What’s love got to do with it? (Investing)
In his book The Five Love Languages, author Gary Chapman hypothesizes that human beings have different preferences—or languages—for expressing and receiving love. For Chapman, every individual has a clear preference, and it’s a finite list of options:
- words of affirmation
- quality time
- receiving gifts
- acts of service
- physical touch
According to Chapman’s model, couples can improve their communication if they make an effort to express their affection in the language the recipient most naturally values.
My wife and I recently thought it would be fun to determine each of our preferred love languages. Having known each other for ten years, the results weren’t terribly surprising. We each prefer to give and receive love using a single language. However, for my wife that language is quality time, whereas I default to acts of service.
This has practical implications. If we go out to dinner on a frigid winter evening, I’ll naturally offer to drop my wife off in front of the restaurant before finding a parking spot, saving her from the elements. But from her perspective, she’s wired to see this act of service not as an expression of love, but rather as an act of betrayal, robbing us of time together (and yes, I’m dramatizing for effect).
Putting aside Chapman’s fifth language, the broader idea that better communication can be achieved by understanding differences in individual preferences strikes me as having many important applications to our jobs as investors. Whether it’s sifting through noise in the market, researching companies, or team communication, all can benefit from such awareness.
(Leave it to the “boring” folks at Mawer to turn an idea about love into a blog about investing.)
Love isn’t always rational—neither are markets
Markets fall in and out of love with things all the time and not always rationally (see: Life at railway speed: lessons from the technology hype cycle). My favourite example in recent past is Long Island Iced Tea Corp., a beverage company, which announced in December 2017 that it was rebranding to Long Blockchain Corp. in a radical new strategic direction to explore investments in blockchain technology. The stock jumped over 250% on the news as this was the height of Bitcoin-fervour. As Matt Levine, one of my favourite columnists at Bloomberg, sarcastically quipped at the time: presumably none of the folks who rushed to buy the stock took the time to critically evaluate the company’s blockchain strategy. Sure enough, a few months later, the company abandoned any plans to purchase Bitcoin mining equipment, the stock was delisted from the NASDAQ, the company was hit with a subpoena from the SEC, and it now trades (over-the-counter) at a fraction of its prior worth.
Just to be clear…we did not own or ever consider buying Long (Island Iced Tea) Blockchain Corp. But it illustrates how investor preferences can have a real impact on investment outcomes. And sometimes, the market’s irrational or “love-sick” nature can present us with opportunities.
We purchased Softcat in January 2017 when it traded at a forward price-to-earnings multiple of 12x. Softcat is a UK-based reseller of IT hardware and software. As a reputable, neutral third-party, Softcat advises its customers as to which software or IT product should be chosen given their customers’ needs, existing infrastructure, and budget. In our opinion, customers tend to be very sticky given Softcat’s strong reputation and the asymmetric payoffs that customers face when switching from a capable operator; after all, IT disruptions can be extremely costly.
Softcat typically earns a small margin on the software and hardware sold to customers. Just as a travel agency won’t purchase an airline ticket until their customer agrees to buy a vacation package, Softcat usually only buys a piece of hardware or software once the customer agrees to a purchase. As a result, Softcat has minimal inventory risk. All-in-all, we view this as a terrific business model and were surprised that its valuation wasn’t reflecting our assessment of its quality.
Why was that? We’ll never know for sure, but we suspect it may have been the market’s fixation on the low operating margins that Softcat reported on its income statement. The other wonderful aspects of its business model didn’t matter: the market seemed determined to equate low margins with a lower-quality business even though Softcat carries little price risk on the underlying goods sold. After all, low but steady operating margins in an asset-light business can translate into very attractive returns on capital employed.
Two years later, the company’s multiple has substantially re-rated (it now trades at 21x forward earnings) while also delivering considerable earnings growth. The stock has more than doubled since we bought it.
Implicit in the Softcat example above—and one of the more obvious manifestations of knowing your preferences—is the benefit of having a clear and well-defined investment philosophy. As readers of our blog will know, we look for three characteristics:
- Wealth-creating companies: companies that can sustainably earn a return on invested capital above their cost of capital by virtue of durable competitive advantages.
