WHY INVEST LIKE US?Global Equity Strategies - A Rationale

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KBI Global Investors

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The futility of prediction was understood well before the ‘Taleb Turkey’:

Lao Tzu:

‘Those who have knowledge don’t predict. Those who predict don’t have knowledge.’

John Kenneth Galbraith:

‘There are two types of forecasters; those who don’t know and those who don’t know they don’t know.’

‘A turkey is fed for 1000 days - every day confirms to its statistical department that the human race cares about its welfare ‘with increased statistical significance’. On the 1001st day, the turkey has a surprise.’

The Futility of Prediction

The fact that the market can be beaten is clearly very different from having a successful approach to beating it. Broadly in line with the findings of many others, the academic and investor Bruce Greenwald in his book, ‘Value Investing: From Graham to Buffett and Beyond’, highlights this harsh reality by noting that:

‘Approximately 70% of active professional investors have done worse than they would have by adhering to a passive and low-cost strategy of simply buying a share of the market as a whole - a representative sample of all available securities.’

In saltier terms, Charlie Munger, the long-time business partner of Warren Buffett famously summarised the challenge of beating the market by saying:

‘It’s not supposed to be easy. Anyone who finds it easy is stupid.’

For many investors, the failure to beat the market is rooted in their futile addiction to prediction. The fact that time spent predicting, or following the predictions of others, is at best likely to be time wasted does not deter the vast majority of active investors from believing that they can do it successfully.

Unfortunately, we don’t invest in a world of the coin toss or the casino, where outcomes and their probabilities are known to us ex-ante. Rather we invest in a world of wrenching uncertainty where very often the most important outcomes are utterly unknowable. Believing that we can predict is a time-consuming and often costly delusion.

The author and philosopher, Nassim Taleb, captures this delusion memorably in his story of the turkey in the run-up to Christmas Day:

Investment Pillar 1The market can be beaten, but prediction is futile.

Chart 1: Anatomy of a Blowup

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Source: Nassim Taleb, ‘The Fourth Quadrant: A Map of the Limits of Statistics’

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Beating the Market; Benefitting from Unpredictability

The futility of prediction has convinced many investors that even if it is possible to beat the market in principle, they are likely better off in practice with a passive approach.

This conclusion fails to account for the following crucial insight summarised by Taleb in his best known work, ‘The Black Swan: The Impact of the Highly Improbable’:

‘Knowing that you cannot predict does not mean that you cannot benefit from unpredictability.’

The challenge for the active investor is to shape portfolios which are not dependent on views of the future; portfolios that are relatively protected from potentially bad news, while simultaneously positioned to benefit from potentially good news.

Or simply put, to beat the market by benefitting from unpredictability.

Signal versus Noise

Dramatic footage of frenzied traders gesticulating wildly in front of flashing screens is the popular image of financial markets and those who operate in them. It seems that every twist and turn of the stock, bond or currency markets is now a staple segment of traditional television news broadcasts, not to mention the proliferation of channels and websites which are now devoted to dissecting every blip across the financial market landscape.

Unfortunately, most of the activity on show and the ‘news’ that drives it is worthless.

The reason why is clear when applied to some sporting examples:

• Imagine you had the opportunity of playing golf against Rory McIlroy. Consider whether your chances of shooting a lower score than him are greater or lesser over one hole, one round, or one tournament?

• Imagine you had the chance of playing tennis against Rafael Nadal. Consider whether your chances of winning are greater or lesser after a point, after a game, or after a set?

• At the beginning of any given Premier League season, consider whether the chances of Manchester United lying lower on the league table than say Aston Villa are greater or lesser after the first week-end of matches, at Christmas, or at the end of the season?

The ‘signal’ in these examples is that Rory McIlroy is a better golfer than you, Rafael Nadal a better tennis player and that Manchester United, although it pains me to say it, are a better football team than Aston Villa.

Clearly, the longer the time-frame considered the greater the likelihood of ‘signal’ and the lesser the likelihood of ‘noise’ in the outcome.

This is as true for investing as it is for golf, tennis or football.

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This is probably best understood as a contrast between a short-term dominated by the ‘noise’ of ‘market mood’, and a longer-term dominated by the ‘signal’ of fundamental factors.

These factors are more likely to be identified by the skilful than the lucky, but crucially, skill needs time to come to the fore.

Taleb put it characteristically well in his classic book ‘Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets’:

‘Over a short time increment, one observes the variability of a portfolio, not the returns. When I see an investor monitoring his portfolio with live prices on his cellular telephone or his handheld, I smile and smile. The same methodology can explain why the news is full of noise and why it is better to read The New Yorker on Mondays than The Wall Street Journal every morning (from the standpoint of frequency, aside from the massive gap of intellectual class between the two publications).’

