In honour of the forthcoming Melbourne Cup, let’s start with a quick trivia question: In how many calendar years has the favourite finished first in each leg of Australian racing’s ‘Grand Slam’? For the record, this four-legged achievement (in more ways than one) takes in the Golden Slipper, the Caulfield Cup, the Cox Plate and the race that, at 3pm AEDST on 7 November, will once again ‘stop a nation’.
While you ponder that, let’s briefly cross to the other side of the world where last month much was made of the 10th anniversary of the moment most people had their first inkling all was not right with the global financial system. On 13 September 2007, word began to spread Northern Rock had asked for emergency funding from the Bank of England, thus prompting the first run on a UK bank for more than a century.
The months that followed Northern Rock’s fall produced a barrage of negative press about the UK banking sector that only grew worse after the collapse of Lehman Brothers a year later – to the extent a major and persistent concern among investors was that one of the big high-street banks could go bust. Yet, in the context of history, with Northern Rock the first UK banking insolvency in nearly 100 years, how likely was that really?
To explore the point further, let’s return to the world of horse-racing and our original question – and congratulations if you answered ‘None’. You might well think it was not so improbable the quartet of horses the market considered the best hopes of winning Australia’s four big races might actually do so in the space of a calendar year but it has only ever come close to happening a handful of times.
Twice – in 1967 and 1990 – the favourites won the Melbourne spring carnival treble but not the Golden Slipper. Then, in 2015, after Vancouver, Mongolian Khan and Winx won the first three legs of the slam, Fame Game – who would have proved the shortest-priced favourite to win the Melbourne Cup since the mighty Phar Lap in 1930 – appeared extremely well-placed finally to complete the sequence.
Conservative estimates of the total amount Australians bet on the Melbourne Cup now run comfortably into the hundreds of millions of dollars and it is reasonable to presume a sizable amount of that was backing a win by Fame Game. Yet in effect, whether they knew it or not, all those punters were betting that something that had never happened before would happen that year. In the event, Fame Game finished 13th in a field of 24.
Whenever a fêted sporting sequence is not achieved – the US and UK Triple Crowns would be two further examples from horse racing – people are surprised but should they be? After all, if it were really that easy to win either Triple Crown, it would have happened on more than just a single instance in either country (the US in 2015) since the 1970s. And the answer to our opening question would not still be ‘None’.
Yet people become swept up in current events – be it horse races or financial crises – and grow ever more convinced something will happen even if history suggests it almost never does. Michael Mauboussin, one of the great thinkers of value investing, has written on this subject a number of times – including about Big Brown who, despite being yet another ‘dead cert’, failed to land the third leg of the US Triple Crown in 2008.
Mauboussin has argued the failure of most people to consider how successful other horses had been when they were in Big Brown’s position illustrates a bias among human beings for the ‘inside view’ – that is, making predictions based on a narrow set of inputs, which may include anecdotal evidence and misperceptions – as opposed to the broader, more fact-oriented ‘outside view’.
One classic example he points to from the world of finance is the way company management teams are always convinced any acquisition they are planning will add value even though history suggests some two-thirds of all such deals do not make the hoped-for return – and nor should fund managers believe they are immune.
After all, every professional investor is convinced they will outperform their benchmark index even though the cold statistics show that, over three years, the average mutual fund manager does not. In which case, you might reasonably ask, what makes us here in the Global Recovery Team believe we will outperform in the long run if the numbers suggest otherwise?
Well, every January we look to see what lessons we can learn from the previous year’s investments. We analyse what we did right – and what we did wrong – in our portfolios and, while the great majority of people would say that all comes down to what made and lost us money, the great majority of people would be completely wrong.
For us, the right lesson to take from the process is, if I took a particular decision 100 times, would I make money on average? As value investors, we want to make investments that make us money 60 or 70 times out of 100. As such, if a particular course of action turns out to have been one of the times we lose money, the lesson is not ‘never do that again’ but ‘just keep doing it – over and over and over’.
That, in essence, is what value investing is – a set of rules that helps to keep you on the right side of the averages so that, instead of being caught out by your own emotions – how likely things feel at the time – you are in a position to exploit the emotions of others.