The Art of Execution
An under-appreciated skill can turn a good investor into a mediocre one – and vice versa. We’ll take a look, plus the mailbag on Thomas Rowe Price, dealing with the media and more…
I’m back from St. Moritz, Switzerland, where I attended MOI Global’s Ideaweek. I enjoyed many of the presentations.
Elliott Turner, who is a co-founder and managing partner at RGA Investment Advisors in New York City, delivered a talk on position sizing. (Position sizing deals with how much do you put in each idea in your portfolio).
Turner started with an interesting observation. (And I’m paraphrasing here…) He knows someone who is a very good analyst but whose returns are mediocre, because his position sizing is off.
He also knows someone who is an average analyst but who delivers good returns because he gets his position sizing right.
Putting these two together, Turner started to think about how position sizing could be a core competence in delivering good returns.
A lively discussion ensued. It seems a lot of people have strong opinions on how to do this.
Turner asked if anyone knew of any books on this subject, or something worth reading. Surprisingly, there doesn’t seem to be much out there. At least, it stumped our group. (Have a suggestion? Please send it in).
The Art of Execution
One book that came up was Lee Freeman-Shor’s The Art of Execution: How the World’s Best Investors Get it Wrong and Still Make Millions (2015). I read this book and I gotta say; it has a great premise.
Freeman-Shor was a fund of funds manager at Old Mutual Global Investors. (Basically, he managed a portfolio of other funds). He ran an experiment that covered a period of seven years: from June 2006 to October 2013. It covered 1,866 investments and 30,874 trades made by 45 of, he says, the world’s top investors.
He gave each of these 45 managers between $20 million and $150 million to invest in his “Best Ideas” fund. They could only invest in ten stocks that represented their best ideas.
The result of this experiment?
Here is Freeman-Shor:
“Personally, I was shocked to discover that only 49% of the very best investment ideas made money.
Even more shocking was that some of these legendary investors were only successful 30% of the time.
What really fascinated me was the fact that, despite some of them only making money on one out of every three investments, overall almost all of them did not lose money. In fact they still made a lot of it.”
Naturally, the rest of the book is about how this happened. And, as you might’ve guessed by now, what allowed these investors to do this was all about position-sizing – how they navigated the ups and downs of their ideas.
For example, let’s say you a buy a stock at the start of the year. Let’s say it drops 30%. And then it finishes the year back where it started. If you did nothing, your return would be 0%.
But, how you respond to that drop can dramatically change the outcome.
What if you bought more? If you doubled up after it fell, say, 20%, then you would have earned an 11% gain on that position. Not bad. (Although, I have to wonder if over the very long run this matters much. Seems to me, the more important skill is the one Thomas Phelps’ preached in 100 to 1 in the Stock Market: buy right and hold on).
What if you sold it quickly and rolled it into something else? Some investors were successful doing this. As Freeman-Shor says, they were quick to “kill” their losses.
There are different ways to do it, but at least in Freeman-Shor’s experiment, it seemed the better performers did one or the other when faced with a position running against them.
He has another chapter where he looks at how investors deal with winning positions. Do they take small profits or let winners ride? The most successful investors in his experiment seemed to let winners ride.
There’s more to it than this, but that’s the gist of it. (I have mixed feelings about the book. At least, it’s a quick easy read. You can finish Freeman-Shor’s book in a day.)
Still, the book doesn’t really deal with position sizing in any detail.
What to Do Depends on Your Style
I think how you do this depends on your style and temperament. I’ve seen all kinds of ways work well enough for different people.
As for me, I’m likely to buy more if a stock I own falls. I tend to own stocks with great balance sheets and insider alignment. And I often have a margin of safety in the valuation as well. So I can have confidence buying more if the stock falls.
I think it would be more difficult to be this way if I were investing in leveraged equities or stocks where I could not trust the insiders to do the right things.
I also tend to start positions such that I have room to buy more. It’s not often I get out of the gate with a full position. And I let winners ride.
I’m also okay holding a stock that doesn’t go anywhere for a few years, as long as I’m confident that the value of the business is still growing and hasn’t been impaired.
Ideally, I’d hold on to my stocks for years… 5-years, 10-years, etc. That’s when you really get the benefits of all tax-free compounding.
That’s a bit how I think about it. In the interest of moving this along, I’ll stop here. Though, there is more in the mailbag that deals with this topic…
While in Switzerland, I got a great e-mail from Preston Athey. (You may remember Preston from my post here.)
