In Support of Specialisation

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Introduction
This Blog builds on one I wrote back on the 3rd September 2020 on the subject of focus and specialisation, which you can read here:
 
https://wheeliedealer.weebly.com/educational-blogs/screening-out-to-reduce-your-opportunity-set
 
I doubt this will be all that long (as usual with my Blogs, I tend to have little idea of how much will be in them until I actually crack on and get some text down on my electronic paper), and the approach I am using is to take some text from an excellent article that Chris Dillow wrote in ‘Investors Chronicle’ on 9th August 2019 on page 18 with the title ‘Is ethical investing doomed?’, and then I will add my own comments around this text (Chris’ text is in italic).
 
Don’t be fooled by the title of Chris’ article, I am not really focusing on the ethical funds but more the principles around what Chris is saying. Perhaps there will be the side-benefit that we can learn something about ethical funds as a bonus !!

Chris starts off with the premise that a theoretical, imaginary, Fund Manager constrains his/her own Opportunity Set by selecting Stocks only from those on the Stockmarket which have names beginning with a letter from the first half of the alphabet, A to M.
 
Chris then makes the contention that ‘common sense’ (that is something I find astonishingly uncommon !!) tells us that such a constrained choice should lead to a less good outcome than having the choice of the Stocks from the full alphabet:
 
‘Common sense, therefore, tells us that the A-M fund must underperform on average over the longer run, because there will be times when N-Z stocks do better. At least sometimes, constraints will bite.’
 
The basis of the unconstrained Fund doing better is because sometimes the half of the alphabet with N to Z Stocks in it will have the better investments. I am sure we will explore this more as this blog develops, but my experience suggests to me that some level of constraints and focus actually leads to better outcomes, and the obvious point to make about Chris’ thought experiment is that the choices of A to M or A to Z are far too random and do not segment the individual Stocks within the whole alphabet into subsets of attributes that are likely to do better. Really the alphabetic distinctions are far to random.
 
How this Relates to Ethical Funds
Chris then follows the paragraph above with the next 3 paragraphs:
 
‘Of course, there are no actual A-M funds, perhaps for this very reason. But there are many funds to whom this same logic applies – ethical, environmental and socially responsible funds. Whether they merely screen out ‘sin stocks’, or actively seek virtuous ones, such funds make constrained choices. Because such constraints will bind at least occasionally, these funds should in theory be worse than unconstrained ones.’
 
‘For example, BAT has lost more than 20 per cent in the past 12 months. This has boosted the relative performance of ethical funds that avoid tobacco stocks. But any good conventional fund manager could also have avoided BAT and so matched ethical funds.’
 
‘For this reason, says Cullen Roche of Orcam Financial Group, ethical funds should “underperform in theory and in reality.”’
 
In line with what I said above, on the face of it I don’t agree with the idea that constrained choices will not work – in fact, my experience tells me that constrained choices actually do better – and that is most certainly what I have found with my own investing. If I stick to Quality Stocks with proper histories of achievement and I buy them at reasonable valuations, then on the whole I do pretty well and I can sleep like a Log that’s been dosing on the Night Nurse (that’s the stuff in the bottle, not what you were fantasizing about). If I slip into buying the more ‘Junky’ end of Stocks (especially loss-making start-up stories on AIM), then I will lose money.
 
Another thought about Chris’ 3 paragraphs above is that it sort of assumes that both the ethical Fund Manager, and the conventional Fund Manager can both avoid choosing BAT. This totally ignores the psychology and the simple fact that everybody makes mistakes, and in this example the ethical Fund Manager should easily avoid BAT but the conventional Fund Manager could buy the turkey. Let’s face it, loads of Fund Managers actually hold BAT.
 
Part of the problem here is Outcome Bias or Hindsight Bias even. We are assessing the performance of BAT after the event. However, if you think back to the time before either Fund Manager held BAT, the ethical Fund Manager could easily avoid the problem, whereas at that point in time, the conventional Fund Manager could have easily bought BAT on the mistaken belief that it would actually be a nice winner for him/her.
 
What is happening here is the psychological concept of a ‘Ulysses pact’ whereby you design and set a constraint upon your own behaviour to avoid you making a mistake (usually an error you have made several times before and you need the Rule to force you to behave in future).
 
It is named after Ulysses because in that classic fable, Ulysses knows that if he listens to the song of the Sirens, then his Ship will smash into the Rocks, but by getting his crew to tie him to the mast of the ship, he is able to observe the beauty of the Sirens and to hear their marvelous singing, without hitting the Rocks and the crew are all wearing Apple Ear Buds or something. I may have got some of that wrong – do you really think I am going to spend loads of time reading that old yarn? (it’s probably written in double Greek anyway).
 
The Case for Constraints
This is the bit where Chris then turns tail and does a 180, and puts the other side of the argument, which is more where I am sitting anyway. You will find that if you read Chris’ articles on a regular basis that he often writes in this way of making a basic premise, and then flipping it on its nut and taking the other side of the debate.
 
