On the Value of Being Generalists
The prevailing trend in the modern investment management industry is for ever-increasing specialization, with professional money managers given mandates to generate alpha in particular niches while being measured against specific benchmarks. This modern development stands in contrast to the initial conception of private investment partnerships as small, “go-anywhere” private pools of capital entrusted to General Partners (“GP”s) by Limited Partners, where the GP is a steward — not merely an agent, however skilled — in a partnership built on trust. In this regard, Discerene, with its broad mandate, is a conscious throwback. Even as we’ve grown, Discerene remains firm in its commitment to generalist, first-principles-based investing. We will elaborate on our beliefs that underpin this choice.
1. A Generalist Investment DNA is More Evolutionarily Antifragile.
Because investing is ultimately a competitive endeavor, we’ve found studying the evidence from evolutionary biology to be helpful to our thinking. Evolutionary biologists recognize that specialization within organisms may evolve because the costs involved in being generalists are high.1 For example, selection for a homeostatic reaction2 may occur in the case of regulation of body temperature in animals (such as mammals) that live in habitats differing in temperature. A constant internal temperature may be beneficial because it allows enzymes to react at their optimal temperature, but the potential to keep body temperature constant can be achieved only by numerous plastic anatomical, physiological, or behavioral mechanisms — all requiring significant resources. Such a generalist strategy may pay off only if organisms do indeed encounter habitats differing in ambient temperature.3 Otherwise, a generalist strategy is costly and evolutionarily inefficient. Instead, successful evolution within specific habitats may involve both specialization (e.g., in the bill length of birds to optimize efficiency in feeding on different prey types) and simplification.4 The analogy to investing is apposite: Under constant conditions, a generalist strategy is often more expensive (in terms of resources, including time, talent, capital, etc.) than a specialist one.
However, competition in biological ecosystems and in investing occurs not just across space(different habitats in the case of organisms, different geographies/industries/asset classes in the case of investors) but also across time. Here, it is crucial to note that long-term investing is generally a non-ergodic endeavor. Consequently, success (for both organisms and investors) is determined by sequential geometric rather than arithmetic mean outcomes.
In the case of evolutionary biology, the generalist vs. specialist debate for competition across time can be couched in “bet-hedging”5 terms.6 In fluctuating biological environments over extended time horizons, organisms can bet-hedge to maximize mean fitness across generations in two ways: (1)“diversifying” bet-hedging by producing different specialist offspring and (2)“conservative” bet-hedging by producing similar generalist offspring. Evolutionary biologists Thomas Ray Haaland, Jonathan Wright, and Irja IdaRatikainen found that for traits with additive fitness effects within lifetimes(e.g., foraging-related traits), genotypes of similar generalists or diversified specialists perform equally well. However, if fitness is multiplicative within lifetimes (e.g., with sequential survival probabilities), generalist individuals are always favored. In fluctuating environments, the optimal genotypic strategy is thus the one that maximizes geometric mean fitness across environmental conditions.7
If the paragraph above seems dense and jargon-y, it’s because it is! Thankfully, its insight can be grasped intuitively. In a fluctuating environment, an organism that produces hyper-specialized offspring will have certain offspring that are well-adapted to a particular environment, while all other offspring become evolutionary dead-ends. However, if the environment then changes, such surviving offspring will be less able to sufficiently adapt to the new environment, increasing the risk of extinction.
Applying these insights to investing, there will likely be more successful investment programs than Discerene’s at any given time. For example, during a time of fertile innovation in particular fields (e.g., software), specialist investment teams will be far more able to capitalize on opportunities in such fields. Likewise, a Brazil-focused investment firm is far more likely to be able to take advantage of on-the-ground Brazilian investment opportunities than we can while sitting in Stamford, Connecticut. However, over the course of a lifetime, the investment environment is likely to change multiple times. Thus, a successful software- or Brazil-focused investor in one environment may experience significantly less successful investment outcomes when the environment changes. Sometimes, the quality that makes the investor so successful in the first place may be the very quality that becomes a blind spot or liability in the new environment. Because investment returns are geometric (i.e., multiplicative, not additive) and non-ergodic, such blind spots brought about by (over) specialization can blow up an investment program. This is indeed consistent with empirical observations.
