The Art of Execution

Lee Freeman-Shor manages over $1 billion in high-alpha and multi-asset strategies. Lee has been ranked as one of the world’s top fund managers in 2012, and has produced one of the best stock trading books of great importance. This is a Harriman House book, and you can receive 20% of all orders from their website using my code: MICHAELT20

Contents

The Art of Execution documents the findings of a period spanning seven years from June 2006 to October 2013 – a period including the worst stock market crashes in living memory. 45 of the world’s top investors were studied, all of their trades documented and analysed, all of whom Lee had the privilege of managing during his job as a fund manager at Old Mutual Global Investors.

Lee’s Best Ideas fund in this period consisted of a total of 1,866 investments and each investor was given between 20 and 150 million dollars to invest in their best ideas! The rationale was that superior returns could be made by giving the best investors the instruction to invest in their best ideas. These were ideas that had been the subject of untold hours of research, by some of the smartest people in the planet. Despite this, most of these investments lost money. Only 49% of all stocks in this study proved profitable to the investors and some of these investors were only successful 30% of the time. However, almost all of them did not lose money in the long run, despite the statistics. How this happened is the subject of this book.

Successful investing in property is all about ‘location, location, location’. In equity investing, it’s ‘execution, execution, execution’. It’s not the ideas of the best money managers in the world that make them money, but how they execute on their ideas.

Every investor in the study had losing positions, but how they responded to them was always one of three ways. In Part I the book has split these investors into three tribes: the Assassins, the Hunters, and the Rabbits.

Part II of the book looks at how these investors managed their winning positions, and these were split into two tribes: the Raiders, and the Connoisseurs.

Key Themes

Rabbits

The investors that belonged to the Rabbits tribe were the investors who did nothing when a stock went down. They neither followed their conviction and bought more, nor admitted they were wrong and sold the stock. Like a rabbit caught in the headlights, they didn’t act and the situation kept getting worse.
One of the most important influences on the Rabbits is the narrative fallacy framing bias. If the stock went up, the investors justified the share price appreciation with their own success. If the stock went down, the investors rationalised that the reason for investing was still the same, and so they did not equate the share price depreciation with their own failure and did not sell.

Primacy issue was another error the Rabbits suffered from. They resolutely stuck to their first impressions of the stock and failed to update it – even when the fundamentals were clearly deteriorating the Rabbits stubbornly held on.

Anchoring is a cognitive mentality in investing where we attach ourselves to the price we paid, and not the price that it is currently worth. We can also drop our intellectual anchor out of sight where we refuse to accept new findings that suggest we should raise it and sail away! The anchored price becomes subject to endowment bias – we own the stock and so therefore to believe it to be of more value than it really is. This is rarely consistent with what the market is really paying, and one of the reasons why some houses stay on the market for years before selling. It’s not that the house is unsellable, but that the owners are suffering from endowment bias and refuse to price the house as to what the market believes it is really worth.

Neuroscientists have found that when we don’t conform, the amygdala (the part of the brain associated with fear) lights up. Going against the crowd is hard and makes investors nervous. The pull of the crowd, ego, and self-attribution bias (it’s not my fault) was also a feature of why the Rabbits lost money. The Rabbits also sought confirmation bias (reasons as to why they were correct despite overwhelming evidence to suggest otherwise), believes stocks were ‘too big to fail’, and that they were also ‘due a win’ – gambling fallacy!

What the Rabbits could’ve done better

The Rabbits could’ve had a plan. Instead they did nothing. They should either have sold, or bought more (averaging down is not something I personally do often and should be used with caution). Ultimately, being right and making are two completely different things. To combat confirmation bias – seek bear opinions. This will force you to evaluate what you think to be correct. Finally, if they had been humble and taken the loss early, this would’ve saved them a lot of money. Instead, the Rabbits provided excuse after excuse, but it did not change the fact that they were holding onto massively offside positions that were only getting worse with them not materially adapting to the situation.

The Assassins

The Assassins understood that losses left unchecked were the biggest destroyer of wealth and so they made it their endeavour to kill losing positions very quickly. They knew that successful investing was about ensuring the upside return potential is significantly greater than the downside of potential loss.

Assassins had two rules: they knew that by creating a plan this would prevent emotional decisions. They also knew that by becoming slaves to the plan would prevent them from making mistakes in emotionally charged situations. As Sun Tzu says in The Art of War: battles are won before they are fought.

The Assassins killed losers either after a specific amount of loss or after a specific amount of time. After all, time is money, and the opportunity cost of sitting on a stagnant stock, even if it is not showing a loss, can rack up.