Preston ran a fund for T. Rowe for a long time and did very well. I take what he says and always give it a good thinking over. Anyway, his email is too good not to share – and deals with the position-sizing topic above. So here it is, slightly edited:
“Chris: One of your mailbag readers seemed skeptical about picking the one winner you could ride when dealing with a concentrated portfolio. He's right in one sense... it is really hard ahead of time to know what stocks will be winners. You've noted that there are some characteristics that improve your odds (owner-operated companies, high stock ownership of management, clearly definable moats, etc.), but a lot of investing is just educated guess work. Here's how I dealt with the conundrum.
1) Run a concentrated portfolio, but don't necessarily restrict the number of names. Huh? It's OK to own 75 names, if the top 10 positions are 40%+ of the value of the portfolio. You own that many names to motivate you to really research and follow them... if you don't own them it is hard to discipline yourself to do the work.
2) When the investment thesis behind one of the bottom 50 does not pan out, shoot it and move on. When it does pan out, look for opportunities to add. People had thousands of opportunities to invest in Danaher in the early years. You could have studied their quarterly results, read the annual report, read transcripts of management meetings, etc. Each time, you would have said "Wow, these guys are smart and they are doing what they said they'd do." If the stock was up on a spike, just hold on. If the market had one of its periodic swoons (happens once or twice a year, on average), then look to add.
3) Then, when a stock really works, DON'T SELL! Let it get big. OK, like you said, you don't let it get to be more than 20% on average. If the investor is jumpy, he'll not let it above 10%. But I say let the stock tell you. Berkshire is 20% of my stock account, ex-TROW. That's fine. Markel could be 20%. Wal-Mart could be 20%. NVidia? I don't think so.
4) Every once in a while, one of your big winners gets old and tired... in fact it is a certainty that that will happen in each company's life. But maybe not in YOUR life. If it gets tired; then OK, shoot it. Mr. Price's life cycle of investing really does happen, and when a company is on the downslope, no excuses. How many people have made excuses for J.C.Penney, Sears, GE, Avon, and GM over the last 25 years? Shoot them! But Exxon... one of these days you will sell it, but their capital allocation is among the best in the industry, and XOM is a very shareholder friendly company. If I had 50x my money in XOM, I'd let it ride.
5) Your story about Joe Rosenfeld at Grinnell sums it up. Make your bets. Trade never unless:
a. You get to lower your average cost on a stock you are building up.
b. You are shooting one that just did not pan out.
c. You are putting cash to work when the market is in turmoil (December, 2018, anyone?)
You and I both know that behavioral economics really rules investing. 95% of investors just can't help themselves, and consistently buy high and sell low. For those of us who pride ourselves on our discipline, investing can be interesting, profitable, and fun.
Preston refers to Mr. Price’s life cycle of investing. For more on that, see John Train’s The Money Masters for a great chapter on Thomas Rowe Price. You can also read Price’s pamphlet “Picking Growth Stocks.” A substantial excerpt is included in Classics: An Investor’s Anthology edited by Charles Ellis.
And speaking of Mr. Price, there is a new book coming out in March about him: T. Rowe Price: The Man, The Company, and The Investment Philosophy By Cornelius Bond.
Finally, I got a good note from my friend Kevin Duffy over at Bearing Asset Management, responding to last week’s post about dealing with media:
I will admit to always struggling with the challenge of consuming news and information – occupational hazard. A friend of mine in the investment business goes to an extreme. He almost completely shuts off the news. When I asked him how he stays informed, he said he reads Grant’s.
One exercise I highly recommend anyone in our business: get a stack of old business magazines – at least 10 years old. Go through them and get a sense for what is important. One thing I learned from this exercise is that anything political and involving government is close to 100% noise. Very little changes in that department and what does should not require most effort.
The biggest value of financial media is contrary opinion. The magazine cover curse is a good example. After filtering out those two significant areas, amid what remains is an occasional gem.
The biggest risk of consuming media is its seductiveness towards instant gratification and away from long-term thinking. In a way, I envy my friend. He chains himself to the mast and resists the temptation altogether.
I personally like twitter because the people I follow act as filters. I also try to prune the people I follow, keeping under 50.
I love the exercise. I’ve done something similar. Recently, I cleaned out a pile of old newsletters I had subscribed too. I couldn’t help but glance at the headlines. Amazing how important these all seemed at the time. But 99% of it was just noise. I would’ve been better off spending that time looking for the next 100-bagger.
Thanks for reading. Send me mail at info [at] woodlockhousefamilycapital.com.
Published: February 14, 2019
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