“Here’s the paradox: the odds are overwhelming I will end up richer by aiming for a good return rather than a brilliant return – and sleep better en route. Folks who seek a killing usually get killed… Consistency is the key. It is close to impossible to get a good, long-term, rate of return if you suffer serious negative numbers en route. It’s the math. A single year that is down 30% means you have to get 30% per year positive returns for the next four years to get back on track for a 15% annual average. Or, if you score 20% annually for four years, and then suffer a 30% decline, your five-year average return is only 7%.”
– Ken Fisher, Forbes, 1989
The task of investing is generally separated into two distinct functions – investment idea generation (finding securities that should generate returns) and asset allocation (determining the appropriate mix and weighting between all the various asset classes). Intuitively this makes sense, each of us has to decide how much of our portfolio is going to be exposed to stocks, bonds, etc. (the allocation decision). Having made that choice, the next logical step is figuring out what specific investments we should make. Should we pick individual stocks, index funds, or invest with a manager who will do the ‘picking’ on our behalf?
In general, most investors, individual and institutional for that matter, delegate the ‘picking’ to a professional manager. A bold few will try to pick individual investments on their own, relying on personal research, reading, and stock idea sources like Barron’s or CNBC.
Because investor focus generally revolves around these two tasks of asset allocation and idea selection, we believe investors in general neglect to consider an important line of inquiry, how does a professional manager go about constructing an effective single asset class portfolio? This is important because investors, in their diversified portfolios of various asset classes, will select managers to make specific investments on their behalf. How that manager takes a group of individual investment ideas and combines them into a portfolio that generates the largest possible return for the risk incurred will determine whether or not the investor views their selection of a particular manager favorably.
Constructing an effective single asset class portfolio is a key function in investing and an area to which we have devoted a significant amount of time and contemplation. We thought it worthwhile to discuss a few thoughts on the matter.
Protecting Against Downside Risk – The Core of Portfolio Management. All active investors want to generate outperformance vs. the market over the long-term (otherwise you would choose passive, index-like funds). Accomplishing this goal is the function of choosing individual investments that can grow capital and avoiding investments that lead to capital losses.
As the Fisher quote we opened with alludes to, incurring losses is perhaps the single greatest inhibitor to delivering long-term investment outperformance. In fact, the simple math of it is, making money is not the hardest part of investing; not losing money is.
As stock markets consistently trend positively over time, there is a decent foundation for some positive investment return. For example, the S&P 500 from 1993-2012 has delivered annualized returns of ~8.2%, even despite the bursting of the Internet Bubble and the global Credit Crisis of 2008. Assuming no active management (i.e., the active selection of specific stocks), stocks have generated a decent rate of return.
But natural cycles of euphoria and fear set the stage for staggering pullbacks in values. Over the same period of time as the average 8.2% return highlighted above, the market saw years in which the S&P 500 fell, 10%, 13%, 23.4% and 38.5%. Adequately weathering these storms is what protects the investor. Because of the toxicity of losses, proper portfolio management must first begin with insulation from losses. We split this task into several key functions: investing with a margin of safety, improving your process to minimize mistakes, diversifying adequately, sizing positions appropriately, and remaining patient.
Our first protection against losses is from investing with a margin of safety. Margin of safety is an investment concept first expounded upon by Ben Graham in his classic The Intelligent Investor, wherein Graham alludes to this as the “central concept of investment.” Margin of safety is the cushion that an investor builds into the evaluation of a stock to provide protection against being wrong. First, we approach margin of safety by looking to buy cheap, unloved stocks. This is the proverbial buying a dollar of value for 50 cents. Even if ultimately it isn’t worth the full dollar, but only 60 cents, the investor’s downside is protected. We call these situations ‘businesses that are in transition.’ By nature, because of their inherent uncertainty and unloved character, these businesses are naturally less popular from the rest of Wall Street (stocks everyone loves are never cheap).
On to these situations, we look to layer an additional margin of safety through a conservative estimate of the earnings power of the business. We approach our analysis of the growth and return prospects of the business with a healthy level of skepticism. Next, we apply a conservative valuation multiple onto our estimation of the earnings potential of the business. Finally, we look to see downside protection in the form of easily monetizable assets, conservatively positioned balance sheets, etc. On the whole, by the time an idea makes it into our portfolio, we work to have constructed a multi-faceted margin of safety.
The second way we protect ourselves against losses is by improving our process to minimize mistakes.
“Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome”
-Robert Rubin
As former Treasury Secretary Rubin emphasizes, it is process, not just outcome that drives long-term success in investment decision making. Working to minimize mistakes in investment decisions is an iterative process. For several years, we have been compiling a check-list of investment mistakes that we and other investors have made. This list forms a core element of our investment process as it pushes us to look in all the dark corners where risk could be hiding. Each step of our investment process is documented and logged to allow us to go back and evaluate the quality of the decisions we made.