What the Assassins could’ve done better

It is worth acknowledging that though the Assassins had great methods of killing losing trades quickly, the habit was a tough one to kill in itself when it came to winning positions: they also often killed them quickly! This goes directly against the stock market mantra of running one’s winners. They avoided the ‘breakeven effect’, whereby an investor turns to risk-seeking when losing, and did not care if a stock bounced back after they had sold it, which often freezes many investors into inaction.  Kahnemann and Taversky found that in 1979 the pain of losing $50 was far greater than the joy of winning $50. Be aware of this when looking at the losing positions on your screen.

The Hunters

The Hunters tribe had a very different strategy to the Assassins. Instead of selling stock, the Hunters actually bought more. In gambling, such behaviour is frowned upon, as it can lead to ruin. In investing, it can still lead to ruins, but in well-chosen stocks the book argues handsome rewards can be made, and cites several examples.

However, the key trait of Hunters was that they always had the intention of buying more shares if the price fell. They weren’t buyers of a stock, then rationalised themselves that they were right and convinced themselves to buy more. They never went all in, and instead scaled into their positions pre-planned as the price fell. They were value investors, and like January sales buyers, they wanted a bargain.

Why the Hunters should be careful

I would consider this strategy to be high risk, as I believe that you cannot ever go bust by continuously taking small losses. If you are wrong when hunting a stock, and it goes bust, you have lost a significant amount of capital that could’ve been put to work in a winning stock. Successful hunting is about patience, understanding what you are buying, and why you are buying it.

The Raiders

When it came to winning, the Raiders snatched at their profits too quickly. Assassins were often Raiders too, and in one example a Raider was correct 70% of the time but never actually made any money!

Why the Raiders should be careful

Raiders sold too soon because it felt good to lock in a profit. This proved they were correct. They also sold simply because they were bored, and wanted action or had found another great idea. They were scared, present-focused rather than future-focused. Various studies have shown that humans would prefer $1 today rather than $2 tomorrow, despite the $2 being 100% greater reward for only a day’s wait. This is called risk-aversion – when selling is more appealing than the uncertainty of a small loss or a big win. This is also true when losing as more risk is more appealing than the certainty of a loss.

The Connoisseurs

This was the most successful tribe of all. They were not paralysed by losers and materially adapted to the situation when losing, but also did not snatch at victory and instead enjoyed it over time. Connoisseurs knew that great stocks are like a fine wine and they get better as they mature, so they’d take a sip every now and again from the bottle rather than emptying it straight away. There is a famous psychological study by Walter Mischel, in which a child is offered a choice between one small marshmallow immediately or two marshmallows if they wait fifteen minutes. The children who ate the marshmallow immediately are the Raiders, and the Connoisseurs are the patient children.

The Connoisseurs actually had the worst hit rate out of all groups losing money six in ten times, but when they did win, they won big. They looked for companies that could continue to generate profits in future years, and companies that had big upside potential in the future. They invested big – sometimes adding to winners – and were not scared out of them.

Connoisseurs had to exercise extreme patience, as they could often be in the same stocks for years with very little action. Normally, when investors see large profits, they are tempted to recycle those profits elsewhere, but not the Coinnoisseurs. This is exactly why many investors do not become successful. It takes great courage and great pain to hold onto a winning position – the pain of the gain.

Why the Connoisseurs should be careful

That said, there are certain dangers of being a Connoisseur. Ned Davis showed that from 1929 to 1998, the bulk of profits in bull markets come from the first third of the rally, and that two-thirds of profits occur in the first half. The longer the bull market goes on, the higher the risk becomes that the easy money has already been made. Momentum can end abruptly, and by taking profits off the table as Connoisseurs do this mitigates the risk.

Conclusion

There were no wildly mind-blowing conclusions to be drawn from the study. Success came from one thing; none of the tribes identified as any different from the other investor. Success came from execution.

All tribes were able to make money apart from Rabbits. Though the other tribes had varying levels of success they all adapted materially to a new situation like a poker player with a bad hand. The Rabbits did not.

When winning, the ones who won big were the ones who knew that they had to try and hit a home run rather than stealing first base. The author believes that many readers of the book will be disappointed in the conclusions, as there is nothing amazing and the conclusions are very simple. How they executed was the only single factor in winning. This only serves to reinforce my view that making money in stocks is not that hard after all.

The Winner’s Checklist

  • Best ideas only
  • Position size matters (free position size calculator)
  • Be greedy when winning
  • Materially adapt when you are losing
  • Only invest in liquid stocks (the book studied fund managers – as we are not mostly not fund managers I disagree with this, though liquidity should definitely be considered)

The Loser’s Checklist

  • Invest in lots of ideas
  • Invest a small amount in each idea
  • Take small profits
  • Stay in an investment idea and refuse ti adapt when losing
  • Do not consider liquidity

The Art of Execution is a splendid book, and all of the key themes are laid out here. As long as you understand the thesis of the book and the key themes described you are unlikely to get much out of it unless you would do so for enjoyment (it is still an enjoyable and easygoing book to read).

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