The ‘skin in the game’ portfolio

Founders have changed the world and will continue as long as capitalism exists. Our system motivates bright individuals to pursue dreams and build companies that improve human lives, just as trees in a canopy compete vertically for sunlight. For us investors, we need not miss out on these game-changers. We can participate in the rise of these companies alongside their founders, and if the analytical judgement is cast correctly, stand to benefit immensely from their journey.

Are all founder-led companies start ups?

Investing in founder-led companies does not mean venture capital investing – there are over 2,000 listed founder-led companies globally, varying in age, size and industry. Not all founders work on new and shiny products, only a small proportion are start ups. In fact, there are many blue-chip founder-led companies that are not in the technology sector, and these global household giants should resonate with many of my readers: Marriott, Morningstar, Hermes, Walmart and Nike.

What are the risks of founder-led companies?

The pros of investing in founder-led companies are well documented by academics and practitioners alike – Credit Suisse and Bain have quantified a +7% outperformance since 2006. Other studies show multi-decade alpha. In business, skin in the game matters and that is why founders make great business owners and operators.

But not all founders are great. Not all founder-led companies turn out to be the next Amazon. Hence everything in moderation, and why diversification is needed to dampen the volatility of owning just one company. This is where a clear portfolio construction recipe comes in.

I have previously likened portfolios to making a cake in this previous publication here . We select our best ingredients and apply them in the right proportions before baking in an oven at the right temperature. What generates returns is not what has happened, but what will happen. And proportions are crucial.

Instead of baking one cake with all our cake mix and hoping it turns out well, we should divide the cake mix to make many cakes. With each cake we make, risk is reduced. That is the key to a well-balanced portfolio of founder-led companies. The sum of the parts is always greater than the whole, especially when it comes to risk management.

There is an optimal way to diversify and the framework for this process is tied with the concept of vintages.

How to diversify a portfolio of founder-led companies

The least volatile founder-led companies are also usually the oldest. Think Walmart, Hermes and Nike, who have each existed for decades. The advantage of these generational companies is the stability of growth and predictability of dividends. They move like ocean liners, their brands carry inertia that spins off free cash flow consistently. You can rely on these founder-led companies to deliver slow and steady growth to your portfolio. The advantages are not without risk though. Older generational companies can become complacent. Their founders may have already reaped the rewards of their lifetime of efforts and become content with sitting back and relaxing. Their succession planning may not be smooth. The companies themselves may not be built the right way to adapt to changing environments. Ocean liners have a huge turning circle; it becomes impossible to navigate fast-changing conditions when they have only been built to travel in straight lines. I’ve written previously about how up-and-coming companies can lower the risk of a portfolio here.

This is why portfolios should be built to capture the full spectrum of founders from different vintages. You want both ocean liners and speedboats. Younger founders are hungry and motivated. They are free of the shackles imposed by legacy constraints. In this day and age, issues caused by use of outdated technology can prove significant for incumbents – you can observe how difficult it is for banks to transform their systems. It is easier and faster to build from scratch than it is to modify, much like how building a new house is faster than renovating an old building. When the pace of change increases, newcomers have the advantage. Niches open up in fast changing industries, and I’ve previously outlined some of these in this article.

Take for example a company my fund is invested in. It’s a Dutch company called Adyen in the global payments market. They’ve been built with technology from the ground up that allows them to outcompete incumbents. As a result, they have been able to win significant market share in a very short period of time and capture the accelerating change in consumer payment behaviour.

When it comes to founder-led companies, there are pros and cons to both old and young. Having all your eggs in either one or the other would be unwise. Spread your portfolio across founders from all vintages.

You want to build a fleet that encompasses the ocean liners, giving stability and reliability, and mix them with speedboats who can navigate changing environments and adapt with the times. This is what can truly mitigate risk.

Skin in the game – when theory meets practice

A final question and thought for my readers: which of these investment opportunities is inherently riskier over the long term:

  1. Multinational blue-chip where the board has employed a salaried CEO on a 5-year contract; or
  2. A mid-cap company where the founder retains majority ownership, is the CEO and Chair.

The multinational blue-chip has existed for much longer, so its share price is more predictable, less volatile. The mid-cap founder-led company has a much more volatile share price – analysts have a wide variety of opinions regarding its prospects.

But which one is riskier over the long term? Which company would you rather invest in?

The answer depends on your understanding of the difference between risk and volatility. One investment is more volatile but is actually less risky over the long term.

Happy compounding.

The all-terrain equities portfolio for today

Epicormic buds lie dormant, hiding underneath tree bark waiting for the right conditions to sprout. They serve a regenerative purpose in the overall forest system and flourish when conditions are at their most dire. Bushfires for example, trigger epicormic buds to sprout with extreme heat and the clearing of nearby vegetation. In other words, the emergence of new growth stems from the wreckage of the established. 

Just as a botanist studies epicormic growth, I’ve been looking at buds and shoots in a different world. The questions remain the same. Which environments foster this latent growth? Where can I find the most regeneration? 

I’ve spent a lot of time investigating these questions in the context of the current investment environment and I’ll outline how I’ve positioned my fund.

