The power of unemotional investing

The demise of African Bank (Abil) has raised questions about the extent to which fund managers are guilty of poor judgment, and how well they really know their investments based on research undertaken with prudence and care.

Fazila Manjoo, Portfolio Manager and Analyst at Prescient Investment Management commented that, after the event, the market’s focus was largely on losses in money market funds, where investors expected capital stability. However, the impact of Abil’s problems on equity funds should not be ignored given that the capital loss was as much as 10% of the overall fund in certain cases.

“This is not the first time that decisions based on forecasting and predicting the future, rather than on the cold, hard facts, has led to disaster. Another example of forecast investing is the dot-com bubble, where investors continued to see blue-sky potential in companies and paid a massive premium for future earnings. Looking back, it seems astonishing that analysts were forecasting even higher company earnings at the beginning of 2008, with no one seeing the risk of a complete reversal.

“These events should encourage investors to consider an alternative: unemotional investing.”

She added that all equity investments carry some risk, and unemotional investing is a process of investing into those risks that have been proven to pay rewards over time. The important fact when investing unemotionally is to employ a consistent process of evaluating shares on a like-for-like basis, without incorporating emotional and, at times, even irrational bias into the comparison, including forecasts of the future. Risk should also play a major role, including a risk diversification process to eliminate the chance of having 10% exposure in a small and very risky share.

Prescient’s Equity Income and Equity Active Funds are ranked fourth and eighth respectively out of 122 funds in the South African General Equity category over the 12-month period to 31 August 2014. These funds invest in shares using a systematic approach without any forecasting. Shares are selected for the value they offer, where value is determined by the actual economic delivery of the company (rather than a forecast) relative to the price compared to other companies.

According to Eldria Fraser, Chief Investment Officer of Prescient Investment Management, “Value and the quality of the company, supported by increasingly positive sentiment, should be blended together to determine which companies will make a good investment and will deliver a better diversified and more stable portfolio over time. This approach removes the risk of basing decisions entirely on the accuracy of forecasts.

“In addition to the unbiased selection process, we also construct the portfolio to take cognizance of the risk each share adds to the portfolio. This includes considering the risk added by not holding a share with a very large market capitalisation weight. This method of constructing portfolios ensures that a very small share does not contribute a disproportionate level of risk in the portfolio.”

Investors too often fall victim to poor judgment, Ms Manjoo said. Being emotionally invested in their winners is the most common bias among professional investors, as many are often hesitant to let go of a position even if there are good reasons to do so.

She added that the unbiased model currently indicates that Naspers, a market favourite, is looking expensive, offering value only if a large positive forecast on earnings from Tencent is included. The Prescient Equity Income Fund which has a mandate to invest in high dividend payers, is selecting British American Tobacco, a share yielding 4% with a very stable record of delivery.

Another common bias among investors is holding on to losers for too long in an attempt to avert losses. Instead of acknowledging and accepting a mistake, investors often irrationally hold on to a poor asset in the hope that it will rebound. A good example of this was Abil.

Abil was not selected by either Prescient’s Equity Income or Equity Active Funds as the value it offered relative to other opportunities was poor when measured across numerous criteria, including value, sentiment and quality. The chart below shows the dividend yields - as proxy for value - and the sentiment for South African banks. Abil’s position is quite clear on this chart and holding Abil made no sense given the other options available in the sector.