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  • Eric Cinnamond

Believers

<August 5, 2020>


As a small cap value manager in 1999, one of the most difficult things to do wasn’t finding value—there were bargains everywhere—it was having the conviction to buy value stocks. It wasn’t too dissimilar from the current environment, except value stocks were inexpensive in absolute terms then, not relatively as some are today. Although value stocks were on sale in 1999, many value managers were reluctant to own them as they were significantly underperforming the broader market, and in particular, growth stocks. However, for value investors that had conviction in their process, the rewards in 2000-2002 were well worth the wait, as growth stocks eventually plummeted and value stocks marched higher.



Conviction is one of the most important attributes of a successful investor. However, you won’t find it in investment textbooks or your CFA studies. Conviction is simply too subjective to accurately measure in an empirical study or regression analysis. Nevertheless, its importance cannot be overstated. Without conviction, investors are rudderless, lost in a sea of market noise, and countless opinions. Investors lacking conviction can fall victim to trend following, excessive turnover, and ultimately, second guessing.


Investing with conviction isn’t easy. The future is unknowable, making it difficult to invest with certainty and according to plan. We’re reminded of the Mike Tyson quote, “Everyone has a plan until they get punched in the mouth.” As seasoned investors know, the market can punch very hard and when it’s least expected! To have conviction, investors must plan for uncertainty, and more importantly, properly account for uncertainty in valuations and decision making. By preparing and accounting for uncertainty, investors are less likely to be prematurely dislodged from their process and positioning.


Facing uncertainty can be particularly challenging when standing apart from the crowd, or as a contrarian. As absolute return investors, our process often requires us to look different, sometimes a lot different, than our benchmark and peers. To generate attractive absolute returns over a market cycle, we often need to pull back when others are pushing forward and push forward when others are pulling back. Investing differently and fighting the seductiveness of the crowd is extremely difficult—significant conviction is required.


Holding a contrarian position with conviction isn’t for everyone. For those less willing to look different, conformity is another option. Over the years, conformity has become increasingly popular in the investment management industry and with relative return investors. As their name implies, relative return investors are measured relative to a benchmark or the crowd. Given the crowd has been consistently rewarded over the past 11 years, it’s not surprising that conformity has gained significant market share over actively managed strategies. As long as the market cycle never ends and asset prices always rise, conforming can be very profitable and relatively easy to implement. In our view, little conviction is required.



The decision to invest with or against the crowd is often out of the hands of many professional investors. The decision is made for them by investment guidelines and restrictions. By following a strict set of rules, “mandate managers” are required to invest according to their investment manual, not necessarily their investment beliefs. As such, a manager’s preferred positioning may be overridden by rules and mandates, even if a manager strongly disagrees. In other words, how a manager wants to invest and how he or she is allowed to invest may be two entirely different things. In our opinion, this isn’t an investment discipline or process, it’s compliance—there is a big difference. Portfolios managed by strict rules and guidelines require little conviction.


The desire to raise assets under management (AUM) may also influence how an investment process is implemented and the need for conviction. Investment consultants often search for portfolio managers that generate higher returns with lower risks. This makes sense to us. Consultants also tend to favor portfolio managers with minimal tracking error, or those that don’t veer too far from their benchmarks and peers. This has never made sense to us. How can an investment manager generate higher returns with less risk by looking like everyone else? This is especially true for value managers that often need to take the road less traveled. For value investors wanting to be hired by an investment consultant, it may make more business sense to label yourself a value investor, but avoid investing like a value investor. While managing a portfolio to satisfy consultants may increase AUM and your W-2, it does not require considerable conviction.


And finally, there are the style drifters and performance chasers. These investors flock to what is working and what they believe will drive performance higher in the near-term. While an investment process built on investing in what’s working may feel good, it can lead to significant extrapolation risk and ultimately permanent loss of capital. Although style drifting and performance chasing can be intoxicating and rewarding during certain periods, we’ve seldom seen it work over full market cycles. In our opinion, such a process is shortsighted and requires little conviction.


In addition to the temptations to conform, appease asset allocators, and chase performance, the current investment environment has made it increasingly challenging to maintain conviction. Central banks have hijacked the free markets with negative real rates, asset purchases, and money printing. COVID-19 has reduced the certainty and distribution of future free cash flows, complicating most business valuations. Soaring debts, fiscal deficits, and extraordinary stimulus programs have made normalizing operating results particularly challenging. Interest rates have collapsed to levels never imagined, encouraging investors to pay exorbitant prices for stocks and bonds. In our opinion, buying most assets today doesn’t require conviction, it requires a tremendous amount of creativity!


While we believe investing with conviction has never been more difficult, we also feel it’s never been more important. As absolute return investors, we must trust our process and remain focused on our full-cycle goals. The history of financial markets is littered with examples of capitulation and “this time is different” tragedies. Regardless of the mounting pressures to conform, we intend to continue to think independently and stay the course. Every cycle is different, but in our eyes, the fundamentals of investing have not changed—prices matter, cycles revert, and risk may hide for extended periods, but it never disappears and should not be underestimated.


Since conviction is extremely difficult to measure, how do we know which managers have it and which managers don’t? It’s simple. Are they willing to underperform when their style or strategy is significantly out of favor? Are they willing to look so different and so out of touch that they may be considered “quirky” and even “stupid”? Are they willing to be overlooked by the asset gatekeepers and risk losing assets under management? Are they even willing to be fired to remain dedicated to their investment process and positioning? The investors I know and respect are more than willing to do all of these things and more. They have conviction, they’re positioned accordingly, and they’re believers.


eric@palmvalleycapital.com



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Definitions:

Russell 2000 Value: The Russell 2000 Value Index is an American small-cap stock market index that includes Russell 2000 companies with lower price to book ratios and lower historical and forecasted growth rates.

Russell 2000 Growth Index is an American small-cap stock market index that includes Russell 2000 companies with higher price to book ratios and higher historical and forecasted growth rates.

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