Wealth Management: Quarterly Letter – Straying from the herd
Helen Watson, CEO, UK Wealth Management
Where to start after a year like 2020? Given the devastating impact COVID-19 has had on so many families and lives, we wouldn’t blame anyone for writing 2020 off as a year they’d like to forget.
But there are perhaps some reasons to be optimistic as we look back over the last 12 months and toward the year ahead. Difficult times often bring out the best in people, and last year was no exception.
The dedication, hard work and tenacity of frontline workers throughout the pandemic has been an inspiration to us all. The public showed incredible community spirit and adaptability, even as their day-to-day lives were continually upended. The arrival of vaccines that could bring us together again after months of lockdowns is a cause for cautious celebration.
None of us could have predicted the year we would have at the start of 2020. Had we known what was in store, we’d all have done things differently. But I hope you feel your Rothschild & Co team have exceeded expectations, working tirelessly to maintain our ‘normal’ high standards of service and communication.
Overall, our portfolios performed well last year, with our diversifying assets helping us to protect portfolios in the downturn and enabling us to add to our positions at attractive prices.
Making calm, objective investment decisions is never easy, particularly during times of uncertainty. It’s tempting to follow the herd when faced with tough choices, but in this Quarterly Letter, we explain why fighting those instincts is important. How our ability to stray from the herd, when necessary, is key to preserving your wealth.
Thank you for your continued support and confidence in us. Wishing you and your families a happy and healthy 2021.
Download the full Quarterly Letter in PDF format (183 KB)
Straying from the herd
While following the herd is part of our natural instincts, we explore how this mentality can be counterproductive in an investment environment.
Every year in January, over a million wildebeest prepare for calving season on the plains of the Serengeti. After a couple of months, the adults and their new offspring embark on the Great Migration, chasing greener pastures along a 300-mile loop from northern Tanzania, through Kenya, and back again.
It's one of nature's most breath-taking spectacles. But the journey is fraught with danger. Some of the world's fiercest predators stalk the savannahs of Africa and while wildebeest are fast, big cats are often faster.
There is safety in numbers, however. The herd provides protection, shielding the weak and preventing opportunistic predators from picking off stragglers. Wildebeest instinctively know not to stray from the herd when danger is afoot.
Sadly, this herding behaviour can be their downfall. After predators, one of the leading causes of death on the Great Migration is drowning.1 Wildebeest get anxious and hesitant when crossing bodies of water, with perilous bottlenecks forming on the riverbank.
Then, once a few finally get the courage to take the plunge, the whole herd follows. If the river is too deep, the current too strong or the opposite bank too steep, hundreds of wildebeest can drown at once.
Investors obviously don't encounter the same life-or-death situations as wildebeest. If they take a long-haul trip, their biggest enemy is jet lag. And there are certainly no crocodiles lurking by the water cooler!
Yet, despite the comparatively sedate surroundings, they often exhibit the same innate herding behaviour as animals. People seek the safety and comfort of the herd. A popular theory is that while civilisation has developed a lot since our early ancestors lived on the African savannahs, our brains are still playing catchup, evolutionarily speaking.
Unfortunately, following the herd can also be counterproductive in an investment environment. Market booms encourage investors to pile into already overvalued stocks, creating fragile equity bubbles. The predatory threat of a bear market can induce panic selling of fundamentally sound investments en-masse.
Even the best of us get swept up by the crowd sometimes. But to quote General George S Patton: "If everyone is thinking alike, then somebody isn't thinking."
We hope our clients value our thinking. So, in this Quarterly Letter we'd like to explain why we're not afraid to stray from the herd, even if it sometimes goes against our natural human instincts.
Emotion versus logic
Do you follow your heart or your head when making decisions?
In the Little Book of Behavioural Investing, James Montier explains there are two regions of the brain that help us process information and make decisions: the X-system and the C-system.
The X-system is where information is processed first. Like a fast-food restaurant, it offers a quick, no-frills service and can handle a lot of queries at once. This part of the brain is largely instinctive and heavily influenced by emotion.
The C-system relies on logic and deductive reasoning to arrive at answers. You have to actively engage the C-system; it's not an automatic process, so it's slower, but your responses are less impulsive, more evidence-based.
What does this have to do with herding? There is still much debate over what causes herd-like behaviour in humans, but research shows a big part of the herding response is instinctive rather than logical.
It's hardwired into our DNA to conform with the crowd.
Follow the leader
A growing body of research shows herd mentality typically leads to bad decisions.3 However, there are limits to what can go wrong walking around a hall, so let's look at what happens when herding is taken to the extreme in a market scenario.
