Letter # 41, 14 May 2021
“He was unprecedented for a European business leader – a Scandinavian who combined old world manners and language skills with American pragmatism and an orientation for action,” writes Phil Rosenzweig in his book The Halo Effect. The press could not get enough of Percy Barnevik, the CEO of ABB, in the mid-1990s as its revenue almost doubled, profit tripled and market cap breached the USD40bn mark between 1988 and 1996.
It started with Sweden’s ASEA and Switzerland’s Brown Boveri merging in 1988; they integrated at break-neck speed, saving millions of dollars in costs. Plants were closed, jobs were cut and overheads slashed, while acquisitions rose. By 1994, ABB had consolidated in Western Europe & North America, and expanded in Emerging Markets, with Percy at the helm.
In early 1990s, magazines like Long Range Planning, Forbes and Business Week gushed over Percy’s management style; academics at management schools praised his persona and Korean Management Association named him ‘world’s best honoured top manager’ – he was getting an award for getting the most awards!
And then came the downfall, starting 1998. The spree of acquisitions, the unrelated expansion (into financing arm, etc.) and the litigations (asbestos) hurt ABB. The size of the problem grew so large that ABB had to sell its petrochem business, its finance division and take unprecedented loans. By 2003, the company was a mere shadow of its previous self, as Jurgen Dormann, ABB’s Chairman remembered, “we had a lack of focus as Percy went on an acquisition spree. The company wasn’t disciplined enough.” Then, managers recalled poor coordination among countries and dysfunctional competition. The board joined the chorus on how Percy had ‘monopolized the flow of information’. By now, the once superstar had to give up more than 60% of his pension pay and his legacy was in tatters.
It’s a nice story—leaders are important, but judging whether a leader is great from the fact that a company has been successful is breaking down a complex problem into bite-size theories. To me, that begs a larger question, given that we are aware that some relationships of cause and effect are complex in nature, why do we have the urge to break them down into heuristics?
And, it is not just about distant corporations and CEOs; our financial markets too are inundated with investment theories that sound simple, but with little effort, we know them to be totally wrong. Over the past few letters, I have written how frameworks that sound simple (buy growth companies with high RoE, don’t buy PSU, don’t buy commodity companies) do not actually work in real life. They are largely a hoax, meant to make the financial guru to sound intelligent and for marketing guys to be able to sell you a product.
Today, let us look at one more of such truisms, “Times are uncertain; stay invested with the leaders in each sector; your portfolio will emerge stronger from the crises.” Over the years, chances are high, that you might have come across someone making similar claim.
The table below summarizes the leading company by revenue (in fiscal 2011) in different sectors. Now imagine one created an equal weight portfolio, investing the same sum in all companies that were leaders a decade ago. This portfolio would have returned ~16% CAGR, a superior return compared to 10% CAGR in Nifty.
However, had one created a similar equal-weight portfolio of contenders, the returns would have been a staggering 22%. To put things in perspective, the ‘contender’ portfolio would have been up 6.6x over the previous decade versus the ‘leader’ portfolio, which would have been up 3.5x. The leader portfolio underperformed the contender portfolio by a staggering 47% in a decade.
We discussed last week (1) how reducing an investment framework to narratives (that sound intelligent) does not hold the test of numbers over time. The result above debunks a similar myth that has been doing the rounds in the world of investments for quite some time now.
As to the broader question of why the urge to break down a complex relationship into bite-size theories that aren’t true, Elliot Aronson, an American psychologist, has a beautiful answer in his book The Social Animal. He observed that “people are not rational begins so much as rationalizing beings. We want explanations. We want the world around us to make sense.”
Experts appearing on CNBC will sound a lot more intelligent if they explain half a point drop in a stock with something that sounds plausible (albeit inaccurate) rather than suggesting that on any given day, stock price fluctuations are more easily explained away with a Brownian motion. That need for the world around us to make sense compels us to form heuristics; it makes our lives easier. It gives us the confidence that we will be able to open a door to a room that we have not previously entered. In life, heuristics serve a useful purpose.
When it comes to investments, however, each situation is different from another. And, while broad rules do apply, boiling down a framework to these rules (buy the leaders, buy high growth high ROE companies, don’t buy PSU etc.) does not work. People who propagate them do a great disservice to the overall investment clan.
At the end, one might have a question—investing in the contender portfolio will help generate superior returns in the next decade, right? Sadly, if one did the same in the FMCG sector in the past decade (buying Nestle instead of the leader Hindustan Unilever), one would have underperformed by a whopping 45%. While trying to debunk the notion that formulas do not work, I am not about to introduce a formula that I think works. Investing is simple, but condensing it down to heuristics is a recipe for disaster.
(1) Numbers matter, not the narrative – Buoyant Capital
This letter was originally published here: https://www.cnbctv18.com/market/heuristics-help-open-doors-but-are-bad-for-investments-9299131.htm
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