“Benign neglect, bordering on sloth, remains the hallmark of our investment process.” – Warren Buffett
“Rule No. 1: Most things will prove to be cyclical. – Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.” Nothing good or bad goes on forever. And yet people extrapolate sometimes as if a phenomenon will go on indefinitely. “If something cannot go on forever it will eventually stop” famously said Herbert Stein. Situations in which mean reversion does not happen are rare enough as to make a mean reversion assumption a consistent friend to the investor. – Howard Marks
In considering this piece a pond in the Turkish city of Urfa came to mind. Urfa has a history that may date back to 9000 BC, it is old by any measure of human civilisation. It is also purported to be the birthplace of Abraham and famous for, amongst other things, an ancient pond.
Legend has it that Abraham was thrown by the evil king Nimrod into a pit of fire and God turned the pit into a pond thus saving him. It is now, naturally, a place of pilgrimage and is filled with a large population of ‘sacred’ carp. Being holy they are fed by the visiting pilgrims.
When food is thrown they slither and crawl over each other to gorge. When more is thrown, forgetting the last they fight for the new treasure.
The whole dance is grotesque, yet undeniably fascinating.
This image neatly encapsulates my model of the attention and style of the investor class. Overwhelmingly attracted to that which is most stimulating to the exclusion of all the rest. This is a zero sum game, fine if you are the fastest and strongest fish but if you aren’t you may struggle being fed to your satisfaction.
The result is either the majority of the riches go to the few and their advantages sustains that state of affairs (I’m talking here about financial markets, I can’t say if this is so with the carp) or luck becomes a major factor. This is a version of the Winner’s Game as set out by Charles Ellis.
The aim in each trading program within the Elif Fund is to move away from fighting in that mass of fish. What other choices are there? To guess where the food will be thrown next is fraught with prediction error. Perhaps then the easiest alternative is to follow in the wake of the mass, feeding off the scraps. Less food but less competition. It isn’t glamorous but you’ll feed well. (I’ll stop here as I think I’ve milked this metaphor to extinction.)
The Large Cap Value Program (LCVP to you and me) is one strategy I use to do so. Of all my investment programs it is perhaps the most reflective of my natural inclinations.
The LCVP was an outgrowth of the financial crisis. Towards the tail end of 2008 I desperately wanted to buy a whole host of ETFs but was so burned and scarred that I could only pull the trigger with tiny positions (thought here). My solution was to scale in. At the time most of my dealing was in the US where commissions are a fraction of the UK (we’re still so far behind in terms of retail investment services). Moving into 2009 I wanted to utilise this technique in the UK and discovered my Selftrade ISA had a monthly investment scheme with discounted commissions.
Thus this program was born. (I’ve since ditched Selftrade). This is also why this program is large cap as it was only that universe that was available. The form I discuss is the end result of an evolution, testing and tweaking with a number of interim dead-ends.
The essence of this program is mean reversion – finding a company or industry that has fallen on hard times but where the problems are unlikely to be terminal. The vision is a dynamic adaptive system – you have to be believe in adaptive environmental regulation or this program will drive you insane. This process is relatively in depth but the key is variant perception and optionality. I try to consider an environment in 5 years that is far different from the current and then ask if the system is able to adapt to that. I don’t need to know the specifics.
What differentiates the LCVP to me are the timelines. This is a very long term program both in the acquisition of a position and its holding period. I will buy in over 9-18 months often beginning when there is worse to come. The idea that things can ever be better should be almost laughable. I want the reaction of others if I told them to be some form of facial scrunching. Actually the best reaction is indifference tinged with aversion. That is the ultimate.
This identification process is thoughtful even if it is ultimately heuristic but I won’t dig in here (see this for more). It is generally better if the company is still paying a dividend as during the dark days it becomes a comfort, and we can reinvest at ‘cheap’ prices. But that is a nice to have rather than must have.
This long accumulation phase is helpful, it takes away the requirement of correct timing as the stock may fall 50% or more before it bottoms. It also allows me to keep an eye on how the story develops. Each position will have a very long leash but I’ll have a hypothesis and hooks on which the hypothesis rests. If they fall apart or an element deviates in weird ways then it is easy to close the position size is small and the loss is likely to be well within parameters.
Ideally at some point operations will stabilise or begin improving but the market will hopefully not be paying attention, instead preferring to parrot old beliefs – in this instance bounded attention is our friend.
If I see this divergence between operational ‘reality’ and the narrative then I can be relatively confident the setup has great potential, I may be more aggressive from this point. If operating performance recovers we can have a potential double whammy from the expansion of earnings and the expansion of p/e as sentiment blossoms. This is the perfect outcome. I don’t expect many but the results can be significant.
