One week ago, after four and a half years working on a special portfolio called Pro, and leading an extremely special community of clients, I left The Motley Fool.
We generated some exceptional returns over that time, so to kick things off, let’s explore three of the biggest reasons why.
Outcome
First, for those just tuning in, here are Pro’s returns on an annual basis since inception in April 2014, through to October 2018. We were just six months in to Year 5 when I stepped down last week.
[Note: from inception in April 2014 to August 2016 I was the Research Analyst for the portfolio, before taking on the Portfolio Manager role myself part way through Year 3. Huge credit over the last 2+ years also goes to our outstanding Research Analyst, Ryan Newman.]
Those returns might not seem so unique to friends in the U.S. where markets have been on a tear for several years, but it is the portfolio’s out-performance vs. our local benchmark (the ASX All Ordinaries Accumulation Index) that we were most proud of:
Pro outperformed the All Ordinaries Accumulation index by 192% over those four and a half years (April 2014 to October 2018).
We generated annualised returns of 31% per year, vs. an 8% return from our benchmark, for an annual out-performance of 23% per year.
Process
There were three core parts of our portfolio management process that set us apart.
#1: Asymmetric bets
We sought out unique investment opportunities which had relatively little downside, combined with very high potential payoffs. In other words we looked for positions that had the potential to either win big, or lose small.
The chart below shows the returns that we generated, on a position by position basis, over the 4.5 years (some positions were only added towards the end of the period, so had less chance to thrive than others).
Over 4.5 years, our worst position only fell by a total of -34%. That is in a portfolio that delivered total returns of 232%, and had eight positions that saw a total return greater than 100%, with five over 200%.
Win big, lose small.
#2: Sell quickly
To deliver on ‘losing small’ requires constant vigilance. And to be willing to sell quickly if a thesis is broken.
So as part of our intrinsic valuation process, we made a downside assessment which sought to answer three questions:
- What could go wrong with our investment thesis?
- How much would that would impact the company’s intrinsic value?
- How could we check if things were going wrong?
The third point is crucial. If we could identify a failed thesis early enough, we could sell before the worst of the downside hit.
For each company we watched certain criteria that would represent a broken thesis if they eventuated. It could be a core operating metric from the company itself, or some intelligence from a supplier, or often from a competitor. We were able to sell very quickly, when those negative outcomes did eventuate, because we had prepared for them ahead of time. It wasn’t flawless, and we got some things wrong, but we avoided the worst falls and kept our losses as minimal as we could.
One of the investment decisions I was most proud to be involved with didn’t make us any money, but it demonstrates this well.
Step back in time with me to early 2014… we had just purchased shares in a local satellite television network which had an enviable monopoly position.
You can probably guess where this is going.
Our thesis at the time was simple: an extremely dominant competitive position, with strong barriers to entry. The company had dealt with disruptive innovation before and had been able to co-opt the new technologies (TiVo devices, DVD-by-mail). Management had a plan to deal with the disruption of Netflix and other online streaming providers while also adding their own internet-based streaming platform.
It was a little over a year in to holding the position, when Netflix launched in the local market. There was a lot of hype, but it was hard to separate the noise from the underlying traction. Was the incumbent going to see off the new challenger once again, as it had done so successfully in the past?
We scoured for new data points that would validate, or invalidate, our thesis. Finally we found one. One of the country’s leading internet service providers made a press release that mentioned that they were seeing huge increases in traffic from video streaming, and most importantly, from the gorilla in the room: Netflix.
We corroborated this new information with other industry sources, and revised our valuation. The shares were now trading below our original purchase price. But despite the fall, the share price was actually above our new valuation once we baked in the new growth rates.
We sold quickly, taking the pain, and realising a total loss of -8%.
As of today the shares have fallen a further -65%. Bullet dodged.
When a thesis is broken, sell quickly.
#3: Buy Low, then Buy Higher
This is a core part of my personal investing strategy, adopted from an excellent private investor, Ian Cassel. “Buy low, sell high” might be the four most famous words in investing, but they cause most investors to sell themselves short.
The market’s long-run average return is not evenly distributed. The big winners dominate the rest of the market, in much the same way that a few actors in Los Angeles star in all the Hollywood blockbusters, while the rest make ends meet waiting tables. A few multi-bagger companies generate the lions share of the market’s overall returns, while the rest do their best to stay in business.
