When examining why the majority of investment managers suffer poor performance, three broad categories were identified as the prime determinants of below average performance:
- A view that risk is measured by “beta”;
- Excessive diversification, and;
- A short investment horizon.
At the same time, a group of managers with above average performance emerged. These “stewards of capital” shared many of the same attributes that we believe contributed to their success. In contrast to the majority of investment managers, these stewards of capital shared these commonalities:
- A view that risk is the “likelihood of permanent capital loss”;
- Concentrated portfolios, and;
- A long time horizon.
Modern portfolio theorists associate higher volatility with greater risk – and apply beta as their quantitative measuring stick. It appears that most portfolio managers subscribe to a similar view, in stark contrast to what the many stewards of capital describe as risk; the likelihood of permanent capital loss.
At a recent meeting of the American Association of Individual Investors in New York City with the notable value manager Bruce Berkowitz, an attendee asked about asset allocation. His response, “What’s that? It’s a bad word. If you mention it in my office you get fired. Next week you will ask me about efficient market theory and beta!”
Warren Buffet liquidated his partnerships in 1969-70 but came back to the markets in 1973-74. (Most investors are unfamiliar with this horrible period for market performance…the broad averages lost roughly half of their value in the largest market rout since the Great Depression.) After avoiding the lion’s share of the 1973-74 losses, he also missed what turned out to be the bottom. Undaunted by his paper losses, he kept making purchases. When the market reached its low point, Mr. Buffett’s holdings were down a full 50%. Proponents of modern portfolio theory (and by extension “beta”) would describe this volatility as risk…but Mr. Buffett viewed the opportunity to buy more shares at greater discounts from intrinsic value as a fantastic opportunity. His brilliance was not diminished because he didn’t pick the exact bottom and his genius was confirmed as he persistently took advantage of the ever-widening gap between the market price and intrinsic value.
Most investment managers have broadly diversified portfolios. They often spread their assets among hundreds of securities from a variety of countries, industries and companies. This approach tends to become very index-like in composition and performance. Combined with the high costs of active management, subpar performance is almost assured.
Stewards of capital tend to concentrate their portfolios in their best ideas. At the same meeting of the American Association of Individual Investors, another attendee asked about diversification and Mr. Berkowitz replied, that it “doesn’t make sense to have more than 10 or 20 positions. Diversification is insurance against ignorance.” Mr. Berkowitz is suggesting, quite forcefully that wide diversification is only required when investors do not understand what they are doing.
“Diversification is not always good. If you are a “know-something investor," Warren Buffett wrote in a 1993 letter to the shareholders of Berkshire Hathaway. Spreading your bets among a large number of stocks is likely "to hurt your results and increase your risk." While there are many companies Berkshire Hathaway has positions in, Coca-Cola, American Express, Proctor & Gamble and Wells Fargo represent ~80% of its portfolio of publicly-traded common stock.
A 2004 academic study entitled "On the Industry Concentration of Actively Managed Mutual Funds” concluded that Mr. Berkowitz and Mr. Buffett may be right. The authors were two University of Michigan finance professors, Clemens Sialm and Lu Zheng, and one of their Ph.D. graduate students, Marcin T. Kacperczyk. The results indicate that, on average, more concentrated funds perform better after controlling for risk and style differences using various performance measures. This finding suggests that investment ability is more evident among managers who hold concentrated portfolios.
Most investment managers claim to be long term investors. Yet, they are measured by their quarterly and annual results so it is no surprise that their behavior reflects their short term environment. One way to measure the length of time the typical portfolio manager holds on to a security is “turnover”. Turnover relates to the volume of trading activity in a given portfolio. A fund's "turnover ratio" measures how often a manager buys and sells securities within one year's time. For a point of reference, here are average mutual fund turnover statistics from Morningstar.com for major types of funds. As of January 2007, domestic stock funds had average turnover of 95% and international stock funds had turnover of 76%.
By contrast, stewards of capital believe that you don't get paid for activity; you just get paid for being right. That there is little to gain (indeed, much to be lost) from trading frantically…And, often, the best course of action is to “take no action”. You see this by their low turnover rates of 10-25% which demonstrates holding positions for 4-10 years and often a willingness to let cash accumulate as investment opportunities dissipate.
Having a long time horizon appears to provide two distinct advantages. First, the frictional costs of trading are expensive. These trading costs include brokerage commissions and the bid/ask spread. In all cases, these “costs” are not generally understood by investors nor easily obtained in the prospectus. Further, there is the additional burden of income taxes as a result of buying and selling. Second, at times of market euphoria or acute market stress in specific industries, market volatility increases and market participants tend to narrow their view and shorten their time frames. There becomes an over-emphasis on the “news of the day” and market movements rather than the long term drivers of business valuation. Long term investors can exploit short term irrationality for longer term gains.
In 1999/2000 when internet, technology and telecom stocks enjoyed tremendous short term performance and were awarded with never before seen valuations…they were the only shares that most investors wanted to buy. Refusing to participate in this environment, most stewards of capital appeared out of step, underperformed (for a short period of time) and in many cases, lost assets under management. While the misguided euphoria gripped both investors and investment managers…real estate investment trusts, industrial companies, small banks and many other solid businesses, in less glamorous industries, could have been purchased for 6-7 times earnings. As the environment changed, many investment managers delivered stunning losses to their investors. By contrast, the stewards of capital generally enjoyed solid performance when measured over the entire market cycle.
Could 2007/2008 be shaping up to be a similar period? The latest incarnation of “must own” companies include energy, metals and commodities. Again, the short term outperformance and compelling story has captured the imagination of investors…along with an increasing commitment of their assets. The commodities story may become another classic example of a common fallacy, overpaying for growth…or at least the hope of growth. It appears that investors are once again buying into the “this time it is different” trap. This can also be described as misinterpreting cyclical growth for permanent growth. This time it is the insatiable demand from China, India and other emerging markets and the constrained supply of limited natural resources. It reminds this author of the spectacular and projected growth of internet users, with traffic doubling every 100 days which justified the astronomical valuations of internet, technology and telecom businesses just eight years ago. There is always a structural argument…but has price once again detached from the fundamentals?
These areas have generally not represented large percentages of the portfolios of the stewards of capital. They have argued that many of these businesses are in cost-competitive industries, with little historical pricing power, presently high valuations and few durable, competitive advantages. If you are focused on momentum, recent performance and what is “working”, you are undoubtedly invested in these “hot” areas. At the same time, healthcare providers, financial services firms and consumer companies have suffered poor short-term performance which has left them with at historically low or reasonable valuations. The stewards of capital, the classic long term investors have been increasing their commitments to these beaten down sectors.
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