Noise, distractions, smoke and epicormic buds

There’s a lot of noise in financial markets. Think back only a few months ago during the Trump presidency. The headlines were volatile and anxiety inducing. We had it all, from a promise to clamp down on big pharma, to the US expulsion of Chinese companies accused of breaching data security, and the US withdrawal from the Paris climate accord. I’ve raised these headlines as examples because as much noise as they created at the time, they have all fizzled out like an old balloon. The world keeps revolving. But feel for Mr. Market, for at the time he was brought to his knees by the amount of anxiety this news had caused him. One can look back now and reassure him everything is ok, but at the time he was in no state.

Today the noise is all to do with interest rates and inflation. Endless predictions about the actions of central bankers and the interpretation of every word spoken at press conferences. The problem with short-termism and quick news is that everyone is focused on it. Everyone has an opinion. It’s a crowded space. It is not where you can get a competitive edge as an investor. Instead, the edge comes from being able to strip away the noise and focus not on the smoke and fire, but seeking out the epicormic buds that are developing underneath. Don’t be like Mr. Market. I’ve written previously about the sources of alpha in this publication.

The most common theme of today

Let me paraphrase today’s rhetoric: 

A huge wave of inflation is coming. Bond yields will rise in response, and so too will interest rates. This leads to a revaluation of assets as the time value of money increases the value of predictable cashflows as opposed to the uncertain. 

This means companies with predictable cashflows come back into favour (value), as opposed to those with unpredictable future revenues (growth). It’s a matter of perception – interest rates alter how analysts value companies, just like how the sea level changes the impression of a mountain’s height.

The fact remains, a valuable company will remain valuable, just as a mountain remains a mountain. The effectiveness of either strategy, growth or value, is driven by the prevailing market conditions and whichever curries favour. Just like fashion trends, market conditions are becoming increasingly unpredictable.

Growth investors flourished last year as technology companies soared, but if your allocation had been solely to growth, you would be having a rough couple of months of late. The key to a resilient strategy is to remain adaptive. This means having a balanced portfolio that flexes with prevailing conditions without being overly extreme any which way. I’ve touched on the importance of asset allocation in this article.

And this is how I’ve positioned my portfolio. 

Structuring a portfolio in today’s environment

Given the inherent uncertainty and whimsical views of the market, there is opportunity to profit from both growth and value when markets flip from one school of thought to the other. With a dual structure, a portfolio remains balanced, there are no big bets and risk is tempered. What I’m seeking is a resilient portfolio that focuses on two types of buds. 

Bud 1: Emerging companies selling new products and services

Bud 2: Existing companies experiencing temporary price dislocations but due for a resurgence

This structure captures the rise of both growth and value whichever the direction of sentiment. A 50/50 split at the start, which is then flexed when the opportunities prevail. 

When I look for the Bud 1’s, I’m looking for emerging companies that offer a compelling new product or service. They aren’t startups, their product should be new, yet proven with growing demand. The customer base absorbs the new product like a fresh paper towel to a drop of water. It solves a problem the world has struggled with previously and craves for.

When analysing the Bud 2’s, the lens is different – I’m looking for a resurgence or reinvention of an established business. Sentiment surrounding them may be negative and they may be facing a challenging macro environment. I’m looking for headlines that make Mr. Market nauseous. The bigger his overreaction, the better the opportunity.

Growth – the first mover advantage

Delving further into the first type of buds – emerging companies selling new products and services. This is all about capturing long-term possibilities and investing in growth opportunities. 

Given today’s market conditions, it’s important to de-risk growth investing given the uncertainty with inflation and interest rates. I mentioned one of the strategies is to stick with proven new products that are already experiencing growing customer demand. Equally important is to find companies facing few competitors. If they’re selling a new product or service, they should be one of the first movers solving a big problem for the world. Again it’s all about de-risking the potential for a margin squeeze if inflation picks up. The safest companies in inflationary environments are those that command monopolistic pricing power.

Some readers may wonder: why not just avoid growth investing altogether? The weakness of this strategy is it assumes you’ll be 100% right about the timing of when interest rates will rise. The all-terrain portfolio seeks to capture gains from any possible direction the market takes, including the next generation of world-changing companies. Sea levels fluctuate with the tide, but mountains will still be mountains.

Value – opportunities lie where there is greatest anxiety

Equally important is the search for the second type of buds – existing companies experiencing temporary price dislocations but due for a resurgence. These are the established businesses that haven’t fully recovered from the pandemic – and there’s plenty of them globally. In Australia we’ve recovered quickly but if you look across Europe, US and Asia, industries such as entertainment, hospitality, drinks, logistics and leisure will explode when their lockdowns abate.

Mr Market ruminates on uncertainty and often winds himself up in knots. Look for areas of greatest anxiety and that’s where you’ll find the greatest value. Value investing is about picking up immediate mispricings and targeting shorter term profits. I cover how investors can determine if the trend is their actual friend in this article. But be prepared when stocks reach full value, you’ll need to offload and recycle the strategy when growth plateaus to normalised rates. 

The problem with short-termism and quick news is that everyone is focused on it. Everyone has an opinion. It’s a crowded space. It is not where you can get a competitive edge as an investor. Instead, the edge comes from being able to strip away the noise and focus not on the smoke and fire, but seeking out the epicormic buds that are developing underneath.

