Investing in Today’s Market With a Valued-Oriented Philosophy
In 2017, the stock market continued to climb despite political and global turmoil. When asked what will happen next, we always answer that we do not have a crystal ball, nor does anyone else for that matter.
Rather than speculate on what may happen in the future, we stick to a discipline based on fundamental investing principles. If we have learned anything from the last financial crisis and from periods of economic bubbles and bursts in our history, it is that these fundamental principles are timeless. This allows us to make independent, courageous, and even unpopular decisions in the face of myths and misconceptions in the marketplace.
We have often repeated at Kingwest that we are long term, value investors in public securities. That matters to you because looking at securities in this way is just different enough to translate into giving us an edge and help us to generate the consistent, attractive returns that everyone wants.
We have never explained why this works so we thought in this letter we would go into a little more detail to give you a deeper insight into what we do and why.
A ‘value’ oriented investment philosophy is grounded on the idea that while securities can be mispriced in the short term, over the longer term, markets are efficient and share prices will gravitate toward reflecting what the business is worth. If prices did not tend towards value, then it would not matter whether we knew what a business was worth or not.
Why do some securities get undervalued in the first place? Can we systematically recognize and take advantage of these situations, to provide a perennially stable frame of reference for making sound and profitable decisions?
Economists have traditionally assumed that individuals behave rationally, making decisions on the basis of all the information readily available to them. That is also true for the conventional way of looking at securities. Conventional wisdom, in other words the preponderance of commentary both professional and otherwise, is based on the idea that share prices are determined by company performance.
That is true, but only to a point. People do not always behave rationally when making decisions, particularly when making decisions about money.
On October 9th, it was announced that the Nobel Prize in economics was awarded to Richard Thaler for his contribution in incorporating realistic assumptions about how people behave into analyses of economic decision making. He has shown how these psychological human traits systematically affect individual decisions as well as market outcomes.
Research has shown that decisions about share prices are not always rational. Rather share prices are the result of human interaction, and the actions of people are driven as much by emotions as reason, especially when making financial and investment decisions. Therefore, movements in share prices reflect not only the actual performance of companies, but also changes with people’s expectations about that performance.
The higher the expectations, the better the company must perform just to keep up. As the Queen of Hearts described in Wonderland to Alice, “Here we must run as fast as we can, just to stay in place”. If the share price is to do better, performance has not only to improve, but it has to outstrip the expectations built into the price. According to the Queen of Hearts, “If you wish to go anywhere you must run twice as fast as that”.
Looking at securities markets in this way is called behavioural finance and it is relatively new way to look at securities. We have been applying these ideas for quite a while. We wrote in our letter of July 22, 2005:
“Daniel Kahneman was awarded the Nobel prize in economics for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty”, essentially recognizing the importance of ‘people’, foibles and all, in economic decisions”.
There is no denying that people are different. The key finding from the research is not that everybody is the same, but that, on average, we tend to err in the same direction. For example, we all think that we are going to finish projects sooner that we will, even though some people procrastinate more than others.
These ideas about how people behave are a critical component in understanding how we go about managing your assets at Kingwest.
We believe that securities can get mispriced in the short term because “people overreact to dramatic and unexpected news events” (quoted from Thaler in “Does the Stock Market Overreact?” 1995). Not everyone overreacts to the same degree, but most people do overreact to negative and unexpected news.
This systematic tendency for people to overreact or under-react opens opportunities to buy things at cheap prices and to earn outsized investment returns.
We are always looking for dislocations where the market has overreacted to a negative macro or company specific development that through research we believe is temporary and fixable. While these events can be either macro or company specific in nature, generally at Kingwest, we are involved in individual company developments.
At other times, people under-react or are very slow to react, to company developments that are very positive and long lasting. Again, the opportunity set is great.
A large portion of the investments in your portfolio are driven by these behavioural ideas. Here are a couple of examples.
Quebecor is a large communications company. Its most profitable division is Videotron, the dominant cable company in Quebec. Videotron broke new ground in 2005 by becoming the first major cable company in Canada to offer residential telephone service via cable. In 2006, Videotron decided to offer land telephone lines to its cable and internet customers, just as Rogers and Shaw have done. It was an overwhelming success in terms of subscriber growth. On the strength of that success, Videotron decided to enter the wireless market focused on Quebec. They were the only new incumbent with a subscriber base and the ability to bundle to compete with Rogers and Bell in their market. The stock market reacted negatively to the news because it foresaw large losses and a questionable future for all of the new entrants.
Quebecor was different; it had a large installed base of customers who purchased two or even three services from them and bundling another service would be relatively easy. We purchased Quebecor at $17 per share; it is now trading at $47. The opportunity was the market’s overreaction to the perceived negative news of Videotron entrance into the mobility business. While it did take a few years to work out, it has been a very successful investment.
Gilead Sciences is a large biopharmaceutical company. The company is the leader in treating HIV and curing Hepatitis C. This enviable position created more profits than the company could spend. Cash was piling up and investors, once excited by the windfall, turned impatient and worried. Having fallen from $120, we purchased the stock in May in the mid $60’s.
In August, Gilead announced the acquisition of Kite Pharma for $11.9 billion. Kite is a leader in the emerging field of cell therapy, which uses a patient’s own immune cells to fight cancer. Since the acquisition was announced, Gilead stock has performed very well and is now trading in the low $80’s.
Our confidence in our prospects for delivering attractive returns remains strong. We believe that buying undervalued companies is the soundest way to compound wealth over the long term. That has been confirmed in countless studies by academics and by our own performance. While value investing does not work all the time, neither does any other investment style. However, focusing on value has been proven to work over the long term. If value investing were both fruitful and easy, everyone would embrace it, and the opportunities we seek would be competed away.
We look forward to more solid investment returns to come.