What I Might Do Differently If I Managed Only My Own Portfolio
Some years ago, one of my partners hired a portfolio manager with an existing clientele. Months later, that manager resigned and retired, with a simple explanation: “In all these years, I did not realize that the one thing I did not like about this business was having clients.”
Before I receive protests and complaints, I want to stress that not only do I not at all feel the same way: In fact, I am immensely grateful for the loyalty and support of my long-time clients.
Still, it has periodically occurred to me that, if I were managing only my own money, I would probably do it somewhat differently. For ethical reasons, I do attempt to manage my own money as closely as possible to the way I manage the money of my client families. There will always be some differences because individuals often have different patrimonial goals and requirements but, by and large, our portfolios tend to own the same investments.
Note: John Mihaljevic, founder and managing editor of The Manual of Ideas, a prestigious network of sophisticated investors which includes my partner Bogumil Baranowski, just sent me a new book: Richer, Wiser, Happier (William Green – Scribner, 2021). As a rule, I don’t have too much interest in interviews with successful investors. However, this one fascinated me by both the choice of interviewees and the skill with which the author distills their philosophies. In this paper, I liberally use some of the reflections that the book has triggered in me.
VALUE INVESTING AND THE CONTRARIAN APPROACH
I am above all a contrarian investor. Like many investors of my generation, who were heavily influenced by Benjamin Graham and his disciples, I started as a fairly pure value investor, primarily interested in companies’ assets and balance sheets. But the strict value approach advocated by Graham has become more challenging with the rapid and massive distribution of financial information, along with the quasi-instantaneous speed with which computers have allowed analysts to filter and analyze data.
For a long time, value investing and contrarian investing were practically synonymous. If you could buy a stock for less than your estimate of the value of its company’s assets, it meant that stock was not popular with the investing public. Hence, your investment was obviously contrarian.
This should still be true, but the way to assess value has been tampered with. First, instead of straightforward and simple measures from companies’ balance sheets, value started being measured against income statement figures such as earnings, cash flow, etc. Soon, current or recent earnings were not deemed sufficient, and estimates of future earnings began to be utilized, introducing the notion of projected growth. More recently, as traditional “tangible” businesses were supplanted by novel, less material ones, the practice developed to try and anticipate how much money a company might earn if it swiftly captured a commanding share of a new market. Companies’ valuations began to be measured against sales, subscriptions, viewership, Internet clicks, etc. Gradually rosy visions of the future replaced factual achievements.
As I witnessed this transformation, I progressively became more of a contrarian than a pure value investor. But this is not a foolproof approach either.
First, you have to measure the crowd consensus against which to take a contrary position. In a market environment where opinions proliferate and trend-susceptible investors adopt new ones frequently, it is sometimes hard to differentiate between minor changes in mood and overwhelming consensuses. Yet the secret of contrarian investing success is to jump in only at or close to the points of irrational exuberance or panic.
Most of the time, moods are not extreme enough to warrant betting aggressively against the consensus. Increasingly, I suspect that if I were concerned solely about my own fortune, I would invest much less often. Motion should not be taken for action, and the concept of “positive inaction” is increasingly attractive to me. You think hard, analyze a lot, but invest only when an opportunity becomes irresistible from a contrarian approach.
CONCENTRATION AND DIVERSIFICATION
No matter how eager a financial analyst you may be, you are probably able to identify only a limited number of absolutely compelling ideas at any given time. To be compelling, an investment idea must identify a company with solid finances and a reasonable-to-good profit outlook, but also one whose shares sell at an irresistible price. Anything less demanding just amounts to portfolio-filling, which brings me to the question of concentration vs. diversification—one that has preoccupied me for many years.
If there are only a handful of truly compelling ideas at a given time, what is the point of owning more? Why not put your few chosen eggs in one basket and watch that basket carefully? Many truly successful investors have achieved superior performances by keeping heavily concentrated portfolios, and the approach does make sense.
The main problem with concentration, even when successful over time, is shorter-term volatility. Ben Graham, the father of value investing, famously said that, in the short term, the market is a voting machine but that, in the long term, it is a weighing machine. As an individual, I welcome volatility, because fluctuating prices create opportunities to buy stocks cheaply. I don’t care about the moods of the “voters” and I am only interested whether the market’s “weighing” function will vindicate my judgment over the long term.
That attitude, unfortunately, is not appropriate for most clients. It takes a strong character to weather serenely the occasional high volatility of concentrated portfolios. If, in addition, clients are influenced by “asset allocators” whose job is to measure the relative performance of portfolios on a quarterly basis (if not more frequently), the higher volatility of the concentrated approach could generate disastrous results in the end.
ON THE OTHER HAND
I have no tendency to underrate myself but, when one’s fortune is at stake is no time to show excessive self-confidence. I have been known to occasionally make mistakes – either of judgement or of calculation. Thus, I am not sure that much larger sums invested in a handful of stocks would leave me as phlegmatic about money as I tend to be most of the time.
Another idea that has tempted me at times is to take the opposite approach: create a very diversified portfolio, achieved by eliminating only stocks that are not attractive. I have enough experience and intuition to discern which companies are unattractive because of irrational valuation, or simply do not pass the “smell test”.
Even that approach is not perfect, though. Often, the companies whose stocks do best are those that are recovering after being near-bankrupt. On the other hand, this situation is more likely to hurt “relative” performance – measured against competitors or “the indices” — than absolute returns. If my only client were myself, I would not care a bit about relative performance as long as I made money and felt secure about my investments.
The solution of that conundrum might be a combination of the two approaches: a core percentage concentrated in a handful of high-conviction stocks, and the rest of the portfolio much more diversified but rigorously purged of “undesirables.”
When compared to the majority of market participants, I am a long-term investor. My potential horizon for holding investments is not defined in advance, but could easily extend to several years. On the other hand, I am not a buy-and-hold investor by nature.
Stocks fluctuate. This means they cycle from undervalued to fully-valued and overvalued. Trained as a value investor, I find it difficult not to sell when stock prices peak even if, in theory, I would like to hold them forever.
There is good reason for holding onto investments you own rather than constantly looking for new ideas. Some years ago, we had an aging client. To avoid the double taxation that would arise from capital gains followed by inevitable estate taxes, we refrained from selling her stocks and realizing gains in her portfolio. Happily, she survived for several years and when reviewing her portfolio, I found out that many of the stocks we would have sold actually outperformed those we might have bought to replace them.
On the other hand, applying an investment discipline is not about maximizing one’s gains over given periods; it is about compounding reasonable gains over one’s lifetime. In a forthcoming book, I illustrate what a difference an additional investment return of 1% per annum does in more than 30 years, and it is simply stunning. My nature commands me to be disciplined and patient while resisting greed, and I believe these qualities are the true secret to riches.
THE IMPORTANCE OF DREAMING
I started this article with the idea of a life of “constructive inaction”. This is not an encouragement to be lazy but day-dreaming, I believe, is essential to creativity and while you refrain from incessant action you may also be avoiding some mistakes.
Earlier in my career, I used to cross Central Park daily, walking and smoking my cigar on the way to my office. During this half-hour or so, I mentally granted myself superhuman powers and assigned myself the task of solving some major world problem. Needless to say, I never quite solved a global crisis, but dreaming about such problems awakened my spirit and often led me to new ideas in totally different fields.
Unfortunately, in addition to having given up my constant cigar-smoking, I don’t walk as much anymore either. These days, I mostly act and I miss the creativity that came with day-dreaming, an activity that I strongly recommended in a letter to my grandson years ago. I hope he still practices it.
François Sicart – August 17, 2021
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