A couple of things I read this week got me thinking. Here’s the story… in three acts:





I. Even Concentrated Portfolios Have Lagged the S&P500 since 2009





The market, in this case, means the S&P500 index. Concentrated investors mean those with fewer than 35 stocks in their portfolio.





Here’s the WSJ :





“Since the start of 2009, equity portfolios with fewer than 35 stockholdings have lagged behind both the S&P 500 and their more diversified peers. Even more highly concentrated portfolios—those holding 20 stocks or fewer—have underperformed by a wider margin, returning 133 percentage points less on average than the total return of the S&P 500, according to Morningstar Direct data.”





This isn’t supposed to happen. Concentrated investors are supposed to do better. So many studies say so. And anecdotally, many great investors got where they are with concentrated portfolios.





Maybe there is something going on here to explain this… which gets me to the second most interesting investing thing I read this week.





II. Most Stocks (~80%) Have Lagged the S&P500





John Authers at Bloomberg cites a chart by Andrew Lapthorne, chief quantitative strategist at Societe Generale SA, who calls it “the most depressing chart ever.”

Authers explains :





“In this chart, Lapthorne took a universe of some 16,000 publicly traded stocks from around the world, and saw what proportion of them had managed a better return than the S&P 500. Over the last two years, barely even 20% of stocks managed this.”





Perhaps another clue? Authers showed that even within the S&P500 Index itself the average stock has trailed the Index in the 5 years:

Another clue. I think it points to a top-heavy index where if you don’t own the big names like FB, GOOG and AAPL, your chances of beating the index are low…





A simple analogy by Oliver Renick (Bloomberg) illustrates this point. Imagine a bag with five poker chips in it. Four of them are worth $10, and one is worth $100. The average value of the poker chips is $28.





Let’s say you can only reach into the bag and pull out two poker chips. A little quick math shows you can only beat the average if you grab the $100 chip. And statistically, you’ll fail to grab that chip six out of 10 times.





The bag of poker chips is akin to the stock market. And stock pickers are like the guys pulling two chips out of the bag. Now you have a good metaphor as to why it’s been so hard to beat the average.





It’s been this way for some time now. But those charts indicate something else, too, if you look again… It’s not always been this way. We’re somewhere near historical extremes. Someday it might be easy to beat the index just by not owning these same names. This is why I don’t think the chart is depressing.





III. The Missing Risk Element





There is a problem in all this kind of analysis that never gets mentioned – it’s not in the Bloomberg or Wall Street Journal articles. And that is, what about risk?

Return is what you see. Risks are the (often) unseen costs of generating that return.





For example, did the fund invest in companies with a lot of debt? Leverage has always been, in my mind, a good starting point to talk about risk – even before valuation. If you paid a bit much to own a good business, time can bail you out. But if you invest in a business at a great price, it won’t matter if the business can’t survive a hiccup.





What if you get a 10% return from a fund that invests in companies with no debt and you get a 20% return with a fund that invests in similar companies with massive financial leverage? Just looking at returns, you’d rather take the 20%. But if you understood more about how those returns came about, you might rather take the no-debt option for the next go round – or the long haul.





The WSJ article does indirectly get to risk when it talks about the mixed record of concentrated funds even in downturns. But it doesn’t explore why some might’ve fared better than others. My guess is that portfolios invested in higher-quality companies with low leverage fared better.





I’m with Davidowitz, a portfolio manager at Polen Capital, quoted in the WSJ article as saying: “In the financial crisis you pretty quickly saw that it didn’t matter how many companies you owned, it really mattered how high-quality they were.”





But how do you measure quality on a portfolio basis? For example, risk from leverage is different for different industries. A 10 to 1 leverage ratio might be fine for a bank, but suicidal for a retailer. And what’s “high quality”? High quality assets exhibit varying characteristics that are hard to capture in a single metric like ROE, etc. Yet, we know it when we see it.





Anyway, those are just two dimensions in which you might look at a fund’s holdings. There are lots of other ways to think about it. Some people might say they just care about the number (the return). But that’s like saying you don’t care where your food comes from as long as it tastes good. Of course, there are lots other ways to think about what you’re eating (such as nutritional value, risk of getting sick, etc.).





I think it also says something about the era we live in when the best performing fund is a quant fund – Jim Simons’ Renaissance Technologies. (Need I repeat the numbers? 66% gross, 39% net for three decades.) I’ve been reading Greg Zuckerman’s book The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution. It’s well done. I’m about halfway through. Yet, not sure I’m going to finish it.





Yes, I was interested in how Jim Simons got started. The book does a good job of telling you his “origin story.” But the biggest reason I’m bogged down is… the book has nothing to do with investing really.





I know it sounds strange. But investing for me starts with understanding individual businesses… trying to value them… buying them at a good price… and, ideally, owning them for a long time. Simons does none of this. His fund specializes in doing things like buying futures contracts, commodities, currencies, bonds and stocks because a computer algorithm found that it was good to buy on certain days at certain times or whatever. Many of these recurring patterns made no logical sense – i.e., the outperformance of stocks that start with the letter A…





What does it say about the markets when the most lucrative strategy ever is based on computers chomping through massive amounts of trading data looking for patterns?





It’s all of a piece. The massive flow of money toward index funds. The success of relatively mechanical momentum strategies. And the dominance of quant funds like Jim Simons’. It’s like the last decade has been a good time to be short the human brain.





But things change…





I like doing the contrarian thing. I don’t mind having less competition. Let 1,000 quant funds bloom. I like a diversity of styles. It makes for a more colorful market. I’ve been in markets for more than 25 years. No strategy works all the time. And to paraphrase Barton Biggs said, there’s no asset class or strategy that too much money can’t spoil.





There is plenty for good old-fashioned stockpickers to look at. I’ve never been bored running Woodlock House. I suspect those who stick with their craft through will be rewarded for their patience.





Thanks for reading!





In my next post, I’ll have my 2020 outlook and some recommendations for the year ahead...





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Published December 6, 2019

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