Centaur Investing: Using Artificial Intelligence for Intelligence Amplification

Two recent articles highlighted the diverse opinions and controversy around the use of artificial intelligence (AI) in investing. One by the Economist, entitled Masters of the Universe, concluded that “human investors are about to discover they are no longer the smartest guys in the room.[1] The other, a Globe & Mail article, discussed the “complete disappointment” and “inconsistent performance” of several AI powered ETFs.[2]

We think neither view is quite right and AI’s role in investing lies somewhere in between. We’ve always believed combining the complementary strengths of tools and technology with human abilities can help make better, more consistent decisions and amplify our intelligence as opposed to replace it. A 2017 TED Talk by chess grandmaster, Garry Kasparov is instructive. In it, he recounts his 1997 loss to IBM’s supercomputer, Deep Blue and some of the events that followed.[3]

Responding to the loss, Kasparov began a journey that inspired the creation of “centaur” chess, where similar to the mythological creature that combined the upper body (brains) of a human with the lower body (power) of a horse, his new game combined human intuition, creativity and strategy with a computer’s brute force ability to calculate with speed.

In 2005, a “freestyle” chess tournament based on Kasparov’s idea, pitted grandmasters, supercomputers and combinations of the two against each other. Despite the significant intellectual and computational power taking part, it was a pair of amateurs that used three ordinary computers simultaneously in a unique process that won. Whenever the three computers disagreed on the next move, the amateurs would investigate further, resulting in a superior decision process to that of their more powerful competitors.

Kasparov reasoned “a weak human player plus a machine plus a better process is superior to a very powerful machine alone but more remarkably, is superior to a strong human player plus machine and an inferior process.”

Exhibit 1. Humans + Machine + Process                                                                                                                                                                                                                            

Source: Garry Kasparov, Bristol Gate Capital Partners.                                                                                                                                                                                                 

Computers are ideally suited to operate in “closed worlds” where outcomes can be well defined based on a series of rules, like a game of chess. But machines on their own have limitations. Just as a bicycle needs human power to make it useful, a computer needs human input and judgement to give it purpose or understanding, and experience to respond to change. They are not optimal for “open worlds” like a stock market, where unexpected and new things can happen. As an example, our machine learning model’s dividend prediction accuracy declined in 2008 relative to other periods. The global financial crisis brought a new situation which differed from the data it had been trained on up to that point. Without a sound process designed and implemented by a human to address this known shortcoming, following a machine blindly could produce disastrous results.

Since inception and to September 2019, our US equity strategy has returned 17.7% annually gross of fees. Assuming we had the most powerful machine in the world that forecasted next year’s dividend growth with 100% accuracy and used that information to invest in a portfolio of the fastest dividend growers, our annual return over the same period would have been 17.5%[4]. Recognizing it’s not a perfect comparison, it is interesting to note despite having inferior dividend growth prediction accuracy, our human + machine + process approach has beaten the theoretical perfect foresight machine outright and it has done so with lower volatility, producing even better risk adjusted returns.

We believe we move towards a better portfolio than the machine alone when combining our model’s prediction with our portfolio managers’ experience. We know our machine approach improves prediction accuracy in the near term and we think our human element addresses the machine’s shortcomings evaluating an “open world”. Layer in a consistent, sound process focused on risk management and we believe the whole is greater than the sum of the parts, augmenting our combined intelligence.

Bristol Gate US Equity Strategy (all returns USD)

The US Equity Strategy gained 3.59% in the third quarter, ahead of the S&P500 Total Return Index® by 189 basis points and 770 basis points YTD. Virtually all excess performance resulted from security selection.

With the Q3 reporting season upon us, we expect our companies to continue performing similar to what they did last quarter when they produced median EPS growth YOY in excess of 13%, on revenue growth of 4%. Dividend growth YOY of the companies is 20%, well ahead of the estimated 9.3% in the broad market.

Risk metrics for the strategy continue to illustrate that the excess returns have not been generated through taking increased risk.

Exhibit 2. US Equity Strategy Returns and Risk                                                                                                                                                                                                                   

Inception: May 15, 2009                                                                                                                                                                                                                                                        

The top three contributors to the quarterly results were Sherwin-Williams, Texas Instruments and Cintas. NetApp, UnitedHealth and Cisco were the top detractors as political issues, both trade and domestic policy related, raised concerns over both technology and healthcare spending.

All securities positions were re-balanced to equal weights on August 27th, 2019.

Bristol Gate Canadian Equity Strategy (all returns CAD)

The Canadian Equity Strategy gained 0.24% in the third quarter, lagging the S&P TSX Composite Total Return Index® by approximately 224 basis points and 130 basis points YTD. The underperformance was a combination of sector allocation and security selection.

