Trivikram Consultants

Portfolio Turnover is the Price of Progress

Portfolio Turnover – Investopedia describes portfolio turnover as a measure of how frequently assets within a fund are bought and sold by the managers. Portfolio turnover is calculated by taking either the total amount of new securities purchased or the number of securities sold (whichever is less) over a particular period, divided by the total net asset value (NAV) of the fund. The measurement is usually reported for a 12-month time period.

Ian Cassel writes that he believes there is an over-glorification of buy and hold investing among active managers. With the rise of private equity and venture capital, everyone is trying to invest in public markets with the same permanent capital mantra. The lower the turnover, the more cerebral and thoughtful you appear to be with initial investment decisions. Nothing looks better than being right from the very beginning. More often than not, low turnover is shown as a badge of honour. Many investors feel great pride and joy being a loyal shareholder of a company. It feels good to say you’ve held a company for 5-10-20 years. But in reality, what really matters is performance.

A big part of what made many investors great was spotting when they were wrong quicker. Successful stock picking isn’t just picking winners. It also means picking out the losers in your portfolio. The greatest advantage in public markets is “You can sell”. But you have to know when to sell.

We normally sell a position for three main reasons: Sell when the story changes for the worse; Sell when we find something better; Sell when a company gets very overvalued.

Investors aren’t going to be right all the time. Acknowledging this fact isn’t a justification for not doing upfront due diligence. What we do acknowledge is that we are willing to accept a degree of uncertainty for the sake of speed – getting in early. Often times, an opportunity is an opportunity because the conditions aren’t perfect yet. The price of certainty can be expensive as it relates to discovery and valuation. When we find a business that aligns with what we like – speed is more important than certainty.

Our initial due diligence might get us into a position, but it is our maintenance due diligence that will keep us invested and/or save us from big losses. Our future returns are based on our ability to course correct and adapt to new information. We are going to have turnover because turnover is the price of progress.

Sometimes when you sell you have gained and sometimes you have losses. Cassel says he learned a long time ago to not let small losses bother him. A big part of being a successful investor is your ability to admit when you are wrong on a company while not letting it crush your confidence and slow you down.

Jonathan Clements explains that there are many investors, and indeed financial advisers, who are still playing by the old rules. Are you one of them? You know those timeless financial principles? Sometimes they don’t age so well. Indeed, if you’re still hewing to the financial wisdom of the 1980s, you’re likely hurting yourself today. Here are three examples:

Goodbye, Star fund Manager: Many investors continued to hunt for the next superstar fund manager. Investors would scour past mutual fund performance, confident that it would be a reliable guide to future results. Today, that confidence has largely evaporated — with good reason: Most fund managers lag behind the market and, among those who don’t, there’s no surefire way to identify the winners ahead of time or distinguish the truly skilful from the merely lucky. Indeed, the proliferation of index funds over the past two decades hasn’t just offered investors an alternative to actively managed funds. It’s also given folks a measuring stick against which to compare those active managers—and, year after year, the managers keep coming up short. What’s amazing isn’t that investors have lost confidence in past performance and their belief in exceptional money managers. Rather, what’s amazing is that it took so long.

Broken Yardsticks: Starting in the 1990s, stock market valuations broke out of their historical range and climbed skyward. Old-timers warned that valuations would soon come crashing back to earth. They’re still waiting. To be sure, rising price-earnings ratios and declining dividend yields can be partly explained by falling interest rates, which have made stocks more attractive relative to the main alternative — bonds. But it seems some enduring financial trends are also driving the rise in stock valuations, including falling investment costs, ever more capital available to invest, a rising appetite for risk, corporations’ growing preference for stock buybacks over dividends, and the move to spend less on plant and equipment and more on research and development. This last change has resulted in lower reported earnings and hence higher price-earnings multiples. The upshot: Today’s stock market valuations are undoubtedly rich by historical standards. But it’s hard to know what to do with that information or whether we should even worry—because it doesn’t tell us anything about short-term returns and it may not be that important to long-run results.

Today’s tiny bond yields: The biggest impact is on retirees. Indeed, the core strategy for many retirees — buying bonds and then paying the household bills with the interest — simply doesn’t work anymore. After all, how many retirees are rich enough to live off a portfolio of high-quality bonds, which today would likely kick off less than 6% in India? It’s time to stop thinking about bonds as a standalone investment. Instead, their sole remaining role is as a complement to stocks. They can provide offsetting gains when the stock market nosedives, a rebalancing partner for stocks, and a way to raise cash if it’s a bad time to sell shares. Clements’ advice for retirees: Forget investing for yield and instead aim to earn a healthy total return by allocating at least half your portfolio to stocks. In buoyant years for the stock market, look to harvest gains. In rough years, get your spending money by selling bonds and cash investments.

Times that try stock picker’s soul

Drew Dickson points out that there is one way to generate excess stock market returns over the long term, and it isn’t to “own winners at any price.” Sure, in hindsight it was, but that is very convenient. It’s very convenient to now ignore the stocks we thought were winners but weren’t. It’s also very convenient to draw parallels between past winners and newer companies as if it is a foregone conclusion they too will win in a similar fashion. Nor do excess returns come from “owning good companies at any price” or “owning high-quality companies at any price.” The “one way” to outperform is to buy a concentrated portfolio of securities that Mr Market doesn’t own; names which are shunned because Mr Market has become overly pessimistic about the fundamental prospects for businesses that are better than he believes or realizes. That’s it. That’s the formula.

