THE ARDEVORA QUARTERLY REVIEW

Ben Fitchew, Jeremy Lang, Gianluca Monaco, William Pattisson

For Professional Investors only

September 2015

Inside Out
Rather like a pack of long distance runners approaching the end of a race, stocks within
markets look particularly strung out. The long distance winners have put on a burst of
speed, while the poor laggards at the back grow ever distant.
Markets are usually populated with pockets of momentum: some stocks rising, others are
falling. Often momentum huddles together in particular areas themes or industries
driven by investors shifting hopes or fears. Efficient market theorists would have you
believe that stock markets are rapid response machines, capable of instantly reflecting all
information in relevant stock prices. If this was so, momentum wouldnt exist. But there are
practical and psychological reasons for doubting the pseudo-scientific EMH (Efficient Market
Hypothesis) view of markets.
Stock Markets are not frictionless. When a big institutional fund manager changes their view
on a stock, they cannot buy or sell instantly. It takes days, weeks or even months to build or
exit a position. This can drive momentum, as every day there can be a skewed pressure
applied to a particular stock price, as a large buyer or seller tries to move around. But it is
not the sole cause of momentum. There is evidence from cognitive psychology that people

are prone to herding, or following the crowd. There always has to be a relative loner who
changes their view first. They tend to hang out at the edge of the crowd. Frequently, when
they head off in a direction, different to the crowd, they become isolated and ignored. But
sometimes they inject doubt into the crowd, and others are tempted to follow. Slowly the
momentum of change builds and the crowd changes direction. Stock markets are crowds of
people. Our view is that momentum exists in markets because of herding.
Stock markets are, like most crowds, chaotic. The edges enveloping a crowd may give the
illusion of shape and form, but inside the crowd there is a lot of noise and jostling. Noise
creates confusion. It is noise, in our view, that creates the illusion of the EMH. Up close, the
day-to-day jostling inside the stock market crowd creates erratic daily movements in stock
prices. Many of these movements are meaningless; nothing has caused them other than the
random bumping of others peoples intentions on a particular day. But another common
bias is the desire for narrative, for meaning, in everything regardless of whether it exists.
Daily stock market commentaries retrospectively fit narrative to the daily moves. Most of
these explanations are spurious. Occasionally one gets a glimpse of the real movers, the
momentum movers, but it is easy to miss amidst the noise.
Another interesting aspect of crowd movement is its tendency to suffer random
disturbances in shape and direction. Migrating flocks of birds predictably travel similar flight
paths every year, but they are never identical. Each years path can be subject to
meanderings that, up close can appear to be contrary to the ultimate direction of intent. So
too, the stock market. Investors can sporadically lurch to extreme views, expecting extreme
events, and when nothing immediately happens, doubt their views and back track. The
views may ultimately be prescient, but just dont unfold as quickly as expected.
Which brings us to current markets: for almost five years stocks have been polarising, with
winners winning and losers losing. Last quarter the direction of opinion shift, of momentum,
was unusually aligned. Stocks with momentum over the last five years were often those
with momentum over three years, a year, six months and three months, both up and down.
When such conditions exist, it is easy for pockets of the crowd to get isolated, to have run
too far ahead; then they can get nervous, feel self-doubt and ultimately scuttle back
towards the middle.
Our investment strategy is about playing bias. Herding is part of our armoury. Playing
herding isnt easy. Most of the time it requires running with the herd, even if the rate at
which it is moving is unsettling. Periodically one has to step to the side, let the herd run on,
and wait for it to over-extend and then come back to meet you. The quick lurches, the short
changes in directions are very, very difficult to predict. But when a herd gets especially
strung out, it is vulnerable to confusion and a temporary loss of direction. Hence we have
recently chosen to step to the side lines on a few of our positions.

We have also made a concerted effort to look at stocks at the opposite extreme to most of
our portfolio the laggards. But there are slim pickings over there. Many may be prone to
short sharp bounces, but timing is unpredictable and the duration of the bounce is likely to
be short. What keeps us out of most of these is the herding behaviour of a different,
important group of people who influence stock markets: company managers.
One of the biases Kahneman touches on in Thinking, Fast and Slow is the inside vs. the
outside view. People inside an activity often miss sources of error, quite obvious to others
who operate outside the activity. Sometimes a combination of the inside-outside view
bias with herding can cause especially dysfunctional behaviour to permeate through a
particular activity. From our perspective there are three areas where our outside view
makes us nervous.
Firstly, we remain nervous about the natural resource industries. We have written about
natural resource companies at length before, but they need to be mentioned again, because
they dominate the multi-period laggards (and one might be tempted to buy them in this
period of extremes). Our outside view is that company managers are in denial about the
likely efficacy of their past investment decisions, which appear to us to have often been
taken with over-confidence and myopia. Past hopes now frame the way managers respond
to disappointment and risk. Many of the recent actions of managers in this sector reinforce
our view. Two particular examples spring to mind: the wave of capital raising in the US Shale
sector, and the use of streaming in the mining sector. US Shales response to a collapsing oil
price has been to go through a renewed round of capital raising, using debt and equity
markets; instead of capital being tempted to leave the industry, the opposite is happening.
Not good. In the mining industry, a very risky source of off-balance sheet financing known as
streaming and usually only used by cash strapped small mining companies, is spreading
through the industry like a virus. Streamers look like the pawnbrokers of the mining industry
to us lenders you go to when you are really in trouble. You agree to hock your few
remaining valuable assets at knock-down prices to get a quick cash hit. There isnt the space
to go into the details here, but when one of the worlds largest miners (Glencore) goes to
the equivalent of the pawnshop, it makes us even more nervous.
Secondly, we are increasingly nervous about the car industry. Government regulation has
been very helpful for the car industry over the last ten years, especially in Europe. Ever
tightening emission standards tied to financial inducements for people to prefer lower
emission vehicles have made it a great period for selling new, higher margin, diesel cars.
Development in diesel engine technology apparently enabled a raft of new low emission,
fuel efficient, powerful cars to be built; except they havent. The advantages of building a
car that could pass ever stricter emission, fuel economy and performance rules appears to
have encouraged one of the worlds largest car makers (VW) to add a bit of new
technology allowing their cars to pass emission and fuel efficiency tests without actually
being low emission, efficient and fast in everyday use. An outside view would wonder
3

