Summer is usually downtime, an opportunity to regroup and clear the mind ready for the autumn. This year has been a little different – more ratatatat, the staccato ebb and flow of action interspersed only with space to rest, not recover. The action is constructive and welcome, but this has left some of the considered elements of the Elif Fund to look after themselves. In particular my small cap value program (SCVp) which is the trading program that requires the most care.
This piece is mostly about that, but as a gentle lead I’ve been thinking about a book I’m currently enjoying, Andrew Ang’s tome on factor investing (looking at investment through the framework of factor risk is, I feel, a smarter way of structuring balanced portfolios than addressing asset class). This is with the usual caveat that all these terms and distinctions are concepts. Concepts made real by belief thus changing behaviour but they are just thought tags that overlay quite well to what is fundamentally a bunch of prices moving in accord with diffuse supply and demand curves.
In any case there is nothing more pleasurable than a book that announces itself with a jolt in the form of a punchy first paragraph. The best I’ve read recently was in David Ogilvy’s ‘Ogilvy on Advertising’*, but Ang carries some heft with a simple yet dense opening sentence:
“The two most important words in investing are bad times.”
Reading that my head nodded so vigorously a contact lens nearly fell out.
How we deal with bad times defines our long term success as investors but few of us have the freedom or … can i say dullness to structure our operations to endure AND profit from the riches beyond tumultuous seas. I just finished a book that references ideas of heroism from antiquity. The author,Chris McDougall, makes an interesting point (his style is a little dramatic (he is a journalist) but colourful and fun if you roll with it). He asserts that in ancient Greece heroism had less to do with taking big blind dramatic risks and far more with applying skill, brains and good judgment to navigate tough choice environments.
Heroism was a skill to be acquired and mastered. And mastery almost always involves a great deal of drudgery. It echoes that choice phrase ‘it took 10 years for me to become an overnight sensation’.
The core of the Elif Fund is that of ‘value’ – Fama and French (and numerous others) have shown value to provide sustainably superior returns to market. Technically this is long-short but even long only will provide improved risk adjusted returns to buying the whole market. I put this down to human and environmental drivers (as I do momentum) but other explanations are available. This environment is too noisy for good science and I am a practitioner, not a theorist. The theory is there to support the action.
The largest of my programs is the Small Cap Value program (SCVp) and combined with the large cap version discussed previously they take 60-70% of Elif assets. These are two programs designed to optimise long term returns. If this means poor short term results then so be it. As mitigation I try to hedge with programs that are ‘smart yet dumb’ and smooth the inevitable downdrafts by hopefully exhibiting low correlation to the UK centric value programs. This is through them being based on momentum and trying to capture wholly different economic drivers.
The SCVp is designed in the following way:
1. Value value value (of course)
· Value is a market price below intrinsic value based on whatever metric you want to use. It must be far enough below to offer a risk-reward potential that is worth the risk. In ascertaining this differential I (and again am repeating myself) am not looking for fine margins. The upside has to be large enough to offset the risk, the uncertainty, my failing nerve and analytical variance.
· I am very keen to look at alternate histories. I do not know the future, so I look for situations where I’ll be ok if nothing much changes. Won’t be blown out of the water if things go sour but reap productive rewards if we either have regression to the mean or some type of ‘special situation’ trigger (the more of these possibilities the better).
· In valuing I am looking at a company, a living breathing entity in the real world. My view is that of an investor who would be looking to acquire the business. If I had control what value could I extract? Is it obvious? It should be.
· I use a checklist (who doesn’t these days?). It is tailored mainly at what can go wrong than the what can go right. When we are dazzled by the prospects of an investment we are more likely to underplay the risks so it is helpful to try and correct as much as possible.
· It is preferable to know why the market valuation is below our perceived ‘value’. The assumption is that the market is on the whole pretty reasonable and rational. Most of the time. The assumption is that I don’t have any special insight relative to other investors.
· I think it is Michael Mauboussin who says (to paraphrase) that we need the market to be both inefficient (to create the mispricing) and then efficient (to rectify it). It helps to be thoughtful of this process and how our perception of it changes with our involvement.
· Below you see a snapshot from a very useful graph provided by Stockopedia. This shows my holdings with (Stockopedia’s proprietary) value scores against quality scores. I hold only one stock that is not an obvious value share (boohoo.com) although my inkling is that it has Munger style ‘value’ qualities. Time will tell. This graph reassures me the program is doing what it says it should.
2. Diversification and Risk
· This is a subject that is exceedingly complex. My inkling is that some people get it on a mathematical level and some get it on a practical level but few get it on both. And to be properly useful you do need to get it on both. (Taleb rants on this in general – Ludic Fallacy)
· Correlations and covariance are critical but they are just numbers, not real. If we can find an underlying economic rationale for a relationship then fine but we cannot forget that this can change rapidly. Markets are highly and ever increasingly connected. Everything can affect everything.This is the enduring lesson of the financial crisis – one big bottleneck can cause untold mayhem. Nothing is fool proof. I cannot stress this enough.
