William Pattisson is the co-founder of Ardevora Asset Management, a boutique asset management company in London that has adopted behavioural science and embedded it in the way they invest. They look to leverage the errors of judgement made by global equity market players, such as CEOs, investment analysts and investors. In a Q&A session, Rob Johnson, head of investments at Nedgroup Investments, explores their unique investment model.
The origins of the Ardevora investment process
William Pattison and Jeremy Lang joined James Capel Fund Managers on the same day in 1986. Their boss had an academic background and followed an investment process, which was unusual in those days where investing was more about networking and who you knew as opposed to what you knew. The process was a value, growth at a reasonable price type of process. An integral part of the process was having the discipline to focus on certain types of stocks with certain characteristics. A distillation of the value side would be trying to buy other people’s anxieties, which was based on some of the academic work that was coming out of the USA. The pair had a lot of freedom to try out what they were learning with the power of making mistakes invaluable in becoming a good fund manager. But, the process did not work all the time and they became increasingly interested in the role of how changing expectations affect human behaviour and what it means for share prices. Thirty five years later they still work together having founded Ardevora in 2010.
Why CEOs are distrusted
Pattison and Lang ran a mixture of funds over a period of ten years, which intellectually were rooted in pure value style and pure growth style. While the funds did well, they were quite volatile and they wanted to understand the volatility in more depth and detail. They concluded that they were not understanding risk deeply enough in the context of how a firm is managed and specifically the actions and behaviour of CEOs. They eventually concluded that the CEOs of companies had a major flaw in their behaviour in that they were prone to taking too much risk. The kind of person who becomes in charge of a large, publically quoted vehicle is usually aggressive and very self-confident, which means they’re not that interested in other people’s opinions and don’t want to be told they’re wrong. These characteristics don’t necessarily make for a good CEO. CEOs should be listening to people and be more realistic about balancing risks and accepting of the likelihood of being wrong and as a result the need to change. Their opinion was that CEOs were hard wired to take too much risk and therefore their default setting was that all companies were basically risky because of the growth plans that CEOs were pursuing. There’s also an added problem in that CEOs are encouraged with their risk-taking activities by the world they live in. Remuneration tends to be structured around short-term payoffs and there is a de facto deal with shareholders who want CEOs to grow the business, so there is a license to go for growth. The three characteristics of remuneration, shareholder attitude and a natural tendency to take too much risk usually results in the business taking too much risk. The investment process starts by looking at the behaviour of CEOs and takes the view that all companies will take too much risk if they can get away with it. They therefore look for the conditions that force a company not to take too much risk. They are very strict on themselves by considering risk in all companies first before they consider reward. If a company looks too risky, they won’t even consider reward. They also look at the behaviour of analysts and investors to work out if there is a reward that is acceptable in the context of their portfolios.
The conditions for investment
Their approach is not to meet with management or the CEO who can be very persuasive and are good at selling their own story. There are two conditions that are interesting in terms of identifying growth stocks. The first is when conditions are relatively benign for a company and they can grow without taking too much risk. The second is where companies have a long runway to growth where analysts underestimate how unusual a company night be and how long that growth may last for. These are the perfect conditions for analysts to be caught out for a long time. This means that earnings forecasts tend to go up a lot more than expected over a meaningful period of time and this is a very powerful cocktail for the share price over the long term. They look for good businesses, which are being sensibly managed because the conditions allow management not to take too much risk and where there is a long runway for growth because the business is genuinely unusual. There are not a lot of businesses like that out there – it is difficult to be unusual.
Recovering value looks at the behaviour of investors and whether they are brave enough to buy other people’s anxiety. People get upset and over excited and if there’s a lot of bad news over a short period of time, they get very upset. Covid was a perfect example in terms of the angst and chaos it caused and provided the conditions for a lot of deep trauma in markets and stocks around the world. People extrapolated short-term trauma, which resulted in the collapse of share prices, especially in companies where the trauma was felt more deeply, e.g. travel, leisure, etc. As investors, we need to assess whether the trauma is long-term or not and what it means for the companies concerned. However, in the depths of a traumatic event, it’s very difficult to see a way out of it and for investors to gauge where the balance of risk and reward is. Ardevora is attracted to companies that have seen significant trauma in terms of their share price collapsing and other people’s anxiety. They will then see if that company is still a good business and whether management realise that they are in a difficult situation and need to do something to get out of it. The trauma of the last year has provided a smokescreen for a lot of companies to solve the problems they have and to blame it on the environment and not their own incompetence.
How Ardevora avoids bias
To survive as a fund manager and do a good job, you need to accept your own limitations. They have a process that tries to exploit the behaviour of other people and tries to understand why smart people make bad decision under certain circumstances. Their framework tries to minimise the damage caused if they do make mistakes. They look at risk before reward, an important part of controlling the overall risk within a portfolio. They do not take macro positions around geographical regions and try to make sure there are no macro calls within the portfolio. They are very focused on stocks and have a lot of stocks. One of the ways to limit the damage when they get things wrong is to have a small stock position. Smaller weightings in a portfolio means that when you make a mistake it is emotionally easier to deal with. They have a rigorous quarterly cycle. If a company does not still fit its original investment case, they will sell it. They have a stock loss in place, which tells them when a stock starts underperforming by more than a certain amount relative to the local equity index, at which point they will sell it. They typically have about 200 positions in the portfolio, which are all equally weighted.