The advice of renowned Canadian investor Peter Cundhill in the tenth anniversary letter to the fortunate investors in his Cundhill Value Fund in 1984 is worth repeating:

‘The most important attribute for success in investing is patience, patience, and more patience; the majority of investors do not possess this characteristic.’

Tailored Diversification

The necessity of diversification is unarguable. However, many investors see it as a necessary evil providing some comfort on the downside, at the price of diluting potential return on the upside.

This may be true for a thoughtlessly applied approach to diversification, but it is the opposite of true for a more tailored approach grounded in a thoughtfully credible investment philosophy.

Indeed, such a thoughtfully tailored approach to diversification can combine the usual benefits of downside comfort, with the upside benefit of exposure to lots of potentially positive news - a portfolio benefitting from unpredictability.

Investment Pillar 2The short-term is dominated by ‘noise’, the longer-term by ‘signal’.

The dominant driver of stock-market performance over any given 1-year period is the change in valuation. By contrast, the dominant drivers over any given 5-year period are dividend yield and dividend growth:

Chart 2: Total Return Components: S&P 500, 1871 - 2010

Source: GMO Asset Management

Dividend YieldDividend GrowthChange in Valuation

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0%1 Year 5 Year

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Investment Pillar 3Diversification can be tailored to capture the usual downside protection benefits, while also capturing the upside benefit of exposure to lots of potentially good news/avoidance of bad news.

Looking across the graph horizontally, the grey boxes show the market-capitalisation weighted or index returns for each of the 24 industry groups over the period.

Many investors spend a great deal of time trying to position their exposure across these industry groups hoping to capture relative performance changes between them.

In order to enhance their potential upside return, such investors are consciously reducing their relative diversification. They are adhering to the conventional perspective that in order to enhance upside potential, the trade-off must be a more concentrated exposure.

Looking down the graph vertically, the blue lines show the dispersion of returns within each of the 24 industry groups over the period.

The huge dispersion of returns within each of the industry groups confirms that the conventionally expected trade-off between upside potential and diversification/concentration has no basis in fact.

Even more tantalisingly, this dispersion raises the real possibility of the opposite being the case - potential upside is enhanced, as diversification is increased.

The opportunity to tilt exposure towards the ‘winners’ across the top of the graph and away from the ‘losers’ across the bottom of the graph is improved by having as wide a diversity of exposures as possible across the global industry groups. Reducing diversification reduces this opportunity.

The approach is to embrace the opportunity of such diversification by owning a large number of stocks, spread across a large number of regions and industries that have a better likelihood of benefitting from good news/not suffering from bad news than their peers.

To possess such a better likelihood, the stock-picking must be grounded in a credible investment philosophy; a philosophy that is value and dividend oriented.

Such a portfolio would possess the very desirable anti-fragile characteristics of facing into the unknowable future tailored to benefit both from the unpredictable and the passage of time.

The potential for such an attractive combination is powerfully illustrated by considering the returns both across and within the 24 MSCI global industry groups over the last 3 years:

Chart 3: Dispersion of Returns - MSCI World

75.2 67.9 69.8 53.6 53.4 66.5 102.1

47.1 52.6 57.6 79.8

54.9 88.9

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129.0 109.5

53.7 83.3 82.3 80.1 69.9 49.9

80.0 32.0

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Source: KBI Global Investors (as at 30th September 2014)Range & Index Returns - Latest 3 Years (Cumulative Return in USD). Axis capped at 500 for ease of display.

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Value Oriented Investing

The famous investor, Warren Buffett, has spent recent years vying with his good friend Bill Gates for top spot in the annual Fortune 500 list of the wealthiest people on the planet. If Buffett was the sole success of value oriented investing it would be difficult to disagree with the efficient market hypotheses that market prices are the efficient discounters of all known information and that attempting to beat the market is the pointless pursuit of the stubbornly deluded. However, in addition to the remarkable success of Buffett, there is a substantial body of evidence to suggest that a value oriented approach to investing has been consistently successful in beating the market.

For example, the article written by Buffett and published in the Columbia Business School magazine in the autumn of 1984: ‘The Super-Investors of Graham and Doddsville’, makes a compelling case for the value oriented approach first formalised by Ben Graham and David Dodd over 70 years ago. By defining ‘a common intellectual home’ for a group of stunningly successful investors as the mythical ‘Graham and Doddsville’, Buffett shows how their success cannot be the result of unskilled luck and is overwhelmingly likely to be the result of their shared but variously applied value oriented philosophy.

