For the quarter ending March 31, 2016 INVESTMENT COMMENTARY

Conformity can be harmful to your wealth By Ted Chisholm, portfolio manager

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”i ―

I recently watched a documentary on the life of E.O. While Wilson had no political agenda, he argued that Wilson, titled Of Ants and Men.ii If you’re interested as scientists he and his peers had a duty to uncover in either the natural world or human nature I highly the truth regardless of political correctness. I think recommend it. Wilson is an entomologist and it’s fair to say that Wilson must have felt very alone biologist and the father of two significant scientific in his beliefs and I can imagine it would have been concepts, sociobiology and biodiversity. In the cold comfort that he found himself on a long list of documentary, Wilson comes across as positive, great scientists who’d been attacked and persecuted engaging, curious and very much a gentleman. He for their beliefs, like Galileo Galilei. While it took time seems like a good role model for growing old so I for the air to clear, Wilson’s theories ultimately led to wanted to find out more about him. him being honoured with scientific prizes, including the National Medal of Science in the U.S. and the I learned that Wilson was a polarizing figure accused prestigious Crafoord Prize from the Royal Swedish of racism, misogyny and eugenics. Without going Academy of Sciences, as well as two Pulitzers. into too much detail, the controversy stemmed from Everything I read about him confirmed that he’s the his hypothesis that human behaviour is shaped by man I saw in the movie: kind, decent, thoughtful and evolutionary forces, a combination of nature and a true gentleman. nurture, rather than solely nurture or environmental factors. This hypothesis flew in the face of By now, I’m sure some of you are asking what the conventional thinking that we’re ostensibly born with heck does this have to do with investing? The a blank slate or tabula rasa and that our behaviour is answer is, a lot. The stock is the product of shaped by experiences. For these views he was thousands of people making independent decisions attacked both physically and mentally by his peers at every day. These decisions are based on their beliefs, Harvard, where he was a professor, along with both in this case on the of a business. There’s atheists and religious groups. Wilson was pretty incentive for being right and punishment for being good at upsetting everyone but he stood by his wrong. On any given day as an investor, it can feel beliefs, which were based on his scientific like you can do no wrong while at other times it feels observation of the natural world. like you can do no right.

In the short term, the market can be an exceptionally with the popular view of the value of a business if we hostile place and it requires courage in your believe it’s wrong. While we haven’t been physically convictions to achieve success. While the attacked for our beliefs (we believe our investors circumstances and beliefs around investing are haven’t had a reason to do so), frequently we’re completely different from Wilson’s, the outcomes called out to defend the idea behind one of our are similar. investments. More importantly, our psyches can be attacked day-to-day by changes in businesses Market circumstances are often driven by short-term we invest in. To believe that it’s easy to feel good reactions to economic or business activity, while when the companies you invest in are down 10%, disputes over beliefs are always about the true value 20%, 40% or more, is to lack basic understanding of of a business based on those circumstances. This human nature. It’s mentally demanding, but only in drives stocks up or down short term. Ben Graham, the short term. the father of security analysis, said it best: “In the short run, the stock market is a voting machine but in Gregory Berns, a professor of at Emory the long run it is a weighing machine.”iii What he University, more recently conducted an experiment meant was in the short term stock can diverge that confirmed earlier findings by social from their true value as businesses but over the long Solomon Asch that only about 25% of humans have term price and value tend to meet. This short-term the ability to stand apart from the crowd.iv He did disconnect between price and value is often caused this by showing participants a wrong answer to a by one of the most powerful forces in human nature, question at the same time they were trying to the urge to conform, and it’s ever-present in the answer that question. More than 40% of the time market. Sometimes this herding behaviour is manic, participants would defer to the answer provided to leading to high prices like during the tech bubble of them. On the other hand, only 14% answered the the late 1990s, while other times the herd is question wrong when no wrong answer was first extremely depressed leading to market crashes like introduced to them. Human beings are very willing to in 1987. To truly achieve success as an investor you conform to the thinking of others even when they must be able to recognize manic periods as an believe they may be wrong in doing so. opportunity to sell and depressed periods as an In a recent article called Animating Mr. Market: opportunity to buy. Adopting a Proper Psychological Attitude, financial At EdgePoint, a central tenet of our investment strategist Michael Mauboussin quotes Berns: philosophy is our willingness to stand apart from the “ ‘We like to think that seeing is believing,’ but, Berns said, crowd. This doesn’t mean we try to be different for the study’s findings show that seeing is believing what the group tells you to believe.”v the sake of it. It means that we’ll avoid conforming

