Compounding: the not-so-secret sauce to extraordinary returns

Published in Money Management magazine 14 September 2017 issue.

Lawrence Lam looks at why compounding should not be overlooked for investors with a long investment horizon during a low growth environment.

Since 2013 we’ve been told by financial forecasters to expect a new world of low earnings growth. We’ve been told that the economic challenges in the US and Europe combined with deceleration in China has led to a new shift in economic paradigm – the “low growth environment”. Investors should temper their return expectations and respond by focusing on high-income assets such as bonds, infrastructure investments and high-dividend paying stocks. In short, capital growth will be hard to achieve, so the advice has been to focus on seeking yield/income generation instead.

For investors with a long investment horizon, I offer an alternative view. I highlight why investing purely for yield overlooks one of the most powerful and not-so-secret concepts in finance – compounding. In this article I’ll highlight why focusing on compounding can lead to superior long term returns.

Compounding – the eighth wonder of the world

Einstein once said “compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t, pays it.” A few centuries earlier, Benjamin Franklin wrote “Money is of a prolific generating nature. Money can beget money and its offspring can beget more.” The advice given by Mr Einstein and Mr Franklin holds true even in today’s uncertain economic environment. In essence, the value of a dollar invested does not grow in a straight line. It grows exponentially. So an investor can truly harness the power of compounding by remaining invested for as long as possible, allowing returns to hockey stick in investments that have the highest return. The below chart from JP Morgan Asset Management visually illustrates the power of compounding.

Firstly, the chart shows that by consistently reinvesting, the value of an investment grows exponentially. The more money you have working for you, the more offspring it will beget you. The weakness of focusing solely on yield is that one ignores the value of reinvestment and instead values withdrawing cash from the investment. In the process of blindly searching for yield, one overlooks one of the greatest advantages an investor has. For an equities manager, instead of focusing on stocks that pay out a large portion of their earnings as dividends, the power of compounding can work in your favour if you select stocks with high rates of capital reinvestment.

For these stocks, cash is retained in the company rather than paid out in dividends. Provided the cash is used sensibly in value-adding reinvestments, it continues to compound at a much higher rate within the company rather than being paid back to investors as cash. So why choose to receive cash now when keeping the money invested generates a higher return?

Total shareholder returns: dividends or capital growth?

Unless you are a retiree or have a strong preference to receive cash, a sensible investor would choose to keep their investment compounding at high rates rather than be paid out. This holds true especially in today’s low interest rate environment. Dividends paid out as cash earn low single digit returns, whereas keeping the money on the compounding train yields the return on equity being generated – most likely higher than current interest rates if the stock has been carefully selected. So although the investor receives less cash now, the money is reinvested back into the company to develop new products, innovate, expand the business, and ultimately increase the intrinsic value of the stock.

So if an investor has a long term horizon and does not have a strong need for cash, they would choose to invest in great compounders where high rates of reinvestment lead to intrinsic value growth, as opposed to cash cow stocks that pay high yield and therefore unable to compound significantly. Total shareholder returns should be the focus, not just yield.

Compounding is even more important in times of uncertainty

The focus on yield comes from the rhetoric that we are in a time of unprecedented uncertainty in global politics, markets and economics. Established companies with long histories are subject to disruption and it has become increasingly difficult for companies to grow earnings. If we take a longer term perspective we can see that this simply isn’t true. For long term investors it would be dangerous to act on these short term economic forecasts.

The chart below shows McKinsey’s study of the average historical rate of return on invested capital (ROIC) from 1963 to 2004 of 7,000 publicly listed non-financial US companies.

ROIC is an indicator of how effective companies are at generating returns on their capital reinvestments. For investors in companies, it is a proxy for the rate of compounding they can expect if a company was to retain its earnings rather than pay them out as dividends. Since 1963, we have had numerous wars, oil shocks, the introduction of the internet and multiple economic cycles over this long term period, the fact is that average ROIC has remained stable. Companies retaining cash to reinvest in their business have generated a return of 7% to 10% regardless of the macroeconomic environment.

History doesn’t repeat, but it does rhyme. And the weight of history tells us that companies will continue to compound at much the same rate. Especially in these times of technological change, it is important for companies to reinvest to adapt to new competitors to drive future growth. Now is the time to invest in companies focused on growth and reinvestment, not cash cows that return high yields.

