The Fog of War – Avoiding System 1 thinking
In Daniel Kahneman’s classic behavioural finance book “Thinking, Fast and Slow” (2011) he describes two modes of thought: System 1 (thinking fast) is fast, instinctive and emotional; System 2 (thinking slow) is slower, more deliberate, and more logical. Here, William Lough, portfolio manager, posits that during times of intense geopolitical upheaval, it is key to pull on System 2 thinking and maintain a keen eye on the true investment drivers of the companies we are investing in, and not be sidetracked by short -term market movements into a System 1 mindset.
Avoiding system 1 thinking
The Russian invasion of Ukraine during the last quarter, along with the ongoing terrible ensuing humanitarian crisis,has been the the most meaningful geopolitical development in many years. There can hardly be anything more ‘System 1 thinking’ inducing than war, with the visceral images displayed across TV (with wall-to-wall coverage), newspapers and social media engaging with our most basic human instincts. How does one think clearly about investment when nuclear apocalypse is seemingly one of the cards on the table? An analyst research note (shown below) garnered significant attention with its precise attempts to assign a probability to a “civilisation-ending global nuclear war” – 10%, apparently – and equally intriguing conclusion about asset allocation flowing from this insight: “The risk of Armageddon has risen dramatically. Stay bullish on stocks over a 12-month horizon.”
Source: BCA Research (via Twitter)
System 1 thinking relies on shortcuts. Three such shortcuts investors have been applying which have created inefficiencies in market pricing might be regional exposure, sector exposure and pricing power.
Looking under the bonnet
Regional exposure and sector exposure become the quick-fix decision-making proxies for analysts, strategists and (yes, we’re guilty too) portfolio managers. War in Europe? Sell European-listed companies (regardless of where they generate revenue). Cost of living crisis in Europe? Definitely sell European consumer discretionary companies. We lost count of the sell-side analyst reports recently downgrading recommendations on companies due to having the ‘highest exposure to Europe among coverage’ (or words to this effect). Maybe in aggregate these conclusions turn out to be correct, but in the stampede for the exit inefficiencies are created – the babies are thrown out with the bathwater.
Take sector classifications. In certain instances these can give misleading signals as to the true drivers of the investment case. They are are commonly used to infer whether a company – and by extension portfolio positioning – is cyclical or defensive. Take for example, the consumer discetionary sector. Within that sector we hold Sony, with its broad array of businesses such as imaging semiconductors (technology), music and TV/film (media) and insurance (financial); we also hold Nikon, where the key driver of the investment case is the growing profit contribution from lithography equipment systems (technology) rather than the cameras for which it has historically been known. Booking Holdings, another investment in some of our portfolios, is exposed to travel, historically a horrible place to be operating in a recession as business travel was a large, high margin contributor. Furthermore, its revenue base is predominantly European. But the base line for business travel today is low so if there is a recession, travel will not be hurt by a weakness in business travel to the extent it was in the past. Then you have a massive pent-up demand impulse from consumers. The evidence is thin so far that consumers are willing to forego their summer holiday due to the war in eastern Europe. On top of that, its business model is a technology platform which operates like a toll-road on the traffic it generates for hotels so has linear pricing power. Should investors avoid this stock because of its sector classification and geographic exposure? Judging by the share price of Booking, many holders did but this doesn’t strike us as the right decision for investors like us with a longer time horizon.
“While we do make data-led and risk management decisions regarding portfolio construction, my portfolios are not built on attempts to make precise predictions about the macro-economic future, but rather by building our convictions at the individual company level through a systematic bottom-up approach.”
