May 2023 - No-one really wants to be known as ‘Poodles’
I’m guessing most readers have heard about behavioural biases that can create mispricing in in the share market. Academics Tversky and Kahneman arguably pioneered this topic when they published a paper in 1974 called “Judgement Under Uncertainty: Heuristics and Biases”. They looked to formalise the way we make everyday decisions as we attempt to lead our lives in an unpredictable and imperfect world, you could think of them as “rules of thumb”. While these rules make decision making quick and easy, they can lead to occasional mistakes because every situation is unique and sometimes the quick and easy decision isn’t the right call.
One lesson I’ve learnt in the past three decades is that people will sell companies even though they know its worth a lot more than the price they are selling it at. This is not rational behaviour and should not happen. But it sometimes does, and it’s a phenomenon that creates opportunities for value investors.
I’m going to go on a slight tangent to illustrate this point. 35 years ago, I learnt that people, even very serious people, can make surprising and apparently irrational decisions. When I was a teenager back in Edinburgh, my family had a very large, powerful, and striking jet-black standard poodle called Dixie. She was an absolute darling except for when it came to people in uniform.
Photo of a lethal Standard Poodle
The root of this issue was our postman. He would open our garden gate, walk up the path, pass in front of the lounge window and deliver the mail through the letter box in our front door and then retrace his steps, in his postman uniform. Dixie felt that this mid-morning, Monday to Friday postman visit was an act of invasion that merited some serious barking. Dixie was never free in our front garden, so the barking took place from inside the lounge and reached its most indignant and vocal phase as the postman walked past that window. This regular, mid-morning ritual got worse over time, and venetian blinds didn’t help either, as they ended up being ripped to shreds by a furious Dixie. We got a clue as to why the situation had got so bad…on a couple of occasions we saw the postman standing at the window, smiling as the venetian blinds were being ripped apart. From these experiences, we noticed that Dixie developed a dislike of any men in uniforms.
One day my dad was on leave and so happened to be at home on a Friday morning. Normally he missed the postman versus Dixie showdown. As mid-morning rolled around, he decided to take Dixie for a walk, so he put a lead on her and went out the front door just as the postman opened our garden gate. Dixie flew for him, snapping the lead in two. She teared down the path and before the postman could take evasive action, Dixie bit his hand. Blood was drawn.
The fallout was, as part of the postman’s “bite money” insurance claim, the police had to be notified of the incident. As a result, one evening two policemen came to visit us. It was a quick chat. Yes, Dixie had bitten the postman. No, we won’t let it happen again. They didn’t even want to see Dixie. However, as they were leaving my dad thought it would be a good idea to show the policemen what a docile dog we had. This was not a wise move. As soon as Dixie saw two large men in uniform in the house, the red mist descended. And before anyone could move, Dixie bit the hand of one of the policemen. Again, blood was drawn.
I tell this story because of what happened next. The policeman looked down and saw that the bite had drawn blood. He quickly put his hand in his pocket, said good night. Then they both departed and were never seen or heard of again. This surprised us; we thought Dixie had gone a bite too far and serious consequences would ensue.
However, in retrospect I think I know why the policeman quickly decided that he wouldn’t be pursuing any “bite money” insurance claim. If he had claimed, then all his colleagues would have found out that he had been mauled by a poodle. And he would probably have been saddled with the nickname “Poodles” for the rest of his career. Instead, he quickly decided to pretend the bite had never happened and go on his way.
Dixie biting a policeman and value investing seem an unlikely equivalent. But I see a strong parallel. Just as that policemen did not want to be known as “Poodles”; most institutional investors do not like to have “dogs” in their portfolio. So even though they know that a disappointing investment is now trading well below its intrinsic value, they will often sell out. This on the face of it is not rational investing, selling low does not help you beat the market.
Often though, an institutional investor can easily rationalise selling low. It’s become a small part of their portfolio due to its price dropping a long way, so why not just get rid of it. It’s a reminder of a mistake every time they review their portfolio, so why not get rid of it. The next series of client and consultant reviews will likely have more time spent talking about it if it’s still in the portfolio, so why not get rid of it. You can see the myriad of pressures that lead to the otherwise irrational act of selling a company at a price the institutional investor knows is too cheap.
In fact, storied investment firm Schroders launched a Recovery Fund as a direct result of these pressures that affect institutional investors. The Recovery Fund essentially owned “dogs” that they hoped would recover in value. The other portfolio managers at Schroders could use the Recovery Fund to tidy up their own portfolios. They could exchange their “dogs” for units of the Recovery Fund. This allowed them to still have some upside if the “dogs” recovered without having to have them as distinct holdings in their own portfolios. In 1970 Schroders launched it as a public fund as it had become one of their best performing strategies.
Value investors know that they will experience episodes of underperformance and equally know that clients and consultants may criticise them for owning a bunch of “dogs”. They also know that buying companies that have been over sold on bad news, in the long run, generally results in beating the market. Even though they run the risk of being called “Poodles” every now and again.
Judgment under Uncertainty: Heuristics and Biases | Science