Time-Honored Path To Success (Part 3)

Cover Story, by Mark Robertson, Managing Partner May 1st, 2010

We continue our discussion with our take on portfolio management including 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. An incremental advantage is gained by diversifying into small-, medium- and large companies as we maintain the overall sales growth forecast for the portfolio. Our attention focuses ever more on holding the best — for as long as it makes sense to do so.

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.

" … 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."

But not if you ignore the lessons.

Heeding matters. Heed the lessons well.

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. This month, we’ll take a closer look at the role of strategic selling in portfolio design and management but first, a recap of the foundations covered so far:

1. It All Starts With Ownership. Own It.

In most cases, effort to understand the realm of long-term investing is rewarded with incrementally higher returns. Take responsibility and behave with a pride of ownership.

2. Invest Regularly. Imagine Success.

As we’ve suggested the advantage gained from “investing regularly” wanes with the passage of time. Hence, we can only assume that the regular investment becomes one of time and attention.

3. Embrace Strategic Selectivity.

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.

4. Seek and Maintain Sufficient Overall Growth

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.

Extended Chronicle for McDonald’s (1994-2010). This longer term perspective on McDonald’s (MCD) displays a relatively stable PAR over the years and a continously excellent quality rating. The exceptions were the drift to a PAR approaching zero in 1998-99 and the swoon in price that led to PARs greater than 20% during 2002. Investing $100 in MCD back in 1994 (over paying because the PAR was less than 10%) and holding it until today would now be worth $539, an annualized total return of 12.6%. Selling it just once (during the 1998 surge) and buying it back in 2003 could now be worth $1830 … or an annualized total return of 20.9%! Think about it. Not exactly frenetic selling, is it? 1 sale of a core stock and 1 repurchase over 15+ years. Realize the difference.

5. Embrace Strategic Selling.

This one proves to be a little more challenging than most. Virtually all of our community practitioners will be quick to admit that it seems like we’re a whole lot better at discovering and buying stocks than selling them.

Or for that matter, building a logical notion on when to sell them …

But the answer and road map — as it turns out — isn’t really as elusive as it seems. Nicholson suggested that nearly 90% of our selling decisions should be based on a simple condition: making the portfolio better.

This is the basis of our portfolio-centered decision-making emphasis and the guidelines deployed by Tin Cup. It can also be thought of as a current day implementation of the Challenge concept. What is the weakest expected return in the portfolio? Can it be replaced with a good fit with better return expectations? Think “survival of the fittest.” Challenge the weakest holdings during a continuous campaign of making the portfolio better.

It also seems logical to embrace selling guidelines that are reflective of the difference between a core and non-core holding. It seems to be common sense that we’d expect more return (during purchase) of a non-core holding while at the same time being less tolerant. From that perspective, why should we hold a non-core company that is projected to underperform the general market (e.g. PAR < MIPAR). Yet, for a core holding — more tolerance (lower PARs) seems justified. As shown in the accompanying chronicle, if our policy were to sell MCD when PAR approached money market rates, we’d have witnessed only a couple of events that fit that description over the last 15+ years. (See 1998-99.)

In fact, selling MCD at the second collision with a PAR of 0% — and holding the high-quality mutual fund, Jensen (JENSX) while awaiting the opportunity to repurchase MCD (in 2003) delivers an end result of 20.9% per year versus a strict buy-and-hold result of 12.6%. Think about it. How many times have you ridden a surging stock up and all the way back down. In this case, $100 invested in MCD grew to become $1830 versus $539 for a oblivious deployment of buy and hold.

The accompanying chart is a dangerous exercise in potential humility — checking for what happened after selling. I think an overreaction to the recessionary impact on the discretionary stocks (BBBY, WSM & URBN) is worth further contemplation — but this kind of humility (and positive impact) we can all live with. Sell. Strategically.

Case Study: Efficacy of Selling Decisions. This is a list of companies sold from the Solomon Select tracking portfolio. In this case, red numbers are “good” reflecting a situation where continuing to hold a position would have resulted in a negative impact. As shown, 60% of the decisions mapped here underperformed the market after being “sold.” The potential for improved long-term performance is anything but imaginary.

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.