Time-Honored Path to Success (Part 2)
Cover Story, by Mark Robertson, Managing Partner April 1st, 2010
This month, we continue our closer look at what we do, why and how we do it, and why our approach to investing works.
This month, we continue our closer look at what we do, why and how we do it … and why (and how well) our championship approach to investing works. It starts with taking ownership and a commitment to invest regularly. Our learn-by-doing investing experience naturally progresses from discovery and a boost from investing regularly to the maturity of strategic selectivity (the reality that both projected returns and quality matter) to careful design and portfolio management that must necessarily include prudent diversification and the willingness to embrace selling opportunities.
Pieces of Our Relative Return Advantage (cont.) We capture a cost advantage by becoming self-directed investors. During the early years, investing regularly also provides a performance boost. During this period, the joys of strategic selectivity (seeking excellent companies at attractive forecasted returns) is added to our arsenal. Portfolio design evolves into management.
" … a group [of investors] heeding the lessons of Graham, Babson and Nicholson has at least one leg up on the crowd and a better than average opportunity to generate exceptional returns."
As many of you know, I served as the administrator of an annual investment club performance contest at the National Association of Investors (NAIC) for several years. Clubs would submit annual and lifetime results, including their portfolios, and we’d characterize their performance based on relative rate of return. Winners were selected on the basis of results achieved … with credit given for average sales growth, EPS predictability, financial strength, PAR and quality of the portfolios. (Sound familiar?)
During that period, we received literally thousands of club portfolios and I had the opportunity to witness collective achievement on a grand scale.
I recently stumbled into one of the old spreadsheets where we collected the club performance data and summarized results. I’m not sure why I missed this — but I apparently did — I was struck by how many of the finalists (year after year) were relatively new clubs. In fact, the average age of the finalists was approximately six years with a concentration in the 3-6 year time frame.
Last month, we started this analysis by suggesting that it’s possible to get a small advantage (1.5%) over “average investors” by taking responsibility and becoming a self-directed investor. We also took a look at the reality that investing regularly provides a performance boost with a form of dollar cost averaging.
But … we must also acknowledge that this advantage is fleeting. In fact, NAIC founder George Nicholson Jr. warned that this incremental advantage would wane as the ratio of infusions to total assets becomes progressively smaller and smaller. In other words, the 3-6 year old clubs had a 1-2% advantage on the older clubs coming out of the gate.
3. Embrace Strategic Selectivity.
We define strategic selectivity as the hunt for the best of the best. Discover, study and own high-quality companies. Own industry leaders. Industry leaders often deliver higher growth while refusing to compromise on profitability. Excellence plays out before us in the shape of routine consistency and effective exploitation of opportunities in served markets. In a word, excellence of management lives as these companies achieve steady profitability track records versus peers and competitors while delivering above-average growth.
Strategic selectivity is captured in two dimensions:
(1) Leadership quality. At MANIFEST, quality is characterized by four components: Financial Strength, Consistency of Profitability and Relative Growth and Relative Profitability.
(2) Projected annual returns (PAR): Forecast returns for all companies are constructed from consensus estimates for growth, profitability and projected P/E ratios.
Both characteristics are important and can’t really be isolated at the exclusion of the other. In fact, academic studies have suggested that an “all-quality emphasis” in a buy-and-hold discipline suggests that underperformance is a foregone conclusion.
Quality served as a buffer (or insurance policy) during one of the worst bear markets in stock market history. These highest-quality companies only declined 19% while the lowest-quality companies declined 40-60%.
A 1987 study focusing on the companies featured in the book, In Search of Excellence, revealed an interesting conclusion. The researchers divided a larger set of companies into “Excellent” and “Unexcellent” companies. A paradox seemed to unfold as the weaker companies outperformed the S&P 500 by 12.4% while the excellent companies managed a mere 1.1% relative return over the same time period. Some cite this research and affiliated efforts as part of the evolution of value vs. growth investing.
When asked whether NAIC-based investing was growth or value, founder Thomas O’Hara often answered: © None of the above.
In his view, our strategic selectivity encompassed both approaches — an effective combination — requiring growth but making sure that purchases were only pursued at very attractive prices (i.e. high projected returns.)
In a recent issue of Better Investing magazine, an editorial suggested, “the stocks suggested by our methods tend to go down more than the overall market when prices are dropping but also go up more than the general market when stocks are rising.”
Bzzzzzt. WRONG. That certainly doesn’t reconcile with my experience and is inconsistent with what we’ve witnessed from legions of investment clubs. The higher-quality companies decline less during corrections and bear markets as shown in the accompanying chart. Using the Jensen (JENSX) mutual fund as an example of high-quality investing, we see the same characteristics: the holdings drop less during the bears, but generally fail to keep up with the stampede of the bulls. See 1996-1999 in the accompanying graphic and note the cushion during the two market breaks shown.
Long-Term Performance of a High-Quality Mutual Fund. The Jensen Fund (JENSX) routinely has the highest overall quality rating among funds that we follow. Over 15 years (1995-2010) Jensen has achieved an annualized return of 9.0% vs. 6.8% for the total stock market.
Strategic selectivity. Seek quality companies. But only buy when the price is right.
Based on the aggregate results of the clubs in the annual contest and Nicholson’s 15% return target, we estimated the incremental contribution of strategic selectivity at 4%. As the years pass, investing regularly continues but emphasis increases on portfolio design and optimization. From that relatively large sample of clubs, we generally found that we could literally predict performance deficits due to one of two conditions:
(1) An overdose of buy-and-hold, and
(2) a refusal to diversify by company size.
We’ll tackle size diversification next, but we noted inferior results from clubs who seemed unwilling to sell stocks. A 2000 survey revealed that the vast majority of investment clubs had virtually 0% turnover.
The Role of Size Diversification. We counsel owning and maintaining a mix or blend of small, medium and large companies in portfolio design. As shown here, the VL Arithmetic Index, a combination of all size companies has significantly (4.2% per year) outperformed the S&P 500, a collection of very large companies.
Folks, Nicholson didn’t say “Buy and Hold.” He counseled buy and hold - for as long as it makes sense to do so. It’s a critically important distinction.
His work on portfolio management, including the Challenge concept, underscores a willingness to embrace strategic selling. We’ll cover this in greater detail shortly. The clubs that purchased carefully (quality when the price was right) and were willing to sell a holding under the right conditions were most often the ones achieving higher relative returns.
4. Seek and Maintain Sufficient Overall Growth
The Pieces of Our Relative Return Advantage. Adding a commitment to strategic selectivity and sufficient sales growth (size diversification) means that our relative advantage stands now at approximately 6%. It should be clear that pursuing sufficient sales growth (smaller companies) ranks as one of the bigger pieces of the puzzle.
You guys already know the drill. It was no accident that the founders emphasized diversification by company size. The intent to to ensure that sufficient growth characteristics are present in the portfolio design. Nicholson counseled an overall average sales growth of 10-12%. We simply are less likely to achieve superior returns without seeking, discovering and owning a sufficient number of medium and small-sized companies.
The accompanying graphic is one of our signature pieces. The return on the S&P 500 (large companies) was 6.2% for 1988-2009. The return on the Value Line Arithmetic Average (small, medium and large companies) was 10.5% for 1988-2009. The difference is 4.2% per year.
Q.E.D. Size diversification. Overall portfolio sales growth forecast. Do it.
Mark Robertson
Mark Robertson is founder and managing partner of Manifest Investing, a source for research and portfolio management focusing on strategic long term investors.