The next step of loss mitigation is through adequate diversification of the portfolio. The oft-remarked refrain for some investors is to ‘Have all your eggs in one basket, and then watch that basket!’ While we would agree that concentration is an important driver of returns, the investor must retain a base line level of diversification. The reason for this being that even the greatest of business have missteps along the way. The classic refrain being that of the 6 foot man who died crossing the river that was 5 feet deep on average. Survivability is more important than returns and undue concentration can put that at risk.
A few key studies illustrate that diversification exhibits a declining marginal benefit, meaning there is a point where further diversification (adding additional investments to the portfolio) does little to further insulate the portfolio from risk and only serves to lower returns. Our view (which is supported by the literature) is that portfolios of 15-20 stocks adequately balance the needs for diversification, but maintain the possibility for performance beyond the index.
Our general opinion has always been that at the 40th / 60th/ 100th idea in the portfolio, the idea quality is simply not as good, and even if the idea is a home run, at 1% of total capital, the impact is likely to be muted on the total portfolio.
One additional point to consider on being overly diversified. The average mutual fund holds ~100 positions in their portfolio and averages 80-100% annualized turnover (i.e. sells every stock holding every 9-12 months). With those statistics, the average fund will need to find close to 100 new investment ideas a year to replace positions that are exited. This translates to almost 2 ideas per week! At that pace, we question the depth of research that can actually be done on a position.
Once the portfolio is sufficiently diverse, the task is of sizing. The slicing of the pie amongst competing alternatives not only insulates the portfolio from additional downside risk in the case of a bad investment, but also sets the portfolio up to deliver the greatest possible return. There are several schools of thought on the slicing of the pie. We will summarize each below and offer some thoughts.
1. 10×10 portfolio (“Ten by ten”) – This portfolio is composed of 10 positions that each represent 10% of assets. While there are several extremely smart investors who run similar portfolios, our view is that this is an outsized amount of downside risk (i.e., losing 10% of capital in one investment mistake can be a difficult error to recover from).
2. Strict 20×5 portfolio – This portfolio is relatively formulaic like a 10×10 portfolio, but allocates capital over 20 ideas at 5% size. In this strategy, 5% positions can contribute meaningful performance, but a total loss would have only half the impact as in a 10×10.
3. Flexible 20×5 – While similar to #2 above, some positions may skew larger than 5% for exceptionally high quality ideas, or smaller than 5% for ideas that while compelling may have other risk factors that warrant a smaller overall position size. Our portfolio management approach is more similar to #3. We look to have ~20 ideas, but are comfortable allowing some variance in the number of positions and in the size of each position.
The task of the ‘slicing the pie’ is a combination of both art and science. At a core level, we believe the investor is managing the relationship of upside to downside risk. We are looking to find opportunities where the amount of upside return potential significantly exceeds the downside loss potential. This is governed more broadly by the maximum dollar amount we would be comfortable losing under our bear case scenario vs. the maximum amount we stand to gain in our base/bull cases.
Once we have a general sense of the upside/downside potential for an opportunity, we have built a proprietary model which allows us to adjust our standard position size (5%) upwards or downwards based on things like business quality, valuation, time frame, and catalyst set. The end goal being of course to be largest in our best ideas and smallest in our less-compelling ideas.
The final key to loss minimization is the ability to be patient. Investor psychology what it is, the average investor typically adds capital to the market at the top (when stocks are most expensive/overvalued), and pulls capital out at the bottom (when stocks are cheapest/ most undervalued). Over time, this backwards psychological propensity is what leads the average investor to significantly under-perform the market. A J.P. Morgan study highlights this performance discrepancy: over the past 20 years (1993-2012), the S&P 500 has delivered an average +8.2% annualized rate of return, while the average investor saw a +2.3% (that is not a typo!) average annualized rate of return.
Fund flows, or the level of dollars flowing in and out of certain asset classes, further reinforce this observation of psychology blinding investors. Mutual funds domestically average ~$5 Trillion in assets under management. Equity funds saw investors pulling out capital in 2009, 2010, 2011, 2012 – almost $400 Billion dollars worth! This is despite a stock market that has now rallied almost 173% from its March 2009 nadir.
As Pascal so aptly noted, “All of human unhappiness comes from one single thing: not knowing how to remain at rest in a room.” Our style of investing requires patience, as “businesses in transition” are not home-runs over night. Despite Wall Street’s quarterly expectations game, change occurs over multiple quarters and multiple years. Because we generally avoid technology stocks, most of the businesses we look at typically see low levels of creative destruction. As such, mean reversion is a powerful force in any company, when managed by a strong, appropriately compensated team.
The great temptation of investment (and speculation of any sort) is to focus solely on the upside potential. While I have made money several times on the craps table, the odds are simply stacked against me in the long haul (as my wife is keen to remind me!) The greater challenge is to focus on downside mitigation. We believe this is done through investing with a margin of safety, improving your process to minimize mistakes, diversifying adequately (but not excessively), sizing positions appropriately, and remaining patient.