In a recent essay, Santa Fe economist Brian Arthur challenges economists to describe the world in more than algebraic terms. He believes they should extend their vocabulary (and minds) to include verbs, alongside their highly prized nouns, to allow the underlying processes, context and organic nature of complex systems to be described in full technicolour.
Arthur’s argument is well founded, and applies to the investment industry as much as any other economic realm. As it stretches to reduce all things to a model, classical economic theory uses quantifiable nouns (amounts, levels and rates) as a base language. The resulting models - inspired by the robustness of physics – ideally deliver clarity and “scientific” logic, but often at a cost. A single-minded approach to narrative effectively sieves what it cannot quantify, and in so doing, easily skips over the natural disorder of people and processes that live behind the numbers.
Unlike the universal laws that govern physics, economies are messy and complex. Humans simply do not behave in the predictable fashion of atoms and neutrons. And herein lies the limitation of a solitarily, algebraic perspective of the world, a perspective that abstracts people and their unique behaviours and motivations, and reduces them to symbolic quantities for comparison and theorisation.
Algebra and the language of nouns
The investment industry has long faced pressure to forego the mess of narrative and embrace the purity of algebra and the language of nouns. Efficient Market Hypothesis, Modern Portfolio Theory2 and the Capital Asset Pricing Formula3 are just some of the popular Newtonian laws4 of the finance classroom, while sharp-edged nuggets – Active Share, Tracking Error, Information ratio, Sharpe ratio – constitute the industry’s trusty algebra.
To complicate matters further, unlike in economics – where there is often agreement on the definition of key nouns – in our industry Risk, arguably the most important noun, has taken on a multitude of definitions. In its most dangerous form it is abstracted, quantified and expressed in relation to another algebraic symbol. Unfortunately it is rarely defined as absolute loss against absolute wealth.
There’s a case to be made that our industry prefers the simplicity of ratios for the simple reason that they travel well. Stories, on the other hand, take time and effort to translate across a throng of intermediaries. Comparatively, there is far less friction in the language of ratios, ratings and rankings: What’s the portfolio P/E? What’s the active share? What’s the tracking error? What’s the ESG score? How big is the investment team? Unfortunately, the quantified answers to these questions quietly sieve out people, their history and culture, and their motivations.
A Darwinian approach
It doesn’t travel as readily, but at Stewart Investors our philosophy has long favoured a Darwinian approach to understanding the quality of people, franchise and financials, and to debating the future.
In On the Origin of Species, Darwin took some 480 pages and roughly 120,000 words to articulate his theory of evolution. His work treated biology as a science where verbs and adjectives bring our gloriously complex world to life. Similarly, our philosophy and culture embrace the context, actions, motives and stories behind the numbers, because we believe human nuance informs long-term returns. Put another way: numbers, ratios and rankings are backward looking, but money is made, and most importantly protected, by looking forward. Successfully allocating capital into a largely unknowable future requires embracing and truly valuing the unquantifiable nouns our industry has trouble pinning down.
Quality is an emergent property. It is never static. Any attempt to reduce it to a simple ratio or statistic is, in our view, not only inappropriate, but also dangerous for one’s capital. Ratios sterilize the magic, organic, complex nature of businesses. When this approach is taken, as it so often is, our favourite topics (enduring qualities like culture, purpose and passion) are supplanted by numerators and denominators that are largely meaningless to anyone trying to understand a company’s ability to protect and grow capital over a decade or longer.
Indeed, our view is that the unquantifiable factors are what enable high-quality companies to enjoy success far beyond the time periods that traditional economic and financial theory seek to quantify.
For example, Marico, an Indian Consumer company, or CSL, an Australian healthcare company, have been held across our funds for close to two decades. With innovative and often unique long-term cultures, these businesses have nurtured world-class franchises and generated 30%5 (Marico in GBP) and 21%6 (CSL in GBP) returns a year7 while also making the world a better place, we believe by improving the health and well-being of people around the globe.
We’ve found some of the most attractive investment opportunities arise when a company changes management. In these situations, historic ratios become even more meaningless. We build our conviction by talking to people and lining their vision of the future up against comparable franchises and cultures across the globe. A small team of geographic and sector generalists is an important resource in this type of pattern recognition.
From a capital protection perspective, our clients have not been invested in many companies commonly perceived as high quality (high ROEs, no debt, smooth earnings growth) because we weren’t comfortable with supposedly unquantifiable “squishy stuff” like culture, time horizon and alignment. Many of the large Chinese internet companies fall into this category. With large addressable markets, attractive margins and sky-high returns on capital, they tick all the quantitative boxes. However, the algebra can be meaningless in an environment where the rules of the game can change overnight for companies that are misaligned with the Chinese Communist Party’s ambitions for China.
Focus on Quality
Our focus on quality and people leads us to embrace stories and narrative. Our investment reports often have sections that run for pages without mentioning many numbers. Anyone observing our investment debates would hopefully also notice how much time we spend deep in the weeds, focusing on the key determinants of quality: culture, values and behaviours.
This is also true for how we think about and incorporate ESG and sustainability into our analysis: we find it impossible to separate our consideration of these things from discussions about quality. We believe our industry’s desire to create new “quantifiable nouns” threatens to replace the living, dynamic nature of companies, and their people, with colour-coded algebra. In fact, our view is that the long list of AAA-rated ESG companies that fail to meet our quality and sustainability requirements reflects the imperative data providers have to force others to see companies through their kaleidoscope of ill-defined, templated, quality.
As with the companies we seek out, independence of thought and the ability to zig when others zag carries the cost of being different. But our view is that long-term success often comes from a willingness to be different.
We also believe, based on past experience and performance as much as anything else, that Stewart Investors’ unconventional comfort in prose over numbers – along with our preference for debating the future over quantifying the past – will continue to result in unconventional portfolios capable of delivering attractive long-term returns to our clients.
View our list of investment terms to help you understand the terminology within this document.
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