Companies are living faster and dying younger; faced with accelerating change, their ability to adapt is crucial for their survival. New technology, connectivity and globalisation will continue to offer new growth opportunities but, at the same time, will bring new threats. As the internet affords start-up companies the global reach of large ones, and emerging market companies compete on the international stage, the world is becoming flatter.
Just as the corporate world needs to adapt, so does a successful investment approach. As traditional methods of forecasting and valuation prove less effective, we look for one thing in the companies we invest in, resilience – an ability to adapt, survive and thrive, whatever the environment.
Equitile finds innovative companies that have healthy relationships with customers and employees, balance sheets that can survive the toughest of times and governance designed to develop assets over the long-term.
We confess to being more than a little obsessed with debt. In his book The Origin of Financial Crises (2008) our Chief Investment Officer, George Cooper, explains why excessive debt is making our financial system increasingly crisis-prone. In Debtonator (2015) our Chief Executive, Andrew McNally, describes how companies mainly financed by equity perform better.
Our views on the dangers of debt permeate our approach to investment, from asset selection through portfolio construction and into risk management. At every stage we seek to enhance investment resilience through a fuller understanding of financial leverage. By avoiding companies most exposed to financial instability, and investing in companies best able to profit from the opportunities such instability presents, we always look to build wealth from a position of financial strength.
Increasing leverage might appeal in theory but in practice it severely distorts markets. It is these distortions that Equitile looks to exploit.
Conventional financial market theory argues that asset prices change when random surprises cause investors to reappraise their valuations. This suggests we cannot anticipate future price movements but we can at least calculate the probability of how an asset’s price could move. This view of risk is rather like that involved in rolling dice: we don’t know which numbers we will get but we do know which numbers we could get. This is the type of risk Donald Rumsfeld famously described as ‘known unknowns’, and it is neatly portrayed by the probability distributions underpinning many value-at-risk calculations.
A more enlightened understanding of financial market behaviour recognises asset prices are often driven by self-reinforcing processes, spurred on by the effects of financial cycles and our human herding tendencies. From this more sophisticated perspective, financial risk can be seen as akin to the behaviour of flocking birds, being neither random nor predictable. In this self-reinforcing complex world risk is much harder to quantify and extreme price movements, described by so-called ‘fat-tailed’ distributions, become more likely. This is the flavour of risk Donald Rumsfeld would have called the ‘unknown unknowns’.
At Equitile we believe complex self-reinforcing behaviour dominates financial markets, especially during financial crises. This is why we believe conventional value-at-risk systems often suffer the ‘chocolate teapot’ problem – they appear to work but fail when needed most. It is this view of financial risk that drives every aspect of our investment philosophy and process.
We humans are not the rational calculating machines financial theory often assumes. In practice our innate biases cause us time and again to make investing mistakes.
For example, when we make an investment we tend to connect its apparent value to the purchase price. This ‘anchoring’ often leads investors to sell assets too quickly when their prices rise. Similarly the related ‘sunk cost fallacy’ causes us to hold poor investments for too long; if the asset’s price falls below our purchase price we become reluctant to crystallise our loss, even if the new price is the right one. The ‘confirmation bias’ and the ‘endowment effect’ likewise impair both our thinking and investing. The endowment effect causes us to overestimate our assets’ value compared to those we don’t own, while the ‘confirmation bias’ makes us seek out information that supports our previous decisions. Consequently investors often pass up new investment opportunities even when they are objectively better than their current ones.
Perhaps the most powerful behaviour is ‘herding’. Contrary to mainstream financial theory we do not make decisions as individuals; instead we form our opinions in groups. In fact, we find it very uncomfortable holding views that differ from consensus opinions. Such behaviour is partly responsible for some of the markets’ wilder gyrations.
At Equitile we acknowledge such biases and use clear guidelines in constructing your portfolios in order to help overcome, and even exploit, these in-built human tendencies.