Flawed Alpha: How Inaccurate and Outdated Theory Has Misled Us

James Anderson — SKAGEN New Year's Conference, October 2024

Note: This transcript was auto-generated from YouTube closed captions and cleaned per SRF Part XVII.3. Filler words and stutters removed; wording preserved as spoken.

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Welcome back you are watching the SKAGEN New Year's conference and we are looking for the best ways to invest in 2024 so for one thing do not trust old theories they may be obsolete that could be the advice from our next speaker he is ready to go live from Stockholm where we have a live audience with us now in Valenborg Hall and also in Valenborg Hall from Skagen is Andreas Buan Andreas what can you tell us about our next speaker James Anderson well Siri it's not every day we have an investment speaker with us at the nearest conference with more than 40 years of experience here in the room James is perhaps most known for his tenure at Bailey gford where he became partner back already in 1987 while there he led the European Equity team and co-founded the long-term growth strategy and was an early investor in companies such as Amazon Tesla and tenens Cent he was also the manager of Scottish mortgage trust for 22 years more recently though he has joined the investment company shinik which is a holding of scotx as the non-executive chairman and is today the managing partner and the CIO of Innovation Investments at the investment firm lingotto so James we are thrilled to finally have you here in Stockholm so please the floor is [Applause] [Music] yours thanks Andre and thank you all for being here it's a a joy to be able to talk to you though I must confess I was quite worried Andreas when you had the clock running down there because one of my totally haunting nightmares it dates back about 20 years ago when we were doing a presentation for CPUs and they just cut you off when the clock goes dead and my colleague probably rightly didn't leave me much time so I was cut off in mids sentence I hope we won't get up to that to today but as I said it's a pleasure to be here so the topic got flaw Alpha and what can we do to try and help our clients make money in the years ahead I feel uncomfortable talking about one year independently but certainly try and talk about the underlying issues one of the authors practitioners not of investment but of many other fields that I've most admired over the last decades was that great sadly late sweet Hans rosling one of his many brilliant sayings was that you should always let the data set data set change your mindset or to put it in terms of my native Edinburgh I was glad to hear Arthur conand being quoted earlier today I'll provide you with another Sherlock Holmes ISM it is a capital mistake to theorize without data so what is the data what is the data about what performance looks like adding value looks like in stock markets we're told that can be easily read off some form of standardized normalized bell curve of a gaussian nature which enables people to do all sorts of mathematics surrounding it and to be able to calculate what risk is somehow defined as volatility which strikes me as very odd but the big question is that right do such topics as Alpha bet chart ratios all this stuff actually exist and I fear the answer is no they don't now I first I hope in a good Conan oil sense because he also said that people's minds are empty cupboards until they start to have experiences my first feeling of unease around all this was when I found that whether one liked it or not and many of my colleagues didn't like it that performance was always generated by three to five stocks nothing else mattered even losses don't really matter it's those small number of hyper winners that matter so tried to follow up this and this took me to a gentleman called Henrik bessen by at Arizona State University who I used to go and visit in the depth of Scottish winter and he is now going back to 1926 for the US markets which if you think about it's quite a good date to start at or 1990 because the data doesn't exist so well internationally for Global Market simply gone back and as a matter of fact providing you with that data that Conan Doyle or rosling would have admired said what has generated returns in markets now this is so extreme and becoming more extreme that any idea that you can think about it as a regular equation is just not true so I'll give you various forms of this hard fact since 1990 just 10 stocks have created a third of the value in the US Stock markets over t- bills since 1926 when M binder firsted his research which was up until 2016 just 90 firms had produced half the value added that number astonishingly is now down to 72 companies or if you look at it on a global basis just 1% of companies have generated all the value added since 1990 you could go on and on but what we're talking about is a situation with profound power laws rather than regularized returns now how should one think about that well I think the even more disturbing part is that there is no factual evidence that everything that the capital asset pricing model tells you is right at all because 57% of companies in America since 1927 have over their lifetime underperformed t- bills there is no systematic return to O own in equities there is thereby very little notion that there is a useful mean in terms of what you're talking about because the variability is so great now I think this knocks on into incredibly important different issues it's firstly apparent that you only gather this if you are thinking about the long term and that's one reason why I think so much of the mistakes have been made because if you analyze on a daily basis monthly datas even quarterly or annual data these relationships will not occur in the data you need to be looking over long periods of time and at best over the lifetime of companies to talk to this so I think it is the problem of short-termism really gets everywhere in what we're talking about and you know one needs to thereby I'm sorry I don't mean seem impolite to the organizers at all to say I refuse to talk about what's going to happen in 2024 these only become apparent over the course of long periods of time and as I said volatility is not a useful measure of risk in fact it's probably its polar opposite of all those 72 truly great companies in America they all have draw Downs at least once and usually much more times than