A Framework for Dealing with Change

By
DOUGLAS ISLES
,
Investment Specialist, Platinum,
11 Jan 2017

Human beings are generally metathesiophobic, i.e. we have an intrinsic fear for change.

On the North Island of New Zealand Roadshow on 7-9 November 2016[i], Douglas Isles, Investment Specialist, delivered a presentation titled “Embracing Change”, which addressed the idea that China’s recovery and political events such as Brexit and Trump’s candidacy were evidence that markets were pointing in the wrong direction at a point of inflexion. This note is a precis of the discussion around the importance of having an analytical framework for dealing with change.

A Framework for Dealing with Change

Human beings are generally metathesiophobic, i.e. we have an intrinsic fear for change.  Modern portfolio theories reinforce this – students of investment management are taught that returns should be proportional to the volatility of assets.  Where there is more uncertainty, investors are conditioned to demand a higher return, or in other words, to pay a lower price.  In recent years, this preference for certainty has led to a crowding into bonds, which confusingly in some cases offer negative yields, and equities with bond-like characteristics, such as real estate investment trusts (REITS), Utilities, and the more predictable Consumer Staples – after all, as we are constantly spun by marketers, we need to clean our teeth, drink coffee and soft drinks, smoke[ii], etc.

As analysts, we need to have a framework for dealing with uncertainty.  At Platinum, we focus on buying companies that we think are being overlooked by the market – where they are temporarily out of favour, and this works over time.  We think it is important to understand change and how to deal with the vast amount of information we are presented with daily.

So, when we look at a business, and once we have assessed what we think is its fair value, we can then try to assess accordingly how the market reacts to new information.  A simple graphical representation follows.  On the horizontal axis, we have variations in the “intrinsic” value of the business, which slowly changes as technology develops, regulations shift, and customers and competitors respond, etc.  The vertical axis represents the market response, which we know from experience is more volatile.

In an ideal (“theoretical”) world, for every small change in the value of a business, the market would react in equal measure.  As a result, we would end up with the 45-degree line shown for changes in market value versus that of the business’s intrinsic value.

However, reality is very different to theory.  The market does not always respond exactly in proportion to changes in business values, contrary to the so-called “efficient market hypothesis”.  This is due to a variety of reasons, including the difficulties we face, as human beings, in processing information.

If we use the underlying value of the business and the “ideal” or theoretical market response as a yardstick, we can see that actual market response typically takes one of four forms.  Two are under-reactions and two are overreactions, each in response to either positive or negative news.  The following chart shows what these look like graphically.  The blank quadrants reflect that there is unlikely to be a negative response to positive news, or vice versa.

Opportunities-in-Change-2-(1).png
This in effect can lead us to one of four opportunities, and once we are aware of this, it can provide us with a framework to better respond to the market’s response.  The two positives are “buy-triggers”, while the two negatives can be used to sell, or even short-sell.

If we look at each of these in turn, we are better placed to deal with events and capture the opportunities, whether it is from binary outcomes that we know in advance we will have to deal with (such as elections/referenda), sudden new pieces of information (e.g. profit warnings, takeovers), or more subtle observations we make as analysts that the market has not yet factored in (e.g. changes in management or strategy).

Over-reaction to negative news (or exaggerated demise) can provide entry points to companies that we like and know to be solid businesses.  For example, when Brexit took place in June this year, there was a negative over-reaction in the share prices of European banks, which provided us with an opportunity to add to positions.  Often when companies appear to be slowing down, investors look elsewhere for opportunity; sometimes this can be a short, sharp shock.  Here, the suggestion is to look at companies that have either seen a violent downward movement in price or where valuation metrics suggest they are cheap.

Under-reaction to positive news (i.e. underappreciated growth) is where the more perceptive analyst can get an edge over the field by observing changes for the better, ahead of the market.  Changes in company strategy, for instance, can be viewed with broader industry understanding and put into a longer term context to get an edge.

Under-reaction to negative news (i.e. broken businesses) – in a world full of disruption, the market may be slow to respond to the threats posed to traditional stalwarts and champions.  This can be an opportunity (to short, or simply to exit) if one can assess that certain changes will lead to serious challenges to incumbents.

Over-reaction to positive news (or dangerous extrapolation) tends to bring stocks to their most dangerous levels where they offer low prospects for longer term returns.  The market has a tendency to “fall in love” with success stories and like to eulogise about their future prospects to the extent that they assume invincibility.  Here, avoiding such traps is advisable, and indeed, again, sometimes what the market sees as a compelling time to buy may in fact be an opportunity to short sell.

This framework can be embedded in our minds by re-casting the previous charts to reflect the underlying message.


So we now have four scenarios which we can take advantage of when the market reacts too much or too little to new information.

We can also characterise the path of a typical company (see chart below) and compare it with market expectations to derive a similar set of opportunities.

