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What is Time? What is Space?

One of the most important investing reminders of 2020 was around one of the few sources of investment edge: time. In particular, what is the right time-frame? Behavioural psychologists have repeatedly and consistently demonstrated that in periods of intense stress, our brain’s limbic system (a.k.a. survival system) overrides kick-in and our time horizon shrinks to focus on the immediate threat. It is the same in reverse for rewards: we prefer smaller immediate rewards over larger but deferred gains. The biological reason we find it next to impossible to think long-term under stress is because it requires the use of a different part of the brain (the frontoparietal network) than our survival system overrides allow. For the long-term investor, our brain can be our worst enemy. So we need to plan ahead for bad times and have a process to override our survival system. We need to override our brain’s override! A well-known sports psychologist1 calls this controlling your “inner chimp” and this is what investment process is for. The power of our clear and disciplined process was evident throughout 2020 as it enabled us to focus on our long investment horizon during a stressful and uncertain period. Honestly, a big part of investing is just committing to a thoughtful process.

In our investment book club we are currently reading Factfulness2 by Hans Rosling which has many insights on calibration—updating our view when the facts change3—and the danger of some of the evolutionary behavioural shortcuts as described above that we all instinctively use. Hans was quite a character and it is worth watching his TED talks and taking the Gapminder test. Some other recent reading has included investing history books such as the recently published Boom and Bust and the twenty year old Engines That Move Markets4. Both look back over the past 200-300 years at what drives value creation and ultimately equity markets and pose questions such as: is it the adoption of new technologies that drive change in society? When does crowd psychology take hope for economic return beyond what valuation can support? And why do markets irregularly detach fundamentals from valuation to their own detriment? Unexpectedly however, a short, timeless book about physics provided some of the most pertinent lessons. In his book “What is Time? What is Space?” Carlo Rovelli reflects on a lifetime spent trying to reconcile Einstein’s theory of General Relativity to Newtonian-based Quantum Mechanics. In Newton’s 1687 masterpiece the Principia he notes that time is unobservable yet it enables a convenient link across variables such as speed, mass and volume. Whilst time is part of his famous laws, it is only a relative variable to enable fundamental comparisons. Rovelli’s proposed solution to the biggest physics quandary of the past 100 years is called “loop quantum gravity” and is grounded in the elimination of time as we know it. If this theory is correct, then time does not exist.

It might seem absurd to even ask if time exists with quarterly letters and annual reports part of our daily lives. But is this information temporary or permanent? Is it compounding or expiring knowledge? What is its half-life? And will we care about what we learn today in five years’ time? We think one of our few advantages or “sources of edge” as investors is the extension of our horizon or, taken to its extreme, the removal of time. At the right price we want to own these businesses forever. One can see this in the fundamental equation of economic value tying a company’s invested capital (IC), return on capital (RoIC), the weighted average cost of capital (WACC) and long-term cash flow growth:

Economic Value = IC * (RoIC - growth) / (WACC - growth)5

At its simplest, the fundamental value equation also has no place for time. What does this actually mean? Isn’t time part of compounding? Or is it a convenient way to measure the relative economic value created between our starting and end points? To hold, this equation of perpetual value requires that the return on capital doesn’t fade to the cost of capital, which is precisely our investment strategy. We aim to buy good companies which have a high RoIC that won’t fade over time and compound that return for as long as we own them. A chart looking at the S&P 500® Index from the 6th edition of McKinsey’s Valuation6 book we used in one of our first letters is worth re-presenting. Simply put, good companies typically stay good companies over a ten year period. Our challenge is to buy them cheaply, and then have the courage and patience to wait7.

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The Global Leaders Strategy invests in a concentrated portfolio of market-leading companies from across the globe. We believe that companies that combine exceptional outcomes for their customers with strong leadership can generate high and sustainable returns on invested capital (ROIC) which can lead to outstanding shareholder returns.

1 Dr Steve Peters, The Chimp Paradox: The Mind Management Program to Help You Achieve Success, Confidence, and Happiness

2 Hans Rosling, Factfulness: Ten Reasons We’re Wrong About the World - and Why Things Are Better Than You Think

3 Recalibration was an internal catch-phrase in March!

4 William Quinn and John D. Turner, Boom and Bust. A Global History of Financial Bubbles; Alastair Nairn, Engines That Move Markets. Technology Investing from Railroads to the Internet and Beyond

5 McKinsey & Company (Keller, Goedhart & Wessels), Valuation: Measuring & Managing the Value of Companies 7th ed. Pg. 52 (nb. this equation assumes RoIC is equal to Return on Incremental Invested Capital (RoIIC) in perpetuity)

6 McKinsey & Company (Keller, Goedhart & Wessels), Valuation: Measuring and Managing the Value of Companies 6th edition

7 "The big money is not in the buying or selling but in the waiting" Charlie Munger

Past performance is not a guarantee of future performance and you may not get back the amount invested.

The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.