Harnessing the power of the compounders

The ‘low growth’ rhetoric isn’t a mindset we ascribe to. On the contrary we remain optimistic about the long term prospects of quality companies. We take a long term investment strategy, we aren’t desperate for cash and would much prefer to maximise total returns rather than simply focusing on yield and miss the benefit of compounding.

The challenge for most investors is not to seek the shelter of yield in times of uncertainty, but it is to find those investments that will continue to compound over the long term.

The historical ROIC from the chart above is an average of US companies. Knowing that history is in our favour is one thing, but fully capturing the benefits of compounding still depends on being able to select specific companies to invest in.

There are many ways to do this and I’ve highlighted only one way in this article via the ROIC. Another way to identify quality compounding investments is to align with quality management. A company’s ability to compound depends on its management’s ability to recognise new markets and execute growth strategies for the long term benefit of the company.

It also depends on the opportunity set available to each company and for this reason it is worthwhile for most investors to consider looking at the entire universe of companies on a global scale. The chances of finding great compounding opportunities is much improved by looking beyond local borders.

For those investors currently focusing solely on yield, you might be unnecessarily narrowing your investment options and missing out on some great compounding companies. They may not be great yield investments, but you’ll have the exponential force of compounding working in your favour instead.

 

Lawrence Lam is Founder & Portfolio Manager of Lumenary Investment Management, a global equities investment firm focused on investing in international founder-led companies.

www.lumenaryinvest.com

How recognising value can help you construct a robust portfolio of quality stocks

Published in Money Management magazine 6 July 2017 issue.

Enterprising investors should distance themselves from the crowd by investing heavily in valuable companies for long-term returns, Lawrence Lam writes.

The fundamental question that drives long term investment decision makers is how best to allocate their capital for optimal returns.  So for those investment managers or fund-of-fund managers investing in the equity markets, their ability to recognise and allocate capital to valuable companies, or align themselves with fund managers that can, will drive investment performance over the long run.

In this article, I outline my approach to recognising valuable companies. This is a framework of thinking based on investing as though the entire business is being purchased, as opposed to viewing a stock as just a price that fluctuates on a stock exchange. When we invest, we back companies, not stock prices.

Investing in valuable companies is profitable

The pursuit of allocating capital to valuable companies is driven by the objective of profit and investment performance, it is not a theoretical exercise of proving corporate best practices. A portfolio of valuable companies will hold up much better in market downturns and be more resilient against incoming disruptive competitors. Since company value drives stock price in the long run, being able to recognise these valuable companies is highly profitable.

Characteristics of a valuable company

A valuable company is one that provides a product or service that its customers want and find value-adding to their lives. How badly the customers want their product or service is a key driver of how valuable a company is. It’s no surprise that Apple, currently the world’s largest company, produces the product that everyone in the world cannot live without. Accordingly, its stock price appreciation has also been phenomenal.

However not all value is equal. Consider the common everyday fidget spinner. The low-friction plastic toys that seemingly defy Newton’s laws. They are currently wanted badly by many, but yet their manufacturers will certainly not make great investments in the long run. The distinction is that a valuable company provides a product or service that is useful and will remain valued by its customers.

There are many ways in which a company can remain valued by its customers and I think about these in two broad categories – internal and external. An analogy to illustrate these categories is that of an enterprising fisherman who is standing next to other fishermen at the side of a river. The enterprising fisherman decides to bring a longer fishing rod to access fish that other fishermen can’t reach. The ploy works well initially, the enterprising fisherman manages to catch more fish. However, the other fishermen standing nearby realise and they too bring a longer rod next time. Eventually all of the fishermen realise and any ongoing advantage to the enterprising fisherman is neutralised.

This analogy describes internal value. The enterprising fisherman improved her chances by internally creating an advantage independent of the other fishermen. However internal value alone is temporary as competitors imitate and eventually erode any such advantage.

In contrast, external value is an attribute that suppresses or discourages competitors and enables a company to remain valued by its customers. If the enterprising fisherman established exclusive ownership of a longer rod and no other fishermen had access to this special rod, then she would have generated tremendous external value. External value is often referred to as an economic moat, these are rare and those that have it are hard to dethrone in the business world.

As investors, we want to find these companies and back them to the fullest.

