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Value Perspective

Imperfect harmony

Signs of unanimous agreement should really set off alarm bells among investors, argues Schroders’ UK equity fund manager and The Value Perspective blogger Kevin Murphy

Society tells us unanimous agreement is a good thing. If all 12 people on a jury agree the defendant is guilty, for example, then a judge will feel pretty comfortable doling out the appropriate punishment. Yet, if 12 witnesses to a mugging unanimously agree the same person in a police line-up is the culprit, the one they identify is less likely to be guilty than if just two or three people had pointed the finger. 

Welcome, then, to the ‘paradox of unanimity’, which holds that the probability of a large number of people all agreeing on something is tiny so society’s confidence in unanimity is not justified. Yes, it is possible to come up with exceptions to the premise – faced with a line-up of five lions and a Siamese cat, for example, one might reasonably expect everyone, if asked, successfully to pick out the moggy.

"Rather than being indicative of a great decision, unanimity is more likely to imply some error within the decision-making process."

 
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That is because that situation is as about as straightforward and certain as it is possible to get – it allows no room for doubt or bias. But real life is rarely straightforward or certain and, as soon as the slightest element of doubt or bias is introduced into a scenario, the chances become very slim that people will not only be unanimous but correctly so. 

Imagine you were asked to toss a coin 10,000 times. Naturally you would expect it to come up heads roughly 50% of the time and so, if it actually came up heads 75% of the time, you could come to one of two conclusions – either the laws of probability have changed or the system is biased (essentially, there is something wrong with the coin). All things considered, the latter would appear more likely. 

Let’s return then to the idea of the line-up – the police version, not the cats – which is the focus of an imminent academic paper discussed in some detail in Why too much evidence can be a bad thing. “In police line-ups, the systemic error may be any kind of bias, such as how the line-up is presented to the witnesses or a personal bias held by the witnesses themselves,” this explains. 

“Importantly, the researchers showed that even a tiny bit of bias can have a very large impact on the results overall. Specifically, they show that when only 1% of the line-ups exhibit a bias toward a particular suspect, the probability that the witnesses are correct begins to decrease after only three unanimous identifications. 

“Counterintuitively, if one of the many witnesses were to identify a different suspect, then the probability that the other witnesses were correct would substantially increase.” Unanimous agreement by the witnesses, on the other hand, would – much like a coin that comes up heads three-quarters of the time – be an indication the system is biased or unreliable. 

If you have not yet spotted the investment angle in all this, just switch ‘unanimity’ to ‘consensus’ and it should become apparent. After all, if you have a group of investors, then – just as with any other group of people – it is highly unlikely you will end up with a wholly independent and unbiased selection of viewpoints. 

So if, say, an investment committee unanimously agrees on something, it is actually a bad sign because it suggests the committee’s system is biased or broken. Rather than being indicative of a great decision therefore, unanimity is more likely to imply some error within the decision-making process. In this context, any difference of opinion is a welcome and positive sign.                          

And of course the same argument holds for consensus broker forecasts. As value investors, we already know it does not bode well when everybody is unanimously bullish about a business because, statistically speaking, when there are substantially more buyers of a stock than sellers, the stock will first become overvalued and then it will underperform. 

It also happens to be the case, however, that if everybody is unanimously bullish about a business and any dissenting voices are only conspicuous by their absence, it makes it more likely some bias has crept into the system, that some fact about the supposed investment case has perhaps not been fully appreciated and that, one way or another, the process has failed.


Value Perspective

Green flags

Lloyds is on the cusp of reclaiming its place as a natural choice for income funds, believes Schroders’ UK equity fund manager and The Value Perspective blogger Nick Kirrage

The last time we suggested that the recovery of the UK’s banking sector was taking so long the market might well have stopped paying attention, in Sneaking up, we likened the situation to the frog in the pan of slowly-heated water – only with, potentially, a much more upbeat ending. On reflection, a happier metaphor than boiled amphibian would have been the changing of the seasons.

If you compare a typical November day with one in May, of course, the differences in temperature, light and so on will be immediately apparent and yet the changes from day to day are barely perceptible. That is not to suggest all is sunshine and warmth for the banks – only that, whether the market is able to see it or not, the outlook is a lot less chilly than it was.

"Rather than worrying about which stocks might pay a high dividend and to what degree that is sustainable, why not consider businesses that pay little or no dividend at all and examine to what degree that situation is sustainable?"

The regulatory headwinds, the apparently never-ending stream of fines for PPI misselling and other poor behaviour, the Government’s stakes in Lloyds and Royal Bank of Scotland – the arguments against investing in the UK’s banks are now so well-rehearsed it can sometimes feel as if the wider market is unable to imagine buying into the sector ever again

That situates it firmly in value investor territory and yet The Value Perspective bloggers believe we are nearing a point when the wider market will finally see those arguments need revisiting. We are, effectively, coming to a denouement on this story – a point where, for example, it is less of a stretch to picture what it might be like without the PPI cloud hanging over Lloyds.

As for that issue of Government ownership, take a look at the chart to the right, which comes from aninteresting note on Lloyds by the financial analysts at Autonomous.

A selling programme that began in steps has moved to more of a dribble – to the extent that, if it continues at its current daily rate, the Government’s stake will be down to 5% by the end of the year, which is neither here nor there.

Autonomous also notes the possibility that Lloyds may be hitting “something of an air pocket as the investor base transitions from a value-focused one to an income-focused one”. As you can see from this next chart, the firm believes that next year could see Lloyds accounting for 5% of every penny paid in dividends across the whole of the FTSE 100. Nor does the consensus particularly disagree there.

Perhaps understandably, the Government’s stake and a lack of dividend has meant Lloyds is no longer the fixture it once was in UK equity income funds. We are convinced, however, that once it is recognised both those situations are changing materially and the bank is reclaiming its place as a natural income-paying stock, it will have a big impact on Lloyds’ share price.

One way to run an equity income fund is to buy stocks with high dividend yields and then hope they are sustainable. It is not the way we invest ourselves – almost by definition, high dividend yields are not sustainable – but even one pay-out of 7% or 8%, say, can provide a real boost to a fund’s own capacity to distribute income.

But there is another way of thinking about equity income. Rather than worrying about which stocks might pay a high dividend and to what degree that is sustainable – a course of action that is leading a lot of managers currently to sniff around the commodities sector – why not consider businesses that pay little or no dividend at all and examine to what degree that situation is sustainable?

With Lloyds to the fore, the UK banks are classic examples of this sort of stock and yet most managers do not think or screen stocks in this way. As a result, they are completely overlooking a great source of potential dividend growth – perhaps not irrespective of the economic outlook but, we believe, even if things do take a turn for the worse.

As value investors, when we analyse a business’s accounts, it is second nature for us to look out for potential risks or concerns. Taken in isolation, none of these ‘red flags’ may be enough to put us off the stock but the presence of half a dozen, say, would strongly suggest we take our search for value elsewhere.

Well, this is the opposite. In our view, ‘green flags’ are popping up all over the UK’s banking sector. Up to now, few investors have noticed and valuations have not moved much as a result. Slowly but surely, however, the seasons are changing for the sector. It may not be shorts and T-shirt weather just yet but things are definitely warming up.

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