Goodhart’s Law states that when a feature of the economy is picked as an indicator of the economy, then it inexorably ceases to function as that indicator because people start to game it. It has taken a more generalize form as follows:
When a measure becomes a target, it ceases to be a good measure.
What does this mean? We can all relate to the following real world examples of Goodhart’s Law at work.
- North American schools that have a hyper focus on grades at the expense of learning the material. It is well understood that your final marks are the determinant for entrance to university or graduate school and scholarships. As a result, students focus on making the grade versus learning or mastering the material. Final marks have been the target and as a result may not be the best indicator of a student’s comprehension. We all know people that achieved high grades but truly do not understand key concepts.
- Google’s search engine used the number of backlinks to rank content. This worked reasonable well until it become known that Google used this metric. Webmasters then developed systems to create and inflate backlinks – thus gaming the system and making backlinks a less reliable measure of web contents value.
In order to understand Goodhart’s Law, you need to be very clear on two things. First, the objective you are trying to achieve (target) and second the metric you are using to track the target. When you confuse these two items (the target and the metric) you run the real risk of going off course.
METRIC - The team was recently asked to provide a small list of investment ideas of high conviction. The challenge was framed as an investment that an individual has high conviction will materially outperform the underlying benchmark over the next 3-5 years (this should be restated as 5-7 years). It was also stated that we will track these ideas going forward – this will become a metric.
TARGET – This is outlined in the Global Equity Team Strategy document sent out to the team in January 2021. As a result of this exercise, I have reviewed this document with the objective of streamlining some concepts, incorporating our newer language (Horizon List) and adding our work on Quality Scores. For the purpose of this note, it is important to focus on the overall Team’s objective and everyone’s individual objective which builds to the Team objective. For convenience, they are restated below:
Team’s Objective: Long term capital appreciation while minimizing the risk of permanent capital loss. We aim to achieve this by owning a collection of approximately 25-40 companies.
Individual’s Objectives (condensed for this note – please see Global Equity Team Strategy for more detail): Every team member is responsible for growing and maintaining their Horizon List. This includes the following key points:
- Research Report or Current View.
- Conviction in the intrinsic value.
- Quality Scores completed.
- All companies on the Horizon List are high quality businesses that we would love the opportunity to own if the valuation was attractive.
- Make high quality investment decisions (TARGET)
The purpose of this note is to address some of the discussion around creating a metric for high conviction investment ideas. This led to some statements like:
- If this is the criteria I would pick differently or in a manner inconsistent with our objective – implies needing a short term focus;
- This is challenge because I don’t know what the market multiples will be in 3-5 years;
- The conviction list will be solid only if strong company economics compound my intrinsic value at an above market rate;
- Levels of overall valuations for higher quality stocks won’t significantly compress.
In a way, these observations are trying to tightly define the metric with the implicit goal of ‘gaming’ the system – trying to find a way to maximize the metric that is inconsistent with our objective (Target).
High Conviction Ideas – The Horizon List and Margin of Safety
The Horizon List needs to be comprised of companies that we would love to own if given the opportunity by the market. There are two points that are absolutely mission critical. The first is that you should be willing to swap any company on your Horizon List for an existing holding at a certain price. If you are not willing to do this, the company did not belong on your Horizon List. At any moment, you should be very happy to own a portfolio of 10 of these companies if you were allowed to name your price. In essence, we are simply waiting for the market to hit your named price.
The second point is that for the companies on your Horizon List, you have confidence in your ability to determine their value. This is the valuation that you have high conviction that you are not going to make a mistake or lose money. This usually comes from companies where you have high confidence in their cash flows or a combination of high confidence in your ability to value the core with equal confidence in the value of the optionality you are acquiring.
The threshold of quality on your Horizon List is the primary determinant to stop mistakes from entering the portfolio. This is absolutely one of the most important concepts within our Risk Management Process. The second primary determinant to stop mistakes from entering the portfolio is your ability to value the business.
If every company on your Horizon List is worthy of owning and your valuation is such that you are confident that ‘whatever the market throws at this company’, your valuation is reasonable correct, you are in a very strong position to compound and perverse capital. This methodology does not preclude a high quality cyclical. The important insight here is that you value the business correctly; putting yourself in a position to be successful even if the business cycles.
Bringing it all together – High Conviction Ideas. If your Horizon List is a collection of truly great businesses that you have conviction in the underlying intrinsic values; a high conviction investment idea is one that made your Horizon List and the market is significantly mispricing on short to mid term emotions. You should be scratching your head and a bit baffled that the market would price your company in this manner. These are investment ideas where:
- We get to own a high quality compounder;
- We get the benefit from the market ultimately realizing that it mispriced the company;
- The mispricing has the additional benefit of protecting our downside.
Image the power of each team member having one company per year – high quality, great long term business – trading at a valuation that is significantly less then their intrinsic value and adding this to the portfolio.
This is why you need to grow out your Horizon List. Clearly having the option to evaluate the investment opportunity on 20 companies is materially better then evaluating 10 companies – you have doubled the opportunity that the market will open up a high conviction opportunity for you. Having the choice of 30 high quality businesses is clearly better than having the choice of 15 high quality businesses. However, this brings us back to Goodhart’s Law. If the metric of having a 50 company Horizon List becomes the target, you may sacrifice the quality of Horizon List which would be detrimental to our objectives (and your performance). Can someone make materially better investment decisions with a 25-30 company Horizon List versus someone with a 50 company Horizon List? Clearly the answer is yes. However, growing out your circle of competence and Horizon List improve the probably of you being successful. Goodhart’s Law highlights the folly in getting caught up in the metric (50 companies) versus the objective (putting yourself and the team in the best possible position for success).
Back to the Metric. Identifying investment opportunities that are consistent with our objective of preserving and compounding capital. Companies pass our hurtle to make the Horizon List and are materially mispriced by the market. This list is beyond identifying a good investment – we are trying to identify where you are seeing a great investment. This is not inconsistent with our investment objectives. But it does require you to diligently maintain the quality of your Horizon List; grow your Horizon List; have confidence in your ability to value a business and have confidence in your ability to identify a great investment when the market presents us with an opportunity.