Intelligent Investing

A Guide to the Practical and Behavioural Aspects of Investment Strategy

Guy Fraser-Sampson

• Publisher: Palgrave Macmillan
• Year: 2013
• Print ISBN: 9781137264084
• eBook ISBN: 9781137264091
• Topic: Business
• Subtopic: Accounting
• Index: Business

Intelligent Investing is first ever practical guide for investors on how to initiate and conduct a strategic planning exercise. Guy Fraser-Sampson explains the concepts and behavioural factors likely to be encountered, and shows how a clear understanding of an investor's strategic positioning flows naturally into good asset allocation practice.

1

What Is Strategy?

This is a book about investment strategy (the title being a bit of a giveaway). It will set out the way in which investors of all types and sizes can work towards identifying and implementing the approach to investment that is most likely to achieve their objectives. As will be seen, this process is infinitely more complex than might at first be thought.

The good news, however, is that it is complex rather than complicated. There is no individual part of the process that is inherently difficult in itself. However, the number of different issues which must be considered, not just individually but also in terms of how they affect and interact with all the others, does present a very real challenge.

That challenge is made all the more daunting by two aspects of the way in which we think. First, we have no experience of thinking strategically during our normal working lives, which are taken up with operational decisions relevant to our day-to-day responsibilities. Second, when we learn about finance and investment they are invariably presented to us as a science, most likely some form of mathematics, and thus we tend to approach investment matters by trying to apply the sort of rigorously objective and quantitative approach demanded by science in order to find the ‘one right answer’. Asset allocation models, commonly called ‘Optimisers’ are good examples of this. As we shall see, however, the strategic process requires a completely different mind-set. Quantitative techniques, for example, are a necessary part of the process, but only a part, and they only take us so far.

More fundamentally, the process is often undone by people not actually understanding just what ‘strategy’ is, which at best leads to them skipping an entire (and vital) stage of analysis, and at worst renders the whole exercise largely meaningless. This, then, must be our starting point.

In part, the confusion arises because the terms ‘strategy’ and ‘tactics’ are often, rather sloppily, used interchangeably in everyday speech when in fact they have quite different meanings and applications. This difference is well appreciated in the field of military affairs, within which much work on strategy has been published, and so perhaps we may begin our discussion of strategy by distinguishing between the three different levels at which thinking and planning should take place: strategic, tactical and operational. We might illustrate this by using as an example the Second Battle of El Alamein in 1942.

The situation at this time was that the German and Italian forces, under German Field Marshal Erwin Rommel, had fought their way to the boundaries of Egypt in a series of brilliant manoeuvres, aided and abetted by some very indifferent generalship on the part of the Allied forces. Recognising these shortcomings almost too late, the Allied Commander-in-Chief, Sir Claude Auchinleck, had dismissed his army commander and taken personal control of proceedings. Snatching victory from the jaws of defeat, he halted Rommel at the First Battle of El Alamein. Most commentators now recognise that this marked the turning point of the desert war. Rommel was left too weakened to dislodge the Allies from their defensive positions, and could not bypass them without being struck in the rear and flank if he did so; Auchinleck had in fact already attempted to do this as the battle drew to a close, but had been let down by his subordinate commanders, who had developed the habit under his predecessor of treating orders as voluntary guidelines.

Auchinleck none the less realised that Rommel’s stubborn persistence would not let him admit that the game was now over without at least one more roll of the dice, and so he prepared to fight another defensive battle along the ridges protecting his position to the south. However, at this juncture, Auchinleck was abruptly sacked by Prime Minister Winston Churchill for political reasons. He was replaced as Commander-in-Chief by Field Marshal Harold Alexander, and as army commander by Lieutenant-General William Gott, yet another highly questionable decision by Churchill, since Gott as a corps commander had been one of the prime offenders during recent months when it came to disregarding orders. However, Gott was killed in a plane crash while flying to take up his command, and so it was Bernard Montgomery, the future Field Marshal, who was to fight what became known as the Battle of Alam el Halfa, using Auchinleck’s plan and his dispositions, as Rommel made his final forlorn attempt to break through. Finally recognising defeat, Rommel settled into prepared defensive positions opposite the allies at El Alamein before departing for medical treatment in Germany. Thus the initiative had shifted decisively to the Allies, especially as they were supplied with substantial reinforcements, including two entire armoured divisions, and hence enjoyed a considerable numerical advantage.

Let us first examine the strategic issues that now faced Alexander and Montgomery. Strategy relates to the big picture. Because it is the starting point, it is vital that we begin at the very top of the pyramid of issues and decisions. We must identify those things that are fundamental, that operate upon other things, but which are not themselves operated on by anything but themselves. In military terms this translates into ‘How can we best win the war?’.