Balancing the risk and reward

How the portfolio gels together is equally important as each individual investment. I spend the same amount of time thinking about the correlations between each investment to ensure the all-terrain portfolio spreads volatility. Look far away to Europe and Asia which are on a different recovery trajectory to the US and Australia. As specialists in founder-led companies, I also find European and Asian founders more prudently focused on generating profits rather than pumping revenue metrics, which again tempers the risk.

After any devastation, there will always be new growth. As the world recovers from this one-in-a-century event, pay attention to both the emerging new buds and the recovery of the existing trees. There are two types of gains to be made so make sure your all-terrain portfolio places you well for both.

Happy compounding. 

 

 

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that invests in the best founder-led companies in the world. We scour the world looking for unique, overlooked companies in markets and industries on the edge of greatness. We are a different type of global fund – for more articles and information about us, visit https://lumenaryinvest.com

Disclaimer

The material in this article is general information only and does not consider any individual’s investment objectives. All stocks mentioned have been used for illustrative purposes only and do not represent any buy or sell recommendations.

Learning From Endowment Funds

This article was first published in Money Management magazine, 8 October 2020

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Why do some sports teams remain perennial title favourites, while others seem to consistently languish for decades? If you’re one of the poor souls who finds themselves rooting for the frequent losers, you’ll know the answer isn’t simply ‘our players aren’t up to scratch’. On the other end of the spectrum, the best teams always seem to have an ability to combine mediocre players into a high-performance unit. They seem to be one step ahead of the competition, playing a long game that presciently fills the gaps in their rosters, drafts the best rookies before others spot them, and adapts their capabilities to the evolution of the sport. This is where the behind-the-scenes manoeuvres of the front office management team lead to long-term dominance. These imperceptible strategic decisions go beyond the coach and players, they are macro decisions that create long-term franchises. In investment parlance, asset allocation is exactly those front office decisions you need to make correctly to ensure long-term success. In this publication, we’ll take a deep dive into how two of the world’s best are manoeuvring their portfolio for the future.

Australia’s Future Fund – anticipate, don’t emulate

A few weeks ago, Future Fund reported their asset allocation on 30 June 2020. Interestingly, they have been cashing in their investments across the board. Their allocation to global equities remains the dominant piece at 27%, but almost all asset classes have decreased across the board. The last time the Future Fund held this level of cash was in September 2017.

Source: Future Fund, Lumenary Analysis

Yes, this does have a little to do with the pandemic, but notice many of the changes were in relation to unlisted assets which take some time to turn over – in other words, many of these liquidations were premeditated and only just came to fruition last quarter. This was far from a spur-of-the-moment reaction to the pandemic.

But just because your cross-town rival makes a change to their team doesn’t mean you should too. Future Fund’s circumstances are far removed from a nimbler private investor and their investment objectives are vastly different. The best sporting teams never emulate the success of others, they create their own success based on independent evaluation. As I delved deeper, the question emerging in my mind was “What can I learn from the intentions of a $161 billion fund, so I can anticipate the next flow of capital, not copy it?”

The bigger they are, the slower they move – but that’s your edge

Delving deeper to uncover the rationale, I found the Future Fund’s CEO had spoken publicly about the portfolio, citing long-term falling interest rates as the cause of asset prices being bid up, which has subsequently led to their cautious view of the world. He went on to explain why he expected headwinds going forward, summarising the year with:

“This year we undertook a material rebalance of the Private Equity portfolio, reducing some of our exposure to international growth and buyout managers following a period of very strong performance. We also completed the sale of other unlisted assets including Gatwick Airport. We deployed some of that capital into new infrastructure themes including fibre and data centres, in Australia and offshore.”

Readers who only skimmed the negative headline would be tempted to cash in the chips and stash money under the pillows. Tempting as it is, I would caution against that. Near-zero rates are fine to accept over the short-term, but a 1% return on cash will destroy wealth over the long-term.

Delve deeper. Future Fund’s high levels of cash are a result of a recent sell down of private equity and partial re-allocation to new infrastructure themes. Enterprising investors can expect this capital to be recycled at some stage, especially as cash returns continue to drag. Expect Future Fund to redeploy this capital, but it will take time. As they’ve already alluded, their capital will continue to flow into non private equity opportunities over the coming quarters. The opportunity now is for investors to move ahead of the pack, to anticipate where this money will land; if June 2020 is anything to go by, increasingly it will likely be in the form of exposures to telecommunications and associated technology infrastructure. If we move up the value chain, we can expect companies in programmable communications and internet infrastructure to create significant value over the long-term, especially when the adoption of 5G and IoT products become mainstream with improved reliability.

As the game evolves, the best management teams recruit the players that will take them to the next level. They have an innate ability to anticipate the direction of others and make decisions ahead of time. Knowing global equities is Future Fund’s largest allocation piqued a broader question in my mind – who else, globally, has a formidable strategic long game?

Learning from best-of-breed endowments

I found particular US Ivy League endowments have done quite well over a long period of time. In particular, Yale and Harvard are the standouts, returning 13.7% p.a. and 11.8% p.a. over the past 20 years. They have greater discretion, tend to be more flexible with their risk/return requirements and don’t have the bureaucratic approach typically seen in sovereign funds (they aren’t accountable to the entire population, after all) – Ivy League endowments run a leaner, more agile operation.