When you find one of these massive multi-baggers early, the trick is to hold on. Or even better, buy more, even at higher prices. As with all investments, what matters is not what the share price has done in the past, but what the business will do in the future.
We often bought more of our biggest winners, even as their share prices increased, because the thesis was improving along with prices. Here is the returns by position chart once again:
To take one example, we purchased shares in ‘Position 3’ on four separate occasions. For our last purchase we paid more than 100% above our initial purchase price.
Most investors do the opposite: they sell a great long term investment simply because it has gone up 30% or 40%, without considering how much the underlying value has increased. Or worse still, they double-down on their biggest losers.
Of course there are times where it makes sense to rebalance. We trimmed ‘Postion 1’ on two occasions to keep the portfolio in balance. And if you are given the chance to buy an outstanding business at an even cheaper price, you should take it.
But most of the time people are really selling because of fear. Fear that their modest gains will disappear. Or fear that if they don’t buy more of a failing position, they will have to face up to their original mistake. Neither are good decision drivers.
Buy low, then buy higher.
Conclusion
There is a lot of great traditional thinking on portfolio management. But to achieve excellent results you need to master all of those basics and then also do a few important things differently. For us there were three crucial differences that set us apart from the rest: win big, lose small; sell quickly when a thesis is broken; and buy low, then buy higher.
And if you are one of those previous special clients reading this, thank you once again for your trust, and continuing to be interested in my thoughts on investing and business.
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A really nice read and a clear strategy. I wonder with small companies how much room you give them to pivot if their ideas don’t work or if you will cut them immediately if they do not follow what you assume will be their game plan.
Also in your personal portfolio would you be more inclined to let a star run without trimming the position back or is it something you would do no matter if it is a portfolio you are managing or your own money.
I can tell I’ll enjoy reading your thoughts here.
Thanks Adam! I am really happy that you took the time to follow the site and write in. Great questions!
With small companies I personally wouldn’t be likely to stick around for a traditional ‘pivot’ in the way the word is typically used in startups, i.e. abandoning a failed approach and pursuing a different product line or market. Most of the time that would likely be a broken thesis in my view and so I would be inclined to sell, and then potentially repurchase if the new approach starts to gain traction.
In my personal portfolio I will still trim back at certain points. But you are right that I might be personally willing to take a little more risk than I would take with clients money. Client’s money is very precious in my view and the market is already volatile enough.
Ideally though if you find enough star companies then they can do the balancing work for you. For example, let’s say you have a 10 stock portfolio. If you have only one company that increases 10x while the rest are flat, that company would be over 50% of your portfolio. That is extremely concentrated and you would likely be trimming along the way. However (very hypothetically) if you are able to find 10 companies that each increase 10x, now each company has grown significantly, but they balance each other out, so that each is still only a 10% position size. Again that is an unrealistically high hit rate, but it illustrates that the more stars you can find in one portfolio, the less you are pushed to trim purely for position sizing purposes.
I am one of those previous ‘special’ clients Matt and your trust was well earned… not just for the returns you were able to generate but also for your clear explanations about decisions made and your willingness to engage with question and (at times) criticism.
As an extension to Adam’s question above, how do determine when to trim a ‘winner’ and when to let it run, potentially even allowing it to become a monster?
Thanks Tim!
It’s a great question, and frankly a book could be written to attempt to give the full answer.
In my view great portfolio management is both an art and a science. Ultimately, the decision to trim comes down to three questions: 1) How does the current price compare to our estimate of current intrinsic value; 2) What possibilities are there for significant out-performance above our estimate; and 3) How well the position is balanced (or not) as part of the portfolio.
Often our decisions to trim were most often driven by the answer to question 3, however as noted in the reply to Adam, often our winners were able to largely balance each other out, which saved us trimming too frequently as some ‘monsters’ grew.
Very good article Matt and one I will try and re-read on occasion to reinforce the principles therein. Some very important principles/tenets to follow as an investor. However, for many investors, quite hard to master I suspect – including :1) knowing when the thesis is broken at an early stage – perhaps you could consider an article on relatively easily identifiable examples of what constitutes a broken thesis (and hence time to sell); and 2) what factors justify buying higher (and avoiding too much trimming/rebalancing).
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