It is in fact very rare for generals to have to address truly strategic issues in a battlefield context. Such decisions are usually taken by ministers and defence chiefs in solemn conference some time previously, and at a distance. That is what makes the Second Battle of El Alamein so interesting, and such a useful example.

You see, what Alexander and Montgomery knew was that Winston Churchill and the US President Franklin D. Roosevelt had agreed to launch Operation Torch, the invasion of North Africa from the west, and that these attacks would be taking place a few weeks hence. When they did, the Axis forces opposite El Alamein would be forced into a lengthy and hasty retreat as they scrambled to link up with their counterparts in the west before the Allied forces could get between them and cut their supply lines. Thus, in addressing the strategic question of ‘How can we best win the war?’ they had a very fundamental decision to make: should they actually fight the battle at all? Would launching an attack contribute anything significant to winning the war, or would it be more sensible to hold all their mobile forces, and particularly their tanks, ready to pursue the enemy as it withdrew, and, it was hoped, to destroy its forces (or at the very least inflict significant losses and dislocation) as they did so?

With the benefit of hindsight it is easy to see that Alexander and Montgomery made the wrong decision. The Allies were to suffer more than 13,000 casualties, would at various times come close to losing (or at least failing to win) the battle despite their overwhelming superiority, and even after it was over, timid generalship by Montgomery would allow the Axis forces, once again under the command of Rommel, recalled from his sickbed, to slip away to the west after all, albeit being only a shadow of their former selves.

This is a classic example of emotion and politics being allowed to interfere with the rational process, something which, alas, happens in business and finance all the time. Montgomery wanted his battle to prove his credentials as a general, and prove he was superior to Auchinleck (though, ironically, if anything it did the opposite, though this was not recognised at the time). There is also a sense that the British realised, from Torch onwards, that they would be the junior partners in the alliance, and that this represented the last chance for a ‘British’ (in fact largely Indian, Australian, New Zealand and South African) army to show that it could inflict a decisive defeat on the German forces. Again, ironically, it would prove to be a technical victory but a moral defeat; with their superiority in men and equipment, and enjoying total control of the air, the ‘British’ should have won easily, and on schedule.

This, then, is the strategic level. As we shall see, it is driven by big, fundamental questions such as ‘Who are we?’ and ‘What are we trying to achieve?’

One level down from this come tactical considerations, which might be characterised by the question: ‘How do we win this battle?’. Viewed in this way, the difference between strategy and tactics, and the danger of confusing the two, will, it is to be hoped, be obvious. Yet it is a common confusion; in my experience most investors largely ignore the strategic level and go straight to tactics. Because of this they are, of course, holding their discussions in a vacuum. Tactics are supposed to be the means of implementing a discussed and agreed strategy. On their own, they are largely irrelevant; they are a means, not an end.

The management writer, Peter Drucker,¹ summed this up perfectly when he pointed out that it is far more important to do the right thing (even if done imperfectly) than to do things in the right way. Doing the wrong thing well and energetically can be disastrous. Drucker reinforced the distinction by urging us to think about strategy as ‘effectiveness’, and tactics as ‘efficiency’. Strategy is about choosing the optimum (most effective) course of action. Tactics is about how well (efficiently) we execute it.

At the Second Battle of El Alamein, Montgomery had a choice between making a broad flanking manoeuvre out into the desert to try to avoid the Axis fixed defences and to find a way round them to the south, or to attack them frontally. He chose the latter, partly because his temperament required him to fight a tightly controlled battle, but perhaps partly because he was unfamiliar, and thus uncomfortable, with the wide expanses of the desert after his experience of the relatively confined battlefields of Northern Europe, and partly because he lacked confidence (with some justification, given their recent history) in his subordinate commanders to follow orders.

His tactics chosen, he then had to decide how best to implement these on the ground, at the level of the individual unit. This is what is called the operational level, and these decisions are often left to subordinate commanders, but Montgomery wanted to control every aspect of the battle, and therefore laid down very carefully what was to happen, even briefing individual battalion commanders personally.