This often isn’t sexy, it often isn’t fashionable, and it often isn’t fun. However, a successful investor outperforming Mr Market over the long term owns companies that, by definition, Mr Market believes are pretty stupid to own.

Instead, Mr Market often thinks growing, glamorous, names are much smarter to own. They definitely are smarter looking. And it is surely more entertaining to own these stocks. It’s also easier to sleep at night. They are obviously more dynamic companies and, in many cases, they indeed are better companies. And there are periods where these growing, good and glamorous names do tremendously, well. During these episodes, it downright sucks to be a fundamentally-driven value investor. Equity markets had one of those periods in 1998-1999, and – in Dickson’s view – they may be having another one of them now. Paraphrasing Thomas Paine, these are the times that try stock-pickers’ souls.

The stock market, at least at the moment, seems most sensitive to whether or not a company is classified as a “good” or “bad” business. And “good” means your stock has already appreciated, is already expensive, and is showing even the slightest degree of business momentum. And no price is high enough for “good”. Because good is good, so why wouldn’t you own it? “Bad” is the opposite. Bad is an already-inexpensive stock that has already sold off, and one that has already exhibited fundamental weakness, even if it’s likely a short-term phenomenon. And no price is low enough for “bad”. Because bad is bad, so why would you own it? As maddening as this behaviour is, it is typical of investor psychology at peaks and troughs; and consequently, the “price” of growth is higher than it has ever been.

Dickson asserts that there is no new era. Stocks are still worth the present value of their future cash flows. While narratives can dominate in the short term, and while the short term is sometimes longer than we like, the fundamentals eventually matter. They have to. We are buying fractions of the equity value of large, liquid, listed, enterprises. The fundamentals “have to matter” because these fractions of equity, these shares, are worth the present value of all future cash flows to that fraction of ownership. We have no idea when “eventually” is going to arrive. Whether or not we are three days or three years away from this growth bubble popping, he doesn’t know. But he is tremendously confident that it isn’t “different this time.”

As an individual investor, what’s the key to success? It’s a question Adam Grossman hears a lot, especially in volatile times like this. The answer, he thinks, is that there isn’t just one key, but rather five. The most successful investors seem to be equal parts optimist, pessimist, analyst, economist and psychologist. Together, he calls these the five minds of the investor. If you can develop and balance all five, that—Grossman believes—is the key to investment success.

Optimist. When Grossman thinks of financial optimists, he immediately thinks of Warren Buffett. Now, you might imagine that it’s easy to be an optimist when you’re a billionaire. But he thinks it’s because Buffett is an optimist that he’s a billionaire. His secret—which really isn’t such a secret—is to bet on the long-term growth of the stock market. When the economy is in a recession, as it is today, with millions out of work, it’s easy to feel dispirited. It is scary, and I don’t want to diminish everything that’s going on. But as Buffett wrote in that 2008 article, “Fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.” Of course, you can’t have 100% of your money in stocks. That brings us to the role of the pessimist.

Pessimist. Many people view themselves as either a glass-half-full or glass-half-empty kind of person. But for investment success, he thinks you want to be a little of each. You’ll notice that Buffett referred to the stock market’s long-term potential. That’s an important qualification. As we’ve seen this year, things can—and do—happen that interrupt the market’s growth. That’s why it’s important to pay as much attention to your inner pessimist as to the optimist. What’s the best way to accomplish that? It isn’t complicated: You just want to keep enough of your assets outside of stocks to help you weather these interruptions. That will give you both the financial ability and the mental fortitude to get through tough times.

Analyst. If the optimist believes that stocks will grow over time, and the pessimist knows that they can’t grow all the time, how do you balance the two? That’s where the analyst comes in. The role of the analyst is that of a mediator—to consider the needs of both the optimist and the pessimist. Your inner analyst should be dispassionate, focusing on the facts of your individual situation. This includes your income, expenses, assets, liabilities and goals. In short, the analyst’s job is to strike the right balance between optimism and pessimism to develop an investment strategy that’s the best fit for you.

Economist. Economics isn’t exactly a scientific field and anyone’s ability to forecast the future is necessarily limited. But successful investing does incorporate certain economic concepts. At a high level, these include fiscal policy (the government’s ability to set tax rates and spending levels) and monetary policy (the Central Bank’s ability to set interest rates). And finally, it includes a sense of economic history and financial cycles. None of this means you’ll be able to predict where the economy is going. None of us can. But it does mean you’ll be better equipped to respond to events as they occur.

Psychologist. Colourful commentary and dramatic predictions are all around us. That’s why the fifth, and maybe most important, ingredient for investment success is to channel your inner psychologist. Among other things, this will help you to understand the motivations—both conscious and unconscious—of others, and to see the subtext of what they’re saying and not saying. This will help you to tune them out, as needed, so you can stick to your plan.

Is investing easy? No, he doesn’t think anyone would (truthfully) claim that. But if you successfully balance these five ideas in your mind, Grossman believes you’ll tilt the odds in your favour.