The results (in USD) in the table below are of the ‘Super-Investors’ referred to in the article:

More recently, as part of a wide-ranging speech delivered in June 2013, ‘The 2008 Collapse and Its Aftermath: A Financial Market Perspective’, Seth Klarman of Baupost succinctly re-framed the success of value oriented investing in more contemporary terms:

‘Despite the comfortable academic consensus of market efficiency, financial markets will never be efficient because markets are, and will always be, driven by human emotion: greed and fear. Markets, and the prices of individual securities, will periodically and unpredictably overshoot. Also, skills and time horizons of market participants will obviously vary. Academics are deliberately blind to the fifty-plus year track record of Warren Buffett as well as those of other accomplished investors, for if markets are efficient, how can their astonishing success possibly be explained?’

Chart 4: The Super-Investors of Graham & Doddsville

Fund Manager Period Fund p.a Market p.a

WJS Limited Walter J. Schloss 1956-1984 21.3% 8.4%

TEK Limited Tom Knapp 1968-1983 20.0% 7.0%

Buffett Partnership Warren Buffett 1957-1969 29.5% 7.4%

Sequoia Fund William J. Ruane 1970-1984 18.2% 10.0%

Charles Munger Limited Charles Munger 1962-1975 19.8% 5.0%

Pacific Partners Limited Rick Guerin 1965-1983 32.9% 7.8%

Perlmeter Investments Stan Perlmeter 1965-1983 23.0% 7.0%

Washington Post Trust 3 different managers 1978-1983 21.8% 7.0%

FMC Pension Fund 8 different managers 1975-1983 17.1% 12.6%

Source: The Super-Investors of Graham and Doddsville, Warren Buffett

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There are many reasons why a dividend oriented approach to picking stocks and shaping portfolios has merit. In particular, a dividend oriented strategy is an important weapon in the battle against the unavoidable agency problem of modern corporate structure. The problem of corporate management behaving or being tempted to behave in ways inconsistent with the interests of corporate owners is lessened, if not eliminated, by the discipline of paying and growing a dividend.

Over the long-term, a share price is a function of the cash earnings distributed to shareholders. Simply put, as equity investors we should always remember that we are owners of a share in a business and that the value of the business to us is ultimately determined by the cash that we take out of it.

When a business makes a profit, it has two options for deploying it:

1) Re-invest it – in either the existing business, or by acquiring all or part of a new one.

2) Distribute it to shareholders – in either a dividend, or by buying back and cancelling some outstanding shares.

Ideally, as shareholders we want the management of the business to take the first option up to the point where it generates a positive net present value to us, and to take the second option with the residual.

However, in the real world even the most appropriately motivated and incentivised management team will find it impossible to live up to this ideal. There are just too many variables outside their control.

The best that we can reasonably hope for is a sensible combination of the two. From the businesses in which we own shares therefore, we should demand capable management to generally generate profit, re-invest or acquire profitably for the future, and/or pay-out a steady stream of income to us.

Dividend Oriented Investing

Many studies attest to the importance of dividend yield and dividend growth to stock-market returns. The graph used earlier from GMO is worth re-highlighting here:

The dominant driver of stock-market performance over any given 1-year period is the change in valuation. By contrast, the dominant drivers over any given 5-year period are dividend yield and dividend growth.

Chart 5: Total Return Components: S&P 500, 1871 - 2010

Source: GMO Asset Management

Dividend YieldDividend GrowthChange in Valuation

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%1 Year 5 Year

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Investment Pillar 4Value & Dividend oriented stock-picking tilts the probability in favour of benefitting from potentially good news/not suffering from potentially bad news relative to peers.

Curiously, many investors eschew this framework and narrowly think of dividends purely as a source of income rather than a function of profitability. They often think of dividends as a sign that growth is slowing down.

In reality a large diversity of businesses both pay and grow dividends. Many of these are enjoying profit growth in excess of the opportunities to re-invest profitably. More generally, companies that can sustain higher dividends tend to be more profitable and those that can’t tend to be under pressure.

Across a portfolio and over time, studying the dividend pattern and investing accordingly can help to tilt the probability in favour of choosing sustainably more profitable businesses and avoiding their less profitable counterparts.

Framed in this way, it should be clear why dividends and earnings are highly correlated over time. The former is just a greater or lesser, but fundamentally more stable, sub-set of the latter:

Chart 6: World DPS and EPS Revisions Ratio

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Ratios defined as number of upwardly revised estimates minus downwardly revised estimates as % of total number of changed estimates

EPS Revisions Ration (3m avg)DPS Revisions Ration (3m avg)

Source: Thomson Reuters Datastream

Investment Team

David HogartyHead of Strategy Development

James CollerySenior Portfolio Manager

Gareth MaherHead of Portfolio Management

John LoobySenior Portfolio Manager

Ian MaddenSenior Portfolio Manager

Massimiliano TondiSenior Portfolio Manager

References‘Value Investing: From Graham to Buffett and Beyond’, Bruce C.N. Greenwald, 2001

‘The Fourth Quadrant: A Map of the Limits of Statistics’, Nassim Taleb, 2008

‘The Black Swan: The Impact of the Highly Improbable’, Nassim Taleb, 2007

‘There’s Always Something to Do: The Peter Cundill Investment Approach’, Christopher Risso-Gill, 2011

‘Anti-Fragile: Things That Gain From Disorder’, Nassim Taleb, 2012

‘The Super-Investors of Graham and Doddsville’, Warren E. Buffett, 1984

‘The 2008 Collapse and Its Aftermath: A Financial Market Perspective’, Seth Klarman

The Global Equity Strategy Team, November 2014

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Summary Conclusions1) The market can be beaten, but prediction is futile.