that of at least 40% in their share price when you are given opportunities to get away from your mistakes of not owning them in the first place and I actually think that probably that is the most challenging part of investing it's enduring those draw Downs rather than actually spotting the companies in the first place which I'll come back to so where are we in terms of this I won't spend much time on the slides and I hope that's what I've been going through but where are we now will this pattern I'm talking about endure or will we suddenly have a lovely time when lots of stocks outperform I doubt it's partly that intellect property based companies are much more naturally exposed to Winer takes all environment the much else is out there and intellectual property companies have plainly become much more important ever since Microsoft went public in 1986 but I think it's also that we have a huge problem in our industry Market are becoming more and more inefficient not efficient more and more short-termist and totally and I think this is perhaps the worst part of all lacking in diversity so by the way when it was mentioned that I might not agree with Jonah's speech before I don't have a problem with that at all I admire anybody who is prepared to do something differently from the norm the type of stuff I hate is people trying to pay attention to quot earnings and trying to outperform by 1% perom I don't think that gets us anywhere at all but I can admire anybody from renaissance's extraordinary results trying to think about data to deep value investors I don't want everybody to think about it in the way I do I just want them to be different and brave in what they're doing I would put this in the context of we have to play different games from those that everybody else is trying to do so I'm as I said earlier from Scotland I know full well that it is completely imposible to believe that the Scottish football team would ever win the World Cup they may be bu good enough to beat Norway but you know most of us can regard that as something quite easy to do but what you can do is you could can be very good if you're trying to play a different game entirely so you know not just do not many people play them but you can also be extremely unfit if you to win a darts or a snooker world championship and these things happen so I think it's the same in investment we should always be aiming to play a different game and the game as I see it because of those pieces of data that are so obvious in terms of outcomes is the task becomes not trying to beat the market not trying to think about what you're going to do over the next 12 months but can you identify what characteristics go into making those truly great companies because as long as at any point in time I can select one or two of them and believe in them for the next 10 years you can be pretty bad at the rest of it to my mind this is growth at an unreasonable price everybody loves the idea of growth at a reasonable price it makes you feel good you should never feel good in stock markets you should always feeling terribly Exposed on what you're doing now unreasonable price is about many of these companies never make the huge great performance you hope that and they are unreasonable in the sense of you paid too much but the outcomes for those that are truly great so dominate that you can get that and I think one of the experiences that I could most want to try and convey to people is that in almost every truly great company which fortunate to be an investor what they've achieved the upside in earnings cash flow sales say share price but you know the fundamentals as well as the share price have way exceeded even your most fervent hopes at the time you bought them now I think that is something that people feel very complex in their attitude towards because it effectively forces investors to do something which is profoundly different to how they're brought up you're brought up to be an analyst but in fact to do this you need imagination and you need to acknowledge that it may well not happen you've got to coope with uncertainty in it all and J mentioned tensent in its introduction I you know I look back with amazement at what we wrote about it 20 years ago but we didn't get close to what this company became and you I could replicate that for many of the other examples so you've got to be deeply different got to be deeply imaginative why might that be becoming more difficult well I once with one of my heroes in Investment Management Bill Miller had a session with a gentleman who many of you may have come across called Charlie Ellis who used to be one of the great gurus behind the CFA and then writing articles about market efficiency and the like who believed that it was impossible to outperform because the industry had been professionalized now I absolutely agree with him in the sense that there are many more people doing it I absolutely agree with him that many of them work extremely hard and many of them are much cleverer than myself even if not bill but the problem is it's been professionalized now I come from a medical family if most doctors tell you something it's probably right if most investors tell you something it's best too late so you know I think actually this whole notion that the market has become more efficient is just wrong and directionally wrong in terms of what you're doing I I think another way of putting that would be that I fear that the numbers don't lie there are something like 220,000 members with a CFA qualification in the world now however much they pretend otherwise the CFA teaches you that all that sharp ratio is Mark of itself stuff is the truth about markets if I compare even the 80,000 people who take the CFA exam every year to awareness of the best in binder article which is now been read something like 45,000 times now that's a lot better than it was two or three years ago but I think we can see what the problem is and I think that's reflected in the way people work and here I become even more troubled because I think it's very dangerous so I'm a trustee of a couple of University Rel ated investment committees these people all say at the beginning of every meeting that it's only the long-term matters to us why would it matter what happens next quarter but they all become obsessed by just the same issues as everybody else and I have to say I am so bored of discussing what the federal reserve's policy is going to be and