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Conquering Confirmation Bias

Behavioural Bias Series - Part 1

Sam Byrnes
Sam Byrnes

Investing involves both art and science. The science aspect includes analysing a company's strategy, industry position, competitive advantage, future opportunities, and risks to determine its potential for generating returns on capital and cash flows, while taking into account the required return for the inherent risks. However, investing also involves the less tangible aspect of mitigating behavioural biases, such as Confirmation Bias. 

Confirmation bias refers to the tendency to seek out and interpret information that confirms one's pre-existing beliefs, while disregarding information that contradicts it. Any Wallabies supporter is very familiar with this bias, as every referee decision seems to go against us - although when playing the All Blacks they ACTUALLY do. 

In the world of investing, this bias can manifest as ‘falling in love’ with a particular stock, leading to over-investment without adequately assessing the risks. This can ultimately lead to significant losses. To mitigate this risk, ECP employs various strategies to ensure that investments are made objectively and with a clear understanding of the potential risks involved.

Rigorous analysis before investing

At ECP, we employ a high conviction, bottom-up approach to stock picking. This means that we only invest after conducting thorough research and analysis. Before a stock is included in our portfolio, an in-depth research report must be presented to the Investment Committee, using our six pillar framework to evaluate the quality of the franchise. These six pillars include: Business, Industry, Competitiveness, Sustainability, Management and Financial.

Our analysts use all available tools to understand a company's sustainable competitive advantage, including evaluating its business model in the context of current industry dynamics, and assessing the experience and sustainability credentials of the management team. We gather information from various sources, including industry experts, customers, suppliers and industry data, to independently verify the quality of the business.

While conducting in-depth research can help to identify and mitigate many high-level risks, it can also increase the likelihood of confirmation bias. This is why we have a team-based approach

Team-based approach

During the research process, the lead analyst works closely with the team to gather diverse perspectives and identify areas of risk. Once the research report is completed, it is made available for the entire team to review and critically evaluate, with a focus on identifying any potential areas of risk or areas that require further investigation. After the research report is approved by the Investment Committee, the company is included in the portfolio, with its portfolio weight determined by its valuation. This approach ensures that all potential risks are thoroughly evaluated before making an investment decision.

Sector-agnostic analysts

At ECP, we believe in the importance of having a team of sector-agnostic analysts who possess diverse experience across different industries. This allows for proper critique and evaluation of research, as each analyst brings their unique strengths and weaknesses to the table, as well as their years of varied experience. This is why we split coverage of certain sectors between team members. 

As an example, if one analyst covered all the financial companies and no other analyst understood the industry, then that analyst could not be challenged and would likely have more bias in his/her decisions. The result is a well-balanced portfolio in a range of different sectors, rather than one dominated by a bias to a sector that a lead portfolio manager's experience may favour.

Separate portfolio construction from the team

At ECP, we construct portfolios using a quantitative approach. Each company is valued based on its projected cash flows and dividends, and the portfolio weights are determined by the 5-year Internal Rate of Return (IRR). 

The companies with the highest IRR receive the highest weights, also taking into account liquidity and other risk factors. This method focuses on the long-term as it only includes companies that have a significant difference between their current price and the valuation in five years. 

Since stock prices fluctuate more frequently than long-term earnings estimates, an IRR approach helps to recycle capital away from overvalued stocks and into undervalued ones - we harvest excess returns from market volatility

Additionally, this process reduces analyst bias as the decision to sell down a company is based on the valuation and earnings estimates, rather than the analyst's personal view on the company's ability to beat earnings forecasts in the current year. This approach ensures that the portfolio is constructed objectively and with a focus on the long-term growth potential of the companies.

Seek out the counter-thesis

Talking with investors and analysts is a valuable way to gain a deeper understanding of a company, but it is important to keep in mind that investors tend to seek out individuals who share their point of view. This can lead to an echo chamber of ideas and a lack of diversity of thought. 

To truly gain a comprehensive understanding of a company, it is beneficial to speak with individuals who hold opposing views. Even if you do not agree with them, you will gain new insights and a greater understanding of the risks involved. This can help you to make more informed and well-rounded investment decisions.

Limit the risk

There are no absolutes in investing - we are always investing for an acceptable return for the risks we are taking. Understanding that no one gets them all right is a key tenant of good investors. 

At ECP, we take a cautious approach when it comes to early-stage companies that do not yet meet our profitability requirements, and have a wider range of potential outcomes. These companies are capped in terms of the weight they can hold in our portfolio, regardless of how high the expected return is.

In addition, when an investment thesis is not going according to plan we act to ensure capital preservation. When issues arise, we work diligently to understand the drivers of the poor performance and identify whether they are short-term issues or systemic in nature. 

When risks are deemed to be short-term, and not a threat to long-term fundamentals, then we accumulate as the expected return increases. However, if the risks are unknown or longer term, we exit our position or limit the weight in the portfolio until we have evidence that the thesis remains in-tact. 

By focusing on the resilience of our investments, our approach ensures capital preservation by ensuring informed investment decisions that protect the integrity of the portfolio. 

Rigour helps overcomes confirmation bias 

Confirmation bias can lead to poor investment outcomes by causing investors to overlook important information that contradicts their preconceptions. To effectively mitigate this risk, ECP implements several safeguards in our process, including our team structure, portfolio construction process, and research methods.

This helps to ensure that our investment decisions are anchored in long-term value creation and not influenced by confirmation bias. By engineering these safeguards, we aim to minimise our confirmation bias as much as possible and make more objective and informed investment decisions.

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