2) Long-term, tailored diversification is the key.

3) Diversification tailored to capture the usual downside protection benefits, while also capturing the upside benefit of exposure to lots of potentially good news.

4) Value & Dividend oriented stock-picking across a wide range of regions, industries and stocks.

5) A portfolio shaped to have a large number of small and tailored risks.

6) Unpredictability and time should both be good friends of this anti-fragile portfolio.

DISCLAIMERS:

ALL MARKETSKBI Global Investors Ltd is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. KBI Global Investors (North America) Ltd is a registered investment adviser with the SEC and regulated by the Central Bank of Ireland. KBI Global Investors (North America) Ltd is a wholly-owned subsidiary of KBI Global Investors Ltd. ‘KBI Global Investors’ refers to KBI Global Investors Ltd and KBI Global Investors (North America) Ltd.

IMPORTANT RISK DISCLOSURE STATEMENT This material is provided for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase any security, product or service including any group trust or fund managed by KBI Global Investors. The information contained herein does not set forth all of the risks associated with this strategy, and is qualified in its entirety by, and subject to, the information contained in other applicable disclosure documents relating to such a strategy. KBI Global Investors’ investment products, like all investments, involve the risk of loss and may not be suitable for all investors, especially those who are unable to sustain a loss of their investment.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTSThis introductory material may not be reproduced or distributed, in whole or in part, without the express prior written consent of KBI Global Investors. The information contained in this introductory material has not been filed with, reviewed by or approved by any regulatory authority or self-regulatory authority and recipients are advised to consult with their own independent advisors, including tax advisors, regarding the products and services described therein. The views expressed are those of KBI Global Investors and should not be construed as investment advice. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. The products mentioned in this Document may not be eligible for sale in some states or countries, nor suitable for all types of investors. Past performance may not be a reliable guide to future performance and the value of investments may fall as well as rise. Investments denominated in foreign currencies are subject to changes in exchange rates that may have an adverse effect on the value, price or income of the product. Income generated from an investment may fluctuate in accordance with market conditions and taxation arrangements. In some tables and charts, due to rounding, the sum of the individual components may not appear to be equal to the stated total(s). Additional information will be provided upon request. Performance for periods of more than 1 year is annualized. All MSCI data is provided “as is”. In no event shall MSCI, its affiliates, or any MSCI data provider have any liability of any kind in connection with the MSCI data. No further distribution or dissemination of the MSCI data is permitted without MSCI’s prior express written consent. Net total return indices reinvest dividends after the deduction of withholding taxes, using (for international indices) a tax rate applicable to non-resident institutional investors who do not benefit from double taxation treaties. A composite presentation is available upon request.

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USA/CANADA SPECIFIC:Gross results shown do not show the deduction of Adviser’s fees. A client’s actual return will be reduced by the advisory fees and any other expenses which may be incurred in the management of an investment advisory account. See Part 2 of Adviser’s Form ADV for a complete description of the investment advisory fees customarily charged by Adviser. For example, a $1,000,000 investment with an assumed annual return of 5% with an advisory fee of 0.85% would accumulate $8,925 in fees during the first year, $48,444 in fees over five years and $107,690 in fees over ten years. The performance results are that of a representative strategy which has been managed on a discretionary basis since its inception. Performance returns for individual investors may differ due to the timing of investments, subsequent subscriptions/redemptions, share classes, fees and expenses. Information about indices is provided to allow for comparison of the performance of the Adviser to that of certain well-known and widely recognized indices. There is no representation that such index is an appropriate benchmark for such comparison. You cannot invest directly in an index, which also does not take into account trading commissions and costs. The volatility of the indices may be materially different from that of the strategy. In addition, the strategy’s holdings may differ substantially from the securities that comprise the indices shown. Stocks mentioned in this document may or may not be held in this strategy at this time. Any projections, market outlooks or estimates in this document are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of the strategy. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. Discussions of market conditions, market high/lows, objectives, strategies, styles, positions, and similar information set forth herein is specifically subject to change if market conditions change, or if KBI Global Investors (North America) Ltd believes, in its discretion, that investors returns can better be achieved by such changes and/or modification. Style descriptions, market movements over time and similar items are meant to be illustrative, and may not represent all market information over the period discussed. Form ADV Part 1 and Part 2 are available on request.

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