· Nonetheless diversification is a free lunch (in the world defined by mean-variance). Every few months I make a check on correlations within the portfolio and between programs. Have a look at the table below for the latest on the SCVp. I have removed a couple of small positions as they have no meaningful impact on results). Correlation over 0.75 are highlighted
· My correlations above look great but they count for little in the face of systemic risk (particularly when market functioning is called into question) where correlations are likely to rise significantly. Below I show the same shares in the run up to the financial crisis and during (caveat: I haven’t cleaned the data, a number of these companies weren’t listed during the whole period. This is just a 5m curiosity exercise):
· On the other hand I’ve spent my career being excessively cautious in this regard and suffered for it. If you’ve done the work you have to trust your boat to float in the storm, and then you have to sail it out of the harbour. But it is worth wearing a life jacket and having a life boat(etc etc).
· I have historically tended to concentration. Recently I am changing style a little and putting out a few more positions then adding to the ones that work (that develop as desired) while not adding or cutting the ones that don’t gain traction as expected.
· Concentration accentuates idiosyncratic risk. In the words of Howard Marks, if you want better results than everyone else you have to do something different. I can adjust my ‘difference’ depending on how ‘cheap’ the market is as a whole and how much edge I feel I have. This is where a degree of meta-cognitive skill is necessary ( a double edged sword):
The answer may not be obvious, but it’s imperative: you have to assemble a portfolio that’s different from those held by most other investors. If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different. And being different is absolutely essential if you want a chance at being superior. In order to get into the top of the performance distribution, you have to escape from the crowd. There are many ways to try. They include being active in unusual market niches; buying things others haven’t found, don’t like or consider too risky to touch; avoiding market darlings that the crowd thinks can’t lose; engaging in contrarian cycle timing; and concentrating heavily in a small number of things you think will deliver exceptional performance. – Howard Marks, Dare to Be Great II
· My habit is to scale in and out as there is an perceptual shift once you have some skin in the game. Everything becomes much sharper. I tend to buy an initial position to develop a feel then add usually another 2 or 3 lots as the opportunity develops.
· An element to consider with the SCVp is that of home bias, it is wholly UK based. This introduces often unconsidered idiosyncratic risk vs the global portfolio. This type of blind idiosyncratic risk pops up in portfolios all the time (and is unconsidered).
4. Position sizing
· This is a favourite subject of mine but mostly of no interest to others. I receive a lot of blank looks when I bring this up before people gently change the subject. But it is rather important. Really!
· Ang writes thoroughly on this as do the guys at GestaltU. A technique that people do mention is the Kelly criterion (Ed Thorp is very good on this as is Ed Seykota) but it is just too aggressive for most investing systems. In the SCVp I prefer a simpler risk based position sizing algorithm as a starting point to standardise a loss per position, then flex this around qualitative risk factors. Science and art. (this is a technique I picked up years ago when I was swing trading based on the work by Van Tharp). In other programs I tend toward risk parity type sizing. At the program level I use good ol’ fashioned portfolio theory (with many constraints).
· Then there is the question of liquidity. Some of my bigger losses come when there is just no market so even if I want to get out I just can’t except at a significant discount (and before it sounds like I’m a big dog I’m really not. Some of these stocks you can struggle to get away a grand.). I’m taking more notice of this in general. And wide spreads, I let many good stocks go as I can’t size my risk adequately because of the spread.
· I haven’t tended to rebalance winning positions to keep a position becoming too hefty. My back testing suggests that over time rebalancing hinders returns. Not rebalancing however does leave regular egg on your face and can be very discouraging. It increases volatility within the portfolio (which I don’t mind if it adds to results over time). Psychologically it is a bit messy. These elements are always a balancing act and if I start to struggle with this I may review.
· Time is on my side. This isn’t as long term a program as the large cap version (insert LINK). But it is long enough and I’m happy to hold as long as value or trend are there.
· I still check prices too often. It is a useless activity (see willpower above) so the best thing I can do is structure my day to make it a pain to flex that reflex of checking prices.
Results have been solid over the years with a number of caveats. Last year (to April) was a down year (we are up around 8% since April, poised for new highs Yes I am ever hopeful). The table is yearly with a financial year running April-April
Seeing the 8.7% average I was initially quite disappointed. However that average is dragged down by 2009-2011 period where we were only 20% and 40% invested. This underinvestment was not an active decision (as I can say it was during the financial crisis with tongue only slightly in cheek). It came about from distraction – studying for a masters, consulting work and … life.
It was only after a major reassessment in 2010 that I applied concentrated effort into the program, developed many of the principles I discuss here and pushed up the invested percentage above 80%. Results improved and I’m reasonably confident I can compound at 12-16% over the next 10 years. It will probably tend to the lower end of that corridor but the challenge of the higher boundary forces me to keep learning.
In the next part I’ll review a few positions and work out some thoughts. it’ll have to be in early September as I’m going to be in a world without computers for the next few weeks.
Markets are turning a little turbulent so keep well
* He wrote “I do not regard advertising as entertainment or an art form, but as a medium of information. When I write an advertisement, I don’t want you to tell me that you find it ‘creative’. I want you to find it so interesting that you buy the product. When Aeschines spoke, they said ‘How well he speaks.’ But when Demosthenes spoke, they said ‘Let us march against Philip.’” (those last two sentences resonate very strongly)