The aggregate characteristics of the portfolio remain consistent with the mandate of investing in high dividend growth companies, with a median dividend growth of 15.4% versus 6.3% for the S&P TSX Composite Index. We continue to believe the portfolio is well positioned given the expected dividend growth, quality characteristics with average return metrics (ROE, ROIC) higher than benchmark and aggregate valuation metrics (P/E, EV/EBIT) lower.

The Canadian Equity Strategy has produced excess returns beyond the YTD timeframe and risk metrics continue to illustrate that performance has not been generated through taking increased risk.

Exhibit 3. Canadian Equity Strategy Returns and Risk                                                                                                                                                                                                   

Inception: July 1, 2013                                                                                                                                                                                                                                                           

The top three detractors for the quarter were Stella-Jones and CCL Industries in the materials sector and NFI Group in the industrials. Industry and company specific issues caused these companies to post results below expectations. Top three contributors were Brookfield Asset Management, Intact Financial and Magna International, the latter of which recovered most of its decline in the second quarter.

All securities positions were re-balanced to equal weights on August 27th, 2019.

Firm Update

At September 30, 2019, Assets Under Administration and Management were approximately CAD $1.2 billion.

In September we announced Peter Simmie’s retirement from his role of Chief Investment Officer, which is planned for the end of this year. Peter will remain a shareholder and Director of the firm and assume the role of Vice Chair. Izet Elmazi will be named Chief Investment Officer and assume responsibility for chairing the firm’s investment committee upon Peter’s retirement, while Achilleas Taxildaris, Portfolio Manager, will join the investment committee and Poorya Ferdowsi, PhD, was promoted to Chief Data Scientist.

The investment team is excited to build on the foundation Peter helped lay while safeguarding the firm’s core principles of continuous improvement, evidence-based decision making and providing investors with a steady stream of growing income, year after year.

Yours sincerely,

Peter Simmie                                               Izet Elmazi                                                    Achilleas Taxildaris

Chief Investment Officer                        Senior Portfolio Manager                         Portfolio Manager


[1] https://www.economist.com/leaders/2019/10/03/the-rise-of-the-financial-machines

[2] https://www.theglobeandmail.com/investing/markets/etfs/article-why-artificial-intelligence-may-not-be-so-smart-when-it-comes-to-your/

[3] https://www.ted.com/talks/garry_kasparov_don_t_fear_intelligent_machines_work_with_them

[4] The perfect foresight portfolio assumes equally weighted investments in the top 20% of the fastest dividend growers of the S&P 500 any given year at the beginning of that particular year or since May 15 in the case of 2009 to coincide with the inception of the fund. Underlying data is sourced from Bloomberg.

Important disclosures

Gross returns in this report refer to the Bristol Gate US Equity Strategy Composite and Canadian Equity Strategy Composite. No allowance has been made for custodial costs, taxes, operating costs, management and performance fees, which will reduce performance. Past performance is not indicative of future results. Allowance for withholding tax in the US strategy composite is partially reflected in the composite returns for periods commencing January 2017 and after.

The Bristol Gate US Equity Strategy Composite was formerly known as the Bristol Gate US Dividend Growth Composite until April 1, 2015. The Composite inception date was May 15, 2009. The Composite consists of equities of publicly traded, dividend paying US companies and is valued in US Dollars.

The Bristol Gate Canadian Equity Strategy Composite was formerly known as the Bristol Gate Canadian Dividend Growth Composite until April 1, 2015. The Composite inception date was July 1, 2013. The Composite consists of equities of publicly traded, dividend paying Canadian and US companies and is valued in Canadian Dollars.

The S&P 500® Total Return Index measures the performance of the broad US equity market, including dividend re-investment, in US dollars. The S&P/TSX Composite Index measures the performance of the broad Canadian equity market, including dividend re-investment, in Canadian dollars. This index has been provided for information only and comparisons to the index has limitations.

There is the opportunity to use leverage up to 30% of the net asset value. Leverage is not used as an investment tool to enhance returns, but for cash management needs of certain composite portfolios.

This Report is for information purposes and should not be construed under any circumstances as a public offering of securities in any jurisdiction in which an offer or solicitation is not authorized. Prospective investors in Bristol Gate’s pooled funds or ETF funds should rely solely on the fund’s offering documents, which outline the risk factors associated with a decision to invest. No representations or warranties of any kind are intended or should be inferred with respect to the economic return or the tax implications of any investment in a Bristol Gate fund.

Bristol Gate claims compliance with the Global Investment Performance Standards [GIPS®]. To receive a list of composite descriptions and/or a presentation that complies with the GIPS® standards, please contact us at info@bristolgate.com. Bristol Gate Capital Partners Inc. has been independently verified for the periods commencing May 2009 until December 2015 by Ashland Partners International PLLC and for the period January 1, 2016 to December 31, 2017 by ACA Compliance Services, LLC.