Portfolio management
It evolves by natural selection
Do we need a portfolio strategy that overarches our ideas on diversification and balance? What might such a strategy look like? The easiest way to answer this is to look at the strategies used by successful investors and draw some conclusions from them. We have looked at diversification and balance as separate topics here and here.
John Neff managed the Windsor Fund for more than 30 years. Over the period when he was at the helm, the average annual total return of the Windsor Fund beat the S&P 500 by 3.15% per annum.
According to Neff, the Windsor Fund adhered to a ‘rigorous, systematic and contrarian portfolio strategy’ that was also ‘flexible’. Neff devised it and it was called “Measured Participation”.
Measured participation
Neff writes:
“Measured Participation gave us a new way to view a portfolio, outside conventional industry classification. It encouraged fresh thinking about diversification and portfolio management. Instead of thinking primarily in terms of industry representation, Measured Participation established four broad investment categories:
1. Highly recognized growth, [8-9%]
2. Less recognized growth, [25%]
3. Moderate growth, [dry powder-35%]
4. Cyclical growth. [30%]
Note that each of the four categories is described as ‘growth’. One might ask if this is value investing or growth investing. This is really a case study that shows the terms ‘value’ investing and ‘growth’ investing are not mutually exclusive and the terms are probably misleading. Windsor participated in each of these categories, irrespective of industry concentrations. When the best values were available in, say, the moderate growth area, we concentrated our investment there….We were not compelled to ensure that Windsor was represented across every industry.” (Neff, John Neff on Investing, 1999) p102
I have added the percentage weightings that the four categories typically represented in the Windsor portfolio square brackets thus [10%].
What is noteworthy is that the classic blue chip growth stocks like Coca Cola and Johnson & Johnson, which would fall in the highly recognized growth category, were a small fraction of the portfolio.
Moderate growth stocks, such as utilities, which Neff called ‘dry powder’, were used as cash equivalents to have cash available to take advantage of bargains in the other categories as they arose.
It is particularly striking that cyclical growth companies were almost the largest category.
Neff describes his approach to cyclical stocks as follows: “We distinguished basic commodity cyclicals, such as oil and aluminum producers, from consumer cyclicals, such as autos, airlines, and home builders. Timing is critical in cyclicals. They usually follow the same pattern. As earnings pick up, investors flock to them. When earnings begin to peak, investors abandon them. Ideally, Windsor bought cyclical stocks six to nine months before earnings swung upward, then sold into rising demand. The trick was to anticipate increases in pricing. We had to start with knowledge of an industry’s capacity, and then make some judgments about sources and timing of demand increases.” (Neff, 1999) p107
Let’s reflect
Before we continue our discussion of portfolio strategy further let’s stop and go back a step.
The writer’s own strategy developed without being articulated as a strategy. What we learn from Neff/Windsor is the idea of formally defining a strategy by classifying companies according to their growth profile, how well recognized they are, the fact that some companies are more cyclical than others and the notion of using some very stable stocks as ‘dry powder’.
Should investors develop one strategy and stick to it? The problem with the idea of having a fixed investment strategy is that the investment world is changing constantly. What we can see from the Winsor example is the strategy of one very successful investor in one investing era.
I would also say that a sector rotation strategy is a losers’ game. It involves market timing, which few do well at. See my post here.
Philip Fisher
Fisher with Ben Graham had a huge influence on Warren Buffett’s thinking. He suggested a mix of larger and smaller companies. Depending on one’s circumstances he thought, for example, one might put 60% of one’s portfolio in large established companies and perhaps 15% in carefully selected smaller young companies with the rest in mid-sized companies.
The thinking here is that the smaller companies are more risky but may have the potential for enormous gains offsetting the added risk.
Fisher, without purporting to lay down any rules, suggests an individual stock in the large established category might comprise ten percent of the portfolio. He suggests that no more than 5% of the portfolio be invested in any individual smaller company stock, certainly no more than the investor is prepared to loose entirely. This connects back to my recent post on diversification here.