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Another element of the experiment worth mentioning is what happened in the brain of those who remained independent (25% of participants). They experienced increased activity in the , the part of the brain that calls for immediate action.

Fear is a powerful trigger for the amygdala, and it’s behind the fight-or-flight response, a psychological Source: A. Petajisto, “Active Share and Mutual Fund Performance”, Financial Analysts Journal v. 60, no. 4 reaction prompting us to fight or flee a perceived (July/August 2013): 79-93. attack or threat to survival. Those who stayed Why does this matter to you as our investor? It’s independent clearly have a very different way of important because it has been proven that truly managing the response than the majority of the active management as defined by two specific population and they deserve admiration because of criteria can add value. Those two criteria are active their ability to overcome such an inherent part of share and tracking error. human nature.

Active share simply means the percentage of a Interestingly, when you look at the world of portfolio that looks different from the benchmark professional investment management you find the index. Funds with a 60% to 90% active share have same tendency for . As we see in the been shown to outperform by 1.6% over the long following chart, 50% of all managed does term while funds with at least a 90% active share nothing more than try to achieve the same results as have outperformed by 3.6% annually.vi EdgePoint an index like the S&P 500. While half of managed Global Portfolio has an active share of 97% and money is considered “active” note that only a little EdgePoint Canadian Portfolio, an active share of more than 20% is considered “highly active.” This is 85% as at December 31, 2015. the group that we fall into and the group willing to manage investment portfolios that look different from the index. The percentage of investment managers in this category fits well with the results of the previously mentioned behavioural experiments in that only about 25% are non-conformists.

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U.S. all-equity mutual funds 1990-2009

Source: M. Cremers & A. Petajisto, “How Active is Your Fund Manager?” Yale School of Management, 2006.

Reflects annualized equal-weighted performance of U.S. all-equity mutual funds for four types of active management. Returns net of fees and transaction costs. Excludes index funds, sector funds and funds with less than $10 million in assets. Four-factor alpha as calculated by Carhart's four-factor alpha model (1997). Source: A. Petajisto, “Active Share and Mutual Fund Performance”, Working Paper, December 15, 2010. Source: M. Cremers et al., “The Mutual Fund Industry We like to say our portfolios are diversified by Worldwide: Explicit and Closet Indexing, Fees, and Performance,” Social Research Network, 2013. business idea and we try not to have much, or any,

The other important factor that isn’t talked about overlap in these ideas. With no factor bets, we nearly as much as active share is tracking error. believe this helps create the circumstances for an Tracking error measures the amount by which a fund appropriate tracking error and hope our approach deviates from the performance of its index. High will lead to superior long-term performance. tracking error will often appear when a fund is If the recent bout of downward market volatility has overweighted or has made a factor bet in a certain left you scared and running for the exits, you have market sector like technology or healthcare. As the lots of company. When stock prices are falling and following chart shows, factor bets have been shown investors are fleeing the market, the Asch and Burns to contribute most to underperformance over time. studies would suggest about 75% of investors’ peers As with so much in life, having too much of will want to join them. Yet while the experience isn’t something is rarely a good thing. pleasant psychologically, it’s at this time, when the

market is a voting machine that we at EdgePoint will invest more in the businesses we believe have the

greatest chance of achieving above-average market

returns long term. That’s because we believe that

over time, the market is a weighing machine and that

a business’s value and its stock price will converge.

