Let us return once again to the Stone Age.1 Our caveman is now seven weeks into his lockdown in his limestone cave. His immediate priority to provide enough meat and fire for his family did not seem to be shared by the rest of the tribe, which was now preoccupied with settling old scores. Some were saying that the elders had not protected the tribe well-enough from the previously unknown menace. Those who had been defeated at the last popular council now said the tribe should stay in the caves indefinitely: they wanted a permanent ban on hunting, the confiscation and redistribution of excess food and wood. The elders defended themselves by saying that they were just following the advice of the shaman: did anyone else have greater knowledge of evil spirits?
The tribe had now established the threat was significantly riskier for the old and frail. The caveman was relieved that his children would be safe and thought it might be sensible for the fitter members of the tribe to now hunt, to provide for those for whom it was considered too dangerous. But others, including the shaman, argued that this was actually very selfish and that unless the whole of the tribe stayed within the caves the predator would never leave the valley.2 Our Neanderthal now worried about the longer-term psychological damage to the tribe from the fear of this unknown killer. Even if it could be beaten, would they now need to retreat to this subterranean existence every time they encountered a new predator? He was also beginning to question how the tribe could ever beat back the mysterious menace or gain any greater understanding, without ever being exposed to it?3 Perhaps some of the other northern tribes had better plans?4
Then one day the shaman was caught coming back from the valley; his loin cloth dishevelled, his face flushed red from exertions. When challenged, he said he was in fact now immune from the predator, whom he had previously claimed was so dangerous that nobody should enter the valley.5 The caveman had always been suspicious of the medicine man, given his previous track record, and now wondered whether the tribe had been told the truth. The elders were supposed to be wise, yet how could they have such poor judgement as to be so reliant on this charlatan for advice?
Our caveman’s concern will now of course be familiar to readers today and leads to a wider debate about expert opinion and the search for the truth. It is now still almost unbelievable that we have been in economic lockdown on the recommendation of a single widely discredited Imperial College model that extrapolated exponential virus growth.6 It is surprising that the financial profession has not been more sceptical since it has arguably done more than any other industry to promote the “rubbish in, rubbish out” model. There exists in the investment profession an apprenticeship involving the diligent building of discounted cash flow models to value individual stocks. Irrespective of modelling skills, the analyst only graduates when they understand how the model can be easily distorted by the inaccuracy of key variable assumptions. Spurious accuracy is often far from the truth.
Like politicians, fund managers also have access to a wide range of expert opinion which is often of little assistance in making successful investment decisions. All investors are familiar with the saying that economists have predicted nine of the last five recessions. When we learn that the epidemiologist behind lockdown predicted that 200 million people would die of bird flu (compared to 282 people who actually did); 65,000 UK citizens from swine flu (compared with 457 who actually did); and as many as 150,000 from mad cow disease (compared to 177 who actually did), we might have thought that government might treat this particular source of expert opinion with a degree of scepticism when it predicted 500,000 UK deaths from coronavirus?7 Unlike investing, there are some professions where credibility does not appear to be symmetrically tarnished by false prophecies of doom, despite the negative economic and other unintended consequences. As Nobel Laureate, Prof Michael Levitt has concluded on the Imperial College epidemiologists, the search for the truth is often corrupted by a fatal cognitive bias:
“They see their role as scaring people into doing something…but in my work, if I say a number is too small and I’m wrong, or too big and I’m wrong, both of those errors are the same”8
Financial markets always price a consensus view of the expectations for key variables like future corporate profits and the cost of capital, which in sum determine the price of stocks. As this median view will always evolve, because the variables are volatile and subject to changing expectations, so market prices are never constant. Successful investors must therefore free themselves from the cognitive cheerleading biases of either bull or bear and instead become disciplined truth seekers. The judgement in recognising a mispriced stock independently of market beta is equivalent to discovering a contrarian truth.
Recently short-sellers have been subject to criticism, as if they have spread a virus or imposed a lockdown, from no less a figure than the new Governor of the Bank of England, who told the BBC: “anybody who says, ‘I can make a load of money by shorting’ which might not be frankly in the interest of the economy, the interest of the people, just stop and think what you’re doing.”9 Companies go bust not when their share price falls but when they run out of cash. Without short sellers, frauds like the multi-billion-dollar Ponzi scheme at NMC Hospitals would not have been exposed. If there are no shorts motivated to uncover the truth, to play the role of market vigilante, we would inevitably have a more dishonest stock market; capital would be allocated less efficiently and over the long-term economic growth would suffer.10 Short-sellers only win when they wager on a truth. It is those who wish to deny unpalatable facts that are acting against the interests of the UK economy and its people.
