Bottom-up thinking is not a typical hallmark of multi-asset investing. However, Francois de Bruin believes the granularity that comes from this approach offers useful diversification and risk benefits.
5 minute read
Anyone who has walked around the Royal Observatory and Flamsteed House in Greenwich will understand its historic and scientific significance. Quite literally, the United Kingdom and the world would not be what they are today without the scientific progress that took place within its grounds over the last few centuries.
As you enter Flamsteed House and weave your way through the curated museum rooms, you are eventually directed to a room containing four timepieces dating back to the 1700s. Their inventor’s story represents perhaps the greatest example in bottom-up thinking ever uncovered; it also represents a true David and Goliath underdog story.
Admiral Sir Clowdisley Shovell, returning home victorious from Gibraltar in foggy darkness on October 22, 1707, misgauged his longitude reading and ran aground off the Isles of Scilly. In all, five ships and over 2,000 sailors were lost that night. Something we take for granted today, thanks to GPS, was causing unnecessary loss of life and made nautical travel uncertain and perilous.
In eventual response, the UK Parliament set up the Longitude Act of 1714 and created the Longitude Board. The £20,000 reward on offer for a solution enticed the greatest mathematicians, scientists and thinkers of the age, who all set to work. Revered scientists and members of the Royal Society looked skywards in search of clues from astronomy and celestial stargazing. Despite their collective brainpower, none of them made the breakthrough. Instead, a practical and plucky Yorkshireman, John Harrison, emerged the victor.
John Harrison solved the greatest challenge of his time by simply building a tough, sturdy clock
A clockmaker by trade, Harrison set about solving the problem in a totally different fashion to his competitors. Instead of reaching for a pencil, sheet of paper and ruler and then looking skyward, he focused on what he knew best. It took him four goes (hence the four timepieces now displayed in Flamsteed House, or chronometers as they are known) and over 20 years, but eventually Harrison’s H4 friction-free design was deemed to have succeeded.
Much to the chagrin of his scientific rivals, Harrison solved the greatest challenge of his time by simply building a tough, sturdy clock capable of keeping its rate constant and enduring the harsh weather conditions great voyages inevitably ran into. His determination and microscopic view paved the way for ships’ longitudinal positions to be accurately calculated while out at sea – saving countless lives.
The engineer’s view of investing
Harrison’s triumph has parallels with investing. Debates over bottom-up and top-down thinking have raged for decades, and there is assuredly a place for both. And while the conversation has typically focused on single asset classes, it is also relevant for multi-asset investing.
Harrison’s mechanical mind can be applied to how we view risks
Harrison’s mechanical mind can be applied to how we view risks. For anyone seeking to get a handle on risk, there are a multitude of challenges and, whether macro or micro navigating them, all can be quite daunting. Harrison would hunker-down and focus on what he could control, scouring for the best assets across the globe, and ones with the potential to generate sustainable income.
While the focus is on each individual asset, its diversification merits are still evaluated in the context of the rest of the portfolio. Importantly, each asset must meet a required hurdle rate. Multi-asset investors face a decreasing pool of assets in aggregate that behave in an uncorrelated way as the risk-free rate is bound close to or below zero, compounded by the low yields on offer in absolute terms; tracking correlation relationships at this level therefore allows diversification to become a vital source of risk management.
Wolters Kluwer is a good example. A global information services company integrated into professional services, its systems are a staple of the law and tax firms that subscribe to its publications, making earnings highly visible and recurring. However, it is crudely placed into the industrial sector by MSCI and yet exhibits none of the same cyclicality or economic properties compared to traditional industrial manufacturers. Its idiosyncratic profile makes Wolters Kluwer highly useful in a broader portfolio context.
Active engagement at the individual company level becomes pivotal
As investors increasingly realise the importance of environmental, social and governance factors when managing portfolio risk and spotting future-proofed opportunities, active engagement at the individual company level also becomes pivotal.
The recent scandal at fast fashion company Boohoo is a good example. After news of alleged illegal work practices in its supplier operations broke in mid-June, almost half of the value was wiped from Boohoo’s share price in less than a month. Even before then, there were several governance red flags, including a questionable culture; excessive remuneration for its leaders; and audit standards below what we would expect of a company with a £5 billion market capitalisation. Additionally, its insistence on keeping its AIM listing, with lower disclosure obligations and shareholder accountabilities, despite being eligible for the FTSE 100, was another clear warning sign.
Beyond active engagement, being unconstrained by a top-down view better allows for daily, weekly and monthly oscillations of share prices to be taken advantage of, even when the fundamental view has not changed. This is because flexing position sizes around a core holding gives an active fund manager an opportunity to build profits even while the long-run thesis remains intact. Indeed, the “art of execution” is best utilised at the individual asset level, as capturing market anomalies – like public equity issuances at a discount, or liquidity driven near-term discounts – is something bottom up investors thrive on.
The income yields that can be uncovered via a bottom-up approach also have the potential to be greater than those on offer from aggregate markets. Sidestepping dividend cuts and corporate defaults is far easier when you are focused on the finer detail, allowing yields to be sustained in harsh environments.
Then there is exposure to sub-sectors too small for traditional multi-asset funds to gain exposure to. Listed property is a great example. It constitutes two per cent of the global equity market, but niche sub-sectors within the asset class like towers, data centres, cold storage and manufactured housing offer the best fundamentals and can be held in material proportions when building the portfolio from the bottom up.
A bottom-up mindset paves the way for intrinsically robust portfolios to be built
A bottom-up mindset essentially paves the way for intrinsically robust portfolios to be built. By introducing what you might call investment modularity – resilience through the diversity of idiosyncratic ideas that are not as reliant on each other as ones merely informed from big, top-down macro themes – greater diversification can be achieved, as well as a more granular view of the opportunities that exist.
It is worth remembering, however, that brick-by-brick analysis is resource intensive. Personal contact with senior decision-makers and engagement on sustainability all take time. But the advantage is that you can gain a deep understanding of each asset’s impact on the planet and its ability to generate cash.
Harrison was not a one-off
If, like me, you are sceptical of cherrypicked anecdotal evidence to support an argument, you will be comforted to know that John Harrison was not a one-off phenomenon. In The Economic Laws of Scientific Research, Terence Kealey offers up yet more evidence of successful bottom-up practitioners:
“In 1733, John Kay invented the flying shuttle, which mechanised weaving, and in 1770 James Hargreaves invented the spinning jenny, which as its name implies, mechanised spinning. These major developments in textile technology, as well as those of Wyatt and Paul (spinning frame, 1758), and Arkwright (water frame, 1769), presaged the Industrial Revolution, yet they owe nothing to science; they were empirical developments based on the trial, error and experimentation of skilled craftsmen who were trying to improve the productivity, and so the profits, of their factories.”1
Practical thinking can and should rival more theoretical approaches
What these examples teach us is that practical thinking can and should rival more theoretical approaches. In the case of the longitude problem and Harrison’s ‘sea clock’, the engineer won out over the scientist. That will not always be true, but as investors we should value the wisdom of practical minds more than we do currently.
Investing is not a hard science (representing a blend of art and scientific method). As human behaviour lies at its core, there is space for both approaches. All I am trying to argue is that outside the tidy world of mathematical models lie a plethora of unexpected developments, all of which have an unfortunate habit of de-railing life. It therefore seems sensible to learn from experience and build resilience by incorporating some bottom-up thinking into a multi-asset investment process.