Ways to spot a valuable company

Many companies innovate and develop internal value. But as we can see, a truly valuable company is one that remains valued by its customers over the long term. This edge can only be sustained if they have an external advantage over its competitors – an economic moat.

Extensive literature has been written about economic moats since Warren Buffett first introduced the concept. Pat Dorsey, formerly of Morningstar, did extensive research on this topic and wrote a book called The Little Book That Builds Wealth. In it he summarises the following types of economic moats to look out for in valuable companies:

  1. Economies of scale
    These valuable companies have developed a supply chain advantage that enables them to deliver their products or services at a lower cost to their rivals. An example of one such company is Inditex. The Spanish clothing company best known for the brand Zara is able to mass produce fashion at a lower cost and faster turnaround time than its competitors such as H&M and Uniqlo. This advantage comes from being able to negotiate lower manufacturing and logistics costs. Operational leverage means that each new piece of clothing produced costs less than the previous item.
  2. High switching costs
    A company with this economic moat has a captive customer base. The cost of switching away is too great and customers are locked in to using the products or services of these companies. An example of a company with a captive customer base is Oracle. The software company has developed database programs used by many corporations. It is too costly and risky for large corporations to migrate their databases once they have been established in Oracle. Similarly, medical equipment suppliers have a captive market as it is often too risky to trial unfamiliar medical equipment and put patients’ health at risk.
  3. Network effect
    A company can create an effective monopoly by connecting different customers through the use of its products. The network effect is commonly observed in valuable technology companies that have created platforms for users to interact. Examples are Facebook, Ebay and Uber. As more users sign on, the network of customers becomes more appealing for new users to sign on. Stock exchanges such as NASDAQ or ASX have also created an economic moat by monopolising the market for buyers and sellers of stocks.
  4. Intangible assets
    This type of economic moat is distinctly different from the accounting concept of intangible assets. Intangible assets in the sense of economic moats can be:
  • Unique corporate / governance structure

We believe that this the most commonly overlooked form of economic moat. From our experience, the structural set up of a company is the DNA for the overall success of the business. We find that companies led by brilliant founders have an advantage in the way they are set up that enables quicker response to their customers and an unrelenting focus on reinvesting in their own business. This type of economic moat has a strong multiplier effect when combined with other forms of economic moats. To us, it is no surprise that five of the world’s six biggest companies are still founder-led.

  • Government approvals / licences

Exclusive government approvals for companies create a barrier to entry for other competitors to freely enter the market. These are valuable intangible assets – think Transurban, which has exclusive government rights to operate and maintain toll roads around the world.

  • Intellectual property

Patents, trademarks and copyrights protect innovative companies from imitators. Pharmaceutical companies such as Sanofi and GlaxoSmithKline aggressively protect their patent pipeline. Apple has a portfolio of patents protecting its designs. Intellectual property protection eventually does expire and for this reason we consider this to be a temporary form of economic moat.

  • Brand

Iconic brands have created a deep-rooted psychological association with its customers. This is a powerful economic moat that lasts generations. Nike and its Swoosh logo have created a strong emotional connection with aspiring sports people around the world. LVMH, the French company behind luxury brands Louis Vuitton, Moët and Hennessey have created a brand that loyal customers aspire for. Different brands have created associations to different customer emotions. The stronger the emotion, the strong the affinity the customer has to the company.

  • Geographical advantage

As Mark Twain once said “Buy land, they’re not making it anymore”. This advantage is easily recognisable and most common in infrastructure or real estate stocks. From experience, the effectiveness of this type of moat has diminished with the rise of technology and for this reason we favour other types of moats.

 How to profit from valuable companies

The source of value has evolved and will continue to evolve just as business models have over time. But the fundamental framework for spotting value will continue to apply as long as businesses exist.

Constructing a portfolio of valuable companies is a sensible method of securing pleasant returns over the long term. Sound businesses with economic moats are likely to remain valued by their customers despite incumbent competitors and other external market changes. As long as a company is valued by its customers, its value will be retained, and its stock price will follow eventually.

For the enterprising investor, there will exist an even greater opportunity to profit during certain windows when the stock price trades below its true value. These windows exist when the market panics and the herd forgets about the true advantages a company has. These opportunities offer an attractive deal to purchase a slice of a valuable company at a low price. It is in these windows that the enterprising investor should distance themselves from the crowd, invest heavily, and watch the returns compound over the long term.