Delving deeper into Yale’s approach, I found one quote which succinctly summarises their mindset:

“Over the past three decades, Yale dramatically reduced the Endowment’s dependence on domestic marketable securities by reallocating assets to non-traditional asset classes. In 1989, 65% of the Endowment was targeted to U.S. stocks and bonds. Today, target allocations call for 9.75% in domestic marketable securities and cash, while the diversifying assets of foreign equity, absolute return, real estate, natural resources, leveraged buyouts and venture capital dominate the Endowment, representing 90.25% of the target portfolio. The heavy allocation to non-traditional asset classes stems from their return potential and diversifying power. Today’s actual and target portfolios have significantly higher expected returns than the 1989 portfolio with similar volatility. Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management.”

From their latest annual report, their asset allocation looks like this:

Source: Yale annual report

This allocation is notably different to the Future Fund’s and Temasek’s of the world, and I would not suggest replicating this structure in entirety; Yale has a significant allocation to venture capital (‘VC’). They have pioneered this space in the endowment world, and off the back of the tech boom have returned about 20% p.a. just from VC investments. They have been able to achieve this by good alumni connections and have preferential deal access that most won’t have.

It’s not the strongest, but the most adaptive

Instead of replicating Yale, investors can borrow some of the underlying principles to improve their existing framework. Notice how the top three allocations are foreign equity, venture capital and absolute return? Most investors have limited access to these asset classes. Coincidentally, or rather not so, they happen to overlap with Yale’s connections with industry. Even though Yale can source the world’s best next-generation investments from around the world, it doesn’t mean other investors can’t also win. Just because other teams have a greater salary cap or more talent scouts, doesn’t mean they will assemble a franchise team. Investing is a game with more than one winner; it rewards resourcefulness and adaptability. If the pundits are right, we’ll be heading into a low-return environment but if you borrow from Yale, investors can mitigate this by focusing on companies with a high growth trajectory – not the old-world companies, but the ones creating new markets never-before-seen in the world, even in a low-growth world, products that add value to our lives never go out of fashion. Investors should be looking globally for the best, not just sorting through our own backyard. The best-of-breed have decades of growth runway ahead, so even if you miss the VC opportunity, plenty of opportunity still remains post-IPO.

In closing

Adapting to change is how the best front offices build franchise teams. They combine the right mix of the tried-and-tested players but continue to inject new blood with rookies that fill the gaps for the future. Much is the same in investing; building a portfolio of the best companies now is equally important as paying heed to future growth areas.

It’s not the biggest budgets and the highest paid teams that win, it’s often the ones that have strategic foresight that don’t emulate others, they build their own strategy. Based on actions taken by Future Fund so far, investors have the chance to move ahead of the pack, particularly in global technology-related infrastructure companies. As the pace of reliability and adoption increases, capital will continue to flow heavily into companies that create new markets and products useful to our changing lives. In other words, build a team with solid performing players, but keep your eye on rookies and anticipate where capital will next flow.

Happy compounding.

 

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach. We are a different type of global fund – for more articles and information about us, visit www.lumenaryinvest.com

 

Searching for the source of alpha

This article was first published in Money Management magazine, 16 July 2020

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We are all baking cakes. The wealth cake. We search for the highest quality ingredients, we put those ingredients into a mixer, then the oven, and voila – here’s one we prepared earlier. With the right recipe, some will end up with a creation that is magnificent, fluffy and moist, far superior to others. But those that get it wrong can end up with a sad puddle of mess. This is high stakes baking where the best result depends not only on having the best flour, freshest eggs, and best elements, but applying them in the right quantities, timing and method. If stock selection is akin to picking the ingredients, then we are only part way there in our quest for alpha. How we allocate also has a big contribution to the result. In this publication I will outline how our fund captures alpha through stock selection, weighting and allocation.

Outperformance originates from unconventional means

You do not win a race by driving in the same lane. Remember, the source of alpha is, by definition, unconventional. It is common for stock analysts to focus on specific sectors or geographies but these attributes are not advantages unique to any one company or investor. 

One of the largest and most successful active managers in the USA, Capital Group, failed several times to launch their Best Ideas fund which took the best single idea from each of their sector specialists. The Best Ideas fund was appealing in theory, but it underperformed because selecting the best companies from each sector is vastly different to simply selecting the best companies full stop. What they thought would be a source of alpha turned out to be a limitation in their stock selection.

How to catch alpha through stock selection

In order to find the freshest ingredients, immerse in catchments where they are most likely found. The first source of alpha comes from either company-specific or investor-specific attributes. Company-specific examples may include board or management characteristics, spin-offs, capital raisings and other corporate actions where unique opportunities flash by for those paying attention. Investor-specific examples include long-term ownership mindset, high concentration, or lower trading frequency. 

Lumenary are experts in founder-led investing – our companies possess a source of outperformance tracing back to an aligned governance and decision-making structure at the core. We find this a profitable universe to play in – founder-led companies have achieved a 7% outperformance over other companies since 2006. The narrower the focus on the source, the better. As you would expect, the source of alpha is not wide. This is a scenario where you would rather delve deep than go wide. Become a specialist rather than a generalist. For example, I have written previously about some niche opportunities I am seeing in technology.