‘If you find all this convincing, however, you shouldn’t. The facts are much less clear than the logic. In the past 10 years some ethical and environmental funds such as those run by Liontrust, Royal London and Standard Life have beaten the market. And in the past five years the US’s vice fund has moved only sideways, despite a strong rise in the S&P500.’
 
Well, that paragraph totally lines up with what I have been saying, both in this Blog already and in the Blog that I wrote back on 3rd September 2020 which I gave you the link to at the start. The essence of this (and the proof of whether this is true or not is another issue) is that ethical Funds appear to perform better and therefore if you constrain yourself in such a way as to avoid non-ethical Stocks, then in theory you should outperform. In effect you are ‘tying yourself to the mast’ of not buying non-ethical Stocks.
 
Didn’t Florence and her Machinery write something about being tied to the mast? Or was it the Stranglers and their ‘Golden Brown’?
 
On the face of it then, buying Ethical Stocks could give an edge and Chris’ next chunk of text that I have reproduced below, goes on to explain possible reasons for such outperformance.
 
‘There are, however, other ways in which ethical investors might do well. One is that they are less exposed to political and legal risk. It’s possible that in future years carbon stocks will face increased taxation and regulation and more lawsuits. In avoiding them, ethical investors are reducing this risk. Similarly, if more investors dump such stocks on ethical grounds then today’s ethical investors would profit from having sold earlier. They might also benefit from being early investors in green stocks, in the same way that it’s profitable to be at the start of any trend.’
 
I think there is much sense in this. I can see the logic of avoiding some Political and Regulatory risk and I am pretty sure this is something I take into consideration when assessing any new Stock that I fancy buying. To an extent I also think about this on Stocks I already hold but maybe not to the same extent (that is more of a failing on my part than a deliberate policy).
 
The latter bit about being early or late into Ethical Stocks suggests that going forwards the returns on such Stocks may not be as good – that is something to weigh up and of course is very much Stock-dependent and in truth, we should consider any Stock on its own merits (and de-merits !!).
 
One simple way in which vice Stocks could suffer is merely that as the Markets perception of them becomes more negative and unsure, they will be awarded a lower P/E Ratio (Rating) and even if their Earnings hold up, a reduction in these P/E Ratios (a ‘De-Rating’) could mean their Share Prices slump. I suspect much of that re-rating has already happened.
 
‘Perhaps, though, there’s something else. Think about the cinema. For many of us, our favourite films are the likes of Casablanca or Brief Encounter – ones made in black and white on modest budgets without special effects. Constraints can therefore produce greatness by focusing the mind.’
 
I certainly agree with the “focusing the mind” bit and it lines up with what I said in my previous Blog on this subject. However, I’m not so sure about those old Black & White Movies which remind me far too much of my younger days watching a tiny Black & White Telly with just 2 Channels (the Aerial was pointing the wrong way to get BBC1 and we could only get ITV and BBC2 !!).
 
‘Maybe a similar thing is true in investing. If we look at fewer stocks we can do so in greater depth and so have a better chance of spotting winners. And we’ve less chance of missing good stocks simply because our attention is elsewhere. If so, the thinking which tells us to expect constrained funds to underperform is plain wrong. Constraints can actually help. As the political theorist Jon Elster wrote in his classic book, ‘Ulysses Unbound’, “sometimes there are benefits from having fewer opportunities.”’
 
Well, that totally supports what I have been saying. In all honesty, I didn’t pick up on the “Ulysses Unbound” bit before and I wrote my piece above without seeing this. Great minds think alike maybe (but Fools seldom differ !!). I highlighted a chunk of that in bold just to emphasise how important I think it is.
 
‘Now, almost everybody should disagree with this……And conventional fund managers don’t think constraints help because they don’t impose them upon themselves; there are no A-M funds.’
 
‘Nevertheless, I suspect there might be something in this. And it is perhaps ethical investors’ best hope.’
 
As I said before, I think the A-M distinction is far too random and would contains a massive pile of Stocks which had countless different attributes and whereas some will be very good, many will be awful and come from areas of the Stock Market you are really best off avoiding.
 
I guess you can widen this whole thing in terms of specialisation and Fund Managers as well from only the Ethical Funds. It could also apply to any kind of specialisation such as Sector Themes like Tech, Health, Banking, Resources etc. By having a constrained opportunity set, the Fund Managers are much more likely to increase their knowledge and understanding of particular Stocks and also to get a better feel of what factors tend to drive the Sector as a whole.
 
The more I write on this, the more I would recommend the concept of Specialising and defining your Opportunity Set in a way that is likely to optimise your Returns. It’s precisely what I try to do.
 
Cheers, WD.
 
 
Related Blogs
The Blog below sort of focuses on TopSlicing but includes loads on psychology that you might like. There are links to the earlier bits right at the bottom of this one:
 
https://wheeliedealer.weebly.com/educational-blogs/the-psychology-of-the-topchop-part-3-of-3