In times of distress, an investment manager’s fortitude or lack thereof is on display. Numerous discussions emphasized that this was actually a very favorable opportunity to invest, not raise cash. Our managers demonstrated conviction in their portfolios and processes by re-underwriting and adding to beaten-down positions, as expected. In some cases, depending on the industry (travel and hospitality), revenues deteriorated significantly, so capable management teams, robust balance sheets, and competitive moats were key determinants of a company’s future health. Investment managers that deeply researched their holdings were better able to analyze the potential range of such outcomes and probabilistically weigh them in an advantaged manner, while effectively communicating this approach to clients and other investing relationships through transparent, responsive, and open dialogue.

Our information and intel gained from constant manager touch points reinforced our views that this underperformance was temporary—a market anomaly. The conclusion also hinged on common sense; while no one is perfect at manager selection, could we be wrong on every value-biased manager that we have known and respected, for over a decade in many cases? While the performance pressure was still painful, the managers were investing like our due diligence determined they would, so terminating them and shifting to what had “worked” in an interim period would not be a prudent decision. Discipline and patience are key in such situations.

While our discussions and analyses were performed in earnest, clients were still experiencing weak returns and losing patience. Synthesizing our due diligence across multiple managers, analyzing portfolio holdings, and reviewing processes, we concluded that the managers processes were not impaired and that the laws of finance and physics (i.e., what goes up...) were still relevant. Forward returns had meaningful upside and limited downside, the asymmetric outcome that most investors work so hard to achieve. With that said, we did not know when such conditions would change, but we knew that abandoning these strategies in favor of those that worked would be a mistake and result in capital impairment.

These challenges were communicated to clients, detailing valuation multiples comparing growth and value stocks around the world. Our communication focused on the degree to which value stocks were currently inexpensive coupled with low investor expectations—any additional unwelcome news would have minimal negative impact. However, maintaining capital with some managers proved difficult. For example, one of our managers, a long-biased, leveraged, Japan-focused deep-value activist, experienced unprecedented underperformance during 2020, down almost 50% at one point during the year. Clients were rightly upset, and some wanted to redeem immediately. We maintained our conviction in the manager, although they had also moved up the capitalization spectrum in their activism on a couple of portfolio companies, deviating from the more mid-capitalization companies in which they’d invested in the past. The manager acknowledged this “mistake” but believed that it could still achieve a positive outcome because of the margin of safety and embedded unrealized value in the portfolio, especially among the larger-capitalization holdings.

As a firm, we preached patience, and suggested clients maintain exposure to the out-of-favor strategies. We provided qualitative and quantitative information to our clients evidencing the cyclicality of the managers and markets, the inexpensive valuations, and the potential capital impairment of abandoning these strategies during such a period of extreme under performance. While we were mostly successful in maintaining exposure across most clients, this was not universally the case. Investment committees have varying degrees of experience and risk appetites; additionally, each institution has unique circumstances that may require a different approach due to liquidity or other constraints. Part of our job is to recognize this and adjust accordingly Therefore, a one-size-fits-all approach is not realistic; one with flexibility and the objective of maximizing long-term returns is best. As one would expect, some clients redeemed, some maintained, and some invested more capital. Those that maintained or invested more capital were well compensated for their patience.

Success was defined by diligent monitoring, staying grounded in rationality, the unsustainability of the growth/value spread, the ultimate spring-loaded future performance projections of these incredibly inexpensive stocks, and our awareness of cognitive biases that could sabotage a performance recovery. Most people are pleasure seeking and pain avoidant; therefore, removing the pain point seems natural and feels good in the moment. Depending on the source of the pain and the end goal, this is sometimes exactly the wrong thing to do. Conviction and discipline are most needed when confronted with the uncomfortable. It is also critical to look for dissenting evidence instead of solely drawing from a familiar and inherently supportive echo chamber. All evidence, positive and negative, should be considered and weighed appropriately to produce robust investment outcomes. This is what we expect of our managers and of ourselves. Ultimately, sustainable long-term performance will speak for itself.