Analytical-Framework-(1).png
The orange line in the next chart shows the potential path of a typical corporate.  Investors often collectively miss the inflexion (“tipping”) point where growth accelerates (though, often, this takes place before listing, e.g. Facebook, Uber), then become too comfortable with a company’s growth trajectory which can lead to excessive valuation (note, in 2016, The Coca-Cola Company’s share price is around the same as it was in 1998 when the company was trading on almost 50X earnings[iii]).  This all leads to a quandary as businesses start to slow.

This quandary opens up many opportunities for Platinum.  In today’s context, the market may be exaggerating the demise of the troubled – but resilient – Europe, or the corporates in Japan that are focused on self-help.  Needless to say, having seen the playbook for Kodak, Xerox and Nokia, the market often sees slow-down as terminal; but good companies like Intel, Samsung and Toyota have demonstrated how to re-emerge.  One must be careful at this point to avoid investing in (or may even consider shorting) those that are in decline – Wal-Mart today may be joining the likes of Woolworths and Tesco, with Amazon posing a real and lasting threat.

We hope that this framework provides a useful way of thinking for our clients.  We have been concerned, though not surprised, by the way in which our collective client base utilises our investment offering.

As we plot an aggregate measure of our performance[iv] over time, we unfortunately see that strong performance attracts investors (dangerous extrapolation?) while periods of less-than-optimal performance tend to be followed by outflows (exaggerated demise?). 

Clients-be-ware-(1).png
The problem with this is not so much the impact on Platinum (indeed, money is generally being withdrawn at times when we want to be buying, ironically increasing the net exposure for those who remain, and vice versa).  The impact is on the client.  A decision-making framework that sells at the bottom likely also buys another asset (often a fund) near its top.  As a result, those who leave us at the wrong time may have a tendency to mis-allocate that capital on receiving the proceeds of their redemption.

The above chart is a stark reminder of the irrationality in human behaviour.  To avoid this, first one must be aware of it, and secondly, once must make appropriate decisions in future.

Our suggestion is that, with world markets at an inflexion point, embracing change and looking forward (not back!) will prove to be the right course of action at this time.

***

Subsequent to the talk, the market had to deal with the surprise event of a Trump presidency which initially led to a violent negative reaction, particularly in the Asian time zone, but activity in the US market was more nuanced with the market selecting winners and losers from perceived shifts in policy.  Within 24 hours, Asia-Pacific markets were regaining ground lost in the knee-jerk response.

 

[i] Wellington, Palmerston North, Napier, Tauranga and Hamilton.

[ii] Note that some of the best performing funds in recent years have been beneficiaries of exposure to the tobacco sector, which we choose not to invest in.

[iii] We own Coca-Cola in the Platinum International Fund and Platinum International Brands Fund at the time of presenting.

[iv] We average 1 and 3 year relative and absolute returns to reflect different time frames and “user needs” (i.e., investors seeking absolute (our offering) and relative (“opportunity cost”) gains) as a composite performance measure. 

 

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.

You may find interesting

Terms and Conditions

Dated: 6 January 2021
IMPORTANT NOTICE – Please read this important notice before proceeding.

This website, www.platinumworldportfolios.ie, is operated by Platinum World Portfolios PLC, a variable capital investment company incorporated under the laws of Ireland under Registered Number 546481 ("the Company", “we” or “us”).

By proceeding to access, view or download information from this website, you acknowledge that you have read, and agree to be bound by, the following terms and conditions. If you do not agree to these terms and conditions, you must not use this website.