Once you have found your source of outperformance, the allocation plan can be built around that foundation by fine-tuning the focus even further.

How to fine-tune an advantage

For instance, founder-led companies tend to outperform over the long-term. But this is not the end of the story, this is just the first tier of advantage. Investigate further to find secondary tiers, tilt the allocation towards these additional pockets of opportunity, and press the advantage further. 

By way of example, contrary to popular belief, the saying “the first generation makes it, the second spends it, and the third blows it” is simply not correct. The data shows a different story altogether. The often (unfairly) maligned second generation is in fact the cohort that delivers the greatest source of performance for founder-led companies. The building of businesses takes time, becoming a dominant player takes years, and it is often the new ideas of the second generation that changes the game, as the foundations paved by the first generation are expanded and taken to new heights by the second. 

As a second tier advantage, we find first and second generation founder-led companies particularly appealing. 

Contrary to popular belief, the second generation adds the most value

If the source of your advantage comes from other origins, find the additional tiers that have the potential to generate the most alpha. Specialists in capital raisings might investigate further to determine whether rights issues, hybrids, or debt opportunities generate the greatest outperformance, for example.

Identifying more advantages

Identifying more secondary tiers will enhance the ability to allocate with a greater degree of conviction. Taking you back to our example, we have established one source of deeper advantage – first and second generation founder-led companies. 

Again we will turn to research to inform our investigation into other secondary tier advantages, guiding our approach to allocation. Long-term research found smaller companies (under USD $3 billion market capitalisation) have greater propensity to compound. “Small” in a global context, are founder-led companies under USD $3 billion in size. Skewing a founder-led portfolio towards these up-and-comers boosts exposure to challengers who have the motivation to topple market leaders, and have the runway to execute.  

‘Smaller’ founder-led companies outperform larger brethren

To illustrate further, a specialist in capital raisings may sniff out certain uses of funding to have foretelling properties as to whether likely future success is imminent. The impact of the coronavirus has forced many companies to raise equity at dilutive prices; the use of these funds will determine the long-term success of these companies. Find the attribute and allocate heavily towards it.

How to allocate using a tiered approach

Sensible investors will acknowledge that basing allocations on research which can be high-level, will provide general guidance, but is limited in its practical considerations which still need addressing when putting actual money to work. In the search for outperformance, how do we allocate with a balanced approach to risk management and concentration?

Simply because a company is run by the daughter of a founder and under $3 billion in size does not automatically guarantee it will outperform. As long-term investors will appreciate, the purpose of portfolio allocation is just as much to protect downside as it is to seek upside. A balanced diet approach is healthiest – everything in moderation. Skew towards the source of outperformance by all means – first and second generation founder-led companies and companies under USD $3 billion, but be mindful to hold cash according to the market climate, and in our case, we balance out the volatility with a blend of larger, more stable founder-led companies. 

The all-weather founder-led portfolio is one dominated by first and second generation companies, companies under USD $3 billion in size, rounded out with a small proportion of larger, steady-state companies which act to temper volatility. Of course the level of cash is important and will depend on prevailing market conditions. In this current climate, there will be more attractive opportunities to come, especially with the possibility of a second wave of coronavirus. As I have written previously, Lumenary has adopted a mindset of opportunism in this environment.

To summarise, the allocation strategy should go past the first level of alpha, but seek to identify secondary tiers, tilting even further within that set, which should be the predominant weighting of the portfolio. An appropriate level of cash and mixing in some companies less susceptible to large price fluctuations will balance the portfolio’s volatility.

Investigate beyond the first tier of outperformance

Closing remarks

How you select from the universe of investment opportunities around the world and how you weight these investments has significant bearing on your returns over the long run. 

The search for outperformance requires a bold conviction to do things differently to others, a high level of specialisation in overlooked areas of opportunity, and improvement on traditional approaches. Outperformance can be found in a wide variety of areas so remain vigilant for company-specific traits where you can cast your net. 

Once you find the source of your advantage, keep the stock selection confined within that zone, examine closely and leverage tier 2 benefits by apportioning heavily into those areas. This is the process of progressively tipping the scales in your favour by concentrating your exposure in high potential areas.

Happy compounding.

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach. We are a different type of global fund – for more articles and information about us, visit www.lumenaryinvest.com

 

Our foot is now firmly on the pedal

This article was first published on Livewire Markets
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Having spoken to many investors, the most common misjudgement I’ve observed is binary thinking. That is the tendency to think in black and white. Let me share two stories that illustrate why investors are missing out because of this, and how you can avoid the same pitfalls.

Investing with fifty shades of grey

In 2017 a reporter erroneously quoted Howard Marks, saying ‘Howard Marks says it’s time to get out ’.

Howard Marks denied this quote and responded ‘there are two things I would never say. One is “get out” and two is “it’s time”. I’m never that sure. And I don’t think anybody can be that sure.’

Marks further went on to say ‘It’s not a matter of in or out, today or tomorrow, all of which have so much precision and definiteness to them. But rather, think of it as a speedometer from zero to one hundred.’