There is a now a new allegation aimed at the pantomime hedge fund villains of Mayfair; that they are agitating for a premature end to lockdown to make speculative gains from putting workers lives at risk. We have certainly been closing some shorts, making selective investments in cyclical industries and increasing our market exposure. We have done this because stocks have fallen a long way, there has been an unprecedented policy response and we think that the truth about the virus is that its excess mortality risk and therefore the rationale for lockdown has been significantly exaggerated.11 In other words, far from talking our own book, in order to continue to invest successfully, we needed to adapt our positioning according to our understanding of the truth.12 Nevertheless, we also see a risk that governments have become prisoners of their own propaganda; that the normalisation of the economy is now delayed for reasons of political expediency. We can hedge this irrationality, the British economy cannot.
If the market already reflects the median view on a stock, professional investors should ask themselves how they might best organise themselves to recognise contrarian truths? With their vast organograms of analyst bots, large asset managers inevitably become the market consensus.13 Instead of focusing on improving investment returns, active fund management has instead sought refuge in fashionably packaged beta. We have recently heard some extraordinary claims such as the current bear market can only accelerate the trends towards “responsible” investing; or that it is an opportunity to end “boom and bust” through government regulation of dividend pay-outs and financial leverage. It is questionable whether in this utopian economy there will be any need for fund managers to pick winners from losers if the outcome has already been predetermined by an omniscient and omnipotent financial regulator.
“Responsible” investing should begin with earning a return on capital. When the success of a fund is measured by something other than its return, correlation and volatility, such as environmental, social and governance factors, we open a Pandora’s box of debates around morality: what is the exact moral compass of the fund and how subjective is this? Can this be applied consistently and not in an arbitrary manner? How is moral success measured and what kind of trade off, if any, should we expect versus return on capital? The industry does not seem to have fully appreciated that this trend, away from objective truths, to priggish fund managers with sanctimonious funds looking to monetize morality, will inevitably lead to a double hazard of poor performance and hypocritical behaviour, rather like a TV evangelist eventually exposed by their own debauchery.
Britain recently celebrated the 75th anniversary of VE day. If this is regarded as the apogee of Winston Churchill’s political career which spanned six decades, his biggest regret was his calamitous reintroduction of the gold standard as Chancellor in 1925, on which expert opinion and the City at the time was almost uniformly positive. When Churchill also considered the unanimous certainty of the advice during WW1 from the Admirals for the convoy system and the Generals for trench warfare, by the 1930s he had begun to seriously doubt the judgement of experts. According to his biographer, and thankfully, for the course of subsequent history, this emboldened Churchill in his wilderness years in his contrarian warnings on the rise of Hitler: “His willingness to attack the entire establishment over appeasement might not have been so complete if he hadn’t seen experts proved wrong time and time again.”14
“Britain has had enough of experts” said a prescient Michael Gove in June 2016, during the Brexit debate, echoing Churchill’s scepticism. Like politicians, fund managers with access to expert opinion, must ensure that they do not outsource judgement, but instead ensure they exercise it with an understanding of cognitive biases and an awareness of the range of probable outcomes, with the aim of discovering the truth, however contrarian.
Barry Norris
Argonaut Capital
May 2020
1 For our previous visits to the Stone Age see https://blog.argonautcapital.co.uk/articles/2020/03/30/the-free-will-of-cavemen-herd-immunity-and-the-value-of-contrarian-truth/
https://blog.argonautcapital.co.uk/articles/2020/04/17/the-rational-risk-taking-of-the-restless-caveman/
2https://unherd.com/thepost/imperials-prof-neil-ferguson-responds-to-the-swedish-critique/
Ferguson has argued that isolating the “old and vulnerable” was “wishful thinking” simply because it had never previously been done well. This leads to his conclusion that infection ratios must be kept low across the entire population even where there is no statistical excess mortality risk. In other words, his advice is that putting the economy into lockdown is easier that protecting the “old and vulnerable”. Really? Why aren’t we having this debate?
3https://www.spectator.co.uk/article/could-the-lockdown-have-side-effects-no-one-has-considered
https://www.spiked-online.com/2020/04/29/delaying-herd-immunity-is-costing-lives/
4https://www.spectator.co.uk/article/covid-19-update-sweden-tames-its-r-number-without-lockdown
https://www.medrxiv.org/content/10.1101/2020.04.24.20078717v1.full.pdf
6 Prof Michael Levitt comments: “In a footnote to a table it said, assuming exponential growth of 15% for six days. Now I had looked at China and had never seen exponential growth that wasn’t decaying rapidly” https://unherd.com/thepost/nobel-prize-winning-scientist-the-covid-19-epidemic-was-never-exponential/ Interestingly there are private sector epidemiological models that are more accurate than the ICL model which are used in the insurance industry but which for practical purposes are still viewed by actuaries with ultra-caution their lack of objective accuracy
https://lockdownsceptics.org/second-analysis-of-fergusons-model/
7https://www.spectator.co.uk/article/six-questions-that-neil-ferguson-should-be-asked
10https://blog.argonautcapital.co.uk/articles/2020/03/27/in-defence-of-short-selling/
12
14 Andrew Roberts, “Walking with Destiny”, 2018