Cognitive psychology tells us that company managers, despite being intelligent and well informed, are especially susceptible to over-confidence bias. If the environment they face allows them to, they can take on too much risk. We take the view that, all things being equal, management are likely to push a business harder than is sensible. This is driven by their self-belief, their shareholders' desire for growth and their companies' remuneration policies.
To get a sense of whether a company is being run in a sensible way, we look at how fast the company is growing, how much cash is being generated by the business and what management are saying about their business and the industry conditions they face. All this helps us make a judgement on management's attitude to risk. If we think a company is straining too hard for growth or in denial about how difficult conditions are becoming, we will not buy the stock.
Once we have identified those companies we think are being well managed, we apply the same lessons from cognitive psychology to financial analysts and investors to find mispriced stocks. In our view, financial analysts can often under-appreciate how fast, and for how long, unusual businesses can grow, especially relative to superficially similar businesses. By exploiting this tendency, we hope to identify interesting ‘growth stocks'. Separately, investors can often become sceptical and nervous about companies after a traumatic event. By exploiting this tendency, we hope to identify interesting ‘value stocks'.
When we have identified a group of companies which we believe are being well managed, and there is something interesting going on in the way financial analysts or investors are viewing these companies, we aim to construct a well-balanced portfolio.
One such example of a well-managed company is Rentokil, which has turned itself into a boring plodder in the last few years. The days of aggressive expansion and a confused corporate strategy are long gone, and the painful period of readjustment - which lasted well over a decade - is now a distant memory. New management re-focused the business on its traditional core markets of hygiene and pest control and the company is delivering modest organic growth, with higher margins, while generating a reassuringly large amount of cash. The problem for investors has moved on from the painful, and extended question of restructuring, to how to value what now looks like a good company with nothing new to get excited about.
Luckily for us, we are attracted to ‘boring' and the prospect of steady - rather than spectacular - organic growth, and continued bolt-on M&A opportunities is sufficient to keep us happy. Management remains focussed on the strategy, which is to drive growth predominantly through its global market-leading pest control business and take advantage of a consolidating industry. As ever, it is hard to know what the ‘right price' is for these slightly underwhelming characteristics, but we do know investors tend to undervalue stocks that keep grinding out steady, low levels of growth. Boring can sometimes be surprisingly exciting.
Jeremy Lang, partner and co-founder of Ardevora Asset Management