Lawrence Lam is Portfolio Manager & Founder of Lumenary Investment Management, a global equities investment firm focused on investing in international founder-led companies over the long term. www.lumenaryinvest.com

At the time of writing, Lumenary Investment Management did not hold positions in any of the companies mentioned in this article.

The Intangible Quality of Great Businesses

Published in Money Management magazine 25 May 2017 issue.

Lawrence Lam looks at why investors should start searching for companies that are founder-led.

We all know this instinctively. We always do better at something when we truly believe in it – when we truly own it.

As Thomas J Watson Snr, former chair and chief executive of IBM, said “to be successful, you have to have your heart in the business, and your business in your heart”.

And yet for something that we all understand intuitively and has such a significant impact on investment decisions, very little attention has been paid to this in the business world until now.

Research from Bain & Company’s 2016 study of the S&P 500 over 14 years revealed that companies where the founder remained a core member of the management team outperformed other S&P 500 companies by 3.1 times.

Another study from the Journal of Financial Quantitative Analysis showed that founder-led companies outperformed the rest of the market by 4.4 per cent per annum over a 10-year period.

These numbers only prove what we already know. Founders put their heart in their businesses. They own their businesses. In this era of fly-in fly-out CEOs with large sign-on bonuses and short-term stock options, founder-led companies are quietly outperforming their more bureaucratic cousins. They’re proving that company performance is more strongly linked to genuine ownership than we first thought.

As the body of evidence supporting this phenomenon mounts, investment professionals and advisers are rethinking their investment strategies to capture the value produced by founder-led companies.

WHY ARE THESE COMPANIES BETTER?

And the reason why founder-companies outperform? It’s because their heart is genuinely in the business. It’s the difference between renting a house and owning a house. Sure, tenants will adequately maintain a house, but it’s not the same feeling. Owners really take care of the property like a home for the long-term, not a house they’re living in for the short-term.

The research shows that great non-founder CEOs exist and they too perform well, but there are an even greater number of great founder-CEOs. So if you had to pick a great CEO, you’ll more likely find one in a founder-CEO.
Bain & Company calls this ‘The Founder’s Mentality’ and it’s characterised by three features:

  1. A strong sense of higher purpose over a long-term horizon;
  2. Obsession with perfecting the customer experience; and
  3. An owner’s mindset – a great sense of responsibility and bias toward speed in decisions and actions.

These are the characteristics in a leader that money can’t buy. We’ve seen many corporations pay exorbitant bonuses to executives in the hope of inducing the same founder’s passion. Instead, what often prevails is that these corporate rock stars focus on managing expectations down so they spend energy justifying why the goalposts should be wider instead of aiming to kick longer.

In contrast, founder-led companies maintain a strong customer focus, cut through the internal bureaucratic hierarchies and sustain a high level of employee loyalty and engagement. If found early, these companies become great investments.

THE EFFECTIVE TIPPING POINT?

It is however a common perception that founders are usually seen as entrepreneurs who are great at innovating new ideas and growing small companies, but once the company grows too large, these founder-CEOs are out of their depth and they should hand over the reins to a professional non-founder-CEO.

This perception is just not true. Research from Purdue University shows that founder-CEOs evolve with the company. They develop managerial and administrative skills as the business grows and they also continue innovating much more than others; a key reason why their companies continue to outperform (think Steve Jobs, Bill Gates, and Mark Zuckerberg).

The study shows that founder-CEOs are more willing to engage research and development and are more effective in doing so – they get more bang for buck for their research and development spend.

What can hinder growth isn’t so much founder involvement, but rather internal headwinds that develop as the company experiences growing pains. Bain & Company’s study found that as size increases, layers form, and leaders can become increasingly distant from their customers. Speed of decisions decline. Bureaucracy and focus on the higher purpose is lost.

But remember, the feeling of owning a home is different to the feeling of renting one. For the exceptional few, the founder breaks through these constraints. They find a way. They have an ownership mentality and they do things differently. They hire the right people and clone the same ownership mentality in them. Importantly, they maintain a leadership role and never relinquish that to others. You can hire the right people with the right skills, but you can never buy the ownership mentality.

USING THIS PHENOMENON

We intuitively know this phenomenon is true so what can we learn from this research? We no longer need to rely on our intuition to explain the intangible qualities that founder-led companies have.

