Sunday, August 26, 2012

A Winning Equity Team

There is a basic belief that selecting the right talents over an extended period of time will give you a winning result. Building a sound team of stock managers is a similar exercise.

Understanding “The Game”

Investing for the long-term, as many institutional and wealthy clients do, presumes with a high degree of certainty that there will be a series of rising and falling markets. Some moves will be broadly-based, where almost all investments will participate in a correlated decline. There will be other more narrowly-based movements where different sectors move in opposite directions. As with all games that involve people, individual persons, regulators, and governments will do unpredicted things, frequently against their own best interests. Often the best teams can overcome the unpredictable actions of those pesky humans.

Increasing the odds on winning

As much as we think we believe that we have a high degree of certainty about the near-term future, the truth is that the future will unfold in a random manner and pace. Long-term winners that I have known have an uncanny record of surmounting different near-term unexpected problems. One of the ways that they do this on a repeated basis, but not all the time, is the selection of talents for their own teams. They are selective in the talents they bring on board and practice disciplined diversity in their portfolio outlook.

Building your dream team

In the real world of assembling your long-term equity portfolio you should use both your selection and diversification skills. If you were building a non-US football team, or a US baseball team, you would select some strikers and pitchers, but you would also add players with other talents who might not generate the same level of headlines but would be critical to the final tally. Therefore, the critical question is building the right mix.

Investment objective mix

There are no two mutual funds that are exactly alike in each and every aspect. On a global basis, depending on definitions, the world probably has on the order of 100,000 funded products. To make comparisons easier, years ago we adopted a strategy of grouping funds according to investment objectives as we defined them. These allocations to different investment objectives are far from perfect, but work reasonably well. The dominant factors used in the allocation scheme are: selecting by main type of security used, sector, industry, or geographical focus. In some cases the way the funds invested for capital appreciation or income led to their assignment. Today, one can choose between some 200 equity investment objectives. (The selection process for fixed income funds is quite different.) I suggest that there are only two initial categories of funds when building an appropriate investment objective diversification: narrowly and broadly-based.

Narrowly-based funds

These funds are like a late inning relief pitcher in baseball, that with great regularity gets the final three hitters to strike out and preserve the victory. Without such a relief man, in a close game the team will be reliant on their tiring pitching staff. However using such a player for every single game would exhaust his effectiveness. I am a believer in utilizing a limited number of narrowly-based funds within a diversified portfolio. For me, the successful narrowly-based fund will add a large increase to a larger, but currently tiring portfolio. In other words, I am looking for an extreme result. The problem with extreme result-oriented funds is that they regularly are found in the fifth as well the first quintile in terms of short-term results. Some examples might include small country investing; e.g., Egypt, Indonesia or perhaps Korea. Further examples could be highly-selected commodities like sugar or an industry focus such as semiconductor equipment manufacturing or offshore re-insurance. The use of this high octane strategy needs to be cautiously applied and should only be used by a limited number of sophisticated accounts who can accept above-normal current volatility in search for long-term gain.

Broadly-based funds

We used to live and invest in a nicely defined world where our future results were largely the results of our own or direct competitors’ activity. That is not the case today. I would submit that the distinctions between international, global, and domestic companies and their securities are interesting, particularly historically, but have less relevance today. A small Midwestern bank has direct or indirect loan exposure to currency fluctuations, crop prices, shipping rates, and changes of foreign government regulations. The remaining railroads will prosper or not on the exports they carry. Our local supply of clothes and foodstuffs are not solely determined by our own local demand. In today’s environment, I believe a prudent strategy is to invest with managers that are not focused primarily on generating near-term dividends and significant buy-backs. I want to invest with managers that are selecting companies with relatively high returns on assets. Actually I like those which have high returns on gross assets to reduce the impact of the financial engineering of acquisitions. I perceive that new discoveries around the world are offering us to invest in new products and industries that not only solve people’s problems but also represent proprietary types of profit margins to the early movers. In selecting Broadly-based funds, those that focus exclusively on the numbers, current market conditions, and the inabilities of politicians can be good near-term positions. The lack of forward focusing on the part of managers and their investments means that we have to look elsewhere.

Where are you finding the future? Please share your thoughts with me.

In response to a reader's question

One of our regular and very savvy readers raised the question as to redeeming a fund too quickly after a series of poor results. The fund in question is now up 30%+ on a year-to-date basis. Was it a mistake to redeem too early?

With the kind of recovery experienced by this fund, one needs to act carefully. I am delighted for those who stayed with the fund. They deserve to be paid for their roller coaster ride.

We started today’s blog with a brief discussion as to my bias in favor of narrowly-based funds. While not by prospectus, but by practice, this fund was an extreme practitioner of the art form of managing narrowly-focused portfolios and was successful for a number of years. If all other things remained equal I would have recommended delaying redemptions through a normal recovery period. In this particular case things did not remain the same.

The portfolio manager of the fund publicly supported the CEO and stock of a major financial institution. In a discussion with the portfolio manager,  I took a very different point of view. After publicly supporting the stock in question, the portfolio manager sold his large position in the institution.

The recovery in the fund’s net asset value is now being driven by its remaining single largest holding, a very large position in a stock with a sizeable US government overhang. I agree with this particular holding, as I have been an owner for many years in the mentioned stock. If the portfolio was a frozen fund with its small number of securities it probably would have been wise to scale out of the fund. As a fiduciary, for me the changing attitudes and personnel added too much risk. As is often the case I was premature.

How would have you handled this?   

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