Super suits, springy shoes, and enduring market opportunities

At Sydney University in February 2008, a hologram of swimming phenom Michael Phelps took the stage wearing revolutionary swimsuit technology, Speedo’s LZR RACER. The body compressing suit, constructed with NASA fabrics and welded seams, reduced drag by 38% and boosted swimmer speeds by four percent.¹ Adoption of the new suit was voracious: at the Beijing Olympics that summer, LZR-wearing swimmers won 98% of all medals and set 23 of 25 new world records.²

We find a similar story in long-distance running. In 2017, Nike debuted the VaporFly 4%, a running shoe incorporating a controversial carbon fiber footplate named for its boost to energy efficiency.³ Vaporfly wearers quickly claimed all long-distance world records and the shoe became ubiquitous in the sport.

In athletics and elsewhere, victory margins narrow as performance capabilities approach natural limits. New advantages become more incremental, but also more valuable, which accelerates their adoption and eventual commoditization. In a matter of mere months, the ground-breaking LZR suit and VaporFly shoes were reduced to nothing more than expensive table-stakes.

Windows of market inefficiency

In the competition of public financial markets, investment advantages—alpha signals—are likewise ravenously pursued and devoured. Windows of market inefficiency begin closing upon discovery, amortizing in value at a pace commensurate to the intensity of their exploitation. This challenge is compounded by the large and growing latency gap between human cognitive ability and the market’s speed and complication. Some investors have adapted by narrowing their aperture to specific industries, situations, or other niche opportunities. Others have pursued just the opposite, deploying scaled computing, algorithms, and artificial intelligence to escape human limitations. Between these polarities of fundamental specialists and sophisticated quants remains a raft of middling traditionalists yet unsure which road to take.

However, over longer time horizons the advantages of algorithmic approaches attenuate and a third path emerges, one lit by windows of market inefficiency that endure even upon discovery. What could be the wellspring of such evergreen opportunity? The answer is rooted in human nature and the various behavioral biases, both cognitive and emotional, embedded deeply therein. As Benjamin Graham put it, “The investor’s chief problem—and even his worst enemy—is likely to be himself.”⁴

What are behavioral biases?

Behavioral biases are subconscious shortcuts that simplify our complex world and speed up decision-making. Some are evolutionarily imbued and static, while others appear to be learned and adaptive. They can reflect our emotions, natural cognitive deficiencies, and even a distillation of our experiences. While sometimes pragmatic, biases can also be very problematic because they abstract logic into blunt generalizations that pay little heed to contextual nuance. These omissions can lead to perspectives and conclusions that 'feel' right but may not be.

Among many, there are two behavioral biases that are particularly helpful for long-term investors:

• The first is an expectation for mean reversion, which is the anticipation for anything unusually good or bad to eventually subside. This expectation is so common it even finds frequent expression in the advice we give each other, such as, “It’s always darkest before the dawn” and “Enjoy it while it lasts.” In corporate finance, profitability analysis⁵ lends empirical support to mean reversion, as shown below. Consequently, markets embed this dynamic universally over longer time frames, creating an arbitrage opportunity where persistence or the defying of such decay is more likely.

Figure 1: ROIC Persistence (Global ex-US stocks, rolling 5yr period averages, 1990-2021)

Source: Ninety One analysis of FactSet data. For the full research methodology, please refer to our white paper entitled ‘Investing in markets the Quality way’ (May 2017) which is available on request. Our research framework involved gathering relevant data from the MSCI All Country World ex-US, dating from 31 December 1990 to 31 December 2016 (this was the furthest point that would provide six full years of data for the analysis, conducted in 2022: one year to establish the ROIC quartiles across all sectors and then five subsequent years to track the decay profile of returns. For further information on investment process, please see the Important Information section.

• The second bias is hyperbolic discounting, which is to say that investors discount rewards—and risks—at increasingly higher rates the further they are expected to occur in the future. In other words, investor preference for immediate gratification increases the longer they must wait. Therefore, imminent opportunities and risks may disproportionately feature in present market values and leave longer-dated rewards on sale.

