The Price Of Being Different
Back in April, I wrote an article discussing Howard Marks (Trades,Portfolio)’ memo Dare to Be Great II; in the memo, Mr. Marks said the following:
“I’m convinced that for many institutional investment organizations the operative rule –intentional or unconscious – is this: ‘We would never buy so much of something that if it doesn’t work, we’ll look bad.’ For many agents and their organizations, the realities of life mandate such a rule. But people who follow this rule must understand that by definition it will keep them from buying enough of something that works for it to make much of a difference for the better.”
“Looking bad” is most notable as declining assets under management; the combination of underperforming investment and investors heading for the doors can pummel AUM – and more importantly from the managers perspective, their fees. The upside beyond a certain level hardly seems to justify the career risk to the downside. As Howard Marks (Trades,Portfolio) notes in the memo, this asymmetrical payoff leads to over-diversification; said differently, closet indexing and herding.
In the past few years (and increasingly so as markets continue to rise), a well-known investor has been in the spotlight; his experience to date offers an example of just how painful stepping away from the herd and making a stand can be if you’re temporarily (or possibly permanently) wrong.
In 2009, John Hussman (Trades, Portfolio)’s flagship Strategic Growth Fund was looking good: while the fund had declined 4.3% in the year to June 30, 2009, that had handily outperformed the S&P 500, which had fallen by more than 25% over the same 12-month period; in the nearly nine years since the fund’s inception, Mr. Hussman had racked up compounded annual returns of 8.9% – trouncing the 3.3% annual decline for the S&P 500 over that period. A year later, the fund would report net assets in excess of $ 6 billion – roughly 4X the amount under management five years earlier.
Fast forward to the present: in the years from 2009 to 2014, Mr. Hussman ceded the entire advantage he built in the first nine years of the fund’s operation back to the S&P 500; at June 30, 2014, he had reported annual returns since inception of 3.7%, against 4.1% for the S&P 500.
When most people are only interested in what you’ve done for them lately, Mr. Hussman finds himself in a painful position: his flagship fund has reported a 6.5% annual loss over the past three years, compared to a 16.5% annualized gain for the S&P 500. That decline alone was enough to deplete the fund’s AUM by nearly 20% from 2011.
Unfortunately, underperformance doesn’t come in a vacuum: investors have run for the doors as well, as Mr. Hussman’s bets have failed to pay off or been wrong (time will tell). From $ 5.64 billion in June 2011, the fund reported net assets of $ 1.14 billion at the end of June 2014 – a decline of 80% in just three years. The AUM for his flagship fund was lower in June 2014 than it was a decade earlier– a period where the index has more than doubled (including dividends).
Jean-Marie Eveillard (Trades, Portfolio) famously said, “I’d rather lose half of my clients than lose half of my clients’ money.” That’s a noble statement, and maybe John Hussman(Trades, Portfolio) agrees; with that said, the interim can be difficult – with returns and AUM both suffering. Most money managers are terrified of underperforming by a wide margin (as Hussman has done) or losing half their clients (which Eveillard did in the late 1990’s), even if it might mean being proven right and looking good at some point in the future. There are managers who were willing to make that trade-off in the late 1990’s rather than participate at the height of the tech bubble – only to lose their jobs before the bust finally came; potential job loss is a strong deterrent from leaving the herd.
As I’ve noted in the past, I think this creates opportunity for the individual investor. Contrary to what most people seem to believe, from the perspective of common stock investment as minority ownership in a business, sufficient diversification does not require twenty-plus positions.
Warren Buffett (Trades, Portfolio) (BRK.A, BRK.B) said it succinctly at the University of Florida back in 1998 (in full here):
“If you really know businesses, you probably shouldn’t own more than six of them. If you can identify six wonderful businesses, that is all the diversification you need – and I can guarantee that going into the seventh one instead of putting more money into your first one is going to be terrible mistake. Very few people have gotten rich on their seventh best idea – but a lot of people have gotten rich on their best idea.”
You can benefit from focusing on your top handful of ideas; importantly, your focus will likely result in a more in-depth understanding of the companies and industries that you’re focused on. Most money managers aren’t anywhere near Warren’s guidelines, and have no interest in getting close; there’s comfort in closet indexing, especially when investors are paying handsomely for your services and are unlikely to leave barring any disasters (see sustained underperformance).
As an individual investor, the constraints faced by most “experts” shouldn’t be overlooked; a willingness to accept a lumpy 15% over a smooth 12% is likely to be rewarded over time.
About the author:
I’m a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.
I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don’t have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question – which if I’ve done my job properly, should be very attractive over many years.