Hayward Holdings, meanwhile, appears in the industrials sector, although the front page of its website illustrates a couple sitting by one of the residential pools for which it provides essential kit. No doubt, were it re-classified it would be as consumer discretionary – either way, from the top-down it would be considered a cyclical business. The near-term market focus is on risk to the business in a slowdown for new pool installations following the pandemic boom and if the volume of new build homes drops in a rising interest rate environment. These high-level observations can be challenged by zooming out for longer-term historical perspective – both in terms of number of pool installations and number of single-family housing starts relative to history – and simultaneously zooming in to better understand the drivers of value for the business. In Hayward’s case, our analysis suggests by far the bigger driver of value (via future cashflows) is the renovation, upgrade and replacement parts revenues that are a function of the installed base of pools. In this sense, ~80% of revenues coming from aftermarket services should prove less discretionary than the initial decision to install a pool.
Figure 1. US new pool construction is running below the ~150k per annum average pre-Global Financial Crisis (GFC) (left); Hayward’s revenues are heavily skewed to aftermarket sales, which are likely to benefit from the old installed base requiring upgrades (right).
Source: Hayward Holdings presentation
Identifying real pricing power
We also see short-cuts being used to assess pricing power, particularly relating to earnings risk for companies with energy comprising a large percentage of total costs, such as glass bottle manufacturer Verallia. The quantum and speed of commodity price moves is such that, even for companies with strong market positions which enable pricing pass-through over time, many will not be able to put all price increases through in one go and will do so in amounts that protect the nominal value of gross profit rather than the percent margin. This is important in two ways:  what matters in discounted cash flow valuation is the nominal figure, not percent margin, and it is immaterial for the valuation if cost recovery is achieved via a series of price rises which result in a six month hit to earnings and  a decrease in gross margin, even where absolute profit is protected (shown in the scenario below), can lead to modelling errors if analysts use the same gross margin for longer-term forecast assumptions, should commodity prices fall. Companies with pricing power can in fact use a reduction in commodity prices to ‘march up’ margins over time, so selling the short-term margin impact risks a ‘System 1’ error.
Figure 2. Scenario analysis for a 30% gross margin business passing through 15% cost inflation to maintain the nominal gross profit figure, then analysing the gross profit / margin impact of a range of pricing scenarios if costs fall -5% the following year 
Source: River and Mercantile Asset Management LLP
Looping back to lasting impacts from the Ukrainian conflict. While we do make data-led and risk management decisions regarding portfolio construction, my portfolios are not built on attempts to make precise predictions about the macro-economic future, but rather by building our convictions at the individual company level through a systematic bottom-up approach. Nonetheless, my colleague James Sym’s commentary sensibly sums up some potential investment conclusions (in terms of broad direction) emerging from the fog of war.
This note is taken from a section of the ES R&M Global High Alpha quarterly report.
 The main thesis of Daniel Kahneman’s classic behavioural finance book Thinking, Fast and Slow (2011) is that of a dichotomy between two modes of thought: "System 1" is fast, instinctive and emotional; "System 2" is slower, more deliberate, and more logical.
 We prefer the classifications cyclical versus less cyclical – in Howard Marks’s words, “It’s essential to remember that just about everything is cyclical”.
 As another example, TopBuild (1.5%) and Owens Corning (2.0%) operate in the same profit pool – Owens Corning provides insulation material which TopBuild distributes and installs into residential housing – yet one is classified consumer discretionary and the other industrial.
 Renovation is typically done every 10 years, pumps, filters & cleaners (Hayward’s core products) aren’t discretionary items within this. This decision to maintain the pool properly and to upgrade to Hayward’s modern pumps has strong economic rationale – 90% energy efficiency gains and 50% chlorine use reduction, while it costs ~$5-10k to remove a pool or $2k to drain (which also induces underground water risks).
 More on pricing power can be found here. https://riverandmercantile.com/higher-inflation-for-investors/
 In scenario 1, the business maintains its gross profit per unit i.e., reduces its pricing in line with the cost decrease; scenario 2 assumes that with some pricing power, the business only gives back half of the decline to its customers via price; scenario 3 assumes that pricing is held flat from the prior year.
This information has been prepared and issued by River and Mercantile Asset Management LLP (trading as “River and Mercantile” and “River and Mercantile Asset Management”). River and Mercantile Asset Management LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference Number 453087).
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