Don't Follow the Herd

Start by being intellectually honest and transparent.

By JAMES CHENG
20/04/2011 BT

I RECENTLY had dinner with three portfolio manager friends whom I have known since I started my career. Collectively with over 100 years of investment experience in Asia, what had we learnt? We debated the following ideas: first, growth is over-priced because most investors look for growth; second, easy money encourages undisciplined investment; and third, when markets turn bearish, investors look for safety and make defensive stocks over-priced. In essence, what we have learnt is centuries-old wisdom - be contrarian and don't follow the herd.

Buy sheep, sell deer: Buying cheap and selling dear is easier said than done - in a deep crisis, investors always expect the low to get lower

As Barton Biggs, founder of Morgan Stanley Investment Management, puts it: 'buy sheep, sell deer' (buy cheap, sell dear), but it's easier said than done. Experience tells us that in a deep crisis, we always expect the low to get lower. In the dark days of February 2009, we noted that the price to book value for Asian corporates was at an all-time low, but everyone made compelling arguments that markets would go even lower.

Was that greed or fear? I argued to get invested because risk had become asymmetric - in other words, the upside potential was much larger than the downside risk given market psychology (drawing on my experience during the unprecedented sell-off in Hong Kong during the Asian Financial Crisis). After you overcome the psychological barrier to buy, beware that you may end up with a portfolio of fully priced safe stocks that will lead to under-performance. Such is the complex behavioural biases that investors have to deal with everyday.

2008 was the fifth major crisis I had experienced close-up in my career: the others being June 4, 1989; the 1994 Tequila Crisis; the Asian Financial Crisis; and 2000's Tech Bubble.

My first lesson in contrarian investing happened in June of 1989. Our chairman, a Wall Street legend, told us to 'buy Hong Kong'. Then I had the audacity to say, 'I don't think this is a good idea.' Fortunately for clients, I was not the one who mattered (the Hang Seng has appreciated 934 per cent from June 30, 1989 to March 31, 2011). In the process, I learnt a Chinese proverb - newborn babies have no fear of tigers. (In a secular bull market, hire young managers and let them loose!) My reaction to crises also matured over time, but it took a lot of discipline and painful reflection.

But how do you define a contrarian position? Technology has enabled instantaneous information flow and market reaction, making it extremely difficult to tell how the market is actually positioned. Financial innovations also made possible faster and deeper reaction to events. Price signals may be inadequate.

The Pavlovian response that worked well 25 years ago may be a ticket to trouble. Having a longer investment horizon is also contrarian today as the market has transformed from one dominated by long-term investors to one where hedge funds, proprietary trading and high frequency trading dominates.

Over time, I have come to realise that modifying mean reversion with a philosophical understanding of the Taoist saying that 'all things taken to the extreme, change form' allows one to handle the dynamic and uncertain nature of developing markets and economies better.

We started turning positive on the Indonesian market in early 2007 and carried the position over a multi-year period. A simplistic use of mean reversion would have led us to exit too early as the market started to move above its long-term averages driven by structural changes. The volatility we sat through was massive.

To cope, we mentally prepared ourselves by developing a thesis for the structural change which we constantly reviewed, tested and updated, while maintaining the flexibility to discard it if we found a flaw. One has to be prepared to spend time developing deep knowledge and careful analysis to manage risk. It is not only about what you can win, but also understanding what you can afford to lose.

In this game of managing human behaviour, the one replicable skill set is discipline. We can start by being intellectually honest and transparent with our decisions. The explosion in the availability and speed of information and limitless computing power has created a delusion of control and a dangerous sense of complacency.

The ego is our biggest enemy. However, a true ego is one that learns from mistakes; understands that they don't have all the answers; always feels the need to constantly regenerate themselves; and understands the need to be constantly at risk in the marketplace. I rely on the 'neural network', a team of portfolio managers who work to ensure intellectual honesty through rigorous debates. However, one has to ensure diversity to avoid groupthink and understand that investing is a lonely pursuit.

How is all this relevant to the market today? A senior UK politician recently remarked: 'There is no recognition in the US and Europe of the sheer change in Asia and the sheer scale of competitiveness emerging.' The semantic debate on decoupling misses the point. The world is getting more 'global' with non-G-7 countries now constituting a meaningful portion of global gross domestic product (GDP) and at the margin, the main driver of global growth.

Going global

Thirty years ago, global really referred to the G-7 and the rest was irrelevant. The composition of the 'global average' has fundamentally changed, something not obvious if we just focus on the 'mean'. That is why in the past when the US/EU sneezed, we caught a cold; but today, they can catch pneumonia and we will still only go down with a cold.

Today, Asia-Pacific ex-Japan market capitalisation is larger than Europe, compared to 35 per cent of Europe's market capitalisation in 2000. What makes this so hard to believe is the lack of theories in understanding why a world that for the past 200 years has less than 20 per cent of its population controlling more than 80 per cent of global GDP is now changing for good.

Part of the reason lies in Lin Yifu's theory of the advantage of backwardness, with information technology enabling rapid dissemination of knowledge and unprecedented economies of scale. In 1800, the midst of the Industrial Revolution, the UK had a population of 10 million and the US five million. Today, China is industrialising with 1,300 million people. Unprecedented economy of scale is a thesis that we are developing to understand the changes taking place.

How else can you explain the rapid price drop in goods such as mobile telephony as China entered the space? Many choose to believe the demographic explanation to everything - that China grew because it had a large population. If this is true, China with more than 300 million people in 1800 would have been the largest economy in the world for the past 200 years. The irony is that the best performing economies for the past 200 years are actually European countries with small population bases.

This powerful secular shift is underpinned by a shift in the global balance of science, with research powerhouses now emerging in the developing world. Today, South Korea has the highest per dollar capita R&D spend globally. For the first time since World War II, developing economies are also producing capital equipment previously dominated by Western companies and at a much lower price. Chinese mobile telecom equipment suppliers such as Huawei and ZTE are supplying equipment at US$50 per subscriber capital expenditure and sub-US$50 handsets, empowering five billion emerging market consumers. This secular shift in favour of developing economies will continue for the foreseeable future.

Are you prepared to bet that this powerful trend will continue and how do you overcome all the noise that will try to convince you that historically, this is not possible?

The writer is managing director and senior portfolio manager, Morgan Stanley Investment Management (MSIM)