I just do not see this as a useful ingredient and I think this takes us into the last point I'll make at this juncture before moving on to some thoughts about the what one might do in the future I think we need to change our whole interpretation of what fund management is I think most of us were brought up in a notion that stock markets were what they were in the 19th century that we provided the capital alocation to build canals railroads and genuinely move the world forward that's not what we are these days the whole process of financialization has been about making our egos greater there's a wonderful passage in Tom Wolf bonfire of the vanities when the failing mock hero has to cond has to allow his wife to explain how he makes so much money and she says it's like baking a cake except they're not baking the cake but that each time you pass the cake ground a lot of golden crumbs flow off into your hands now I think that's absolutely right and I think we need to get back to making cakes to doing something useful that doesn't translate into disappointing returns because actually if you try and make lots of money by the sense of saying this is going to go up you won't you need to employ obliquity and if you can make yourself think about what creates great companies then you've got a chance so use an example of this which I think is the most important where we need to go in the world that we face today we should be trying to solve problems now I've had plenty of disagreements and they're not necessarily being comfortable with Mr musk but I really admired what he said to the S Bon about why he was trying to make cars he said many expletives deleted and I don't know how they sounded in French but many expletives deleted that if anybody thought he was making electric cars to find an easy way to make money they were being really stupid this is an intensely hard industry going through a major technological change but the point is that climate change is the most important problem we're facing and that is a way of addressing it I think we should always be concentrating on what we can do to help companies solve those deep underlying problems now I think that requires not just at different time frame I'm talking about that different imagination but I think it requires you to have a real understanding of exponential forces and that is the most important thing that we can do chip Miller this morning said that he thought that semiconductors were completely unique in this context yeah I think that's right because we just don't realize asml have tried to work back Moore's Law not just to when Gordon Moore wrote the article in the 6s but to when they think it first started they think it first started in 1900 now since that period of time Moors law has increased the power of semiconductors by 9 million trillion times I defy anybody not to be able to either make money out of that if they could understand that was going to happen nor do I believe that any of us in 1900 could really have imagined what was going to happen as a consequence of all this so I think you need that and what do you need to get at that sort of information well again I apologize if I offend anybody in the room but I have not talk to a stock broker apart from to arrange meetings for several decades I think inherently they suck you back into this game of guessing and prediction that I really don't believe helps you I think on the other hand you can have enormous Joy enormous advantages by changing your information set so it's about trying to talk to the greatest intellectuals the greatest academics in the world as well as the greatest managers from the Santa Fe Institute to various individuals that I name it that really has been where most of our best insights most of my best insights come about I to go back to the renewable energy and Battery Technology things there a lady called Jessica tranic at MIT who 15 years ago was predicting what was going to be able to be done without making any wild leaps of course you don't know precisely when and she wouldn't claim to know precisely when but you can have confidence in a way you can't have Pro confidence in Market predictions about what that does for you I L endo on upm Market thought about this really genuinely upbeat for all the absolute Horrors that that happen in our world and I suppose in a way it's come back to Hance rosling it is one of his other great phrases about the secret silent progress of humanity what's gone on in the semiconductor world is no longer confined to the semiconductor world that process of deep exponential change is broadening out and is becoming astonishingly important in meeting those problematic areas very briefly I would say that we have close to 100% of the technological means to stop climate change it's a matter of putting them to PR nowy even more excitingly H the healthc care industry has for a long period of time been the opposite of Moors law some people say it's Iron's law but there's real chance that if you combine genomics Big Data with effectively AI enabling us to understand human biology that the industry may be transformed over the coming years and many of these companies completely unlike the Magnificent C have been very much out of favor so I any risk that I was 40 years younger rather than having 40 years experience because I think the opportunity is if you think about investing in an independent way for the long term with these deep forces in your favor could be enormously exciting do I promise that will translate into returns in 2024 no I don't but I don't really see why that ultimately matters what we should be trying to do is build great companies that Advance the world and in the long run provide magnificent well beyond Market expectation types levels of performance but you can't guarantee it every year so hope but long-termism is where I'd like to leave it thank you thank you James don't want to sound like your teacher here but thank you for a very solid presentation so we are now starting the Q&A session and like I said earlier today for all of you here in the Valenborg hall you just raise your hand and you can then pick up your microphone that's next to your seat press the button when it turns red you may speak but I'll just start with the with one question James building on the contention that markets are becoming more inefficient and short-termist it should actually suggest that it could be getting easier than to generate Alpha