how a company could be tempted, apparently, to actively cheat the rules and not expect to
be rumbled. An inside view probably focuses on the ego boosting feeling of propelling a
company to being the largest car company in the world. An outside view might also
speculate as to how it is possible for the rest of the industry to have rule-based statistics
that are clustered around VWs without resorting to cheating as well; either VWs cars are
really bad or everyone else is cheating. This industry looks too risky for us.
Thirdly, there is the curious inside-out case of the US drug industry. Five years ago the US
healthcare industry lay under a cloud of gloom. The combination of regulatory change
(Obamacare) and a swathe of important drugs approaching the end of their patents created
an expectation of pricing pressure. Drug companies appear to have been able to get away
with sneakily raising prices on their entire range of drugs at 5-7% a year, through a variety of
tactics like smallish general price rises, and introducing slightly more expensive new drugs to
the overall mix. But it was feared that the drag from successful drugs suffering sharp price
declines, as their patents expired, and the more widespread reliance on government funded
healthcare programs, would cause a sharp deceleration (or maybe even a decline) in pricing.
Instead average drug price inflation in the US looks like it has accelerated to above 10% p.a.
How has this happened? A raft of new businesses has emerged, some started by people
from outside the drug industry. Simplistically, their business model has been to buy
portfolios of unwanted, mature, niche drugs from the big drug companies and jack their
prices up aggressively. These drugs had often sat quietly within larger companies, viewed as
slowly wasting assets. Their relative obscurity and lower profit margins allowed them to
avoid competition. Smart outsiders from the drug industry realised they could take
advantage of this neglect, and aggressively put up prices. There are no regulations to
prevent it and no competition waiting to undercut them. Belatedly the big drug companies
have caught on. They have stopped blindly selling whats left of their older drugs, and
instead resorted to similar tactics. For decades the US drug industry has operated within a
set of un-written rules. New drugs can be sold at high prices to fund the R&D to keep
discovering new drugs. These unwritten rules have been busted open by recent practice,
initiated by outsiders.
As a genuine outsider we find it interesting how a pattern of behaviour so obviously shortsighted and ultimately destructive could have been allowed to take hold. To us it looks like a
form of the Prisoners Dilemma from Game Theory. If an outsider comes into a previously
stable system, cheats the rules and wins, it encourages others to do the same. Eventually
previously well behaved participants are deemed stupid for not cheating the rules as well.
The norm of behaviour shifts, the original stigma is lost with time, and the inside view
insidiously accepts and justifies the new behaviour as sensible. Unfortunately for the drug
industry, and fortunately for the rest of us, a few high profile outsiders have rumbled this
particular game and drawn the outside crowds attention to it.

The latter two industries were, until very recently, well represented in the list of long-term,
multi-period winning stocks. The breakdown of behaviour in these two areas is, in our view,
ultimately good for stock markets. It legitimately takes some of the steam out of high end
momentum. But the continued poor behaviour in natural resources makes it too risky, in
our view, to be looking to back laggards.
Instead, our new ideas are generally among the jostling middle of the crowd. We have
removed some of our more extreme winners, flushed out whats left of our auto exposure
and squeezed down in healthcare, to get a more balanced and, in our view, lower risk
portfolio. Our sense is that markets will do well from here, but for paradoxical reasons: bad
news is good news at the moment. The troubles of large commodity traders and large car
financing companies have injected a new source of financial instability. Governments hate
financial instability, so QE looks to be limbering up on the side line, to bail out the reckless
again. We can but sigh, and stick to our lower risk principles.

_______________________________________________
Important Information
This material is for distribution to Professional Clients only, as defined under the Financial Conduct Authoritys
(FCA) conduct of business rules, and should not be relied upon by any other persons. Issued by Ardevora
Asset Management LLP (authorised and regulated by the FCA). Registered office: 6 New Bridge Street, London
EC4V 6AB. Registered in England No. OC351772. Tel: 020 7842 0630. Past performance is not a guide to future
performance. Care has been taken to ensure the accuracy of this documents content, but no responsibility is
accepted for any errors or omissions herein. The views expressed do not constitute investment or any other
advice and are subject to change. In particular, we are not recommending or expressing an opinion on the
merits of buying or selling any securities mentioned herein.