Earlier this year, when Mr. Market wasn’t too impressed by the collection of companies within my investment portfolio, I wrote an article about the importance of focusing on process versus outcomes. In that article, I argued that I was comfortable with periods of substantial underperformance in the short term because I believe my process is built on a solid foundation:
“What leads me to believe that my process is superior to the average market participant? For one, I think I can be smarter in spots by focusing exclusively on a handful of companies that are likely to do well over time. If I read a decade of annual reports, track competitors, spend time studying an industry and come away with a clear understanding of the key factors that will determine individual companies' long-term success, that is likely to be valuable information known by few others; mixed with a fair bit of patience, I believe I can find opportunities where better-than-average returns (based on what the market has historically produced) can be expected with a high degree of confidence over time. That last qualifier – 'over time' – is the second reason why I think my process can be superior: I’m willing and capable of waiting years for events to play out, while many other market participants are constrained by the need for immediate results.”
While I believe my approach is both sensible and a good fit for my personality / way of thinking (an important point that shouldn’t be overlooked), it also has some notable shortcomings. This is an attempt to identify those shortcomings, as well as a few ideas for mitigating them.
To start with, I run a fairly concentrated portfolio. At the end of 2014, two companies accounted for half of my equity portfolio; my top five holdings accounted for ~75% of my equity portfolio.
In the short term, I face the risk of being on the wrong side of Mr. Market’s mood swings – even if I’ve accurately assessed the underlying fundamentals for the business in question. Long term, there’s always the risk that I make a mistake in my research; there’s also the possibility that management may be misleading investors by hiding or distorting relevant information. In those cases, investors with ~20% of their portfolios in a single company will be in for some pain.
The individuals at Sequoia Fund may argue that the current situation at Valeant (VRX), which accounted for ~30% of their portfolio in May, is more reflective of Mr. Market’s erratic behavior than anything else. I’m sure they’re confident in the research they’ve done to support that claim.
In the meantime, that doesn’t change the fact that they are currently living through the most difficult period in their investment careers. It has led to concerns among the fund’s independent directors: two resigned at the end of October, with the remaining three insisting that Sequoia’s mangers do not purchase any more Valeant shares (according to the New York Times - link); it has also undoubtedly led to concern among investors and sizable withdrawals from the fund.
Concentration can lead to painful periods of underperformance in the short term. In the instances where you’re ultimately proven wrong, underperformance will bleed into long-term results as well. Unlike when you own 50 positions at 2% of your portfolio, mistakes will be very painful.
Time will tell how Valeant works out for Sequoia Fund, Pershing Square and others; from where we sit today, concentration has led to a painful year for both of these investors.
Personally, I think concentration risk is amplified by the way I approach investing. I consider my research pretty thorough; as a result, I’m comfortable sticking with my positions – and usually adding more – when Mr. Market makes me look like a fool. In the past, I’ve almost always used small declines (~5% or so) as an opportunity to buy more: if I liked “x” at $100 per share, why wouldn’t I buy more at $95 per share? The end result on a few occasions was that a new position (one I had added to my portfolio a few weeks / months earlier) suddenly became a material part of my portfolio after a relatively small decline in the share price (less than 20%).
Recently, I’ve tried to move away from this practice. First off, I’ve realized that owning part of a company and starting to follow its progression over time is somewhat different than reading old annual reports (at least for me); I can get a better grasp of what matters, why it matters, and how I feel about the management team once I’ve had a chance to be their partner for some time (for better or for worse).
In addition, I realized that, if my investment time horizon is five-plus years, it doesn’t make much sense to be hypersensitive to relatively small changes in valuation. I think that’s most applicable in situations where there’s work to be done in stabilizing / improving the underlying business.
A current example is Walmart (WMT): despite Mr. Market’s pessimism in recent months (and, in this case, a pretty sizable decline in the stock price), I’ve been tentative to add more. There are a few reason why that’s the case: (1) I plan on being an investor for years and don’t want to move too quickly when there are few reasons to be optimistic in the near term; (2) I need to continue seeing improvements in key areas in order to remain confident in my thesis; (3) I’m simply not comfortable making a retailer ~20% or more of my portfolio at this point in my investment career based on the lackluster results I’ve generated in my past few attempts.
Beyond position sizing and a more tempered pace of share purchases (when appropriate), I’ve also started thinking of other ways to try and avoid becoming overexposed to holdings where the story is not playing out as expected.
In the past, I’ve advocated using an investment journal (and articles) as a way to put your thesis in writing; as a result, you’re held accountable to your thought process at the time you made the investment. Otherwise, you are susceptible to tricking yourself into thinking that what you currently believe, which has been shaped by what you’ve seen happen over time, meshes with what you’ve always thought about the company / investment.
In addition to using a journal or writing articles, I’ve been thinking that it would make sense to start outlining a list of deal breakers before initiating a position. This list would try and identify factors that suggest the moat is narrowing or that I’ve overstated normalized earnings power. If the company fails to meet my expectations on these measures, that would lead me to seriously consider dumping the position – and eliminate the possibility of adding more ~99% of the time.
As an example, I recently purchased a small position in Yelp (YELP). My research concluded that revenue growth (even after assuming a material slowdown in the coming years) combined with a continued improvement in key expense lines as a percentage of sales painted a compelling picture three to five years down the road. After falling ~75% from its highs, I thought the valuation was sufficiently attractive to justify nibbling (with a company like Yelp, it's unlikely that I'd do much more than "nibbling").
So with that in mind, here are a few key factors that would make me question my thesis: (1) a material change in claimed local business growth, local account growth and repeat rates (which would question the viability of the business model / value of product offering); (2) an inability to leverage “Sales and Marketing” and “General and Administrative” expenses over time (required to meet margin targets); (3) a slowdown in unique device growth (measures engagement / usage).
The hard part (as I see it) will be finding a balance between overreacting to short term results and recognizing reality when cracks start to show. I have a feeling this will be more art than science.
Conclusion
I’ve had trouble in the past selling holdings on weak results – because I usually believe that the subsequent decline in the stock price overstates the resulting change in intrinsic value (due to the fact that most market participants have a short-term time horizon). Sometimes I’ve compounded my initial mistake by purchasing even more as a result of Mr. Market’s reaction to poor results.
Finding a balance between overreacting to weak quarterly results and stubbornly sticking to your original thesis is difficult (at least for me); hopefully some of the ideas I laid out above will move me closer to a workable solution.
Addressing and mitigating the shortcomings inherent in my approach to investing (and my own peculiarities as a person) is a work in progress. In some cases, it might be as drastic as simply excluding a sector / industry from consideration (Guy Spier has said “my plan is to get through life without ever investing in a retailer” – link). If you aren’t concerned with looking like the Standard & Poor's 500 (or your index of choice), that doesn’t sound like the worst idea in the world.
As always, the important thing is to keep learning and improving. If you have other ideas I’d love to hear your thoughts.