Bursting your bubble
Tulips are all the rage in the Netherlands. They are the de-facto national flower, which is an impressive feat in a country where approximately a third of all the world's plant and flower trade passes through.4 The Netherlands exports up to 2 billion tulips every year.5
Today, a pack of 10 tulip bulbs will likely cost you less than €10 in the Netherlands. But in the winter of 1637, a single bulb of a highly prized type of tulip reportedly fetched 5,200 guilders, more than enough to buy a lavish canal-side property on Amsterdam's most prestigious street.
To put this in perspective, Dutch painter Rembrandt was paid just 1,600 guilders in 1642 for his enormous masterpiece, The Night Watch.
The Netherlands was firmly in the grip of tulip mania. Why? Many tulip bulbs had started being sold under legal agreements similar to futures contracts. Growers would commit to selling the bulbs, which were still in the ground, to buyers at a set price on a certain date in the future.
As the popularity of tulips soared, buyers quickly realised they could sell their contracts on to a third party for a healthy profit before the bulbs were cultivated. Word spread and soon everyone was dabbling in tulip speculation, from nobles and merchants to farmers, labourers and chimney sweeps.
People saw their neighbours getting rich and sold their homes and land to invest in flowers.
This herding behaviour allegedly caused the world's first known asset bubble. And like most bubbles, it eventually burst. Tulip prices tumbled, greed turned to fear, and speculators began panic selling. When the herd changed direction, many failed to recoup their original investments and were financially ruined.
As James Montier aptly puts it: ‘Crowded exits don't end well. Inevitably, some are crushed in the stampede.’
Like the wildebeest at the riverbank, ill-fated tulip investors had rushed headlong into uncharted waters and been pulled under by volatile currents.
Fear and greed
X-systems and C-systems. Rational and irrational herding. Information cascades and greater fools. It's a lot to take in.
That's without mentioning many of the other cognitive quirks that may cloud a person's judgement. Optimism bias, recency bias, the endowment effect and anchoring can all be factors that steer investors towards the herd.8
What makes these decisions especially tricky is that following the direction of the herd may be the right move. For instance, aggregating the collective opinions of large groups tends to deliver more accurate results than polling individual experts.9 This has been called 'the wisdom of the crowd', an allusion (and counterargument) to McKay's work.
Prediction markets and betting lines are obvious examples. If you had to bet your house on a horse race, would you pick the overwhelming favourite or the rank outsider? The sensible bet is to back the front-runner, unless you have convincing evidence to the contrary.
So, the question becomes: how do you know the right moment to stray from the herd?
Always bucking the trend simply for the sake of it is unlikely to be a winning formula in the long run. Amazon founder Jeff Bezos summed it up well when he said: "You have to remember that contrarians are usually wrong."
That's why we advocate independent thinking, not contrarianism. At Rothschild & Co, we make decisions based on our, and our network’s, knowledge and expertise rather than taking recommendations from others. We avoid following the herd.
That said, there will be times when we move in the same direction as the herd. That's not because we're following the actions of other investors, however. Our analysis and research have simply convinced us the herd is on the right path.
But we are also human. We're therefore not immune to the deep-seated behavioural biases that influence decision-making. We strive to counter this by creating an environment that not only has robust systems and processes, but also promotes intellectual curiosity and rigorous debate.
Putting theory into practice
We've talked a lot about the theory behind herding, but let's look at a real-life example to see how our investment principles guard against this type of cognitive bias.
Equipment rental provider Ashtead has been a part of our portfolio since December 2019. Increasingly, organisations are leasing equipment rather than purchasing outright – a trend that is expected to continue – and we felt Ashtead was in a strong position to benefit from ongoing consolidation within the market.
Our analysis confirmed Sunbelt, Ashtead's North American business and primary revenue generator, enjoyed efficient scale and notable cost advantages over its competitors.
Prior to investing, we were confident the company would experience healthy growth and continue to capture market share.
However, demand for rental equipment took a heavy hit when the construction industry came under severe pressure due to COVID-19 shortly after. Ashtead's stock price fell sharply and experienced large daily swings as the scale of the crisis began to emerge.
As we've seen, following the herd is an instinctive reaction during times of uncertainty. But we wanted to respond quickly, not hastily, to the pandemic. We revisited our initial analysis, thoroughly reviewed balance sheets and spoke to management teams.
What we found at Ashtead was encouraging. In response to the crisis, the company was well-organised, halving its spending, halting mergers and acquisitions and extending its line of credit. Ashtead also recognised the importance of maintaining its highly skilled workforce by announcing no redundancies, emphasising its long-term outlook.
Ultimately, we estimated the business could withstand an 80% drop in revenue for three consecutive quarters before its cash reserves ran dry.
Not only were we reassured in our initial investment, but we added to our holdings in Ashtead at the start of March when prices fell to very attractive levels. Rather than follow the herd, we chose our own path and made decisions based on our disciplined investment approach.
Since then, Ashtead has performed better than even we expected. By the latter half of 2020, the company's revenues and operating margins were three times higher than their lows during the first wave of the pandemic.