Over the long run, we believe that business in general and capital allocation in particular are fundamentally generalist disciplines. There is good empirical support for this. To name just two examples: In 2007, Kevin Murphy and Jan Zabojnik found a rising trend of hiring generalists rather than industry specialists for CEO positions and attributed their findings to the increased importance of multi-product market and inter-industry knowledge, fierce international competition that requires a broad vision, technology, and management innovation, and the complexity of contemporary business issues.8 On the other side of the world, in a 2021 paper titled “Generalists vs. Specialists: Who Are Better Acquirers?”, Yan Xu, Nianhang Xu, Kam Chan, and Zhe Li reported that among all corporate mergers and acquisitions completed in China from 2002 to 2018, those led by generalist top executives generated better long-term returns than those led by specialist top executives.9
Ceteris paribus (i.e., given the same amounts of resources, capital, talent, etc.),we believe that a generalist, first-principles-based approach to investing like Discerene’s is likely to be more anti-fragile and ultimately more successful over the course of an investing lifetime.
2. It Is Dangerous to Be an Institutionalized “Hammer in Search of Nails.”
As a broad investing principle, we think that it is unwise to make investment decisions using a rear-view mirror. Where we have generated returns in the past is not necessarily — and often not likely to be — where we expect to generate returns in the future. We are not likely to spend our time looking for ways to relive past glories, or fight yesterday’s investment battles.
The problems created by rear-view-mirror-based investing get amplified by principal-agent issues. When a particular investment mandate is deemed to have worked in the past, a flood of capital is typically then raised to keep executing the mandate. Professional money managers awarded these investment mandates have clear incentives to (i) keep raising new capital and (ii) keep putting this capital to work, regardless of potential prospective returns. Such principal-agent issues make it unlikely for such managers — who may otherwise be best positioned to see the limits of a particular mandate — to “pull the Andon chord”10 and return cash to their investors when a relevant investment opportunity disappears. Instead, as more and more money managers, armed with ever larger pools of capital, begin competing for the exact same investment opportunities, price bubbles get created in specific, mimesis-reinforced “asset classes” or“ themes,” while broad swaths of the investment universe are ignored. Ironically, the narrower and more focused the mandates that are handed out to professional money managers, the more likely it is that assets will be significantly mispriced.
3. Being Contrarian Necessitates a Broad Potential Investment Universe.
There is no a priori reason for value investing to “work” in all states of the world. Like other investment strategies, value investing is self-immolating; if everyone becomes a value investor who only buys assets at steep discounts to intrinsic value in order to hold them long term, there will be no one to buy these assets from. Value investing works because of empirical human behavior; in aggregate, people do invest with rear-view mirrors, become overconfident with recent success, and seek to relive past glories. Principal-agent issues do remain unresolved, with various agents (bankers, analysts, money managers, etc.) continuing to be enthusiastic cheerleaders for particular investment opportunities long after prices have overshot fair values. It is precisely when the attractiveness of such investment opportunities becomes the conventional wisdom that a contrarian value investor most shines — by taking the opposite stance. Therefore, value investors must always be a minority group, and value investing can never be the dominant strategy of the day.
We believe this also means that value investors should be generalists. Regardless of how much domain expertise we might have on Malaysian businesses, for example, we will almost certainly generate poor absolute returns investing in on Malaysian companies during times when others are irrationally exuberant about the country’s future prospects. When there is nothing cheap in a particular space, value investors must have the option of doing nothing, going elsewhere in search of opportunities,11 or taking the opposite side of the popular investment ideas of the day.12
4. The Microstructures of Businesses Are the Most Important Drivers of Business Value in the Long Run.
Over a ten-year time horizon, we believe that the impact of fundamental microeconomic structures of a business on its performance outweighs those of shorter-term factors, including the temporary brilliance/missteps of individual business managers13 and temporary headwinds/tailwinds of the macroeconomic environment. Consequently, we posit that an investor who focuses on understanding such structures is likely to be served better in the long run than one who focuses solely on shorter-term investing tools. While remaining an industry and geographic generalist, the long-term, microeconomics-focused value investor is nevertheless a domain expert in his/her own right.