and excess returns so why do you think that so few stock Pickers actually do outperform consistently and what should you as an asset owner look for when choosing an active manager so firstly if you'll allow me I will take out the word consistent because I think that's dangerous because you know I do not believe that you can add real value if you are preoccupied with trying to beat the index on a quarterly basis or whatever but I really not meaning to get away from the big part of the question and she said I don't think it is surprising that most people don't because I think most people are following as I was trying to indicate those professional instructions that you get and that you know more and more academic research would tell you that people are so intensely sociable that they do not want to go out of the norm and once there is an accepted way of thinking about anything then I think that you get that danger that people will be playing the same games and playing them badly I would say this feeds through in company terms as well all just about all those 72 companies I talking about earlier in fact 71 of them the sole exception being IBM was doing something at the start that was deeply controversial here remember with Amazon what was thought it to be doing and I think you therefore should as asset allocators employers of managers be trying to find people who show the ability to think completely for themselves and that you know you can tell whether it's actually makes sense or not and they need to go about doing that in practice as well as in their words thank you very interesting do you have any questions from the room if you just raise your hand and ask a question typically Sweden huh so over then to another question as a very long-term investor what actually tests your patients and are there any triggers or behaviors in companies that are for you an automatic cell signal I so I think ultimately and I think this is really important that the whole notion of what companies need to be aspiring to if this data is correct as I see no reason not to think about it needs to become much more demanding much more radical in terms of what's doing so what I've always tried to do on that score and you know we can talk about millions of other different examples but the companies have to keep wanting to be ambitious in what they're doing and to try and be amb to grow all the data tells you that these companies need to be growing at somewhere bottom 20% more often 30% plus per anom for the next 10 years to be the top cohorts of outcomes so I shall now give an example of my sheer stupidity in putting this into practice I sold Apple six or seven years ago because I thought they had become conservative now that analysis was totally corre correct Tim Cook actually hates Innovation it's not you know the notion that it's anything like Steve's company is a very strange one but what they' built was just so huge that they didn't actually need to do anything other than milk it so you know I would absolutely keep to that view that you need to keep having companies carry on being outrageous but it hasn't always worked so how much of a role do you think then valuation actually plays you mentioned apple and that you sold the stock six seven years ago and can any multiple be justified if you think that you've actually found an outlier I I think that's absolutely right but you know I often I got I used to get quite annoyed I think I've got over it now when people said you don't care about valuation cuz I think I absolutely do care about valuation but there are two parts of that you need to factor in valuation as we all ultimately know is the long-term free cash flows of a company it is not the PE next year that tells you nothing about the value of a company and equally in thinking about those long-term free cash flows you need to acknowledge profound doubt you know I used to get my colleague Tom St used to get about 10 documents from hedge funds every month saying this is what our value of Tesla is and this is why you're stupid to own it and they all provided you with a set figure at the end of it now we don't know so you know I always thought in value you would try and get those longterm free Clash flows but I always have and still do this usually about five different scenarios and assigning some sort of loose probability around those to what matters because I don't think I know that much about what's going on so I think we need to have humility about this but valuation absolutely matters but it's about those long-term free cash flows did I see someone here in the room yeah please just use the mic thank you index investing have been very over the last decade that has obviously created good returns because you get inherent Alpha through the Magnificent Seven yeah do you think the train that this trend will change going back to more actively managed U portfolio strategies so it might be worth saying context of this my largest client at Bailey Gord and people who I was deeply fond of were Vanguard and we had this conversation often with them and go through the best and bind data and we got him to go and talk to them Etc there are two possible ways to go one is to try and be very explicit in saying you can have an edge in selecting these companies because other people aren't trying to play that game the other and Vanguard were very comforted by this was to go down the route you're suggesting that you will get exposure to it now I don't think they would be offended if I said that there is one complication this and a complication that until the last couple of years was a very serious problem for index providers which is companies were going public much later on and what do you do when a Facebook a bite dance or a Space X isn't going public until they're worth more than 100 billion because you can't necessarily within those structures get exposure to it's very difficult from a cost point of view quite apart from anything else so you know I absolutely think that philosophically that is one answer one of the two potential answers but it has its complications we had an interesting talk during Lun here regarding countries and their ability to innovate we compare Norway and Sweden and the UK what conditions and structures do you think need to be in place to help support innovators and what are the barriers that you see yeah you I I you know I think I'm glad you asking just I think this is you know one of the serious