Tuesday, November 21, 2017 UTC
Opinion

A little knowledge is a dangerous thing; so is a lot

Paul Bosman, Portfolio Manager,‎ PSG Asset Management
Oct. 18, 2017, 10:11 p.m.
90

Word count: 515

When it comes to investing, the quote above from Albert Einstein is extremely apt; especially today, when many investors are concerned about where future returns will come from. 

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When it comes to investing, the quote above from Albert Einstein is extremely apt; especially today, when many investors are concerned about where future returns will come from. 

Locally, political uncertainty, financially depleted state-owned enterprises and weak GDP growth remain top of mind. Globally, the dominant narrative is that the prolonged era of accommodative monetary policy in developed markets is gradually coming to an end. The result will see the normalisation of bond yields (i.e. capital losses for bond investors) and the end of the steamy equity bull market. Or so the story goes.

Against this background, how can one generate satisfactory returns? 

Not by knowing a lot… 

Trying to understand each and every possible market driver and building multivariate regression models to predict security prices would be one way to approach the problem. However, this can be dangerous. It is very hard to predict the future, and equally as hard to predict the impact of future events on security prices. Probability theory teaches us that multiplying two unlikely success rates results in an even lower hit rate. 

… but also not by knowing only a little.

Another approach would be to buy an index or a basket of stocks that seem to be running and are widely held. This hedges your bets in terms of relative performance. However, this approach is dangerous too. In the long run, markets don’t have mercy for the lazy. 

The answer is to know a lot about investments that match your specific criteria. 

A good starting point is to focus on the equities or bonds of companies that are managed by capable individuals and have some kind of protection from ruthless free market forces. Having identified such opportunities, a very rigorous research process must be undertaken to estimate an intrinsic value for the security (share or bond). If its price is below this estimated intrinsic value, it would qualify for inclusion in an investment portfolio.

In this instance, the drivers of future investment returns would be broken down into the following:

·savvy management teams allocating capital to opportunities that deliver good returns and drive profit growth 

·the leveraging of economic moats (competitive advantages) that allow companies to increase revenue by more than costs and thereby grow profits faster than GDP

·the rerating of security prices towards intrinsic value

(Share prices are driven higher by greater profits and/or movements towards fair value, while bond returns are obtained from regular coupons and/or movements of bond prices towards fair value.) 

There is also a fourth important driver of returns: the practice of rotating into cash when securities become fairly priced or marginally overvalued, so that when undervalued securities become available, there is money in hand to pounce.

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