The category of smaller companies are decidedly not penny stocks. They are companies that in their smaller way have all the attributes Fisher is looking for in a larger company; they are superbly managed and solidly financed growth companies. (Fisher, Common Stocks and Uncommon Profits and Other Writings 1958, 1996) p144
Peter Lynch
Peter Lynch wrote One Up on Wall Street in 1989. At that point he had been in the investment business for twenty years and had been manager of the Fidelity Magellan Fund since 1977. In 1989, the Magellan Fund had one million fundholders and the book jacket says that if you had invested $10,000 in the Magellan Fund when Lynch became manager, ten years late you would have had $190,000. It was a heady time and the tone of the book reflects this.
Peter Lynch writes: “Some people ascribe my success to my having specialized in growth stocks. But that’s only partly accurate. I never put more the 30-40 percent of my fund’s assets into growth stocks. The rest I spread out among the other categories described in this book. Normally I keep about 10-20 percent or so in the stalwarts, another 10-20 percent or so in the cyclicals, and the rest in the turnarounds.” (Lynch, One Up on Wall Street 1989, 1990) p243
My own portfolio
Since the early 1970s, over almost 50 years, the compounded total return on our family savings has been 13.42%, beating the S&P 500 by almost 3%. In the last dozen years our compounded total return has been 15.19%, so something seems to be working. If the writer were to describe his current strategy using the Windsor format it would come out looking like the following, with percent weightings as they happen to be at the time of writing today:
1. Solid growth with high owner earnings (58.5%) For more on owner earnings see here.
2. Anticipated growth with expected high owner earnings (25.7%)
3. Natural resource/commodity growth (7.2%)
4. Book value growth (8.0%)
5. Cash (0.7%)
6. Experiment with one index ETF and one factor ETF (0.5%)
Stocks in the first category have market capitalizations ranging from over $1.5 trillion down to about $10 billion. Management and the board are co-invested in common shares. They are the mainstay of the portfolio.
The stocks in the second category have market capitalizations of less than $10 billion. They represent companies with entrepreneurial management with vision and with most of their substantial personal net worth invested in common shares of the company. Typically, company founders are still running the company.
The third group is a mining companies with a market capitalization of about $15 billion with co-invested management.
The forth group is a single company. It is a publicly listed private equity company with a market capitalization of about $7 billion with management’s financial interests well aligned with shareholders.
They all have financially strong balance sheets built through company operations rather than through stock issuance. Again, with few exceptions, management have a major part of their net worth tied up in common stock of the company.
None of the companies equate with Winsor’s ‘moderate growth’, the companies that provide ballast and a bit of dry powder. I do not hold a significant amount of cash. My views on cash and dry powder are explained in a post here.
There is no cyclical category. It is the writer’s view that almost all companies are cyclical in one way or another. They are affected by economic cycles, industry cycles or their own internal product or service cycles. There is no industry or sector distinction. The sector weightings relative to the S&P 500 are irrelevant.
The experiment with one index ETF and one factor ETF are to learn about the products so I can advise my children who have little interest in becoming active investors.
Conclusion
In sports, in war, and in the battle for investment survival it is helpful to distinguish between strategy and tactics. I think John Neff does us a favour in articulating his strategy. It doesn’t matter what style of investing you practice. You might be a dividend investor, a tech investor or an ETF investor. Articulating your portfolio strategy helps to clarify your thinking.
The practical reality is that a strategy is not created in some theoretical fashion. It evolves by natural selection in a very organic way when one invests using sound principles of operation. It is opportunistic and constantly subject to review. What works during some eras in the stock market will not work in others.
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To dig a bit deeper into this subject take a look at the Motherlode Chapter 36. Diversification, balance and strategy
That chapter is divided into Sections with titles as follows:
36.02 Digression to idiosyncratic risks and unexpectables
36.06 An aside on industrial commodities and agriculture
36.07 Correlation and the business cycle
36.08 A sector rotation strategy
36.12 Thinking about currencies in the context of diversification
36.13 International diversification
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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