In Artchived Items, Perspectives

The human race’s evolutionary wiring is a marvel: it has enabled us to avoid predators, feed ourselves and thrive in even the least hospitable parts of the planet. Unfortunately, the same wiring has made humans struggle as investors. Following age-old impulses of fear and greed, our species consistently behaves in a manner that often reduces our investment returns.
Ironically, our tendency to commit behavioral errors provides opportunity for disciplined investors to perform better and helps to inform Crestwood’s investment process. Crestwood’s investment process seeks to outperform the market over a full market cycle – with less volatility – by understating, and avoiding, common behavioral errors in the market. Indeed, our investment approach is designed to take advantage of the predictable, self-defeating behaviors of so many market participants.

Behavioral Finance 

Let’s look at a small sampling of the many innate hurdles to successful investing that typical investors must contend with:

Overconfidence: Investors systemically overestimate their knowledge and their ability, and the results can be unpleasant. In 2014, the S&P 500 index returned 13.7%–but the average equity mutual fund investor earned just 5.5%, according to research firm Dalbar. The discrepancy is explained by investors’ well-documented tendency to sell low and buy high. Additionally, high rates of “turnover”—holding investments for a short time, and then dumping them to buy others—demonstrates overconfidence that one investor knows more than others, even though historically low-turnover portfolios have outperformed high-turnover portfolios.

Overconfidence plagues amateur and professional investors alike, with mutual fund managers and other pros frequently making inaccurate predictions of everything from a company’s earnings to the market’s direction. Overconfident investors consistently buy investments regardless of valuation and without regard to company fundamentals. Furthermore, they exaggerate their wins and forget their losses—and often, they don’t really know their actual portfolio returns or whether they have beaten the market or not.

Herding: Market participants tend to act as a group. A prime example of the herding effect can be seen in the late-1990s tech bubble. In hindsight, it is clear how crazy investor behavior was during this episode. Advisors and managers faced pressure to own technology securities even as valuations became irrelevant. Unless one has a process and patience, herding, and the pressure to conform to the market’s benchmarks even in the short term, is the norm.

Crestwood’s U.S. Equity Investment Philosophy – Patience, quality and process

Crestwood’s investment process for building stock portfolios is designed to avoid common behavioral errors. Investors are extremely impatient with an average stock holding period of less than a year. This creates opportunities to buy high-quality businesses that might be facing temporary issues at attractive prices as fear forces emotional or irrational selling. Crestwood’s targeted holding period is three to five years, ideally providing an advantage over impatient investors.  Warren Buffett has called the stock market “a highly efficient mechanism for the transfer of wealth from the impatient to the patient.” Buffett’s words are timely, given the market’s turbulent year. Undisciplined investors have been selling good companies, which has allowed other investors to buy them at a discount.

Research shows that investors can beat the market over the long term by buying high-quality companies that are mispriced. It’s a message that has been preached by Benjamin Graham, Warren Buffett, Joel Greenblatt and many other respected and successful investors. Hence, Crestwood seeks to invest in:

  • Well-run businesses in growing industries, with sound balance sheets, shareholder friendly management, and improving or sustainable, above-average returns on invested capital. Purchased at attractive valuations, such investments have the potential to deliver strong returns to shareholders over time.
  • Low-volatility/low-risk stocks. Contrary to conventional wisdom, low-volatility stocks don’t fluctuate as widely in price and tend to outperform high-volatility stocks over the long term. And, they typically do so with less downside risk.
  • Shareholder friendly management. Over the past 80 years, dividends accounted for approximately 40% of stocks’ total return. We seek investments with growing dividends and pay close attention to other ways that companies can return excess capital to shareholders, including share buybacks.

Crestwood’s disciplined process focuses on owning quality businesses that can compound their returns at higher rates than the market for several years. We strive to evaluate investments with an objective view, driven by proprietary fundamental research and valuation work that may point to contrarian conclusions. Crestwood’s sell discipline dictates that we make a change when there is either a fundamental change in a stock’s valuation, a change in the underlying business, or if our thesis does not work as expected.

Depending on the size of an account, sometimes exposure to U.S. large cap securities is most appropriately implemented through mutual funds or ETFs. For these accounts, we seek funds that we believe have a similar investment philosophy and process as well as long-term, risk-adjusted returns.
Given the very real risk of behavioral errors, we believe investors should rely on a process that has effective guardrails. Crestwood has a due-diligence process and a valuation methodology grounded in:

  1. A common-sense approach to analyzing businesses and industries with the mindset of a private owner with a multi-year investment horizon
  2. A fluency in accounting, financial statement analysis and valuation methodologies.
  3. Risk management through the size of our positions based on their risk and reward characteristics.

Importantly, we are willing to avoid hot areas of the market that have high valuations. And we believe that deviating from the benchmark with a concentrated portfolio of quality businesses at attractive valuations should deliver superior risk-adjusted returns over a full market cycle.

Our independence and flexible approach – across sectors and market capitalizations – expands our opportunity set and enables an investing discipline that positions our portfolios to benefit from the market’s irrational behavior.

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