Investors commonly oversimplify investment decisions based on market trends. This is fine except when investors react in a binary way. For example, popular current examples include ‘‘tech stocks are tanking, I should get out’, or ‘trade wars will last for a while, I shouldn’t invest in global equities’. Blanket thoughts like these are wealth harming. If your concern with the macroeconomy causes you to react this way, you’ll likely miss opportunities.

The lesson?

Right now general sentiment is negative. Human nature impels us to steer clear of equity markets. But don’t think in black and white. You have the option of adjusting your allocation to cash or stocks to capture today’s sentiment. You don’t need to be fully in or fully out of the market. In the past year, we’ve had our speedometer at 50.

But in the past few months, companies we’ve been stalking for a while have fallen into bargain territory. Our foot is now firmly on the pedal and we’re now cruising at 80, having recently snapped up a few quality buys.

Why you shouldn’t read the news

As humans, we are attracted to extreme statements. They capture our attention. We like them because they simplify how we see the world. They give us a short internal summary which we can easily file away in our memory bank. But the world is complex and investment opportunities are not black and white.

Right now all the economic headlines are negative. But it was only at the start of the year that the market was bullish. Headlines change on a dime. Whilst this makes for entertaining reading, they shouldn’t be used to form investment decisions. Journalists are here to sell papers after all.

Instead, investors should focus on the detail underpinning each company. There are always companies that make money even in the most dire economic environments (example below). Excellent investment decisions are made with a scalpel, not a hammer. It is the perception of a company’s prospects that can change overnight, not the actual prospect itself. Actual prospects often take years to play out. So read the company news section, not the economic headlines.

We’ll use Nike as an example given we’re an investor and I’m very familiar with them. Binary investors relying on economic headlines in 2008-2009 exited equities altogether based on 2009 headlines such as ‘The biggest crash since the 1930’s will take decades to recover’ and other similarly extremist views. Nike’s share price fell 20% and yet earnings were increasing through the GFC.

Investors who studied the company rather than the headlines would have reaped a handsome 400% reward over the ensuing 10 years.

The lesson?

There are successful companies in every country and in every economic environment. You just need to look for them. Be influenced by macroeconomic headlines at your peril.

Closing remarks

Investors can’t be blamed for thinking in extremities given recent news. But relying too much on popular sentiment can lead to missed opportunities. As the herd is withdrawing, quality companies are becoming better value.

For this reason, we are stepping on our accelerator.

If you find yourself following headlines, just keep the following quote in mind:

‘No one goes there nowadays, it’s too crowded’ – Yogi Berra.

This doesn’t just apply to industries and stocks, the sidelines can get overcrowded too. Remember it’s not just about Afterpay, or not Afterpay, Aussie or international. Oceans of quality companies in a range of industries and countries are thriving in today’s economic conditions.

If you believe the news, you won’t look twice.

And if you don’t look, you’ll regret missing the opportunities once this hoo-haa inevitably passes.

Pick up your scalpel, and happy compounding.

Lawrence Lam

Picking better eggs and baskets

This article was first published on Livewire Markets
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In this wire, we discuss building a diversified portfolio without sacrificing on returns. Not only is it essential to diversify your eggs across different baskets, it’s equally important to make sure you’ve got concrete eggs and steel baskets.

Focus on defense, but don’t forget about your offense

Given the current focus on regulation and risk management stemming from the Royal Commission, it’s not surprising to see most funds err on conservatism with their approach to investing. Willingness for fund managers to deviate from industry norms with asset allocation or stock selection is at all time lows. I’d like to highlight that there is nothing wrong with this approach. In fact it’s perfectly understandable given there is no incentive for salaried fund managers to punt one’s career unnecessarily. It’s safer to stick with commonly accepted mainstream trends. However the result of this is herd behaviour often represented by portfolios with an over-diversified soup of stocks that closely resemble an index Exchange Traded Fund (ETF). You’d expect to be getting average returns if you’re sticking to the herd.

Whilst the focus on risk management is important, there are many ways to achieve this without blindly increasing the quantity of stocks in your portfolio. For enterprising investors, just because you’re focusing on downside protection doesn’t mean you should lose focus on your offensive game. We’re here to make money. So we need to find the optimal trade-off between risk and return. I’d proffer this balance is not optimal in a portfolio with hundreds of stocks. So what’s the right balance? Here’s some food for thought below.

You are already life-diversified

From a life perspective, you are most likely quite diversified already. If you own a home or investment property, you already have significant exposure to property. If you have an offset account with your mortgage, you will already have exposure to interest rates. If you have a mainstream superannuation account you will most likely be highly diversified already – ‘balanced’ funds typically hold thousands of investments across all asset classes. If you run your own business, then you have already dedicated significant personal funding and time to one equity investment. If you’re employed full-time, your wealth is strongly linked to your employer and the industry they’re in.

As you can see, even before you’ve started actively investing, you will likely have exposure to specific asset classes and industries. When it comes to stock market investing, you should consider filling the gaps in your life. For example, if you’re employed by an Australian company, focus internationally. Start by looking for stocks in different geographies and industries for companies that you aren’t already exposed to.

