READ TO SUCCEED ? A BOOK REVIEW
Fund management is a funny industry. Numerous studies over time have shown that professional investors in charge of actively managed funds consistently fail to beat their benchmark. In other words, they don’t do what they are paid to do. One of the most recent studies in this area, carried out by S&P Dow Jones Indices, found that nine out of ten actively managed European equity funds have underperformed in the past decade.
There aren’t many other industries where such failure to deliver would be tolerated. A doctor who only correctly diagnosed one in ten patients wouldn’t be employed for long. And a football manager whose team won 10% of its games would definitely be sacked ? Jose Mourinho was recently given the boot after winning 40% of matches this season. Yet, despite the poor showing from active managers, trillions of pounds a year continue to be managed by and pumped into their funds. The Art of Execution, written by fund manager Lee Freeman-Shor, begins with this theme.
Best ideas, worst performance?
As a manager at Old Mutual, Freeman-Shor ran the “Best Ideas” fund. The rationale was that it should be easy to make money by asking the best investors to invest in their best ideas. Freeman-Shor gave 45 such investors between $20 million and $150 million of the fund’s money with the strict instruction that they only invest in their ten best stock ideas.
The result? Most individual investments actually lost money. The stats showed that only 49% of what were supposed to be the “very best” investment ideas actually turned a profit. And some investors were only successful 30% of the time ? a success rate worse than betting on red at a roulette table.
Yet, here comes the twist. While most individual investment ideas lost money, overall almost no managers were in the red. In fact, most made a lot of money. So the question is: how could these managers still be making money if most of their ideas turn out to be wrong? The answer: The art of execution.
Execution, execution, execution
The term “execution” referred to in the book does not relate to a grizzly death. In this context we are talking about exactly how investment ideas are put into practice and managed. The main thing we are talking about here is money management. As legendary investor George Soros once said, “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong”.
The main body of the book runs on this theme, being divided into two sections, one focussing on what to do with your money when your investments are doing badly and the other on what to do when they are going well. The analysis is based upon a review of 1,866 investments, involving over 30,874 trades.
Rabbits, Assassins and Hunters
In Part 1, focussed on how to act when you are losing money, we are introduced to three different “tribes” of investors. Each tribe consists of individuals who acted in a similar manner.
The Rabbits are the least successful of the investors encountered by author ? unfortunately all remain anonymous, which is no fun as many are said to have been big names in the City and Wall Street. This tribe had the habit of digging holes for themselves which they never get out of, doing nothing as their investments plunged in value.
Our bunny friends in fact had a lot of human flaws, especially behavioural finance related biases and failings. Most readers will probably admit to making these investing mistakes from time to time ? for example, buying glamour stocks, becoming emotionally attached to an investment, blaming others for their losses, being afraid to realise a loss, and many others. Overall, they were too afraid to take action and suffered from it as their bad investments continued to plunge in value. You could say that they got caught in the headlights.
Fortunately there are some simple rules that Rabbit like investors can put in place to keep themselves out of trouble. Most important of these is the one exhibited by a better performing tribe ? the Assassins.
Following Warren Buffett’s main rule of investing (never lose money) the Assassins were very good at killing their losing positions in order to preserve their capital. They had hard rules which told them what to do if a stock fell below a certain level, usually between 20%-33%, then sold out (using stop losses) without any emotion. Recognising the other key rule, “time is money” the Assassins also sold out of stocks if they were down by any amount of money and the investment showed no sign of recovery after a certain period of time.
In contrast to the above two tribes, but also being successful, are the Hunters. They didn’t stand by and do nothing as their investments fell, nor sell out as things got bad. In fact they bought more shares as the price went down and profited as it went back up ? benefiting from the process known as “averaging down”. You may think that this strategy is in contrast to the advice given to the Rabbits. But the difference with the Hunters is that they were mainly in value stocks which recovered over time. They also spread their investments out over time and didn’t go all in at the outset like the Rabbits did ? thus benefiting from a well planned and well executed strategy. You’ll learn more in the book about exactly how they did it.
Raiders and Connoisseurs
Part 2 covers what investors should do when their investments are in profit. Of course being in a winning position is a lot better than being in a losing one. But how you act is just as important.
The first of the two tribes we meet in this situation are the Raiders ? those who took a small profit on their investments as soon as they saw fit. While they ensured they made at least some return on their investment they could have made a lot more by running their winners. One investor thought he was clever by banking a 15% gain in just a month but rued the decision as it went on to more than double in value. Again, like the Rabbits, the Raiders suffered from psychological biases such as poor self-control, fear of making losses and short-termism. Overall, Freeman-Shor’s analysis showed that holding on would have resulted in much bigger gains. After all, selling small winners means you can never have big winners.
Then again we have the Connoisseurs, the most successful investor type encountered by the author. This is interesting given that their hit rate was the worst amongst all the tribes ? six out of ten ideas lost money. But when they won, they won big. How did they do it? One of their techniques was to buy quality companies ? those which they thought had a low chance of delivering negative surprises ? with a view of holding for ten years or more. Another was to look for stocks with large upside potential, so that when they won, they won big. To increase their odds of hitting the jackpot they also built up big positions. Perhaps most importantly of all they held on to their winners.
To sum up, the final brief chapter provides a useful checklist of the five best habits of winning investors, alongside a list of the five worst habits of the not so successful managers.
The Art of Execution is unique in the investment literature in that it doesn’t teach you how to find investment ideas or how to value stocks. That is interesting given that the investment industry spends a lot of time on idea generation. Instead the book advises and guides the reader as to what they should do after they have made an investment, depending on certain circumstances. The principles are often driven by investment theory and supported by interesting and detailed examples from the author’s experience.
Some may argue that Freeman-Shor cherry picks data to back-up his arguments and also ignores some concepts of portfolio theory ? i.e. losing positions may not have been sold as other stocks in the portfolio may have been doing well. But the overall message is clear ? the best investors make money because they get rid of their losers more quickly and let their winning ideas run. Overall, The Art of Execution is a great complement to the retail investor’s library.
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