It explains why some of Australia’s best performing companies are founder-led. Great Australian examples include Nick Scali, Count Financial (since bought by CBA), Corporate Travel Management, Wotif (since bought by Expedia), and Reece.

It would have been a profitable venture had you invested in these companies in their early stages. As investors, founder-led companies are an ideal place to begin searching for investments. All else equal, they are less risky and give you a higher likelihood of outperformance.

And whilst not every founder-led company will be successful, the odds of finding a great company are higher. That’s why investors should start, not finish, the search for great companies here. We should still focus on the merits of the business, its performance and its competitive edge. If you can tick these boxes and have an inspirational founder at the helm, you can expect returns in the multiples.

Lawrence Lam is founder and portfolio manager of Lumenary Investment Management.

How to pick a good investment manager

“The most important quality for an investor is temperament, not intellect… You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.” – Warren Buffett


We are cognisant of the irony regarding this chosen topic. However it is a question we are asked with regularity. It is an important question for those who do not have the time to dedicate to stock market monitoring and have chosen to trust their funds with a professional manager. So we hope that in providing our view on this topic, we raise the awareness of what really matters to clients and drive improvement in the industry.

The decision of picking a good investment manager is an important one. It’s a decision that should not be based solely on fund performance. Doing so would be akin to buying a car solely based on its top speed. But what about other factors such as comfort and longevity? What about fuel efficiency? Does the car have enough space for your needs?

No doubt performance is one of the fundamental parameters to be considered, but equally important are temperamental factors of the investment manager. Just like a quality thoroughbred, a fund manager with the right temperament has staying power and longevity in the industry. You know they will be a front runner over the long haul.

Integrity

A fund manager with integrity pays the word more than just lip service. They will behave fairly and equitably for its investors. This extends to principles about the broader ethics of the companies they invest in. They will be transparent and communicate in an understandable, jargon-free style. They value the trust placed in them and uphold the highest ethical and moral standards.

This requires more due diligence than just reading offer documents. Importantly, aim to speak directly to the investment managers. Large investment managers may be harder to reach directly and their values diluted in bigger teams, but speaking directly with boutique fund managers is a good way to gauge if you feel a strong sense of trust. Look beyond the investment proposal and look for genuine signs of honesty. This trait is inherent in one’s personality. You either have it or you don’t. It’s not something you can learn or buy with money.

Curiosity

Curiosity indicates that the investment manager wants to learn more. Curious investment managers delve deeper into investment opportunities and will ask more pointed questions. Curiosity also hints at a sense of humility – a recognition that business models are constantly evolving and no investment manager knows it all.

Be mindful of those that exude unequivocal confidence in all aspects of their investing abilities. The test here is overconfidence. If the investment manager is overconfident, decision blind spots are more likely to lead to unsatisfactory investment outcomes.  As Warren Buffett says,

“In the world of investing a few people after making some money tend to imagine they are invincible and great. This is the worst thing that could happen to any investor, because it surely means that the investor will end up taking unnecessary risks and end up losing everything – arrogance, ego and overconfidence are very lethal.”

A good investment manager should be ‘appropriately confident’ – confident that their investment principles will serve them well, yet curious about ways to grow knowledge about new businesses and learn from past mistakes.

A pleasant outcome of a curious investment manager is that investors benefit from their expanding sphere of knowledge. They’re happy to share their knowledge and educate investors on what they’ve learnt.

Knowledge

The attributes above are temperamental for good reason. Investing is predominantly a behavioural art and success correlates highly with one’s ability to manage emotions. Temperamental attributes are personality based and can’t be learnt – they form the fundamental building blocks of a good investment manager.

But to win a race, every great thoroughbred relies on a great jockey. This is where financial knowledge is relevant. Every great investor draws upon a strong foundation of knowledge and sharp intellect. They should be appropriately qualified in finance, but more importantly, have an in depth understanding of how business strategy relates to financial theory. Their knowledge should be broad – seemingly unrelated industries can have huge impacts on business growth. Narrow thinkers would have failed to recognise the impact cloud computing would have on the traditional taxi industry.

An investment manager’s knowledge should shine through in their investment updates. Their commentary should be based on independent analysis.

Conviction

None of the above is useful without the final ingredient – conviction. When the research is done and the conclusion drawn, good investment managers won’t be hugging the index. They will have the conviction to trust their own knowledge and avoid over-researching. If necessary, they’re prepared to go against market consensus.