In this case, the Axis defences were protected by deep minefields, which were in turn covered by anti-tank guns. Montgomery therefore directed that the infantry (since there were not nearly enough engineers to do the job on their own) should clear narrow lanes through the minefields for the tanks to use. This was done by the simple, though highly dangerous, expedient of walking slowly ahead (while being shot at), and poking the ground with a bayonet. The fact that troops in Afghanistan had to resort to an identical procedure some 70 years later is a sad comment on the ongoing failure of the British army to supply its men with the right tools for the job.²

So there we have the three levels of decision-making: strategic, tactical and operational. Clearly, they are listed in declining order of importance. Getting your infantry platoon moving ahead smartly will not be much use if you are advancing towards the strongest, rather than the weakest, part of the enemy line. Similarly, even if your battle plan is a model of intellectual rigour, it will not help you if, while you are busy winning this battle, a different enemy force is cutting off your communications and supplies. Nor if your leaders are ordering large parts of your forces off to different theatres of war (as happened with some of Montgomery’s predecessors), so that you will be unable to follow up your victory even if you achieve it.

The levels of decision-making are also stated in declining order of their easiness to change. If your platoon is pinned down by an enemy machine gun, it is a relatively simple matter to send half a dozen men off to outflank it while the rest provide covering fire. If you decide that a whole division is attacking in the wrong place, it can take several days (as it did at El Alamein) to move it and all its support echelons from one location to another. Trying to change your strategy in midstream (as the British and French did when they dithered over invading Norway in 1940) leads to whole shiploads of troops and supplies being, loaded, unloaded, reloaded and re-routed. Ensuing disaster, as in that case, is usually both predictable and inevitable. As another management guru, Michael Porter,³ said: ‘strategy must have continuity; it can’t be constantly reinvented’.

It follows, then, that strategic decisions have far more impact than tactical ones on resulting events, even though they may seem to be more remote from the decision. There is research that purports to show this. A 1991 study,⁴ following from an earlier one undertaken in 1986, found that asset allocation (strategic) decisions accounted for over 90 per cent of investor outperformance when compared with manager selection (tactical) decisions. Note the word ‘purports’. This study has been rightly criticised for ignoring the effect of management fees. It is also only fair to point out that the asset types considered were a fairly narrow selection, as was customary at the time. Its methodology in calculating returns has also been queried.⁵

However, while the extent to which the outcomes of strategic decisions outweigh those of tactical decisions may be open to question, the general principle is not. A peer-reviewed academic paper published in 2000,⁶ which looked at mutual funds rather than pension funds (as the 1991 one had done), broadly supports this, while refining the questions asked. It finds that effectively 100% of an individual fund’s outperformance may be ascribed to strategic asset allocation (using what the study calls ‘the policy return’). However, when it comes to comparing any one fund with any other as an external observer, such as a financial analyst seeking to choose between them, asset allocation explained about 40per cent of the variation in returns. Whatever the case, it seems clear that, for investors, it is asking the right strategic questions, and answering them correctly, that will account for most, if not all, investment outperformance.

All of which strongly suggests that any investment decision-making body, such as the investment committee or board of trustees of a pension fund, should spend at least 90 per cent of their time discussing strategic issues (choosing the right asset types) rather than tactical issues (choosing the right managers). After all, if you have chosen the wrong asset type in the first place, then what difference does it make if you happen to choose one or two managers who may outperform against their peers within that mistakenly chosen asset class? Drucker says that doing the wrong thing very efficiently is frequently worse than doing nothing at all – and academic studies support him. They show that choosing the right asset types may account for almost all of outperformance, whereas choosing the right managers (particularly within the wrong asset type) may account for almost none.

Yet any one who has attended the meetings of such a body will know that in fact the opposite is true. Whole meetings can pass without a single strategic issue being raised, with the attendees proceeding robotically through a fixed and packed agenda, quizzing managers on past performance, and asking consultants for ever more complicated analyses of it, all incidentally based on the fundamental and unquestioned assumption that the future will simply be a repeat showing of the past for those who were unlucky enough to miss out on it the first time round.

For those who glimpse the true significance of the bigger picture, such meetings are at best tedious, and at worst futile and frustrating. Yes, choosing the right managers can make an enormous difference in some areas, such as private equity, but only if you have first chosen the right asset types, and made sensible allocations to each. These asset allocation decisions can only properly be the output of the strategic process, and the fact that so many investors get them wrong is usually because they have never attempt...

Table of contents

• Cover
• Title
• 1  What Is Strategy?
• 2  Emotional Issues and Their Effects
• 3  Conducting the Process
• 4  What Sorts of Investor Are We? Different Perspectives on Liquidity and Volatility
• 5  SWOT Analysis for Investors
• 6  What Are We Trying to Achieve?
• 7  Asset Allocation: Theory and Practice
• 8  Asset Allocation in Practice
• 9  How to Access Asset Types: Selecting Passive and Active Managers
• 10  New Developments: Trend and Risk-Factor Investing
• 11  Ten Do and Dont Guidelines
• 12  Concluding Thoughts: Where Are We Going?
• Index