Below is my attempt to capture the cycle between IV, price and sentiment:
I’ll hold the position until there is an operational reason not to or if it the risk-to-reward picture doesn’t offer enough upside to justify the risks.This can happen if the valuation is initially too rich. We saw this recently with Tesco where I was hoping for complete capitulation (sub 140p). However it recovered too quickly, I had only a ¼ position and the upside potential with the price over 200p was not particularly enticing. I sold. (green B is a buy the red S is a sale)
Otherwise if the position goes to plan I’ll manage it according to valuation then ride the trend as far as I dare. My intention is to hold for as long as is sensible.
My target returns are 12% p.a, volatility is not a concern. Returns have been better than that these past 4 years, but before we get too excited I would posit this is indicative of the current market phase rather than the promise of perpetually higher returns (returns below are by tax year April to April). In fact since these year end figures we’ve sold off and are down around 5%.
There haven’t been too trades over the years but here are a couple of examples (blue is accumulation, red is sale):
TRG was almost textbook, I wanted European exposure and TRG was also selling at a 20% discount to NAV. Europe recovered, the NAV went up and the discount narrowed. I sold as I didn’t want to be exposed during the move from Selftrade and wanted to lighten some positions during the move. This made the cut as the discount had narrowed:
HOME was one where I hoped for more but although operational performance improved you always sensed the headwinds were too strong. Once expectations starting matching performance I couldn’t see the necessary juice either from earnings or from p/e expansion to provide a suitable payoff profile so got out on price weakness:
PSN was my first big position in the program. I’ve started to lighten up the position in the past week as the valuation is leaving less and less room for error. I actually came close to selling at £12 but ending up buying more and selling TRG instead. It has been a large success as well as paying out decent chunks of dividends.
GSK has been my one losing position in this program (it’s pretty much breakeven thanks to the divs) and it is still open. You can see with this one I didn’t follow the rules I’ve set out. I actually bought this on a different basis (which seemed solid at the time). I could write a whole blog post on GSK but that is for another time:
A program is more than individual positions. The flavour is how you it is put together. I hoped to space out positions such that as one position is in accumulation (and thus losing), others should be ripening. In practice this hasn’t been practical as cheapness (or otherwise) comes in clusters. This is fine I’ll happily take lumpiness if the long term results are good. Other programs are there to smooth out returns at the top line.
This is a concentrated program. Holding more than 8 positions at any time is unlikely as I don’t find enough candidates. Turnover is low, in 5 years I’ve probably only held 10-12 positions. I’ll adjust size a little according to safety and my perceived risk of ruin. I’ll also look to diversify or size according to sector i.e. if I have 2 banks I’ll treat them as one position (or one and half if I really like what I see).
Also I don’t rebalance based on position size relative to total equity. This is an uncomfortable stance as the instances where one should have rebalanced are more available than the instances it would be better not to. This is an important note, I’m expecting a long tail payoff profile. If one position takes off every few years we’ll achieve more than decent returns. If not hopefully we’ll still do well enough.
Nonetheless I do rebalance if valuation risk is heightened. Managing distribution is the hardest skill in investment. If I can manage the broad strokes I won’t beat myself up too much. It is an area with a lifetime of improvement to look forward to.
And that is it. Very simple and light touch. This program requires perhaps 2-8 hours per month depending on the cycle, it is pretty much fire and forget. In fact I was so terrified of getting in the way of letting things be that I didn’t measure performance for the first few years or have the stocks on my watch list. I’ve relented on that and regret it a little.
My belief is that this system will deliver strong returns in perpetuity for as simple as it is most investors are structurally or temperamentally not aligned to implement it.
First, negative feedback is the default. Contrarianism comes in a few flavours. This isn’t the nice kind where you’ll receive admiration and plaudits on your insight and bravery. This is the kind that will be met with light ridicule. Also to receive negative feedback and do nothing is taxing. It can be dissatisfying.
Second we welcome price weakness, this is absolutely rational as we should only want high prices when we wish to sell but the only investor I know who says it and is happy about it is Warren Buffett. Right now I have started to buy into some platinum producers. Since making the first purchase one of them has fallen 20% and the other 10%. You have to love it when this happens. I want prices to fall, I want the gap between price and intrinsic value to widen even if intrinsic value is falling.
Another struggle are the long timelines. In my market model the short term is dominated by momentum and the long term by reversion to the mean. Mean reversion is not available on command and trying to time this is a frustrating business. The longer our timeline the more likely we are to capture that mean reversion. But a timeline of years is not feasible for most professional investors and although it should be for private investors, emotions and narrow framing probably scupper good intentions.
This leaves me with far less competition. Less competition is always welcome.
There you have it. An investment program that is idiosyncractic, hopefully robust, requires little care or attention, provides the basis for solid returns ……. and enables you to jump on a plane to Urfa and feed some fish, should you so wish.