Near certainty is almost always undervalued by Mr. Market. That is the beauty of owning quality, as we illustrated last October in Buffet vs Modigliani-Miller. Stability is just not exciting for investors. We get it. We all crave excitement and sex sells. But the question remains, why are so many managers selling sex these days and how much does it cost the average investor?
A paper by Nardin Baker and Robert Haugen suggests a rather straightforward answer – many investment managers, not unlike certain women of the night, get paid very well to sell sex. Like everything else in this world, it’s all about incentives and the structural outperformance of low-risk stocks can also be explained by the nature of manager compensation, as beautifully illustrated below.
The bottom line is that a more volatile portfolio increases the expected value of a manager’s compensation. Unfortunately, it also increases the number of sleepness nights for the client, but most managers are not paid for encouraging forty winks. It’s also interesting that owning volatile stocks makes it easier for portfolio managers to explain changes in the portfolio to their clients. And as such, the authors suggest that, “Consequently, these agency issues create demand by professional investors and their clients for highly volatile stocks. This demand overvalues the prices of volatile stocks and suppresses their future returns.” In conclusion, “We find that (a) financial institutions hold more volatile stocks, (b) analysts’ coverage is significantly greater for more volatile stocks, and (c) news coverage is more intense for more volatile stocks. All the evidence is consistent with our hypothesis that agency issues are responsible for creating demand for volatile stocks, which results in their over-pricing and their production of inferior returns in the future.”
The result is the systematic undervaluation of boring stocks, which provides us with the potential for systematically higher returns over time. For our part, we’ll continue to focus on a concentrated portfolio of high quality companies with sustainable competitive advantages. We think this rare combination in the marketplace results in high returns on capital for the business, and when purchased at the right price, very attractive returns for our investors. We’ll continue to highlight these gems as we mine them.