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We also believe that our ability to think think it would have a volatile stock price but it does. independently is one of our key competitive As an investment, Alere is a great example of how advantages. we don’t follow the herd. Many times over the years Our approach at work of our ownership about Alere’s short-

Since the end of 2011, Alere Inc. has been one of the term performance caused downward volatility in its largest equity weights in our Global Portfolio, a share price. There were two FDA product recalls, significant position in the foreign content of our several missed quarterly earnings estimates, a 50% Canadian Portfolio and a substantial fixed-income share price drop, many daily 10% declines, an activist position in our Growth & Income Portfolios. Alere investor that accused the board of ignoring its recently received a takeover offer from Abbott fiduciary duty by not making shareholders aware of a Laboratories supporting our long-term investment bid for the company, and the resignation of the thesis in the company. founder and CEO as well as most of his team. In quite a few cases the stock sold off due to these Alere is the global leader in point-of-care diagnostics. issues and we often not only purchased stock but If your doctor has given you a strep test and got the also increased Alere’s weight in the Portfolios as you results in 15 minutes, there’s a good chance it was an can see in the following chart. Alere test. It’s a very stable business so you wouldn’t

Source: Bloomberg LP. January 5, 2009 to February 2, 2016. In US$. Weights in EdgePoint Global Portfolio as at: (1) 16-09- 09, (2) 30-09-11, (3) 31-12-12, (4) 10-06-13, (5) 01-07-14, (6) 09-01-15, (7) 15-10-2015, (8) 28-01-2016, (9) 01-02-2016. 50% price decrease: September 2, 2009 to October 3, 2011. Since the takeover, as EdgePoint has sold down its position, the stock price has fluctuated.

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Because of our long-term belief in Alere, uncertainty Alere is a perfect example of the market being a and downward volatility allowed us to substantially short-term voting machine and a long-term weighing increase our stake in the company which ultimately machine. Stock price and business value can diverge increased the payoff to our investors. Believe it or over shorter timeframes but long term the two tend not, we were buying Alere at less than $36 on to come together. Some three years ago you could January 28, 2016, when it was down as much as have bought Alere for $18 per share; today a 8.7% from the previous day’s close due to volatility competitor thought it was worth $56 per share. I in the healthcare sector. This was a mere two trading don’t know if being non-conformist is the product of days before Abbott’s $56 takeover offer. nature or nurture but in the case of Alere, the result has been very positive for us and our investors.

iJohn Maynard Keynes, The General Theory of Employment, and Money (London: Macmillan, 1936). iiE.O. Wilson – Of Ants and Men. Directed by Shelley Schulze. Washington: Shining Red Productions, Inc. for PBS, 2015. iiiGraham, Benjamin and David L. Dodd, Security Analysis: Principles and Technique (McGraw-Hill Companies, 1962). ivSolomon E. Asch, Studies of independence and conformity: A minority of one against a unanimous majority, Psychological Monographs: General and Applied, Col. 70(9), 1956, p. 1-70. vMichael Mauboussin and Dan Callahan, Animating Mr. Market: Adopting a Proper Psychological Attitude, Credit Suisse, February 10, 2015. viCremers, M. et al., “The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance,” Social Science Research Network, 2013.

Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Please read the prospectus and Fund Facts before investing. Copies are available from your financial advisor or at www.edgepointwealth.com. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This is not an offer to purchase. Mutual funds can only be purchased through a registered dealer and are available only in those jurisdictions where they may be lawfully offered for sale. This document is not intended to provide legal, accounting, tax or specific investment advice. Information contained in this document was obtained from sources believed to be reliable; however, EdgePoint does not assume any responsibility for losses, whether direct, special or consequential, that arise out of the use of this information. Portfolio holdings are subject to change. EdgePoint mutual funds are managed by EdgePoint Investment Group Inc., a related party of EdgePoint Wealth Management Inc. EdgePoint® and Owned and Operated by InvestorsTM are registered trademarks of EdgePoint Investment Group Inc. Published April 11, 2016.

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