Luckily, the job of picking a good investment manager is easier than picking the winner of a horse race. It’s picking the winning horse over thousands of races, not just one race – and good horses with the right temperament and jockey will outperform over the long run.

Should investors adopt short-selling?

Short-selling is a trading strategy, not a long term investment strategy. It relies on correctly identifying both the direction of the stock price movement and then anticipating market sentiment. The “difficulty to benefit” equation is not one we view favourably

Taxes and interest are hidden costs that further erode any potential short-selling profits


Profiting from market sentiment

Since the start of this year, Harvey Norman (HVN) and Myer (MYR) have been on the receiving end of increased short-seller activity. The stock prices of both retailers have decreased significantly since the start of the year with the imminent arrival of Amazon(AMZN) to the Australian retail market.

Source: AFR

Whilst many have found success with short-selling strategies (think the film The Big Short), we are not proponents of this style of investing for three main reasons. First, short-selling relies on predicting market sentiment. Short-selling relies on being ahead of the market and selling before the rest of the market does. Unlike how it is portraying in The Big Short, this is difficult to do consistently over the long run, as every short sale relies on a buyer who believes in the opposite – that the stock will appreciate. With the high level of public information available today, we are sceptical of those pundits purporting to be able to consistently out-predict the market. It is for this reason we do not play the short-term trading game.

Second, not only is the level of difficulty high, but the rewards are capped since stock prices can never fall below zero. We prefer to target investments that produce profits in the multiples and short-selling does not allow that to occur. From our experience, good businesses return many multiples over the long run and gains are limitless.

Third, the short-selling strategy is very rarely based on objective information. For example, the impact that Amazon will have on Harvey Norman and Myer is based on modelling and assumptions made by analysts. The market cannot accurately quantify the exact impact to Harvey Norman or Myer’s profitability. And because the trade is based on subjective information, ie the imminent arrival of Amazon, this information is available to all and not highly reliable.

Hidden costs of short-selling

It is important to highlight the impact of taxes and interest cost to the short-selling strategy which erode any profits of short-selling. Trades that occur over a period of less than one year incur a higher tax rate. Moreover, short-selling typically involves paying an interest charge during the period which the position is held, which is the cost of waiting for the stock price to fall.

The “difficulty to benefit” equation

The degree of difficulty of short-selling is high for the reasons outlined above, yet the profits are capped. Combined with hidden transactions costs that erode the potential gains significantly, short-selling seems to us a counter-intuitive strategy. One that increases the level of investing difficulty but has a cap on increased profit potential.

For us, our profitability has come from taking advantage of market sentiment that has presented itself, not predicting market sentiment. As Warren Buffett aptly describes his approach judging the “difficulty to benefit” equation: “I like to go for cinches. I like to shoot fish in a barrel. But I do it after the water has run out.”

The outcome of how the recent short-selling activity plays out may well present us with interesting opportunities should the market overreact. That is when we will join the party.

Summary of the 2017 AFR Business Summit

Globalisation will fail if wealth gap between rich and poor is not addressed fairly.

CEOs and managers with long term outlook produce far superior businesses over the long term.


Last week I attended the 2017 AFR Business Summit held in Sydney over two days. An extensive roster of Australia’s most successful business people, politicians and entrepreneurs were invited to speak and discuss the future of Australia.

Many themes were discussed over the two day summit and the speakers I found most insightful were:

Anthony Pratt

Anthony Pratt (Executive Chairman, Visy Industries) – emphasised the importance of growing businesses organically over the long term. Growing businesses from within its own existing circle of competency whilst avoiding growth by over extending into industries or locations unrelated to the current business.

Christian Majgaard

Christian Majgaard (former Head of Global Brand & Business Development, Lego) – grow businesses that focus on the customers/clients needs.

Tim Sims

Tim Sims (second from right: Managing Director, Pacific Equity Partners) – bonuses and other short term incentives for CEOs and managers ineffective. CEOs and managers will aim to set lower targets with the view to exceeding them and maximising their bonus.

Malcolm Turnbull

Malcolm Turnbull (Prime Minister of Australia) – increasing international competition requires Australia to review its company tax rate whilst ensuring globalisation and free trade leave all Australians better off.

