I would like to start with a quick story. I used to work in trading. Early in my trading career a trader colleague asked a good question to the team: Are we making all these trades because we need to, or because we like making trades and if we made fewer trades, we would get bored? An analysis of our performance showed that most of the profit and loss across all the trader portfolios were made in just a few trades, but most of the trades resulted in about broke even performance. It was consistent with the Pareto principle. We decided to trade a bit less to try to eliminate the transaction costs associated with the low conviction break even trades. After a while this proved very helpful for our performance.
At another firm I noted that our best performing trader rarely traded. He spent most of his time doing research and analysing risk and he only held a very small number of positions or often no positions at all. I really admired this, having learned the lessons from the first firm. He was consistently the best performer.
Another trader at the same firm behaved in the opposite manner. He traded a lot, in and out. His target for the year was to make $10million profit. Through some fluke and probably because his position sizes were also too big, he suddenly found himself with a profit of $10m by the end of January. Other traders congratulated him and said he could take the rest of the year off. He rejected this and said "I'm paid to trade, so I'm going to keep trading." Immediately he put more positions on because his habit was to trade actively – as he enjoyed talking to brokers. By mid-February he had lost $10m and his year-to-date performance was flat. The firm fired him because his drawdown of $10m had breached his risk limits. He complained saying that his year-to-date performance was not down. I must say, even though this chap was a nice guy, I didn't feel sorry for him. He didn't realize his job as a trader wasn't to trade, it was to manage risk and he had failed to do that because he simply enjoyed the activity of trading more than he enjoyed managing risk.
James Anderson has the same view, but for fund management. In the blog post We Are Resolute, he notes that:
"There's no evidence that frenetic activity is productive of impressive returns to clients and that instead all the evidence suggests that the great investors are dull, patient and resolute."
So why do so many investors feel the need to be active?
"Fund management is the modern equivalent of an isolated citadel being attacked by a furious fusillade of weapons. Instead of canon and burning oil we have corporate earnings canisters fired at us, macroeconomic data lobbed over our defences, politics used to terrify us."
True investors should be interested in the ultimate value of an asset as eventually revealed by its free cash-flow, not noise amplified by brokers and the media who themselves make a living off increased activity. So, what is needed in successful long-term investing is the resolve to hold onto positions. Given Mr. Anderson has held on to many massively successful positions for many years, I would suggest that this has been part of his success. Of course, this is predicated on getting your long-term analysis broadly right. But if you save time and resources on trading and short-term thinking, you have more time for deeper, more thoughtful analysis on what truly matters: finding some of the small number of stocks which are going to outperform over time.
"The reality of stock market investing is that outstanding returns are reliant on the ownership of a remarkably small number of stocks over very long periods."
We will revisit this idea in an upcoming post. For now, all this reminds me of that excellent passage in Reminiscences of a Stock Operator which ends in the following:
"My dear boy," said old Partridge, in great distress "my dear boy, if I sold that stock now I'd lose my position; and then where would I be?"
Financial Utopia
In a nod to that investment classic "Where Are the Customers' Yachts?," Anderson attacks the short-term and risk adverse mentality in The City as bad for society and self-serving. Referring to the UK investment industry:
Might it not be that our failings go beyond self-obsession and greed to playing a major part in the stagnation of modern capitalism?
As a UK investor I must agree. UK investors are interested in immediate earnings, seemingly forgetting that equity investing should be about funding long-term visions. A point in case is Scottish Mortgage's investment in Tesla (TSLA) which Anderson notes was the investment in which he received most criticism. He asks could Tesla fail. Yes, it could, but then asks are there any equity investments that are worthwhile (or indeed credible) that cannot? On the other side, could Tesla improve the world and continue to multiply the wealth of shareholders? Yes again. Of course, Elon Musk needs capital to fund his many ambitious projects, and that's what the equity markets are supposed to be there for. So, the attacks on Anderson for his Tesla investment were just a demonstration that equity markets, or perhaps more accurately many of the participants in them have become too short-term oriented and too incentivised by short-term metrics.
Anderson sees a similar problem in the healthcare sector:
We may well be on the cusp of extraordinary medical advances. The foundations of transforming science appear to be in place after long years of experimentation. This applies in genomics, in gene therapies, in immunology and in the application of data to our health. But if we are to accomplish this great task it will be no thanks to the major pharmaceutical companies who have - accompanied by cheering fund managers - abandoned clinical ambition for me-too drugs and billions in marketing expenses… Sadly, this is a sphere in which Britain can claim to be a world leader.
London's universe of risk averse fund managers and deal-mad investment banks brings bad outcomes for the UK's ability to build world scale innovative companies despite the great scientific and entrepreneurial resources we have to offer. ARM was a case in point,.Anderson notes it had the chance to become a global technology giant, but it needed to invest at the expense of immediate profits for it to do so, and its investors were not patient enough and rolled over to allow the company to be sold to Japan's SoftBank (TSE:9984) as this would provide an immediate realization of capital gains on the investment. If The City had had the patience that U.S. investors have for their tech firms, ARM might have been buying Nvidia (NVDA, Financial) now, not the other way around.
It's probably this culture that caused Anderson to pivot his fund Scottish Mortgage, previously a UK focused fund, to become international and allow it to seek the growth opportunities that would be allowed to flourish on the stock market and not get taken over on the cheap. It also explains why the UK equity market has such a small number of technology listings of any reasonable size. Again, it's a lesson to think long-term, understand what equity markets are really there for, and to be contrarian. Should we worry too much about short-term earnings? No, we should look at the opportunity set a company has and support them in capex decisions if the opportunity set is more rewarding than what we can achieve with funds simply returned to us as shareholders. Also, it shows that to achieve outsized returns, we must take on investments that others might perceive to be high risk and we might need to look for these outside of our home markets or in areas we didn't usually invest in.
This theme is revisited in What is The Point of Financial Markets? where Anderson makes the point that the fund management industry is more obsessed with beating an index than funding or nurturing innovative or worthwhile businesses. So, the point is in public markets many underserving companies get too much access to capital and many deserving companies don't get enough access.
Having researched Anderson quite deeply it is worth pointing out that his strategy is a hybrid of public and private equity investing. Not only does Scottish Mortgage invest in private companies, but Anderson's team engage deeply with managements not just to gain insight but also to offer advice and patient capital which is more akin to private equity and venture capital investing. While smaller investors probably could not do this in larger companies as they don't have the access to managements, its worth asking yourself if you have investments in small companies and you have the relevant expertise then engagement with your companies could be a highly mutually beneficial strategy.
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