Your customers will protect you

The stocks in your portfolio have customers and these people and businesses are your customers too. They are the ones who will protect you from the next downturn.

Your customers should be widely dispersed across the world. Your customers should also be diversified across multiple industries and product lines. The trap that professional fund managers fall into is they become sector specialists. They become biased towards one industry with a concentrated set of customers. As an individual investor, you have the freedom to float across industries and capture the most loyal customers of each country in each sector.

For example, Fuchs Petrolub (FPE.DE) is a boring family-owned company in Germany. It also happens to be the largest independent lubricant manufacturer in the world. Fuchs makes custom lubricants for industry-critical machines. They service customers all over the world in all industries ranging from manufacturing, auto, aviation, construction and racing. For as long as friction exists, there will be a need for lubricant. By investing in just one company, you’ve accessed a loyal global customer base diversified across geographies and industries.

Think of the underlying customers in your portfolio as adding a layer of reinforcement to the shells of your financial eggs, and giving you further protection against a falling market.

The false comfort of quantity

Conventional practitioners of diversification are uncomfortable with a portfolio consisting of a small number of stocks. They believe there is a magic minimum number of stocks they must hold which will protect their portfolios from any downside. In reality it is the quality of your holdings which is far more important than the quantity. As we saw in the Global Financial Crisis (‘GFC’), when markets crash, all stocks crash. It doesn’t matter how many you hold.

Quality companies are the ones that will bounce back quickly from downturns. These companies have loyal customers and their products or services will always remain valued by society. They will continue to generate profits through any macro environment. Quality companies will have a prudent attitude towards debt so are unlikely to default.

Instead of focusing on reaching a magic number of companies in your portfolio, focus on the goods or services each company offers. Focus on the quality of their product offering. How essential to society are their products and services? A quality company will have customers continuing to buy their products through any cycle.

Concluding remarks

The mainstream approach to diversification states that purchasing a large number of different stocks is the safest and best-performing choice regardless of market conditions. Followers of this approach seek to build a financial safety net by gathering together many stocks. The trap here is that over-diversification of your stock portfolio is neither an effective safety net in difficult times nor an optimal growth strategy in good times. While it is sensible and valuable to seek a variety of investments, there comes a point when blindly adding to the quantity of different stocks you own does little or nothing to improve the quality of your portfolio.

Remember, your ultimate aim as an investor is to make money in a way that effectively balances risks and returns. Rather than following the conservative herd, you should begin by looking at your stock portfolio within the context of your financial life as a whole. Avoid the temptation to acquire ever-increasing numbers of stocks. and devote yourself to seeking a limited number of high quality companies.

The aim of a well diversified portfolio is to serve as wide a range of loyal clients as possible by investing in as small a number of companies as possible. Rather than focus on more eggs and more baskets, focus on choosing concrete eggs and steel baskets.

Happy compounding.

Pleasant outcomes of a concentrated portfolio

Finance theory tells us diversification reduces risk – we subscribe only partly to this theory. We believe in diversification across asset classes (eg. cash, property, stocks), but not within an asset class.

A prudent risk management approach can be implemented with a concentrated stock portfolio.


Diversify across different asset classes, but not within each asset class.

Imagine you’re given a $1m inheritance. But before you can spend it, the inheritance has a condition to it – in exactly 10 years to the day from now, the $1m must be worth at least $3m. You ponder this daunting task – the condition implies that in exactly 10 years, the portfolio must have generated an average return of 11.6% p.a over the next 10 years.

Ideally, there would be an investment that guaranteed you 11.6% over the next 10 years with no risk. We know there are no such investments. If we invested it all in cash, we know we would not achieve 11.6% growth. We could invest it all in property, but we would need to be certain that we’ve picked the right property and even then, 11.6% is a high hurdle.

Investing all of the money in stocks gives us the best chance of achieving this target – over the long term, stocks generate the highest returns of these 3 asset classes, given they are inherently more volatile. However before we invest it all in stocks, there is a possibility that there could be a stock market crash in exactly 10 years time that leads us to fail the condition on the last day. Given our preference for stocks, how can we best duly mitigate risk, whilst attaining our targeted 11.6% return?

We need to balance risk protection, without being so conservative that we are inhibited from generating adequate returns. From our experience, the answer to this question lies in a 2 tiered approach. First, we should spread our investments across cash, property and stocks. Diversification across these asset classes gives us an initial level of protection against potential crash in any one of these markets in 10 years time. In a stock market crash, all stocks crash. Not one sector or industry is immune. Therefore diversification through buying different stocks does not give us much comfort. However, it is less likely that interest rates, housing prices and stock prices all fall simultaneously together on the same day. Therefore, diversifying across asset classes (ie. cash, property, stocks) gives us much greater protection than diversifying in just one asset class (ie. buying many different stocks in the hope of immunising against a stock market crash).

Second, we should look to manage risk within each class. Once we are comfortable with our asset class allocation, we have minimised a large proportion of risk. The smaller portion of risk that remains is how each asset class performs. Conventional financial theorists will argue that diversification within each asset class provides further risk reduction. That is, for cash, we would buy several different bonds. For property, we would aim to buy different property in different suburbs. For stocks, we would buy stocks in different sectors and industries. From experience, we consider diversification to be one such technique when it comes to risk management within an asset class, but not the most effective.

