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Confidence
A daunting paradox in investment management is that participants want the ideas they hear to be conveyed with conviction, yet overconfidence is at the root of many bad decisions.
A new paper (“Confidence: Methods to Assess Confidence Under Uncertainty”) from Michael Mauboussin and Dan Callahan covers a range of foundational concepts about confidence. Among them, that we tend to “overweight our experience in a way that distorts our perception. Thoughtful forecasts are a blend of base rates and the inside view, but we tend to overweight the inside view.”
Also:
Confidence in the reliability of available evidence is a mix of its strength and weight. Strength reflects the extremeness of outcomes, and weight is the predictive validity based on sample size.
[F]orecasters tend to overemphasize the strength of evidence at the expense of its justified weight. This leads to a predictable pattern. Analysts are overconfident when the strength is high and weight is low . . . and underconfident when the strength is low and the weight is high.
That’s something that’s particularly evident in the judgment of performance throughout the ecosystem.
The old economy is changing
The latest analysis from Kai Wu of Sparkline Capital, “Digitizing the Old Economy,” pushes back against the notion that so-called “old economy” companies are in the crosshairs of technological disruption and about to meet their demise. On the contrary, many are “transforming their work cultures to attract talent,” and are being digitally remade from the inside.
The piece uses categories of firms (innovators, early adopters, early majority, late majority, and laggards) from the theory of technological diffusion to highlight a potential opportunity in the early-majority cohort, noting that:
While innovation is good, investors must also consider the price paid to obtain this innovation. We only want to invest in companies for which the market is failing to appreciate some aspect of value.
That “early majority” is clearly lumped in with its old-economy brethren when it comes to valuation.
However, if you plot measures of intangible value, those firms look like they belong on the other side of the line.
Activists
“The Evolving Battlefronts of Shareholder Activism,” by Andrew Baker, et. al, looks at changes in the landscape of shareholder activism, and the effect that universal proxies may have on the dynamics of the interactions between companies and activists.
An interesting subtext: “Despite the extensive research evidence, there is still much we do not know about activism.” While stocks pop initially, “the long-term impacts are less clear.” Studies that show long-term benefits from activism are skewed by microcaps; “the total abnormal returns across all activist campaigns are zero.” And the impact on operating performance is “mixed.”
The introduction to “Barbarians Inside the Gates: Raiders, Activists, and the Risk of Mistargeting,” by Zohar Goshen and Reilly Steel, summarizes an important distinction in the incentives of raiders, who buy whole companies, and activists, who take minority positions. The thrust of it:
This Article argues that the conventional wisdom — corporate raiders break things and activist hedge funds fix them — is wrong. Activists are no better than raiders; if anything, they are likely worse. Because, as we argue, activists have a higher risk of mistargeting — mistakenly shaking things up at firms that only appear to be underperforming — they are much more likely than raiders to destroy value and, ultimately, social wealth.
There is a key difference between the hurdle rates that motivate the two camps into action; “as potential 100% owners of the target’s stock, raiders cannot shift risk onto other parties, further incentivizing them to invest more in information and take only prudent risks.” Activists can agitate for much smaller (and shorter-lasting) gains and have “an ability to shift some of the cost of mistakes onto other shareholders.”
Other reads
Short-Term Gain, Long-Term Pain, Part 2,” Ted Seides, Capital Allocators.
It’s time to sharpen our pencils on first principles because things are about to get interesting. Re-underwrite a manager’s competitive advantage in sourcing, due diligence, decision-making, portfolio construction, and risk management. When a manager finds an opportunity in the mess and calls for the ball, confirm that their first principles resonate with the opportunity set and be ready to pounce.
“The Remaking of Kleiner Perkins,” Mario Gabriele, The Generalist. A look at a half century of history of the legendary venture capital firm, including its pivot back to relevance.
“Accounting-Fraud Indicator Signals Coming Economic Trouble,” Josh Zumbrun, Wall Street Journal. Aggregate readings for the M-Score (a measure which indicates the likelihood of earnings manipulation) are at their highest level in over forty years.
“Society’s Technical Debt and Software’s Gutenberg Moment,” Paul Kedrosky and Eric Norlin, Irregular Ideas.
Software production has been too complex and expensive for too long, which has caused us to underproduce software for decades, resulting in immense, society-wide technical debt.
This technical debt is about to contract in a dramatic, economy-wide fashion as the cost and complexity of software production collapses, releasing a wave of innovation.
“Merger Arbitrage,” Nick Sertl, Verdad. Trends in merger arb, its relationship to other assets, and the return dynamics (“deals with higher spreads generated higher returns, despite the drag caused by higher cancellation rates”).
“CFA Institute Makes ‘Biggest Single Package of Changes’ in Its History,” Alicia McElhaney, Institutional Investor. How will current members, aspiring professionals, and the industry respond to these modifications? (CAIA, another credentialing organization, weighed in.)
“4 habits of highly effective CIOs,” Peter Corippo, Russell. The “best in the business routinely exhibit these four traits.”
“Investment Consultants in Private Equity,” Jose Vicente Martinez and Yiming Qian, SSRN.
The consultant trait that seems to be most associated with asset owner performance is the size of the PE manager list their clients draw from. Asset owners advised by consultants that rely on a narrow list of PE managers do better than asset owners advised by consultants that work with a larger list of managers.
“Is your PM a psychopath? These are some (possible) red flags,” Tania Mitra, Citywire Pro Buyer. “Is it because when you take empathy out of the brain, all that’s left is the desire to win?”
“SVB’s challenges will accelerate valuation down rounds, startup mortality, and layoffs,” CB Insights. “Debt was being used to avoid pressured valuations.”
“On Share Buybacks, Directors Should Stick with Economics, Avoid Politics,” Lawrence Cunningham, Mayer Brown.
In short, as the history and economics of buybacks confirm, they are never always good or always bad.
“Anomalies Wanted: A counterintuitive call to innovate that can set businesses apart, Christensen Institute. “There is an art and science to searching for anomalies.”
“Steve Leuthold, Influential Fund Manager With a Wild Streak, Dies at 85,” James Hagerty, Wall Street Journal. Leuthold’s “green book” was one of the most widely-read publications in the investment industry.
What you need
“Rules are great at preventing problems you’ve seen before. Culture is better at preventing problems you can’t foresee.” — Mark Brooks.
Postings
Two recent postings for paid subscribers:
“Ascendance of the Pod Masters.” Multi-manager, multi-strategy funds are the subject of attention and fascination now. What are the implications of their success and popularity?
“The Killer App Still Dominates in Middle Age.” Microsoft Excel is everywhere in the investment world. A reflection on uses, errors, and history, as well as some wizards of columns and rows.
All of the content published by The Investment Ecosystem is available in the archives.
Thanks for reading. Many happy total returns.
Published: March 27, 2023
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