It was encouraging to hear these prominent speakers recognise the importance of wealth distribution. Significant time was spent discussing ways of ensuring the positive economic effects of globalisation were properly distributed to those contributing to Australia’s success. Increasing wages and the role of government in redistributing income were heavily emphasised. In my view, it is imperative that business and government seek to address effective wealth distribution – protectionism and closing trade flows is not a viable alternative long term solution.

Disproportionate CEO and senior executive remuneration has also contributed to overall public discontent. In my opinion, this topic must be addressed on a case-by-case basis. Discussion at a generalist level does not adequate address the performance versus salary of each individual CEO.

As an investment manager, the importance of CEO remuneration is relevant to the long term performance and growth of the business – so it matters greatly. The objective of incentives is to align the CEO’s pay packet with those of the investors. In theory, the use of bonuses seems reasonable. In practice, however, they are ineffective. CEO’s will inevitably ‘manage expectations’ of the board by setting their performance targets lower to enable higher outperformance of annual targets. The focus becomes a game of short term expectations management rather than long term business growth.

For an investment manager, it is important to recognise true ownership – we have found that businesses with long term heart keep growing and become more profitable over time.

Warren Buffett’s latest wager

The debate between the merits of active versus passive investing needn’t be one. These are just tools in toolkit that every investor should use depending on the investing environment.

The wager

In his most recent 2016 letter to shareholders released last weekend, Warren Buffett described a bet which he had with a hedge fund manager. Commencing in 2008 and now in its 9th year, Warren Buffett wagered that over a 10 year period, a passive index fund invested purely in the S&P 500 Index would outperform a collection of five hedge funds to be selected by an investment professional.

Buffett’s thesis was this – actively managed hedge funds, whilst charging higher fees for investment expertise, could not outperform a passively managed index fund with low fees. The result? With one year to run on the wager, the annual return of the index fund is 7.1% pa and the collection of five hedge funds are returning 2.2% pa. So the lesson it appears, besides from never betting against Warren Buffett, is that every investor should simply invest in index funds.

9 years into Buffett’s wager, here are the results from his annual letter

But I proffer a slightly different argument. Investors should treat active and passive investing as weapons in their arsenal to be used under different investing circumstances. We should not be constrained by the dogma defining us as being a strictly active or strictly passive investor.

A different angle from the Australian perspective

Buffett’s bet should be taken into context. First, his bet is focused on the US stock market. The S&P 500 Index is a collection of the 500 largest companies in America – a truly wide collection of businesses in different industries reflecting the diverse American economy. Of course, Australians can invest in the S&P 500 Index, but from a practical perspective, there would be an implicit foreign exchange exposure distorting the true stock-only returns of the index. The performance would not be an apples for apples comparison. So instead, which indices would a passively minded Australian investor consider? The two possible considerations would be the ASX 300 Index or the All Ordinaries Index.

However we know that the Australian stock market is heavily dominated by the big 4 banks and mining/materials companies. This is the nature of the Australian economy. As shown in the 2 comparison charts below, a passive investor in the ASX 300 is not very passive at all. They are investing over half of their funds in the banking and mining/materials industries.

Source: S&P Dow Jones Indices as at 2 March 2017

Compare this to the S&P 500 index which is much more diversified. The chart below shows that the American passive investor is truly passive and diversified across many sectors. They are not overweight or underweight in any industry.

Source: S&P Dow Jones Indices as at 2 March 2017

Second, Buffett’s bet commenced in 2008 and is due to finish in 2018 – an unprecedented bull market following the extensive downturn of the Global Financial Crisis. The overall stock market has recovered strongly over this decade. The rising tide has lifted all boats. It is much harder to separate active stock pickers from the overall market if all stocks have rebounded strongly following the GFC. During market downturns is where the great stock pickers are able to separate themselves from the rest of the market.

Why every investor should combine active and passive investing

Instead of defining ourselves as strictly active or strictly passive, we advocate the use of both approaches depending on the environment. From our perspective, we observe that the businesses we would like to purchase are currently overpriced. As such, in this environment, we prefer to allocate our funds to a more passive investing approach. This allows us to temporarily ride the upward tide with the rest of the market. As the tide recedes, we shift towards active stock picking. Our allocation towards purchasing specific businesses increases as we see opportunities arise in the market during a downturn. We have found this approach to be flexible and profitable. It does not tie us down to any strict doctrine but instead allows us to benefit from the best of both worlds.

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.