, Vinny Value and Sue Sensible.
The tale of Danny Defensive
Danny Defensive, was an extremely confident fund manager very convinced about his own ability to forecast macro-economic trends and seemingly permanently gloomy about the state of the economy. He therefore structured his portfolio to cope with the depression that he always thought was on the horizon by owning large defensive equities.
As the economy swung into a downturn, Danny would do very well, and speak to large audiences about ‘how he had seen it coming’. This usually meant lots of money pouring into his fund when his favourite defensive stocks were very popular (and very expensive) and just before the cycle picked up and they did very badly. The salesforce would then spend the next couple of years advising the new clients to hang on for the next economic downturn when the fund was bound to start doing well again.
The tale of Ivor Income
Ivor Income had read many studies which showed that stocks with high dividend yields do better than the market over time. These studies seemed to rank all the stocks in the market by dividend yield and showed how the highest yielding part produced superior returns in the long run.
“This is great,” thought Ivor, and planned to spend a couple of hours at the start of January sorting the market by dividend yield and buying those shares for his fund. For a while this worked well as Ivor’s fund did well on average.
In 2008, something strange happened – at the start of the year, Ivor noticed the banks, housebuilders, airlines, retailers and insurers all had great big yields and low price-to-earnings ratios to boot. Anticipating a great year, Ivor and his sales team started marketing a campaign showing how high Ivor’s fund yield was. Over the course of the year, many of his companies had cut their dividends, some had rescue rights issues and some no longer existed at all. Ivor’s sales team were not happy when they had to tell their clients who had bought the promise of the high yield that they were cutting the dividend on Ivor’s fund.
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The tale of Vinny Value
Vinny Value had read lots of books about Warren Buffett, John Templeton and Ben Graham and convinced himself that contrarian deep value was the way to go. For many years, this had worked well as he waited for the economy to turn down then stepped in to buy all the lowly valued cyclicals that Harry Hedge Fund was selling. So far, the central banks had always stepped in by slashing interest rates and sometimes printing money which meant the share prices of the beaten down cyclicals soared, and Vinny’s fund did well.
As markets plummeted in 2008, Vinny saw another great opportunity as some financials traded at less than half their tangible book value and Vinny stepped in to take advantage of other people’s fear. He loaded up on names like AIG, Fannie Mae, Freddie Mac and Lehmans in the US, whilst also buying HBOS and Royal Bank of Scotland in the UK and sat back to wait for the recovery. In 2008, Vinny’s fund was down 55%, wiping out his 10 year track record. In 2009, he lost half his assets to redemptions.
The tale of Sue Sensible
Sue Sensible was less confident about her ability to forecast things than her male colleagues. The sales team didn’t like this as when asked for her opinion on the economy or market, she would often say she ‘didn’t know’, whereas Danny, Ivor and Vinny always had an opinion. Like Vinny, she also had an eye for a bargain, but unlike him, she always bought well.
Vinny had once come back to the office with ten pairs of boxer shorts he bought in the market place for £5, but which only lasted him a month. Sue on the other hand, had once saved up for a Chanel suit which she waited to buy until it was half price in the sales. Sue’s strategy to selecting stocks for her fund was similar; like Danny, she looked for high quality defensive stocks but she only bought them when they were cheap. Like Ivor, she was attracted to beaten down stocks, but she would avoid poor quality businesses or those with excessive financial leverage. Like Ivor, she liked shares with high dividend yield but she tended to avoid the ones with the highest yields, which experience had taught her were high for a reason.
The sales force never spent much time pushing Sue’s fund as, whilst it was better than average most years, it was never in the top decile which was what they needed to shift product to meet their sales targets. Then one morning, Simon Snakeoil, Head of Distribution at Global Megabucks said in the weekly sales meeting: “OMG. Sue is top decile over the last five years! Get her out on the road right NOW!”
Some serious points about the story
Income and Value are frequently regarded as being one and the same, but this is not always the case. Assuming a high dividend yield stock is good value can backfire – particularly when dividends are being paid out of unsustainable earnings (i.e. banks in 2008) or when they are paid using borrowed money (i.e. utility companies now).
There is a perception that value is defensive in a stock market decline. Whilst ‘Value Indices’ are often dominated by sectors such as autos, airlines, steel and financials, real value rotates around the market often as a function of the economic cycle.
In the early stages of a downturn, investors usually sell cyclicals and buy defensives meaning that the former group ends up representing good value whilst the latter becomes expensive. This was seen in 2020 as the world entered a recession brought on by the response to the pandemic. At the first sign that we were exiting the lockdown, market leadership switched to lowly valued cyclicals.
No investment approach works all the time. Short term performance and being temporarily in vogue tells you very little about a fund manager’s skills in the long term. Most successful investors tend to act differently from the market, and as they cannot control when the market comes round to their way of thinking, their performance will naturally diverge from that of the market, sometimes positively but sometimes negatively. Consecutive, positive, annual relative returns are generally not the hallmark of great investors and nor should they be.
The worst thing to do is act upon these random patterns aforementioned, i.e buy Danny after his defensives have done well, or sell Vinny because his value stocks have fared badly.
In Ian and Nick’s opinion, the key to selecting a good fund manager involves asking:
- Do you understand their philosophy? Are you buying Danny, Ivor, Vinny or Sue?
- Is there evidence that this philosophy can provide excess returns in the long run? Buying lowly valued stocks can be shown to produce excess returns; the same cannot be said for ‘we are good at identifying themes’ or ‘we have 200 analysts who attend 5000 meetings a year’
- Can they demonstrate that they have successfully applied this strategy over a long period of time?
- How can you ensure that they are in the right operating environment? Do they have the mental fortitude to stick with it when it is not working? Does their boss? Do you?
- Lastly if you are confident in their long term ability, are you willing to invest when their style is out of fashion, when short term numbers are poor, and to be patient for at least five years?