Managing risk in a bespoke way

Diversification within an asset class, for example stocks, is a scatter-gun approach that poses too great an impost on returns. In our view, it is a crude way of approaching risk management that produces average returns.

In contrast, an investor should delve into the detail of each stock to analyse the risk of the underlying business. How prudent is the management team? Do they have a genuine interest to see the business succeed over the long term? Is the business operating in a viable industry? How much debt does the company have? Is the business profitable? These are the pertinent questions that ultimately manage risk, not a scatter-gun approach. Analysis and detail should be used to protect against loss, not broad sector generalisations. We much prefer to carefully select one solid basket to keep our eggs in rather than wantonly select a lot of different baskets in hope that on average they will be good enough. We only invest when we are confident in our understanding of the risks within each business. On the other hand, diversification implies a certain level of uncertainty and lack of conviction in one’s analysis.

Risk management is at the forefront of our investment approach. Thinking back to our example, imagine how hard it would be to generate the required return if we were to lose a significant portion of our capital at the start. Wealth can only be generated over the long term if we first protect ourselves against potential losses. In our search to mitigate risk, we often find that a pleasant benefit of our approach is that we discover great businesses along the way that produce outstanding returns over the long run.

You are an inadvertent investor

 Investing is not an optional activity – we are currently all investors, whether intentionally or inadvertently.

Given that investing is not an optional activity, we need to be aware of our investments and what implications these (intentional / inadvertent) decisions will have on our future.

Regardless of investment goals, investing should be, at the very least, a defence against inflation.


Investing is not an optional activity

Constant updates on financial news, information and statistics fill our newspapers, TVs and personal devices every day. These updates provide us with very detailed information regarding aspects of the economy that may not affect our everyday lives. So why is this information so important that it needs to be on the daily news? The answer, I argue, is that we are currently all investors, whether we choose to be or not. And this news is relevant to all of us whether we like it or not.

Most of us have a bank account and that bank account will contain some money. The money we have that bank account will serve a purpose in our lives. For example, we may be saving for a home, we may be purchasing goods with the money, we may be using it to pay off our debts, or we may just be saving the money as a buffer against unforeseen circumstances. Ultimately, we want this money to serve a purpose for us. We unconsciously make two choices:

1.     spend the money now; or

2.     keep the money for use later.

If we choose to spend the money now, we have less to spend in the future. In economic jargon, this is called an intertemporal choice. [If you’re more interested in this topic, the Chicago Booth School of Business has published an interesting paper here: http://faculty.chicagobooth.edu/richard.thaler/research/pdf/intertemporal%20choice.pdf]. For the majority of us, we will spend some money now, and keep some for later.

Of the proportion we keep, regardless of whether we make a conscious decision regarding where to keep the money, we will make an investment decision. Even if we choose to do nothing and keep the money in our bank account, we have already unconsciously decided to keep the money as cash. We have invested the money in a bank deposit.

As long as we have savings, we will be making investment decisions, so we are already investors. And as long as we are investors, we should be, at the very least, aware of our choices and what impact these choices will have on our future.

Implications of our choices on our future

Each type of investment has its risks and rewards. Over the short term, we may be more concerned about risks rather than returns. For example, if we anticipate an upcoming expenditure, we will be more inclined to set that money aside in a bank deposit until such time it is required so that the amount is kept safe. The implication of this decision is that a bank deposit typically has a low rate of return compared to other investment options. Over the short term, we would rather preserve our money than take excessive risk, so it is understandable that we may choose to forgo a higher rate of return in favour of preserving our money.

However, the implications change significantly if we adopt a longer-term view. I argue that it is necessary to take risk in our investments over the long term in order to preserve wealth. It is not a choice. The eroding waves of inflation make it unwise to keep all our money in a bank deposit.

Investment as defence against inflation

Over the past 10 years, the price of goods and services in Australia has risen at an annual rate of 2.4% per annum (http://www.rba.gov.au/calculator/annualDecimal.html). In other words, a $100 item in 2006, would now cost us $127 in 2016. If our income remained unchanged over the past 10 years, our ability to purchase goods would have decreased by 27%. The rising cost of goods and services forces us to keep up, otherwise our wealth is eroded over the long term.

Over the long run, term deposits average a 5% to 7% rate of return, providing us with reasonable protection from inflation. Risk is low, but returns are equally low. Some argue that term deposits are safe investments over the long term. I would agree, but I would add that shares are equally low risk of over a long-term horizon. The chart provided by Fidelity confirms that the Australian ASX 200 index has always appreciated over any 6-year period since 1986. See the chart here: http://www.fidelity.com.au/fidelityP2/?LinkServID=B91D14A6-B125-E8DC-BB83AAD60C35BC5A. For no additional downside risk over a 6-year period, shares have generated a return of 9.5% per annum.

With current bank deposits returning 2% to 3%, in my view, it is not an option, but a necessity, to look for investments beyond bank deposits. Investments with the ability to increase along with inflation are preferred instruments for preserving long-term wealth. Whether you are aware or not, we are already running in an investing marathon against the constant headwinds of inflation.