  • Distribution of the information contained on this website in certain jurisdictions may be restricted by law. The information contained on this website is intended only for persons and entities in those jurisdictions where access to such information and use thereof is not contrary to local laws or regulations. Accordingly, all persons who access this website are required to inform themselves and to comply with such restrictions. In addition, this website and its contents have not been prepared for and are not intended for access by US persons as defined in the Securities Act of 1933.
  • For persons resident in the United Kingdom or the European Union (“UK or EU persons”): You are about to enter a website which contains information aimed at professional clients within the meaning of Article 4.1(10) of the Markets in Financial Services Directive 2014/65/EU (MiFID II) (“Professional Client”). If you are a UK or EU person, by entering this website you confirm that you are a Professional Client. This website does not constitute an offer or invitation to subscribe for shares in the Company and no UK or EU person other than a Professional Client should act or rely on this website. Platinum UK Asset Management Limited of 20 North Audley Street, London W1K 6LX (“PAM UK”) has been appointed as the sub-distributor of the Company in the United Kingdom. PAM UK is a tied agent of Mirabella Advisers LLP which is authorised and regulated by the Financial Conduct Authority - number 606792. Platinum Management Malta Limited of 171, Old Bakery Street, Valletta VLT 1455, Malta (“PAM Malta”) has been appointed as the sub-distributor of the Company in certain European Union member states. PAM Malta is a tied agent of Mirabella Malta Advisers Limited, which is licensed and regulated by the Malta Financial Services Authority. The content of this website has been approved by both Mirabella Advisers LLP and Mirabella Malta Advisers Limited.
  • When using this website, you are responsible for complying with all applicable local, national and international laws and regulations, including those related to data privacy and intellectual property. It may be illegal to access or download the information contained on this website in certain jurisdictions and we disclaim all responsibility if you access or download any information from this website in breach of any law or regulation of the jurisdiction in which you reside or from which you are accessing this website.
  • The investment funds, strategies and financial products and services described in this website may not be available in all jurisdictions and may not be available to some or all investors in a certain jurisdiction. Nothing contained on this website constitutes or is intended to constitute an offer or a solicitation to subscribe for, redeem or convert shares in the Company or any of its sub-funds in any jurisdiction in which such an offer or solicitation is not authorised or to any person to whom it is unlawful to make such an offer or solicitation. Investments into any fund or sub-fund referred to on this website or any other Platinum product or strategy can only be made through and in accordance with information contained in the relevant offering and subscription documents.
  • The content on this website is provided for general information only. Nothing contained on this website is intended to constitute investment, legal, tax, accounting or other advice. We strongly suggest that investors consult financial and other professional advisers prior to taking, or refraining from, any action on the basis of the content on this website and that you carefully consider your particular investment needs, objectives and financial circumstances. This website does not take into account the investment objectives, financial situation or particular needs of any person and should not be used as the basis for making investment, financial or other decisions. The information is selective and may not be complete or accurate for your particular purposes and should not be construed as a recommendation to invest in any particular investment strategy, security, fund, sub-fund or product, whether or not offered by the Company.
  • The information provided on this website is given in good faith and is believed to be accurate at the time of compilation. The Company may, without notice, amend or remove any information on or from this website at any time. Neither the Company nor any of its directors, officers or agents (including, without limitation, the Company’s investment manager, administrator or custodian) make any representation or warranty as to the accuracy, reliability, timeliness or completeness of the information. To the extent permissible by law, the Company and its directors, officer and agents (including, without limitation, the Company’s investment manager, administrator or custodian) disclaim all liability (whether arising in contract, tort, negligence or otherwise) for any error, omission, loss or damage (whether direct, indirect, consequential or otherwise). To the extent permitted by law, we exclude all conditions, warranties, representations or other terms which may apply to our website or any content on it, whether express or implied.
  • Opinions expressed on this website reflects our views only at the time at which such opinions are expressed and may depend on assumptions or projections that may not prove to be correct or are subject to change.
  • This website may provide information, articles and material, or links to such, that are written or prepared by people who are not associated with the Company. This material is only provided for your interest and convenience. The Company is not responsible for the content or accuracy of this material and any opinion expressed in the material should not be taken as an endorsement, recommendation or opinion of the Company.
  • We do not guarantee that this website, or any content on it, will always be available or be uninterrupted. Access to this website is permitted on a temporary basis. We may suspend, withdraw, discontinue or change all or any part of this website without notice. We will not be liable to you if for any reason this website is unavailable at any time or for any period. You are responsible for making all arrangements necessary for you to have access to this website. You are also responsible for ensuring that all persons who access this website through your internet connection are aware of these terms of use and other applicable terms and conditions, and that they comply with them.
  • Performance figures quoted on this website are past performance. Past performance is not an indicator of future performance. Neither the Company nor any of its directors, officers or agents (including, without limitation, the Company’s investment manager, administrator or custodian) or any associate guarantee or make any representation as to the performance of any of the sub-funds offered by the Company, the maintenance or repayment of capital, the price at which shares in the Company or any of its sub-funds may trade or any particular rate of return.
  • Your acknowledge that neither MSCI Inc. nor any other party involved in or related to compiling, computing or creating any of the MSCI index data referred to on this website makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI Inc., any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI index data is permitted without express written consent of MSCI Inc.
  • You acknowledge and agree that the collection, disclosure or use of information about you from accessing this website is subject to the terms of the Company's Privacy Policy.
  • The Company may from time to time amend the terms and conditions of accessing this website by posting an amended version of this notice on this website. You agree to continue to be bound by any amended terms and conditions and that the Company has no obligation to notify you of such amendments other than by posting an amended version of this notice on this website.
  • The Company owns the copyright in the content contained in this website (other than materials that have been included with the permission of others who own the applicable copyright). You may print a copy of any page for personal or non-commercial purposes provided that you do not remove any copyright notices or any trademarks or logos of the Company or persons or entities associated with it. Except for a purpose or a use permitted by statute, or the prior written consent of the Company, you must not copy, modify, sell, distribute, adapt, publish, frame, reproduce or otherwise use any of the material on this website or trademarks or logos of the Company or persons or entities associated with it.
  • These terms and conditions of use are be governed by and construed in accordance with the laws of Ireland, and you agree to the non-exclusive jurisdiction of the Courts of Ireland.