Because the alpha (returns in excess of the market) in our Framework Investing portfolio is generated primarily from good investing ideas, it can appear that our research is focused only on generating those ideas. But one of the cautions we get from people who are initially interested in our services, particularly on the retail side, is that we “do not publish enough new ideas.” This critique has given us pause and we think shown up a fundamental difference in investing philosophies and what we understand to be true about the capital markets.
We are analyzing these companies and creating ideas with the sense that perhaps one or two good ideas in a year will give our portfolios the boost they need, particularly if those ideas include some leveraged component. So, while we may screen through 30 or more companies in a year, we come at that with the idea that practically speaking, we might look carefully at 10-12 and then invest in one to two. But, when we do invest, we are confident about those investments – some more than others, obviously. Additionally, some macro market environments are more “target rich” in terms of “mispricing” than others; March of 2009 vs. today, for example.
Is this different from how most investors construct their portfolios?
Well, it is different than a mutual fund or hedge fund for sure. Those companies charge high fees to employ rafts of analysts and computer code to create portfolios of sometimes hundreds of securities and, in many cases, still only end up being “closet indexers”. For all that “knowledge”, investors pay a substantial fee (read fee as “portion of their returns”.)
It is different than most of the retail portfolios we see, where DIY “stock pickers” have constructed mutual funds of their own – small positions, not deeply researched/understood, with single name risk (idiosyncratic risk) managed out by diversification. Do these kinds of portfolios BEAT the broad market indicies? More often than not, the answer is NO.
What’s happening here? Well, the rules, or maybe better, operating principles, that govern Mr. Market are hard at work. Let’s take a look at those rules and their consequences. These rules are the cornerstones of the Efficient Market Hypothesis:
Rule 1: The price is always right. This is provably untrue for individual securities at least and certainly for the market as whole. Otherwise bubbles and crashes would not exist. Indeed Warren Buffett provides us with the recipe for how to take advantage of this rule in the following quote.
Rule 2: There is no free lunch. Translation, it’s bloody difficult to beat the market over a reasonable time horizon. This is provably true. Witness the rush to passive strategies over the last 5 years. In 2016, US investors favored passive funds over active by a record margin (active funds saw an OUTFLOW of ~$340Bn vs. passive funds saw an INFLOW of ~$500Bn.) That is being driven by data where active managers have had a decade of underperformance in combination with rising market prices in general. No free lunch indeed.
As investors who care about our results, these rules should give us pause at least. In our view at Framework Investing, they bound our portfolio thinking. What are the consequences?
First, since the price is NOT always right, there must be both undervalued and overvalued securities in the market at any time. In times of exuberance, those undervalued targets will be probabilistically fewer, but they are out there…somewhere. Our challenge is to hunt them down on the basis of cash flow valuations. Getting good at this will add above -market returns because we understand these businesses well enough to confidently structure and size positions that take maximum advantage of these “mispricings”. We don’t expect to win them all, but we are running above 80% today. That’s pretty good.
Second, since it is difficult to beat the market, some material proportion of our portfolio should be an index or “smart” index that allows us to take advantage of the market in some way (maybe we have a factor tilt or some other quantitatively driven strategy) where we DO NOT HAVE a knowledge advantage. We also assume the benefits of diversification to help us with this lack of relative knowledge. We don’t have to know about every name in an index if we understand the role of that index in our portfolio.
Our job as managers is to think carefully about our portfolio design with respect to these two important rules. Both are real and have real consequences, but the right portfolio design in response to them shouldn’t be an all or nothing approach.
How is your portfolio structured to make peace with these operating principles? Join us for Office Hours this week and let’s talk about it together.
We leave it here this week. Next week we will look at some examples of portfolio designs that operate in different ways relative to these Market Operating Principles and see how those investment vehicles have done for themselves in terms of return over time. Indeed we will show you that your investing Framework learned here can also inform how you think about portfolio design.