Portfolio Principles: The Real Cost of Investing
This article is authored by Matthew Campbell CFA, a Director in our Discretionary Portfolio Management team. It was originally released as a client report in the summer of 2021 but it’s core messaging still holds true for our invested clients.
Please note: This article explains aspects of our investment philosophy. Reference to specific companies in this article is not an opinion as to their present or future value and should not be considered an investment recommendation, investment advice or a personal recommendation.
The most significant cost associated with our investment strategies isn’t annual management charges, trading costs or taxes, but rather opportunity cost – the cost of missing out on investment opportunities superior to those we actually choose to invest in.
Opportunity cost can be particularly acute within equities due to the asymmetry of the long-term payoff profile meaning your worst possible outcome is -100% on the downside but your upside is, in theory at least, uncapped.
One of our primary tasks as Portfolio Managers at Barclays Private Bank, is to limit opportunity costs by finding a collection of investments that we believe will perform better than the market over a reasonable period of time, meaning we intend to make decisions that will look good in 5+ years’ time, in hindsight.
As long-term, low-turnover investors, the basic building blocks of this outperformance will ultimately come down to the ability of our portfolio holdings to generate both superior cash return on capital compared to the average company, and plough a significant amount of this cash flow back into their businesses at high incremental rates of return for an extended period of time. Investment opportunities such as these are vanishingly rare which results in us building concentrated portfolios around such businesses.
While this may sound simple in theory, it can often be very difficult in practice. Firstly, the prevalence of cheap, readily available news and data means that we are bombarded with a high volume of information on a daily basis. It takes some discipline to tune this noise out and we find that curating our reading lists appropriately, as well as speaking with and listening to differentiated sources of information, make a significant difference to the longer-term context we seek to gain compared to using industry standard sell-side research.
Secondly, public equities are liquid assets that can be traded in a few moments and with increasingly less frictional cost. Being able to change holdings with such ease is no doubt a factor in the average equity holding period now falling to only 5 ½ months1.
Thirdly, behavioural biases also come into play and need careful management. Going back to the original point regarding the asymmetry payoff profiles inherent in equity market investing, it is worth bearing in mind that in practice you can lose more than 100% of your initial investment if you average in to a stock that turns out to be a loser. From our perspective this is one of the main cardinal sins of equity market investing as the thesis behind averaging into a loser tends to come about as a result of anchoring bias (i.e. sticking doggedly to an investment thesis that turns out to be wrong), and an unwarranted belief in the powers of mean reversion. This behaviour can result in substantial opportunity cost as not only is the investor averaging into a poorly performing stock, but they are also in all likelihood selling a winner to fund the loser. There is an old saying in the financial community that ‘it’s never wrong to take a profit’ - we profoundly disagree and believe it is one of the worst habitual decisions an investor can make.
We have tended to find that the world’s most successful investors are those that are highly adept at screening out short-term noise and the ever changing opinions of the various talking heads that grace our TV screens and Bloomberg Top Stories page. These successful investors have tended to adopt a long-term mentality that the majority of other investors cannot or will not do, either through a lack of conviction, composure or, quite frankly, through a lack of long-term incentives. Ironically, in our view the best and most disciplined investor behaviour often isn’t seen in the investment industry (although there are a number of investors we do admire and respect), but tends to be seen in entrepreneurs and even staff who have participated in employee stock programmes.
I recently read Sam Walton’s brilliant autobiography ‘Made in America’ which tells the story of Walmart (a stock we do not hold). In it he discussed the profit-sharing plan that the fledgling business put in place in the early 1970s after a tennis trip to London when he spotted a large sign in a department store telling customers about the stores’ partnership structure (the retailer was Lewis Company, or John Lewis as it is now). Bob Clark, who started working for Walmart as a truck driver in 1972 when it only had 16 rigs on the road said ‘The first month I went to a driver’s safety meeting, and he [Sam Walton] always came to those. There were about 15 of us there, and I’ll never forget, he said, ‘If you’ll just stay with me for 20 years, I guarantee you’ll have $100,000 in profit sharing.’ I thought, ‘Big deal. Bob Clark never will see that kind of money in his life’… Well, last time I checked I had $707,000 in profit sharing’2. Note that this book was published in 1992 meaning that stock, if left untouched, would now be worth around $11.5m, including reinvested dividends.
Bob Clark no doubt knew a good thing when he saw it and undisturbed by events ranging from the Vietnam War, Nixon’s impeachment, the economic turmoil and inflation of the 1970s, the fall of the Berlin Wall etc. saw his net worth climb steadily and meaningfully over time, entirely due to the company specific dynamism and success of Walmart. Furthermore, Bob also had to tolerate quite a number of very significant drawdowns in Walmart’s stock price with the stock often falling 20- 30% or more on a month on month basis in the 70s and 80s. Bob’s patience and composure is a lesson to all of us in an industry that chooses to focus its attention on trying to sound smart in the moment regarding current macro events of limited real relevance and which can often demonstrate a general lack of equanimity when the going gets tough. Walmart is one of the businesses that features prominently in the brilliant Hendrik Bessembinder article ‘Do Stocks Outperform Treasury Bills?’, which describes how the overwhelming majority of long-term stock market returns are generated by a very small number of companies3.
At Barclays Private Bank, we seek to find quality companies, hold on to them for the long run and, crucially, not sell too early. If we manage to do this, even reasonably well, this will in turn help to minimise the impact of opportunity cost for our clients, which in turn should also result in outperformance versus. the broader market.
When will we sell?
The view of the world that I have just articulated is of course overly simplistic and while we strive not to make poor investments, invariably there have been and will continue to be instances where we misjudge things. We can at least minimise the impact of these errors of judgement by not averaging in to a losing position, as described earlier, but in some instances we will have to conclude that a position must be sold. The decision to sell normally occurs for fundamental reasons such as an adverse change in management, a loss of competitive advantage, the misallocation of capital, or on finding an alternative investment that we believe is demonstrably better quality than something we already own (although this has a high hurdle as it carries reinvestment risk given we will have much more accumulated knowledge on the deep reality of our current holdings than we will on new ideas).
We do not sell due to macroeconomic or political developments as our preferred types of business should be very able to withstand different economic conditions. Sales also do not tend to occur on valuation grounds and never occur on price targets. That is not to say that valuation is irrelevant, it very much is and we spend a considerable amount of time thinking about this, especially for a new position. However, we tend to find that trying to sell or trim due to valuation introduces market timing decisions where we have no real informational edge and the idiosyncrasy of each business means that comparing investments based on valuation often misses the most important aspects of how these businesses create shareholder value on a forward looking basis. Furthermore, while we can choose from a universe of thousands of businesses, in reality those that demonstrate our desired characteristics only number in the hundreds meaning relative valuation ideas are very few and far between anyway.
The whole crux of our investment philosophy is not only to find great businesses but also to allow ample time for the compounding of their intrinsic worth to be reflected in their share price. In the short term we have no doubt that some of these decisions can look silly or perplexing, however, investing well requires a high degree of emotional discipline and a willingness to be wrong in the short term, in order to reach our long-term goals. If done well, that is how we seek to outperform our peers and the wider market over time and build on the track record going forward. For our investors, it is worth stressing that the best client outcomes tend to come as a function of time spent in the market. Where clients struggle with short-term noise, the multi-asset solutions are ideal in offering partial participation in equity markets in a less volatile manner which in turn helps the clients to get invested and stay invested.
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