July 19th, 2013

The Tortoise, the Hare and Decision Bias

“A cognitive bias is the human tendency to make systematic decisions in certain circumstances based on cognitive factors rather than evidence. Bias arises from various processes that are sometimes difficult to distinguish. These processes include information-processing shortcuts, motivational factors, and social influence. Such biases can result from information-processing shortcuts called heuristics. They include errors in judgment, social attribution, and memory. Cognitive biases are a common outcome of human thought, and often drastically skew the reliability of anecdotal and legal evidence. It is a phenomenon studied in cognitive science and social psychology. A cognitive bias also has the tendency to make systematic decisions in certain situations.” This is the definition of Decision Bias in Wikipedia. Investing is, in many respects, society expressing its bias towards competing choices for its capital; what companies, what industries, countries, bonds, stocks, cash etc.

Now to our story: We all know the story of The Tortoise and the Hare. The hare and the tortoise find themselves in a race. The hare soon leaves the tortoise behind and, confident of winning, takes a nap midway through the course. The tortoise gets tired but he keeps going and wins the race.

As in most fables, there are moral lessons that teach us about behavior that is to be avoided. Our parents all likely first told us this story because we had done something wrong. It forever framed our cognitive thinking in some respect. Interpreters have asserted that it is the proverbial ‘the more haste, the worse speed’. Others have emphasized the hare’s foolish over-confidence that brings about his defeat. We could go on and expand the list but you get the point. Society repeatedly takes these fables and ‘truisms’ and draws conclusions and comfort from their lessons. I am often reminded that life is like an onion; it has many layers and peeling the layers can bring tears to ones eyes if not done carefully. Drawing conclusions about a present problem by applying lessons from the past is fraught with cognitive bias. To illustrate the risks of drawing conclusions from past ‘performance’ a further investigation of this famous race is required.

In his short story, The True History of the Tortoise and the Hare, Lord Dunsany proposes that the hare realizes the stupidity of the challenge and refuses to compete. The obstinate tortoise continues to the finishing line and is proclaimed the swiftest by his backers. But, continues Dunsany, “the reason that this version of the race is not widely known is that very few of those that witnessed it survived the great forest-fire that happened shortly after. It came up over the weald by night with a great wind. The Hare and the Tortoise and a very few of the beasts saw it far off from a high bare hill that was at the edge of the trees, and they hurriedly called a meeting to decide what messenger they should send to warn the beasts in the forest. They sent the Tortoise.”

There you have it; past performance can be dangerous to one’s health. At Davis Rea, we have a natural bias towards conservative and disciplined thinking. We call it Common Sense Investing. We have been advocating a conservative stance and we continue to do so. Your portfolio performance continues to be strong with this conservative bias. Nonetheless, we are aware of the risks of this bias and we strive to challenge our hypothesis continually.

Our previous report expressed concern about the valuation of equities, calling them fair but high enough to be susceptible to correction and offering what we consider to be poor returns in consideration of the risks to the global economy. The past quarter has seen some of these concerns fester further and, at the same time we have seen some progress in the U.S. economic evolution. Equities remain little changed after 90 days of increasingly volatile trade.

Investors are focused on three key risks:

1. U.S. Federal Reserve decisions on interest rates and quantitative easing.

2. China’s economic slowdown.

3. Japans economic direction.

The recent sharp correction in equity prices and, in particular in dividend paying equities when fears of rising interest rates were raised highlights the extent to which we feel valuations are being supported by un-naturally low interest rates. Investors, rightly will remain on a vigil now that the “Fed” has warned (we think in common sense language) that cheap money will not last forever if things continue to improve. The U.S. economic recovery continues in spite of the continued contraction of the government’s contribution to the economy. This bodes well for U.S. domestically-focused companies.

We believe the U.S. economy can continue to advance at very modest rates for the foreseeable future. Rising interest rates are a signal of underlying strength in a low inflationary mode. Interest rates will remain at absolutely low levels or the government will intervene. The negative effects of fiscal restraint in the U.S. will increasingly fade over time.

China’s economic growth continues to decelerate proving that the new regime is serious about reforming its increasingly bloated and unruly financial sector. China can no longer be counted upon to support the commodity boom theory nor be the solution to global reacceleration. They are pursuing the short-term pain for long-term gain plan. This is bullish for the longer-term thinkers but will be a headwind for the next year. At a minimum, it is challenging for commodity-oriented countries like Canada.

Japan is finally getting serious about fixing its long-running depression. It is the third largest economy in the world and supports massive amounts of government debt. Failure to create economic growth that can support these debt loads would be a global nightmare. The panic would be quickly inferred upon the U.S. and European sovereign debt loads. We remain cautiously optimistic that under the surface progress is being made.

Investors continue to put a high premium on future profits because of recent success. Slowly investors’ fears are giving way to positive bias. Good news means corporate profits will run further and hence stocks will advance. Bad news means that interest rates will remain low and investors in stocks that pay dividends will do better than those invested in bonds. It seems little can go wrong for stock investors.

We have built models encompassing 15 years worth of corporate activity on over 500 stocks. We have analyzed the data and continue to ponder the investment merits within the context of the current and expected economic landscape. We continue to apply the tried and true processes we have used successfully for decades. Trying to avoid decision bias of our own, we have examined a wide range of scenarios in our return forecasts and we still arrive at substandard projected returns within the context of ‘risk-free returns’.

Corporate profits have been boosted by aggressive cost cutting (particularly labour), productivity has improved (make people work harder for less), interest rates have fallen (boosting profits) and a weak U.S. dollar has swollen foreign profits (that are stashed in offshore tax havens). All of these profit boosters are on the radar screens of labour and government. This is an additional and we believe underappreciated risk to corporate profits down the road.

We have recently effected the transition to a 10% minimum weight for most of our clients into the Davis Rea Equity Fund, which is now more than 60% invested in the United States. We firmly believe that the U.S. will outperform the Canadian markets for years to come. There will be companies in Canada that will keep pace but they will be rare compared to the rich selection south of the border. The Canadian dollar will continue to weaken against its southern neighbours, augmenting our returns.

We are not saying that corporate profits will collapse and/or investors will flee equities. We are merely saying that the race that started four years ago is not the same as the race today and investors would be wise to exercise caution extrapolating past performance when projecting future returns. Just like the lessons of The Tortoise and the Hare, we remain vigilant of our and others’ bias. What we are certain of is that we are not running a race. We are investing your wealth and in the end, common sense and prudence will always be our talisman.


John M. O’Connell, CFA
Chairman & CEO


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