Complex adaptive systems, herding effects and portfolio construction
I’ve recently enjoyed reading Michael Mauboussin’s ‘More Than You Know’, a collection of essays written while he was a strategist at Credit Suisse First Boston (CSFB). Most of these were written in the years following the bursting of the TMT Bubble, so aside from being a timeless look at the benefits of interdisciplinary thinking they are particularly relevant to today’s market environment.
One of the key concepts explored is the stock market as a ‘complex adaptive system’. The diversity of individual participants generates efficient outcomes in complex systems, that’s to say the collective outperforms the individual. Examples used to prove the power of the collective for decision-making come from nature (social insects such as ants and bees acquiring food or new nests), or from the use of experts by the US Navy to find a lost nuclear bomb (!). The stock market often exhibits these characteristics, with multiple information sources, different investment approaches, styles and time horizons generally providing sufficient diversity to yield an efficient market – put another way, “when investors err independently, markets are functionally efficient”.
Markets lose this efficiency if there is a diversity breakdown, which in stock market terms means herding – or “making decisions based on the observations of others, independent of their own knowledge”. While there’s no single barometer for accurately and consistently measuring market phases where “one sentiment becomes dominant”, I’d argue they can generally be identified when price momentum becomes the dominant factor at the almost total expense of the valuation factor. We’re witnessing the breakdown of one of these, in long duration growth equities – particularly unprofitable, early-stage technology – and potentially the forming of a new herding (albeit not in the same postcode in terms of scale) in low volatility or defensive shares.
Amidst the broadening recognition of a multitude of macro challenges in the near term, from inflation to recession risk to geopolitics, the latter have just witnessed their best 6-month excess return versus the broader market since the GFC – global financial crisis (see below). We are consequently not convinced that a well-constructed portfolio should have all its eggs in this particular basket today.
Low volatility companies have materially re-rated in recent monthsSource: Credit Suisse HOLT. Data to 6 May 2022.
Our portfolio construction is not tone-deaf to the increasingly shrill dog whistle of economic challenges, but we believe portfolio ballast can be provided by certain de-rated quality growth businesses. The general toxicity of anything considered to have duration in financial markets has led to one of the breakdowns in efficiency described by Mauboussin – several attractive, cash generative businesses with long-term growth runways have been de-rated to levels providing attractive margin of safety.
It’s particularly important today to distinguish between the scale of sensitivity to discount rates embedded into a quality growth business with strong free cash generation, compounding revenues at mid-to-high single digit and earnings in double-digits – such as Waters Corp, Avantor, Henry Schein or TopBuild in the portfolio – compared to low or no profitability businesses with very elevated revenue growth and therefore all potential value lying far in the future.
Segment median market implied yield spread: Quality Defensives vs Quality GrowthSource: Credit Suisse HOLT. Data to 6 May 2022.
“Whisper it quietly, but share prices in several sectors considered economic lead indicators by the legendary macro investor Stanley Druckenmiller – Trucking, Homebuilding and Retail – have begun to bottom out and outperform the broader benchmark…”
We’re also less obsessed than the market today about whether the long-term growth we’re accessing has an element of volatility, or cyclicality, to it. To re-iterate, we are conscious of recession risk and have built the portfolio with this in mind (e.g., 21% in Healthcare) but have written in the past about the opportunity that softer economic environments provide for strong cyclical businesses which are well capitalised to accelerate their growth compounding, taking share from or acquiring weaker competitors who have over-stretched themselves financially or operationally.
A consistent theme running through the portfolio is strong balance sheets which provide the scope to execute on opportunities or, indeed, to provide attractive visibility to investors around cash returns to shareholders. The latter have an enhanced importance within total return considerations during tougher stock market environments.
Finally, we do still see merit in having select exposure to deeper cyclicals given the extreme risk premium currently applied (see below) and the feasible prospect that the economic out-turn is better than markets fear. Generally, we look to see our holdings in this space have a valuation that is backed by a well-invested asset base, such as Owens Corning or Whitbread, or to be generating attractive levels of near-term cash flow, for example Shell.
Global cyclical value: market implied yield spread relative to the broader marketSource: Credit Suisse HOLT. Data to 30 April 2022.
Whisper it quietly, but share prices in several sectors considered economic lead indicators by the legendary macro investor Stanley Druckenmiller – Trucking, Homebuilding and Retail – have begun to bottom out and outperform the broader benchmark…
Trucking, Homebuilding and Retail sectors shown relative to the equal-weighted S&P 500Source: Bloomberg. Data to 22 July 2022.
 Predominantly explored in Part 4: ‘Science and Complexity Theory’.
 We define ‘quality growth’ as high cash return on investment with higher re-investment rates allowing consistent growth compounding, contrasting with lower growth ‘quality defensives’ (typically higher dividend payouts and higher debt loads) or ‘hyper growth’, which have high growth but low (or no) profitability / free cash generation today.
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