Our approach to investing is fundamental. We are stock pickers. We look at many of the same things as other fundamental investors, but we think we do it in a slightly different way. Like most investors we aim to invest in well managed, low risk businesses. But, unlike most, we think the best way to do this is to take the results of academic research from cognitive psychology, on errors and biases, and apply them to financial markets. We believe successful stock picking requires an understanding of how three groups of people interact: company managers, financial analysts and investors. Each group is potentially subject to bias, and the biases affecting each group are different.
Cognitive psychology tells us that company managers, despite being intelligent and well informed, are especially susceptible to over-confidence bias. If the environment they face allows them to, they can take on too much risk. We take the view that, all things being equal, management are likely to push a business harder than is sensible. This is driven by their self-belief, their shareholders’ desire for growth and their companies’ remuneration policies. To get a sense of whether a company is being run in a sensible way we look at how fast the company is growing, how much cash is being generated by the business and what management are saying about their business and the industry conditions they face. All this helps us make a judgement on management’s attitude to risk. If we think a company is straining too hard for growth or in denial about how difficult conditions are becoming we will not buy the stock. Once we have identified those companies we think are being well managed, we apply the same lessons from cognitive psychology to financial analysts and investors to find mispriced stocks. In our view, financial analysts can often under-appreciate how fast, and for how long, unusual businesses can grow, especially relative to superficially similar businesses. By exploiting this tendency we hope to identify interesting ‘growth stocks’. Separately, investors can often become sceptical and nervous about companies after a traumatic event. By exploiting this tendency we hope to identify interesting ‘value stocks’.
When we have identified a group of companies which we believe are being well managed, and there is something interesting going on in the way financial analysts or investors are viewing these companies, we aim to construct a well balanced portfolio which allows our focus on stocks to add value. All stocks are equally weighted. As with our children, we believe it is better not to have favourites.
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