element investment managers

Presentation to the Senate Group

René Prinsloo & Terence Craig

19 March 2015

Psychology of Investing:

Avoiding common pitfalls

Source: Kevin Kallaugher 2

Portfolio Managers

21 years’ industry experience

Joined Element as Director & CIO in March

2001

Since April 2001 responsible for:

Investment philosophy and process

Portfolio management

Investment team development

Prior:

Allan Gray – Portfolio Manager

Taita (Private Equity) - Director

Terence Craig49, Chief Investment Officer

B Bus Sc (Hons), CA (SA), CFA

14 : 21Element : Industry Experience

René Prinsloo35, Portfolio Manager

B Sc (Hons) - Act Sci, FFA, CFA

8 : 10Element : Industry Experience

10 years’ industry experience

Glacier, Investment Analyst

Lecturer at Stellenbosch

University

Joined Element in Nov 2007

Appointed PM in June 2012

3

Agenda

Investing biases:

Herd behaviour

Optimism

Overconfidence & the Valence effect

Anchoring

Familiarity

Framing

Denial

Loss-aversion

Illusion of Control

Ignoring the warning signs

4

Herd behaviour

Rand forecasts

5

Herd behaviour in Rand forecasts…

Difficult to forecast

Rational forecasts

Irrational, herd driven

6

Current forecasts not yet indicative of herd behaviour

7

Avoid the Herd by sticking to a process…

R/$ exchange rate

PPP fair value

20% band

At extremes, reversion to mean becomes increasingly likely

Source: Element Investment Managers, 28 Feb 2015

8

Coping with Herd behaviour

Large market moves can become self-fulfilling

Important to try insulate oneself from the “noise”

Sticking to a process becomes increasingly important

Important to be able to “hang your hat” on something

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Optimism bias

Earnings Forecasts

10

Forecast for ALSI earnings vs Actual

ALSI earnings nearly always lower than what had been expected

Feb 14: 10.2% higher

Feb 13: 13.5% higher

Aug 14: 8.6% higher


11

Consensus nearly always too optimistic


12

Very important to adjust for analyst bias


13

Conclusion: ALSI more expensive than it appears


14

Standard Bank: Downside > up-side surprises


15

Group 5: Downside >up-side surprises


16

Woolworths: Exceeded expectations


17

Nampak: Perennial disappointment


18

Coping with the Optimism bias

Analyst forecasts, collectively, are almost always too high

Forward PEs are too low, the market is likely (80% to 90%

probability) more expensive than it looks

We should expect to be disappointed

Analyst bias can easily be adjusted for

19

Overconfidence & The Valence Effect

Inflation forecasts

20

Overconfidence bias…

“A careful survey in Sweden

showed that 90 percent of

automobile drivers

considered themselves

above average. And people

who are successfully selling

something, as investment

counsellors do, make

Swedish drivers sound like

depressives.” Charlie

Munger

“Every parent thinks their

child is above average

until they get that first

report card”

Typical response to survey: “I

know everyone thinks they are

above average, but I am!”

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SARB Inflation Forecasts -Good Forecasting

Oct 02CPIX

May 09

CPI

Oct 10

Source: Element Investment Managers, SARB

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Poor Forecasting

23

Oct 01

May 04

Nov 07 Jun 14


SARB almost always gets the direction right

Feb 2010

Source: Element Investment Managers

24

Most Recent – December 2014

5%

5%

5%5%

5%5%

5%

5%5%

5%5%

5%5%

5%5%5%

5%

5%

5%

This outcome has happened 16.5% of the time!


25

Extreme events happen more often than expected

Source: Element Investment Managers

26

Important to adjust for tail risk


27

Coping with the Overconfidence bias

Overconfidence – my standard deviation expectation is too low

“Unlikely” events are more likely than I think

Valence effect

Overestimate the likelihood of positive outcomes and

underestimate the likelihood of negative ones

“Experts” are often more susceptible than laymen

Re-assess what is unlikely; recalibrate expectations

Make sure clients know roughly how frequently 10%, 20%, 30%

etc. corrections occur

They are likely to naturally underestimate these events

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Surprises to look out for in 2015

Low oil prices cause more problems than benefits

The Empire strikes back – increased geopolitical risk

SA’s credit rating gets downgraded again

The JSE ends the year down

JZ retires “ill” to Nkandla

“Grexit” happens in some form

Ireland wins RWC 2015!

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Anchoring

Inflation forecasts

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Bond market is great at forecasting what just happened!

Source: INET BFA, 28 Feb 2015

Bond market’s expectation for inflation over the next c10 years

Inflation over the past year

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Coping with AnchoringAnchoring:

Relying too heavily on a specific piece of information

In this case the present environment

What is happening today tends to feel more “normal” than what

happened 10 years ago

Avoid the temptation of considering the present more representative of

what is likely than the past

Understand cycles and where in the cycle we are currently

Avoid mistaking a cyclical shift for a structural one

Take sufficient history into account when forming expectations

Ensure clients aren’t basing long-term expectations on recent bull

market performance

The phenomenon can create opportunities, as abnormal conditions become

perceived to be normal

32

Familiarity Bias

Stock Recommendations

33Source: Bernard Schoenbaum

Example: BHP Billiton

Current Recommendations:

Date: 17-Mar-15

Inet Cons: Buy

Score 75%

# 6 6 0

% 50% 50% 0%

Positive Neutral Negative

1 Barnard Jacobs Mellet SBG

2 Deutsche Securities Citi

3 Macquarie First South JPMorgan

4 UBS Ltd Investec

5 RMB Morgan Stanley Credit Suisse

6 Absa Capital Merrill Lynch

Source: UBS, Element Investment Managers, 28 Feb 2015

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How can the average share be above average?


