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Investors must avoid the "Holy Trinity of Error-Driven Biases"

Nicholas Earl, 13/02/2020

Investors need to focus more on the long-term history of businesses and consumer demand, rather than worry about erratic chief executive officers (CEOs) and expensive valuations, according to Jeremy Lang, co-founder of Ardevora Asset Management (Ardevora).

In a presentation highlighting investment biases at the Nedgroup Investments Conference in the London Stock Exchange, Mr Lang argued that businesses with extensive track records and continuous consumers appetite are more likely to provide investors with desirable returns, even if they are seemingly over-priced relative to their competitors.

The age of Hermes 

Commenting on the strategies of its own funds, he highlighted its selection of Hermes, a stock Ardevora has invested in off-and-on for the past decade that specialises in luxury fashion accessories such as handbags. Pointing to the age of the Paris-based company, which was founded in 1837, he believed it had an established culture and method of business that made it immune from potential scare factors such as risky CEOs.

Mr Lang explained: “If your business survives for a really long time doing what it does really well, it can create an environment where the CEOs that run them are viewed more as custodians of the business, rather than as vehicles for their own ego to demonstrate how wonderful they are. This is especially the case if they have established a pattern of running themselves that has worked for a very long time.”

In his view, it was important that investors did not exaggerate the importance of CEOs to the direction of the business. Although CEOs were prone to suffer from overconfidence, a bias that could lead to poor business decisions, this could be contained in a business with a settled modus operandi and a maintained demand from consumers for its products.

He said: “A lot of investors, for the wrong sorts of reasons, feel like Hermes is risky. From our point of view, whether you have a risky CEO who tries to blow up the business, it is still really low risk.”

Elaborating on this position, he added: “As long as there is a demand for high-status fashion, married with a careful control of supply, it is basically pretty difficult for a CEO to screw up.”

Ardevora’s co-founder also noted that the quality of Hermes’ products and its historical reputation meant that the demand for its products would remain, despite periods of uncertainty and instability in the market.

He said: “Even if there are unpredictable things that can be thrown at that business – from temporary drops of demand due to the weather or the eruption of some kind of unpredictable virus – in the end it doesn’t really make much difference because it simply delays rather than removes the demand for what they do.”

The Holy Trinity of Error-Driving Biases

Mr Lang outlined his position while establishing what he perceived as the “Holy Trinity of Error-Driving Biases”. Alongside overconfidence, he noted the negative effects of both anchoring and confirmation.

An example of anchoring that negatively affected investment decisions was how people worried about the cost of Hermes to invest in rather than the fundamentals of its business, which were unusual in the market and made it an attractive outlier.

Mr Lang said: “This is a form of anchoring, because they worry about what would happen if Hermes did not look like what it does now. They worry about if it didn’t look unusual, and looked more like other retails or purveyors and other brands that people also find desirable. These other businesses often sell on lower valuations. So, they fret about what could happen if Hermes did not look like what it does now, and what that would do to the valuation.”

The three biases selected by Mr Lang not only resulted in both investors and asset managers making mistakes, but in them failing to learn from their slip-ups as well.

He said: “The problem with mistakes due to bias, is that they are very difficult to learn from and do something about them. This is why we should care about bias, as bias can lead to bad judgements. Often, these are the types of judgements that are not easy to learn from and fancy qualifications and lots of information are no defence.”

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