5. “Out-Of-The-Box” Creativity Requires the Development of Lateral Pattern Recognition Abilities.
Our generalist instinct is also rooted in motivational psychology. We observe that many intellectually curious and growth-minded analysts (including those at Discerene) are intrinsically driven to “spread their minds over the world” and, in so doing, understand it better. For such analysts, investing is not just away to make a living; it is also a way of life. It can be cognitively dissonant to tell them that, for example, their knowledge should be limited to the West(or East) of the Bosphorus.
The modern investment professional tends to express his/her thoughts in the technical language of net present value, risk-reward, asset price correlations, etc. This makes it seem like the job is cut and dried: One “does the work” on a business, projects its cashflow, decides on the right discount rate, and — voila — out pops an estimate of fair value. Of course, the challenge is that every other investor, armed with similar intelligence and resources, is doing the same thing. For investing to be successful in such a competitive world, we think that intellectual creativity is as important as brute analytical strength.
We believe that analytical creativity is more likely to be cultivated if an investment analyst is given the freedom to look outside a particular sand box. The freedom to spread his/her mind over a large investment universe allows the analyst to collect empirical data across distinct geographies, industries, and time periods; interact with more management teams with heterogeneous approaches to running businesses,14 examine more outcomes that developed contrary to a priori expectations,15 develop more “mental models,”16 and cultivate more nuanced (more “brush”- and less “hammer”-like) business evaluation skills — allowing more original insight to emerge.
Because of this creative element, we believe that good business analysis can indeed be beautiful. We appreciate the aesthetics of an analyst seeing something about a business that others do not, acting with conviction and against the grain on that insight, and ultimately being right. Original thinking has its own elegance. Expressed in creative terms, we all “paint our own paintings” as investors over the course of our lifetimes. The Discerene “painting” is very much still a work in progress, but we believe that how compelling it is may be affected by how large a tapestry we have to paint on, and the color palette we have to paint with.
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We’re aware that our commitment to a generalist investment program isn’t without tradeoffs. We believe that they are worthwhile ones.
1. Bradshaw (1965), “Evolutionary Significance of Phenotypic Plasticity in Plants,” Advanced Generics. Volume 3, pages 115-155.
2. Defined as “any process living things use to actively maintain fairly stable conditions necessary for survival.” See, e.g., https://www.scientificamerican.com/article/what-is-homeostasis/
3. Van Tenderen (*1991), “Evolution of Generalists and Specialists in Spatially Heterogeneous Environments,” Evolution, Volume 45(6), pages 1317-1331.
4. See, e.g., https://kozielska-reid.eu/2022/01/31/when-evolution-leads-to-simplification/.
5. An evolutionary strategy where organisms suffer decreased fitness in their typical conditions in exchange for increased fitness in stressful conditions. See, e.g., https://www.sciencedirect.com/topics/earth-and-planetary-sciences/bet-hedging.
6. See Haaland, Wright, and Ratikainen (2020), “Generalists Versus Specialists in Fluctuating Environments: A Bet-Hedging Perspective,” Oikos, Volume 129, pages 879-890.
7. Lewontin and Cohen (1969), “On Population Growth in a Randomly Varying Environment,” Proceedings of the National Academy of Sciences, Volume 62, pages 1056-1060; Simon (2002),“The Continuity of Microevolution and Macroevolution,” Journal of Evolutionary Biology, Volume 15, pages 688-701.
8. Murply and Zabojnik (2007),“Managerial Capital and the Market for CEOs,” Social Science Research Network.
9. Xu, Xu, Chan, and Li (2021), Journal of Corporate Finance, Volume 67.
10. In Kaizen language.
11. Note that none of this requires the value investor to develop top-down views. While we can never predict how markets trade, we can always rely on our bottom-up estimates of intrinsic value, and how divorced market prices are from these estimates in particular areas.
12. When nothing appears to be a bargain, it is usually risk that is priced too cheaply.
13. Cf. Warren Buffett’s 1980 Berkshire Hathaway shareholder letter: “…with few exceptions, when a manager with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”
14. We have found that this often results in the analyst becoming less dogmatic about how a business ought to be run.
15. E.g., why do some businesses fail despite promising initial conditions?
16. Cf. Charlie Munger’s discussions on this topic.