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Avram Fisher, Founder & Portfolio Manager of Long Cast Advisers, is a former equity analyst at CSFB and BMO covering industrials and business services. He has prior experience in private equity; as a corporate governance analyst; as a writer; reporter and private investigator; and as a lifeguard and busboy (I still clear plates when my kids don't). This blog is an open book of ideas about patient investing and about starting up a small-cap focused RIA. It is part decision-diary, part investment observations and part general musings. Nothing on this blog is a solicitation for business nor a recommendation to buy or sell securities. It is simply a way to organize and share thoughts with an expanding audience of independent, patient and talented small cap investors. www.longcastadvisers.com

Sunday, November 13, 2016

EMH and the "CON" in Consensus

Anyone who spends time in business meetings, or on boards, or in any engagement with other people (including even sitting around a table and deciding what to have for dinner), probably recognizes that the efficiency of a meeting - ie the achievement through consensus of an optimal outcome - often declines as more people are involved.

And yet, one of the basic tenets of the efficient market hypothesis is that when it comes to market prices, a larger cohort achieves the most efficiency since the price aggregates information "dispersed amongst individuals within a society." (Recall that "efficient" in EMH isn't fitter / happier / more productive but is more a form of "consensus").

But why should a wider and larger base of participants yield more "efficient" results in the stock market, when so much evidence in other avenues of life exists to the contrary?

Perhaps we should think more productively about how often - and where - its likely to be wrong. I think that's a muscle investors regularly exercise.


The trouble with "consensus" - in a meeting and in the stock market - is that people are often anchored on the last comment, or the last stock price, or "what everyone else is doing" - and they mistake these data points as "sources of information" when actually they're forms of biases.

I recall reading once how the last thing Buffett looks at when analyzing a business is its price and chart, preferring to read all other filings first in order to make his own unbiased assessment divorced from the anchoring phenomenon.

It's a useful parable on how to not use consensus. Another is William Goldman's famous saying: "Nobody knows nothing." I say that to myself all the time.


The trend towards passive indexing - a massive trend - is supported by three things:

1. Efficient market hypothesis. If you can't beat the market, why bother trying?
2. Active management returns, which "on average" underperforms the market
3. The difficulty of identifying skilled asset managers who consistently outperform the market over long periods.

So the consequence of taking the EMH as fact has trillions of dollars in consequences.

As well, the "poor returns of active investors". But just as a reminder for a moment; investing is a zero sum game. There are two parties to every trade, a buyer and a seller. Reason therefore dictates that in aggregate, the average of all active investors, after fees, should underperform the market, roughly by the delta of fees.

Now, investors who want to follow a benchmark with the most undifferentiated and readily available solution can and should pursue the lowest cost index funds available to them. Anything else - anyone steered to a higher cost model - is a con job.

But investors who want a differentiated solution - who want an experience apart from and are willing to accept results that are different from the market - should either spend time learning how to invest or find someone with experience and skills who can do it for them.

The difficulty of finding that person, the difficulty of separating luck from skill, salespeople from super investors, wheat from chaff, etc. is the third and perhaps largest foundation of the trend towards passive investing.

It's so difficult even for institutions to identify high quality investment managers, and doubly so for individuals.

All in, you have this easy solution (passive investing) that solves / avoids the problem of having to find good managers yet still supports Wall Street's desire to separate you from your money. It plugs perfectly into the rubric of the industry as it already exists.


But here's where I think EMH and the passive trend have it all wrong and where the opportunity for good investors grows everyday: Finding high quality capital allocators is the only job within the entire investment ecosystem. I take an almost ideological view on this and I think its where investing shares at least as much with the practices of other art (and ethics) as it does with finance and accounting.

As a steward of capital seeking to invest in publicly traded companies I look for executives who allocate capital wisely. These CEO's and CFO's in turn look for managers who can manage capital (staff, equipment, etc) effectively. They in turn prize employees that convert their labor productively, and on and on.

It's the capital equivalent of turtles all the way down.

But since passive investing disabuses the notion that anyone can outperform the market, and EMH says that prices are all accurate, the conclusion is to ignore the search for better capital allocators and simply spread your bets and diversify.

Which is why the price for capital allocators is going down.

But the value of finding good capital allocators - from the CEO down to the line worker, from the endowment to the startup investment manager, from the QB to the special teams coach - is not going away. And for those who desire exceptional outcomes, it never will.

Over time, we who search for good capital allocators will get better at it while the competitive field diminishes.


I was going to write more about a specific idea I've been working on, but I'm still drawing information on it so I'll close with a brief comment on investing with incomplete information.

The other day I wrote about an inference drawn from one company to learn something incremental about another company. It helped to lock in gains and avoid losses for my clients and since a penny saved is a penny earned, I feel it justified my 1% fee.

The opposite of those inferences is acknowledging and valuing incomplete information when making investment decisions, and compensating for that with price and portfolio positioning.

I think good stockpickers, even when they dig down for that 3rd, 4th or nth piece of information, acknowledge the limits of what they know.

For this reason, I am cautious of detailed checklists, b/c it risks creating a false impression that on completing it, we'll have certainty. There never is certainly. I prefer a broad functionary checklist at the top of which I write in big letters: "What don't I know?"

Even as we dig a bit deeper and contextualize financial data with qualitative information, there are always going to be unknowns and surprises.

There's a value to what we don't know. I believe for "good investments" - and by that I mean investments in companies managed by "quality capital allocators" - time and patience is the best way to manage and offsets the risks of the unknowns. It seems an important concept that EMH totally ignores.

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