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What's a "good" track record? + SATS Spinoff

Would you be interested in a fund that underperformed its benchmark in five years out of six? Would you consider this a “good” track record?


Investment track records fascinate me. Partly, I think, it is because they are so difficult to interpret. A “strong” track record could disguise dangerous risk-taking. A “weak” track record could mask resilience and long-term outperformance. Figuring whether a track record is really any good is almost an art in itself.


I was thinking of this after reading Rupal Bhansali’s book Non-Consensus Investing. Bhansali is a portfolio manager at Ariel. Her book is a simple, easy-to-read presentation of her investment philosophy and lessons learned.


And, of course, she talks about track records. Here is a table from her book that inspired me to write today’s post:

Bhansali calls this a “risk aware” fund, because the manager’s chief aim is to manage risks by avoiding big losses, rather than trying produce high returns. There are at least a few interesting observations to make here.


First, note that the fund outperformed in only four out of the ten years. And second, it underperformed in six out of the seven years in which its benchmark went up. Despite this, the fund produced a ten-year CAGR that was nearly double the benchmark. The key is that it suffered less in those years when the benchmark declined.


Of course, it’s hard to know what a fund will do in a bear market until it happens. And it’s hard for most people to stick with a manager that trails for so long. Imagine seeing the same chart, but starting it in 2003. Now you’ve got a fund that has trailed for five straight years. Are you likely to stick with such a manager?


In the sixth year, the manager’s risk mitigation skills finally reveal themselves in a nasty bear market, after which the fund pulls decisively ahead of its benchmark. But, again, you had to sit through five years of trailing the benchmark.


That’s a seeming eternity in a world where investors get monthly statements and quarterly letters and daily stock prices. For the manager, it takes nerve and a stable capital base to stay the course. (I am lucky at Woodlock House in that more than half of the fund’s capital comes from my partner and I).


So, lesson number one in looking at a track record is to consider a full cycle of returns.


Another aspect of thinking about a track record is the sample size. With the fund above, I’d feel pretty confident that the ten-year track record indicates a skilled manager. But statistically speaking, such confidence would be misplaced. There would still need to be plenty of room for doubt.


To get really confident would require a much larger sample size. Bhansali refers to research by Richard Grinold and Ronald Kahn, which show “it takes 16 years of performance data to prove skill over luck with a high degree (95%) of statistical confidence.”


That’s a lot, but financial history has plenty of examples of seemingly long track records dissolving in the acid of a bear market. I always think of Bill Miller, whom I sympathize with, as an example of someone who had a seeming great long-term track record and then lost it. He beat his benchmark every year from 1991 to 2005. By the end of 2008, his record was in tatters, among the worst in its class. See "The Stock Picker's Defeat")


Proper evaluation of a track record is more than just looking at numbers anyway. You really got to get under the hood. What are the managers actually doing? Did they use leverage? Did they invest in leveraged companies? Did they make one “big call” (i.e., heavy in one sector) and get it right? As Bhansali says, higher returns may reflect “aggression” not skill.


These kinds of questions are the most important questions to ask a manager. The answers are not always in the data of a past record. Bhansali writes:


“Evaluating skills and capability has predictive power; looking at historical performance does not. Sadly, data, however misleading, wields more power because it is tangible to look at, while skill is hard to figure out. But easy does not equal right.”


With the S&P500 having a strong year, I think the message above is timely. Whether you are managing your own money or you’re invested in a fund, don’t focus on short-term performance. Think more comprehensively about the process of investing. Most importantly, keep in mind the risks you are taking.

More likely than not, they will determine what your long-term return will be.


As for the questions I opened with, the answers are, I hope, obvious by now. The only correct answers are “It depends.”


*** Low-Risk, But Good Upside


Since I have trouble writing these posts without including talk about an idea somewhere, I'll re-visit a stock I wrote about on June 25. It was, at the time, a low-risk idea because of the valuation, cash-rich balance sheet and non-cyclical recurring cash flows, plus you had an upcoming transaction that would unlock value.


I wrote then:


“I think an interesting opportunity exists in EchoStar (SATS) to own a growing, un-levered, non-cyclical asset trading for ~5.75x EBITDA…


A recent transaction will make this apparent, but it won’t happen until the second half of the year. (Disclosure: Woodlock House is long shares of EchoStar with an average cost of ~$38 per share.)


Back in May, EchoStar announced it was selling certain assets to Dish Network in exchange for 22.9 million Dish shares. (In an interesting twist, the shares will go to EchoStar shareholders. If you don’t want to own Dish, you can sell your shares and just own EchoStar). In addition, about $253 million of liabilities transfer to Dish…


What remains at EchoStar is essentially Hughes Network Systems with other interesting assets that could be worth a significant sum. For now, let’s focus on Hughes.


Hughes basically provides broadband satellite service to individuals and businesses. Over the last few years, sales growth clocked in at ~10% annually and EBITDA growth at ~14%. Not bad.


Last year, EBITDA was $601 million – just for Hughes. EchoStar, net of the Dish transaction, trades for about 5.75x EBITDA [before corporate overhead]. Viasat is probably Hughes closest comparable. Hughes is much bigger and is not competing directly with cable/DSL. Nonetheless, Viasat trades at a multiple more twice EchoStar’s. Even if EchoStar traded for 7x EBITDA, that would be quite a lift for the stock…


All in all, it seems a good risk-reward proposition to me.”


Well, the transaction happened. Woodlock House received nearly $9 per share in DISH shares, which I sold. This reduced my cost basis in EchoStar to ~$31 per share. We have a 28% gain on the stock; it’s up 18% since my June post.


As of this post, we still own EchoStar. There are some details yet to be determined (such as what share of corporate overhead EchoStar retains). But I think the stock is still undervalued. In addition to Hughes, EchoStar owns a number of investments (such as DISH Mexico, other JVs, Jupiter 3 and European spectrum assets) that could provide more than a billion dollars in “hidden value.” That’s significant for a company whose enterprise value today is ~$4 billion.


I think EchoStar is a good example of how low-risk stocks can produce high returns. In a future post, I’ll share another such idea.


Of course, they don’t always work, or work out so quickly. But a portfolio of such opportunities is bound to be rewarding over time.


Thanks for reading!


***

Published September 25, 2019

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