In combination, these biases can encourage valuation inefficiencies that are especially relevant for businesses capable of producing consistent, superior rewards well into the future. Such companies typically present a rare combination of durable competitive advantage, accretive reinvestment, strong cash production, low debt, and sustainable stakeholder relationships. Interestingly, even as these companies deliver, these biases are often simply rolled forward to affect future periods.

Finding these opportunities requires both a differentiated understanding of a business’ long-term economic trajectory and a disciplined valuation framework. The latter informs the critical matters of investment timing and capital protection over shorter timeframes when other behavioral biases, contagions such as greed and FOMO⁶, may temporarily predominate and reduce prospective returns. Notwithstanding the importance of valuation guardrails, it’s ultimately most essential to correctly judge the course of a company’s financial productivity as delivered in tangible terms such as cash earnings growth and dividends.

Figure 2: TSR breakdown

Source: Ninety One analysis of Bloomberg data, December 2012-December 2022, USD. Proportional impact in absolute terms on Total Shareholder returns (TSR) of Change in valuation, Free cash flow growth and Dividend yield. Change in valuation derived from subtracting FCF growth from the price return. NB: The change in valuation de-rated across the holding periods. Dividend Yield is the residual of TSR - (FCF Yield + Change in Valuation). TSRs - 1Yr 18%, 3Yr 4.5%, 5Yr 5.8%, 10Yr 8.6%.

Human engagement, whether directly on a noisy trading floor or vicariously by code, brings financial markets to life. Markets are thus infused with human nature, and humans evolve very, very slowly. As a species, our intelligence is little improved⁷ over time, and we appear to gain most of our practical knowledge not by study or observation, but by the most inefficient means possible—personal experience.⁸ A further complication for investors is participant churn: market experience only accrues to those that survive…no small prerequisite when the cost of such experience can be brutally absolute. Even more challenging than gaining knowledge is converting it into good judgement or wisdom, as the often sad “rhyming” of history⁹ would suggest. In fighting bias, wisdom is essential because it inspires the counter-intuitive thinking required to do so. Its rarity, however, ensures that bias and its attendant problems—or opportunities in this case—persist.

An appreciation for market bias can help investors distinguish insights of enduring value from distractions. Compare these two examples: first, knowing how the VaporFly launch will impact Nike’s quarterly earnings; or second, understanding the company’s ability to grow its brand by consistently delivering performance-based innovation. Both insights are challenging to acquire, but only the latter has paid investors handsomely for decades.

Our markets continue to originate bias and reflect its inefficiencies. These alpha signals are “wisdom of the crowds” phenomena, which means most investors are actually propagating these gaps rather than consuming them. Instead, these opportunities are deprioritized in favor of chasing what’s immediate, loud, and new.

At launch, the LZR RACER and Vaporfly 4% were ground-breaking innovations, but in the end they offered nothing for the competitiveness of any individual athlete. Despite new gear, a racer’s winning strategy—superior talent, conditioning, technique, and focus—never changed. Neither has the winning formula of trading against common behavioral biases by owning quality compounders for the long term. A classic, but as it would appear, still unconventional approach.

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¹ Compared to LYRCA suits. The Rocket Swimsuit: Speedo’s LZR RACER.
² NASA: Record breaking benefits.
³ A Comparison of the Energetic Cost of Running in Marathon Racing Shoes.
⁴ Graham, Benjamin, 1894-1976. The Intelligent Investor: A Book of Practical Counsel. New York: Harper, 1959.
⁵ Ninety One analysis of FactSet data. For the full research methodology, please refer to our white paper entitled ‘Investing in markets the Quality way’ (May 2017) which is available on request.
⁶ FOMO, of Fear Of Missing Out. Feelings of anxiety that an exciting opportunity or experience will be missed, lost, or taken away.
⁷ PNAS: Flynn effect and its reversal are both environmentally caused.
⁸ 70-20-10 Model for Learning and Development. Center for Creative Leadership. McCall, Lombardo, and Eichinger. This model, based on empirical study, suggests knowledge is acquired 70% by experience, 20% by instruction, and 10% by study.
⁹ “History never repeats itself, but it does often rhyme.” Observation attributed to Mark Twain.