Ardevora Annual Review - 2021

Our Investment Process

Most traditional fund managers have a style, but we believe there is nothing inherent in the characteristics of value, growth or quality that causes good rewards. We believe the path to reward requires an understanding of the psychology of mistakes.

We have been running money, using what we know about the psychology of mistakes, for over thirty years. We have approached the task from the bottom up, applying lessons learnt about the mistakes investors, analysts and CEOs can make, to pick stocks.

We try to understand what moves a stock price. Analyst mistakes are a powerful mover of stock prices. In our experience, if you can work out where analysts’ forecasts are heading you can get good rewards, most of the time.

When we started (back in the 1980s) growth investing was unfashionable. Many people believed growth stocks were unattractive after a long period of poor returns. What intrigued us was the relatively small number of growth stocks that did do well.

Good growth stocks tend to catch analysts out. Often these surprises aren’t big in any given quarter, but the surprises are persistent. Growth stocks maintaining high growth rates for longer than expected do very well. If you can work out why analysts are getting their forecasts wrong, it can be very rewarding.

Value stocks have an interesting pattern of analyst behaviour before they become value stocks. Many value stocks gain their value properties (low valuation, weak and volatile stock price history) following an unusually long period of analyst disappointment. What is the difference between good and bad value stocks? Good ones eventually surprise – analysts stop being over-optimistic and start being too conservative. Bad ones keep disappointing.

Successful value stocks usually have powerful anchors from prior disappointment. If a recovery takes hold, it is easy for analysts to distrust the recovery. The ability for a recovery to take place tends to be closely tied to CEO behaviour. Analysts can struggle with the rate, and duration, of the path back to normality. In addition, analysts are often surprised by how businesses adapt in a crisis, and then by their leverage to the recovery.

In sum, our investment approach uses an understanding of bias to find stocks more likely to surprise persistently. This is usually rewarding. There is opportunity for rewarding surprise in both growth and value. Being wary of CEO behaviour usually gives us protection when we are wrong.

Why we struggled in 2021

We do not like underperforming. We have invested using our approach for many years and, despite a good long-term record, we have had a few painful periods. These usually coincide with a lot of macro unpredictability.

The worst was 2003/04 which was a period of dislocation. During this period, we were whipsawed between defensive and value stocks and had a ‘reward’ problem. (We think of reward as how much a stock goes up when it surprises).

We were good at finding surprising stocks, but our returns were poor, with many of our stocks experiencing a compression in valuations while we owned them.

When COVID hit, we feared we were in for another tricky period. Lots of unpredictability and macro dislocation can play havoc with analyst and investor behaviour, create a lot of hard to predict mistakes and cripple persistent surprise. We managed to navigate 2020 remarkably well but 2021, in contrast, looks poor. We had to contend with four problems. One was to do with stock picking, and three to do with portfolio construction.

2021 was one of our best years for finding surprising stocks, but we had a reward problem. The continuing recovery from COVID outstripped analysts’ expectations almost everywhere, making it easy for a stock to surprise. We found more surprising stocks than average, but this was offset by a lower-than-average reward for those surprises. Net-net our stock picking was a drag on performance.

Three portfolio construction choices significantly affected performance:

First, Financials. When we started Ardevora we made a deliberate choice not to invest in banks as we felt the risks were too high. At the start of last year, we wrote about how our views began to shift in 2017, leading to three years of research and a change in view. In the first quarter of 2021 we made our first investments in banks but, because we moved slowly, we suffered a relative performance drag from our low bank exposure.

Second, fossil fuels. We believe there are significant back-end loaded risks associated with owning companies involved in fossil fuel production. Not owning fossil fuel stocks was painful last year. Oil and gas prices bounced sharply, taking stock prices with them.

It was hard to find rewarding value stocks in 2021 without investing in either fossil fuels or financials.

Third, our approach to individual stock weightings. We have always built highly diversified portfolios as we believe it is safer not to have too much riding on any single stock. We felt it was easiest to embody this belief by aiming to keep our stock weights broadly similar. This ensures a portfolio with lots of small stock bets, but it can present a problem when a few large companies dominate the market. Over the last few years a few tech titans in the US stock market have performed exceptionally well so, despite owning stocks like Google, Amazon and Microsoft, they have been a source of relative underperformance. The drag was especially high in 2021.

The outlook for 2022

We started last year with an even mix of value and growth. This didn’t help us. Our growth stocks lagged the mega-cap leaders and the rewards for value stocks were heavily skewed to financials and energy. While many of the structural growth themes are still strong, we worry about the lack of reward while investors navigate the path back to a more balanced economy, no longer requiring government support.

Tactically we have reduced our exposure to structural growth themes and shifted our portfolio mix back to value. There are still plenty of value stocks surprising analysts, especially in areas investors prefer as bond yields rise. The longer-term outlook for growth stocks, however, still looks exciting.

It is easy to forget we have been through a very unusual period for the economy, one where bond yields collapsed to 0.5%, deflation anxiety soared, and economies shrunk at an unprecedented rate. We think the Fed’s change of direction in December signals we are firmly on the path to normality.

Important Information

This material is for distribution to Professional Clients only, as defined under the Financial Conduct Authority’s (“FCA”) conduct of business rules, and should not be relied upon by any other persons. Issued by Ardevora Asset Management LLP (authorised and regulated by the Financial Conduct Authority). Registered office: 6 New Bridge Street, London EC4V 6AB. Registered in England No. OC351772. Past performance is not a guide to future performance. Care has been taken to ensure the accuracy of this document’s content, but no responsibility is accepted for any errors or omissions herein. The views expressed are our own and do not constitute investment or any other advice and are subject to change None of the information contained in this communication constitutes an offer to buy or sell or a solicitation by or on behalf of Ardevora Asset Management LLP to buy or sell any security, product, service or investment. This communication is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. Ardevora Asset Management LLP is authorised and regulated in the United Kingdom by the Financial Conduct Authority, and operates in the United States as an “exempt reporting adviser” in reliance on the exemption in Section 203(m) of the US Investment Advisers Act of 1940.

Previous Commentaries

Quarterly Commentary Period ending September 2021
Quarterly Commentary Period ending June 2021
Quarterly Commentary Period ending March 2021
Annual Commentary Period ending December 2020

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