35

Familiarity bias is persistent…


36

Coping with the Familiarity bias

Familiarity bias:

Favouring what I am more familiar with

Analysts tend to “fall in love” with their companies

Increase in familiarity/ knowledge may lead to loss of

objectivity

Knowing a company/ asset manager too well may be as

damaging as not knowing them well enough

Related – analysts look for evidence that confirms their view

and ignore that which contradicts it

Guard against objectivity being influenced by marketing

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(Narrow) Framing Bias

Pro-Forma or Adjusted Earnings

38

Narrow framing…

“The best example of narrow framing that I can think

of is the use of pro forma earnings. Essentially this is

a company turning up and saying, hello I’m lying to

you, these are the earnings I didn’t make, but I’d be

jolly grateful if we could all just pretend I did.”

James Montier, SocGen, 11 March2010

39

Narrow framing: US Earnings growth is an illusion…

“Whatever it takes to get that (customized earnings) number up to support a valuation, is what they’ll back out,” Anthony Catanach, University of Villanova Accounting professor

Adeptus Health: $15.8m loss to $18m profit (incl. stripping out management bonuses)!

LendingClub: Contribution margin went from negative to +44.1%(incl. stripping out general and admin expenses i.e. normal overhead)!

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“Denial Ain’t just a River in Egypt.”

“Sometimes reality is too

painful to bear, so you just

distort it until it’s

bearable.”

Charlie Munger

“The first principle is that

you must not fool yourself–

and you are the easiest

person to fool.”

Richard Feynman

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Illusion of control bias…

“If people want high numbers, they’ll roll the dice really

hard, but when they want lower numbers, they roll them

very gently.”

After 9/11 many people drove to their destinations rather

than fly:

"Scientists studied the aftermath and about 50% more

people died in automobile accidents in the wake of

9/11 than people who actually got on an airplane after

that tragic day.“

Michael Mauboussin

Chief Investment Strategist, Legg Mason Capital

42

Cognitive dissonance bias…

“Never try to teach a pig to sing; it wastes your time and

annoys the pig.”

Where we see an even greater discomfort is when a person of a

given mind-set or ideology is confronted with facts that

directly contradict their previously held beliefs.

“Cognitive Dissidents”: They will continue to dissent from

reality for as long as it takes to get everyone else to believe as

they do, no matter how much evidence there is to the

contrary.

When confronted with someone who has a fervent belief based

not on evidence or reason or data or logic, do not waste your

time convincing them the earth is not flat; their cognitive

facilities simply will not allow them to recognize the world is

round.

Barry Ritholtz.

43

Ignoring the warnings signs

44

Speculation in the tech sector is rife again…

Source: V. Prem Watsa, Chairman & CEO, Fairfax Financial Holdings-Letter to shareholders. 6 March 2015

45

…and has spread to the private sector…

Source: V. Prem Watsa, Chairman & CEO, Fairfax Financial Holdings-Letter to shareholders. 6 March 2015

46

The rise of Unicorns* goes exponential…

>80 private companies valued at >$1bn* by VCs (per WSJ)

c35 at time of Dot-com crash

Like most speculations – this is likely to end badly for investors!

47

What are the billionaires saying…"People have no place else to put their money, and the stock market is getting more than its share. It's very likely that something has to give here.“

Sam Zell

"There are some parallels with the collapse in home prices which preceded the financial crisis…It strikes me as completely plausible that a further decline in the euro triggers a recession in the US."

Andy Redleaf

"I am fearful that today our obsession with what will happen to markets and the economy in the near term is causing us to misjudge the accumulation of much greater long term risks to our economy."

Stan Druckenmiller

“There's no argument - you have to worry about the excessive printing of money!“ Carl Icahn

“You and I have got grandstand seats here [to an imminent market shock]," and investors are about to "find out just how illiquid it really is out there.“

Crispin Odey

“Financial markets have been exuberant over the past year ... dancing mainly to the tune of central bank decisions. Obviously, market participants are pricing in hardly any risks.”

Bank of International Settlements, 84th Annual Report

48

Managing client emotions

49

"What would you recommend in dealing with clients to eliminate

emotions and fight these forces that are out there?"

"Don't give them statistics, don't tell them what the big

macro issues are.

"This is one of the problems in our industry. We try to

communicate by using this long terminology, very fact-based

and rational and it's not effective.

Tell them stories, make it very personal - here are the

problems, recognize the extremes, be prepared for them

-- people will relate to that.“

Michael Mauboussin,

Chief Investment Strategist, Legg Mason Capital Management

ConclusionThose who do not learn from history are doomed to repeat it*

Important to learn from behavioural errors others have made

“Experts” and the rest of us are equally susceptible to biases

Knowing about behavioural biases does not remove them

It is important to remain continually aware of them

Behavioural biases create both pitfalls as well as opportunities

*George Santayana

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