The Toronto Raptors are the 2019 NBA Champions. They went from being underdogs to beating the reigning champions in six games. This win has captured the attention of long-term fans and bandwagoners alike and one of the main protagonists has been Kawhi Leonard, the Raptor’s elusive star who has consistently been the difference maker throughout the entire playoffs. One thing that stands out about Kawhi is his demeanour: he appears emotionless. The Wall Street Journal analyzed 254 shots taken by Kawhi throughout his career in the last five minutes of close games and in 78% of those shots, Kawhi had no reaction and in the instances when he did react, the reactions were muted.1 The same can be said of missed shots where Kawhi shows little sign of being rattled.
In basketball, each possession is a game in-and-of-itself so the ability to stay even-keeled on the current possession is a huge advantage. Once teams get rattled, it can lead to lapses, opening opportunities for opposing teams to go on runs. Kawhi’s ability to manage the inevitable swings of the game have been a key factor in the Raptor’s success.
There are many parallels with investing. Investing is a game of defense and offense, but it is also a game of emotions. The best opportunities for offense arise when the market is nervous, whereas the most important times for defense arise when the market lets its guard down, especially with respect to risk. You need emotional stability to take advantage of these situations. You can’t let the game rattle you and you can never let your guard down.
The small-cap team recognizes that investing is about keeping our guard up and staying emotionless, irrespective of what the market is doing, and we have specific processes to combat the inevitable swings and emotions happening around us. I’ll give two examples.
Great investment opportunities are rare so when I think I’ve found one, I’m ecstatic. However, we subject our analysis to a barrage of questioning and criticism in team meetings. If you looked at my face after one of these meetings, I do not look like I just found an exciting investment opportunity. We try and humble ourselves in these meetings. The entire small-cap team is expected to come prepared with pointed questions to take account of all risks.
For example, in the case of Jardine Lloyd Thompson Group plc, a portfolio holding of the Invesco Global Small Companies Class, we met with the management team twice, met with the CEO of a major competitor, and talked to experienced executives in the industry to gain full comfort around all the issues that arose from my initial analysis. That is how we play defense. Our defensive work ultimately paid off as we were able to significantly add to our position during subsequent weakness and ultimately benefit from the company being acquired by Marsh & McLennan Companies, Inc. at a significant premium.
However, we won’t let ourselves get too excited, as we don’t want to let our guard down and let the opposing team go on a run. After the Raptor’s defeated the Golden State Warriors in Game 4 to give them a 3-1 lead, reporters remarked that the Raptors looked like the losing team as they walked off the court. We have a similar mentality.
When one of our portfolio companies reacts negatively to a piece of news, the natural reaction is fear. However, the small-cap team realizes that there is a big difference between risk and uncertainty. Negative stock reactions are often an emotional response to uncertainty rather than a rational response to increased risk. This is especially true for small caps that often have less coverage. For example, many of our holdings in the Invesco Global Small Companies Class have fewer than two brokers covering them, with the coverage often spotty. As a result, investors often react emotionally to news without understanding the implications. For example, shares of Equiniti Group plc experienced weakness throughout Q3 of 2018 because of delays in their integration of one of their acquisitions. While the acquisition integration was delayed by one quarter, we believed it would benefit us for dozens of subsequent quarters. We did additional work visiting with management, talking with managers at the acquired company, and scrubbing our numbers. Despite the share price weakness, the small-cap team did not look like a team that just lost a game. Rather, we were trying to contain our excitement as we took advantage of the layup the market gave us and increased our holding at a discounted price.