April 2011
Blue collar research best for big caps, white collar research for small caps.
Equity research is viewed as a highly intellectual occupation that combines a forensic approach to accounting and an ability to explain complex business models in a simple elegant manner. And it is. Ferreting around in the notes to the accounts, or cross examining executives to get to the kernel of what drives a business can be deeply satisfying. In the same way the detailed knowledge a sector analyst has of his business can be quite awesome.
The problem is stuff happens that isn’t in the accounts or part of a competitor’s business plan. Nassim Taleb took a whole book to explain the phenomenon of “Black Swans”. Donald Rumsfeld captured the concept in one phrase when he described the “unknown unknowns” that can so disrupt life. A global view of the supply and demand for oil and a huge spreadsheet forecasting BP’s cash flow was made instantly irrelevant when its Macondo 252 well blew up in the Gulf of Mexico last year. The shares went from 655p to 302p and the company cut its dividend. An explosion on a platform that is drilling into flammable hydrocarbons at great depth and pressure is not really a Black Swan event. It is a dangerous operation and capable of going badly wrong. It is a tribute to the industry that it happens so rarely.
Hiccups such as these are not rare. The bank crisis of 2008 was perhaps exceptional but few analysts forecast it and even fewer managers sold all their bank shares in anticipation. Even those that did still got caught in the market turmoil and suffered along with those who held on. That just reminds us that over 90% of the variability of portfolio returns comes from the asset class and not stock selection as Brinson and others proved in the seminal paper of 1986.
Even though people like picking stocks the reality is that for most managers it is a rather unproductive game. No one would have favoured Shell over BP because it was “safer”. Indeed, Shell itself came very close to a similar incident in the North Sea later in the year. In the same way trying to choose between GlaxoSmithKline and AstraZeneca or rival stocks in any number of sectors is a hugely labour intensive process with no guarantee of getting the right result. Eventually, the exercise becomes less an inspired insight into the prospects of an industry or a company than a large discounted cash flow spreadsheet based on some assumptions that have very precious little hard data behind them.
The white collar analyst and manager simply cannot process all the news flow from even the 100 companies in the FTSE 100 with their twice yearly results, trading updates, corporate actions and geopolitical events. Like nailing jelly to the wall there is simply too much going on to be sure that his attention is focussed in the right place and not missing something more important elsewhere.
In contrast the blue collar worker who simply processes the available data in a methodical and systematic way has a good chance of delivering steady, if unspectacular, returns on a consistent basis. This new breed of process driven, or asset allocation strategy funds, such as The Munro Fund, iShares Dividend Plus or the RAFI UK, might be seen by some as the eating the lunch of the traditional portfolio manager.
This is not the case. Instead, it takes away the drudgery of stock picking between large, well researched stocks. Even better, it generates an arithmetic logic for individual position weights. The time this frees up can be used for active asset allocation which, remember, is where 90% of the variance in returns comes from. Having a simple cheap fund at the core of a portfolio also allows the manager to take bigger risks, and hence potentially bigger returns, around the edges.
Stock picking is not dead and will never die. It is time consuming though. Trying to add a lot of value from the big caps is hard work when the information playing field is so flat. There are much better pickings in the small caps if managers can devote the resources to really understanding what a company’s business model is. The business model for BP is simple; find oil, sell it and don’t upset the President of the United States or the Russians. Small companies are different. They have a huge variety of niches they exploit on a unique basis. Getting your head round these is not always easy, but it can be very rewarding for the true white collar researcher who cares to take the time.