problems that we face and I would argue that actually the more prominent financial markets are in any City the more difficult it's to do this I think the most of it though is about regions rather than countries you know people used to say I had lots of money invested America well no not really he used to have lots of money invested in a 100 Mile Stretch of the western states of America which was profoundly different in its notion of capitalism but I think there is something here I mean if people talk you know you read Talib and people like this about power law type returns and non-an returns they will say that one of the Prime characteristics is interdependence and I think that's true of businesses too I think you need this whole ecosystem and this sense of tradition of following up something that you do there to be very strong and you know I often think that Silicon Valley there so many stories about individuals and the like but I actually think it's much more like one giant Japanese ketu or South Korean chor in that really these people all cooperate with each other at most levels and the skill sets are all there and I think you need to do that I think by the way there is something to me intensely admirable about Sweden from that point of view and as you probably guess I don't normally say things that are tactful but I really mean this how despite all the pressures the entrepreneurial tradition in this country survives and flourishes still strikes me as truly remarkable and deeply unusual in the European context Siri are you with us from Oslo with a couple of questions perhaps from the audience on the platform absolutely and questions are coming in and I'd like to ring in one here about playing a different game is chinik playing a different game when it comes to investment and if chinik is doing that what is the goal oh I I think firstly it plainly is because the results over various different time periods but certainly including last year would not be so different in the market if you were playing the the same game no I I think the type of philosophy that I'm talking about here is not the course of me but is absolutely right it is saying that if you can back truly great entrepreneurs trying to adjust serious problems then you will over the course of time I have a real chance of making great returns I you know I fear the word goal is in a sense one of the unusual phrases that throws up one of the usual phrases sorry that throws up that we can't get out of our mind football when we're talking about this I used to have lots of talks in America about the difference between cricket and baseball the main one being that in cricket you don't have to run when you hit the ball and I think in a certain extent that that is true of shinovi though I never tried this comparison on the on the management who I suspect might not know that much about Cricket I think what you're trying to do is say you can over the course of time have a dedication to a small number of companies that have the opportunity to enable you not just to want to run in cricket terms but also to take up Jeff basis' analogy that in baseball he always used to complain when people talk in baseball terms as they do so often in America if you succeeded you hit a grand slam that was only four runs baseball that's a constraint in business it's not in business you can make hundreds thousand times your money and I think that is what we are aiming to do over the course of time in shinc of course you know I'm deeply aware of the complications of the time and you know acknowledgement of mistakes that have been made but that is the objective thank you let's have a second question from the audience we have a vast digital audience today and we're getting questions from them as well and once says you said you have not talked to a broker in many years how would you apply that approach for private investors without a huge Network and access to the industry experts well I think it may go back to the prior question about what you know for whom is it right to be trying to hit these home runs or exaggerating who is it better to be cheap cheaply fed an index t product and I think in many cases it is better for people to do that I you know I don't expect private investors to have the same obsessions that I or other investors I adire as they've got better jobs more important jobs to be doing and hence I actually think it is very hard but as a as a retail investor you do have one mark one advantage in that you can set your own time frames and you can set your own targets you don't need to face the pressure that I'm sure you and your colleagues feel of justifying how performance has been over 3 or 12 months and I think that you know the best way to think about what you can do well as a private investor is to think about you know what's important to you and over what period of time are you looking to attain it and we have can have one last question Andreas there from our digital audience it's about timing and how do you know when it is right to actually engage and invest I think that is incredibly hard to do as a market timing issue but I think the other timing angle important I've increasingly noticed that you should not invest before any broadly defined area say synthetic biology gets to 1% of its potential and you shouldn't invest in individual companies exclusively until you get to 5% market shares I think you learn more at those moments so those are driven not by the Market's mood the Market's pricing of it but how they are in genuine business terms you know again go back to the Amazon example when internet retailing in America first became a big issue I owned both eBay and Amazon because I didn't think at that time we got to the 1% but we hadn't got to the 5% I didn't think you could tell who was going to be the winner now in retrospect that seems really stupid because there was no you know no comparison between them and I was only finally confirmed in this view when talking to the then boss of E who said who got up and said I'm no Jeff Bezos and I thought yeah you are no Jeff Bezos and that matters a lot within this so I think there has to be about your own disciplines as an investor rather than what the Market's imposing on thank you so much James for being with us and giving us your experience here many thanks on behalf of the viewers that have put the questions up for you and many thanks also to Andreas from Stockholm thank you thank you yeah