You Can’t Run A Portfolio Like a Business – Part 2
By: Scott Middleton
T he first of this two-part article examined the merits of businesses responding to buyers’ demands, while portfolio allocation decisions need to avoid chasing what is popular. Part two of this article examines the importance of identifying and utilizing the “right” people in business, while stubborn devotion to fund managers – through good times and bad – can be a secret to portfolio
outperformance over time.
“Effective leadership is not about making speeches or being liked; leadership is defined by results not attributes.” —Peter Drucker (1909 – 2005)
Considered a founding father of modern management theory, Peter Drucker spent his career studying the importance of human capital and challenging common thinking about how organizations should be run. He believed that organizations struggled because of outdated ideas, in-the-box problem solving and internal misunderstandings. His solution – and ensuing work with the heads of giants like General Motors, General Electric and IBM – stemmed from his conviction that people are an organization’s most valuable resource. Drucker’s work paved the way for today’s emphasis on the importance of leadership to companies’ outcomes.
Hiring and firing decisions have enormous opportunity costs for companies: resource drain, bruised employee morale, diminished productivity and, worst of all, unfulfilled potential and unrealized upside. A 2009 study by AIMM Consulting indicated that the cost of a mis-hire is 25-times base compensation for those earning less than $100,000 and 40-times base compensation for those earning between $100,000 and $250,000. Identifying and diminishing the impact of a noxious individual is important, but what differentiates the good from the great in business is the ability to get the right fit. The opportunity cost of a “do no evil” leader can be the difference between “cutting edge” and “run-of-the-mill.”
Take the case of Walt Disney Company. In 2005, Bob Iger replaced Michael Eisner as CEO of the production powerhouse. Nothing catastrophic happened under Eisner’s 20-year command. In fact, the company did well under his leadership: Disney acquired Miramax Films and many animated hits were released, including Aladdin, Toy Story and Monsters, Inc. The stock price grew substantially, though it largely tracked the growth of the S&P 500. However, by the end of Eisner’s regime, Disney was becoming eclipsed by Pixar and shareholders feared the company was living off past successes. Eisner was no longer the right fit for Disney and the opportunity cost of his “do no evil” approach was endangering the long-term success of the company. Within Iger’s first year, he led Disney to acquire Pixar, which paved the way for later acquisitions of Marvel Entertainment in 2009 and Lucasfilm in 2012. These tactical acquisitions helped solidify Disney’s relevance amongst 21st century producers and realize the potential of the brand that Eisner was unable to tap. Shareholders have been rewarded under Iger’s leadership: the stock price more than quadrupled in value in little more than 10 years and vastly outperformed the S&P 500.
Manager Selection and Buffett’s “Fourth Law of Motion”
In his 2005 letter to shareholders of Berkshire Hathaway, Warren Buffett added a fourth law to Sir Isaac Newton’s famed three laws of motion: “For investors as a whole, returns decrease as motion increases.” With so much focus on finding the right fit in business leadership, the typical behavior with firing or hiring investment managers is to fire underperformers once patience has run out. Investor impatience during periods of underperformance violates the principle “buy low, sell high.”
A study published in The Journal of Finance in August 2008, “The Selection and Termination of Investment Management Firms by Plan Sponsors,” surveyed the manager hiring and firing decision of more than 3,000 plan sponsors with hundreds of billions in assets under management over an eight-year period. When making fund manager changes, the newly hired managers had notably better performance track-records than the fired managers over the preceding one-, two-, and three-year time periods. However, these newly hired managers underperformed the fired firms over the one-, two-, and three-year periods following a change. Impatience-induced manager churn can lead to significant underperformance over time.
Even the best funds inevitably spend some time out of favor. One notable example is Dodge & Cox Stock Fund. The highly respected large cap value fund, on top of underperforming in 2005 and 2006, lagged its peer group and the S&P 500 Value Index by more than 4% from November 2007 to 2008, losing 46.33%. For the three-year period of 2006 to 2008, the fund underperformed its benchmark by more than three percent annualized, ending in the 96th percentile (the bottom four percent) of its peer group.
Innovest noted that Dodge & Cox Stock Fund’s managers, philosophy and process remained unchanged during its period of underperformance. The recommendation was to stay the course with the fund, which was especially frustrating for clients who were already spooked by the bear market and were hungry for action. However, patience yielded excellent results for investors in 2009 when the fund returned to the top-quartile relative to peers and outperformed the S&P 500 Value Index by more than 10%. As of the end of 2016, the fund was in the top decile of large value managers for the trailing three, five and seven years.
Particularly over the short term, unexpected market events can waylay even the highest quality portfolios. Economic cycles can favor certain companies over others and sometimes a company’s thesis can take more time to materialize than anticipated. In investing as in life, bad things can happen to good managers.
Like a Bridge Over Troubled Waters: Rules to Avoid the Fourth Law of Motion
Good advisors and successful investors use three proven strategies to avoid the trap of impatience-induced underperformance:
- Remember that performance does not exist in a vacuum. Do not focus primarily on performance when deciding whether to hire or fire a manager. Instead, center primarily on qualitative catalysts, such as the organization, people, philosophy, investment process, style consistency and asset base of a fund. If one or more of these factors has begun to deteriorate (in addition to, or even in isolation from performance concerns), find out why and decide if a change is warranted.
- Distinguish characteristic performance from uncharacteristic performance, positive or negative. Understand the nuances of manager processes: their biases and which market conditions should support, vs. harm, their approach. Investors pay managers to stick to their style in good times and in bad. Uncharacteristic performance can indicate a change in process, which might merit a switch.
- Don’t live and die by comparison metrics. Relative performance versus an index or peer percentile reporting can exacerbate investor impatience. Peer metrics are important for accountability and transparency, but they also frequently initiate a return-chasing mentality in investors whose funds didn’t place at the top of the pack. Rather, maintain focus on longer-term rankings and performance consistency.
Successful businesses are set apart from their competitors by the drive to respond quickly to consumer demand and the “quest for best” in executive staff. However, successful portfolio management requires a different, and somewhat counterintuitive, approach. This two-part article has focused on the skills necessary to avoid chasing consumer demand in asset allocation decisions and avoid chasing performance in manager hiring and firing decisions. In investing, acting on regret is usually an exercise that leads to poor results. Instead, a forward-looking view and patience are essential.
For more than 20 years, Innovest has provided excellent client service as well as forward-looking, innovative investment solutions for endowments and foundations, retirement plans and families. We are an independent provider of investment-related consulting services and work on a fee-only basis.
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