- Excellent management teams: able and honest allocators of capital with a track record of intentional and value-creating decisions for shareholders.
- A discount to intrinsic value: ensuring a margin of safety for such companies by evaluating future cash flows probabilistically under thousands of different scenarios.
Furthermore, this investment philosophy is firm-wide. Everyone speaks the same language when it comes to what we love to see in investment ideas.
I recently spent time with our global small cap team on a reverse roadshow. Essentially, as a means of efficiently conducting preliminary due-diligence on new investment ideas, the team will lock themselves in a room for a week and schedule back-to-back-to-back conference calls with 30-40 management teams. After every call, each team member assigns a preliminary score for that company across the three elements of our investment philosophy. The process is intended to act as a funnel and drive focus: companies that garner the highest scores by consensus are those that are most deserving of deeper analysis and future consideration for our portfolios.
This process only works because we speak a common language. The reverse roadshow is a highly effective means of determining whether a company’s business model, management, and valuation have the potential to meet our investment criteria. And the language of our investment philosophy provides an important framework to isolate the source of any differences of opinion among the team.
Healthily resolving differences
This last sentence is an important one. While we’re often in agreement with one another with regards to the merits of a certain business model, differences in opinion among the team are encouraged. In fact, we’ve purpose-built our team for cognitive diversity to get varied and independent viewpoints on the problems we’re trying to tackle as investors and to ensure our ideas are vetted as fully as possible.
But this cognitive diversity comes with risks, many of which are rooted in behavioural biases and the fragile nature of the human ego. Our ego’s natural languages of greed and fear are often a hindrance in the conversations we have as investors. When presented with an opinion that directly contradicts our own, our ego is hardwired to react defensively. We want to win. We want to be right.
Jim Ware of Chicago-based Focus Consulting has written extensively on the subject of culture’s role in high-performing investment teams and effective decision-making. One of Jim’s key ideas is that harnessing the benefits of cognitive diversity through respectful debate necessitates a culture of curiosity as opposed to closed-mindedness, a candid environment, and a high degree of trust. With Jim and his team’s help, we’ve found a few semantic techniques to be handy in keeping us “above the line.”
First, is a healthy dose of humility toward markets and constant reminders that investing is an inherently uncertain endeavour. Language that emphasizes probabilistic thinking at the expense of single point estimates—thereby embracing this uncertainty—typically leads to more open discussions. It’s more intellectually honest to say: “In most scenarios, I think Company ABC will be able to grow revenues between 2-5% over the next three years” vs. a sharp-edged statement such as: “Revenue growth will be 3.5%.”
Second, we use language to help reduce the potential to trigger the ego’s predisposition toward defensiveness. As Jim writes: “If team members learn how to share [their] views in a non-threatening way, they learn to hold them lightly, not needing to be right, [and] other team members tend to be better at maintaining curiosity as they listen.” What does this entail in practice? Mainly it means overtly differentiating between fact and opinion, or as Jim calls it, “story.” Instead of bluntly affirming: “Your revenue growth assumptions are wrong,” we are deliberate in pre-disclosing our opinions: “My story is that revenue growth might be lower going forward given the number of new entrants in the industry.”
Finally, there is a language we like best: facts. What hard evidence can we gather in support of our stories? Part of our investment thesis in Japanese drug store operator Kusuri No Aoki is that it should be able to earn returns greater than its cost of capital given its dominant market position within the Hokuriku region which gives it operational scale over its competitors. Indeed, management claims to have 30% market share by store count. But this claim was merely that: a story. In order to substantiate that claim, we took the time (via Google Maps and competitor websites) to count every single store that Kusuri and its competitors own in each of the regions in which Kusuri operates—an admittedly tedious exercise that ultimately yielded a measure of support for management’s claim.
Language matters. It is the primary means by which we communicate. And, as human beings, we all have our own preferred ways of sending and receiving information. A greater understanding of these preferences and where we differ can make us more effective communicators—an essential feature of high performing teams. Ignoring them increases the likelihood of bias and ego contributing to poor decision-making.
And, if nothing else—perhaps this piece may prompt you to reflect about your partner’s preferred love language ahead of Valentine’s Day—possibly helping to shape your plans for February 14th.
At least, that’s my story.