Portfolio, page-58

"I'd be interested in the thought process behind selecting the three. Did you go into the search with a criteria or were the selections based on the available options?"


To preface my answer: it is well-known that the overwhelming majority of individual investors fail to generate investment returns better than the broader market over time (and worse, in generating those sub-optimal returns, individual investors take on more risk).

So I think every investor ultimately gets to the point (or he/she should get there, for their own good) of deciding to outsource the investment of their capital (or at least most of it) to a credible specialist or in the absence of identifying one, simply buying an Index fund.

To that end, I am happy to share my experience of this outsourcing process because it has not been easy.


A bit of contextual background is needed to best answer your question.

Looking to outsource some of my capital to other managers was a confluence of two major events:

1.) The structure of the equity market in Australia was changing in a way that didn't accord with what I saw as necessarily being my personal investing competitive advantage.

2.) As I've crossed over the summer, and into what I hope is just the early autumn, of my life, I am devoting more of my time to activities other than researching and analysing industries and companies. (I still have a passion for it, but I have other interests which I am increasingly pursuing.)


Point 2.) is, I think, self explanatory, but I think Point 1.) requires some clarification:

For most of my investing career in Australia (which commenced in the 1990s) the nature and structure of the ASX could be described as being dominated by a few large dominant companies operating:

a.) within cosy duopoly (and often monopoly) industry structures
(think commercial banking, grocery retailing, healthcare (esp. hospitals and specialised medical devices), hardware, insurance, infrastructure (airports, ports, stevedoring, energy generation and transmission), and even building materials.), and

b.) businesses with high degree of cyclicality (to this day, the Australian economy remains dominated by Real Estate, Banking, Retailing, Mining & Energy, Construction, Agriculture, Financial Services, Insurance, Tourism... all cyclical industries offering limited organic growth in a relatively small domestic economy with challenged demographics), as opposed to long-term structural growth attributes (Healthcare is the exception, but this has historically represented a small part of the ASX in terms of stock numbers).


Which means that, in order to be a successful equity investor in Australia between the 1980s and the early 2010s, the key skill you needed to possess was an understanding of the cycles of the various business sectors and to simply buy at cycle troughs and sell at cycle peaks. (In fact, this cyclical nature of ASX was so pronounced in the 1990s and early 2000s that I recall the top-rated stockbroking analysts were not the ones who necessarily knew their stocks the best, but the ones that maintained the best databases of leading indicators for the sectors they covered.)

But about five or so years ago, I started to notice a major fundamental change in the nature of the ASX, especially in terms of the sorts of companies that were IPO'ing: the vast majority of them were very different to the traditional ASX-type stock, in that they were mostly technology-based businesses. Not just that, but they were globally scale-able i.e., while many of them were still quite conceptual they presented the possibility for long-duration structural growth characteristics, which the typical ASX stock distinctly lacked.

Fast forward to today, and more than a third of the stocks I own by number are such "growth" companies that couldn't even have existed 7 or 8 years ago because the technology that facilitated those business models hadn't even come into being yet! That, I think, is a most telling observation.

The trouble for me, with these "new-generation", technology-driven, long-duration growth stocks that have burst onto the ASX scene over the past 5 years, is that they are invariably very small (micro- and nono-caps, even), and very illiquid (that lack of liquidity compounded by the fact that the ones I tend to gravitate to invariably have large founder and/or management shareholdings).

So to physically buy these stocks is invariably quite a challenge and there are few things I loathe more in life than monitoring a market depth screen for hours on end in order to execute a share transaction. Every minute spent trying to execute a trade in a stock is a minute that I could be doing something far more meaningful, such as reading Annual Reports, conducting fundamental research or building a financial model for a business (or, heck, walking my dog, even).


To summarise, I think that in life, irrespective of how much self-confidence one has based on one's own investment track record, it is important to recognise and accept one's limitations.

So, the decision to carve out some of my family's capital arose from an acceptance that the world was changing and that I had limitations in terms of understanding the nature of the "new generation of ASX" companies, and that there were other people - specialists in the micro and nano-cap space - who naturally understood this exciting new world of technology stocks far better than I did (or wanted to).

Also, these fund managers have commercial relationships with brokers (intentionally, I have zero interaction with brokers or broking analysts), so when it comes to the important aspect of trade execution, they are better able to source lines of stock in order to get set in their funds.

I am happy to pay for the outsourcing of that trade execution and expertise in understanding of investing in "new- generation", technology-driven micro-cap businesses.


CHOOSING MANAGERS:

This has proven to be far more difficult that I initially thought would be the case.

For starters, there is a large body of evidence that shows that very few investment managers outperform their benchmark over the long-term. Not just that, but of those that do, almost none outperform all of the time.. every manager undergoes periods of under-performance from time to time.


There were a number of criteria the I sought to have satisfied in my choice of manager, but the two most critical ones were (obviously):

1.) Investment competence, and

2.) Honesty and trustworthiness.


These might be self-evident, but establishing these is fiendishly difficult.

Even investment competence is not obvious.

Just because a manager reports X% outperformance over his/her benchmark over a period of time, in isolation that doesn't really mean all that much and it needs to be qualified by determining exactly how that ALPHA was actually generated:

1. How much risk was taken on board?
No good performing well because you owned a whole lot of highly leveraged financial stocks, or punted the bulk of the fund on a new medical breakthrough or on some kind of new economic fad coming into being. That's highly unlikely to be sustainable. In fact, it is highly likely to result in blowing up, sooner or later.

2. In attribution analysis, how much portfolio concentration was there?
If two or three stocks were 20-baggers but most of the other stocks in the portfolio under-performed, then while the overall portfolio returns might look attractive, quality-wise, they are poor.

3. What was the volatility and timing of those investment returns?
Again, no good making X% out-performance when it means the volatility of those returns are multiples of standard deviations higher than the variability of the underlying benchmark. In terms of timing of the delivery of ALPHA, I knew of a 10-year old fund (now closed down) which produced decent overall returns when averaged over its life, but if you analysed the ALPHA timeline, for 9 of those 10 years the fund failed to outperform its benchmark and it was only over two brief periods that all of the fund's out-performance was compressed. It absolutely shot the lights out for 6 months in 2011, when the market tanked due to the Greek debt default crisis, and again in 2015 when the market had a "taper tantrum" caused by fears of Fed tightening.
(Needless to say, this was a bearish hedge fund so it did extremely well on its short book when markets tanked. But investing in such a fund is akin to little else than trying to time the market on the short side. As it happened, the fund's clients redeemed all their money in 2019 after the roaring bull market in the preceding three years absolutely demolished the fund's performance ... literally a few months before Covid torpedoed the market. [I think there's a lesson in there somewhere!] )

4. What were the prevailing market conditions?
For example, a great number fund managers operating in Australia today - I'd argue that 80% and more of them - today have known nothing other than conditions of a 10-year decline in the cost of capital, which has dramatically driven up asset prices. It's incredibly hard to totally blow up a fund with that sort of tailwind. But how have those managers performed when the market conditions were different.


As for trustworthiness, this is so very important, yet how does one establish that?

Certainly, it cannot be determined just from the monthly reports produced by investment managers.

For the managers I chose, before making the commitment to invest, I had spent several years following them (bordering on stalking them online, eg. their Twitter accounts and even on HotCopper when they used to post here), listening to them talk and ask questions in company presentations, I asked others in the industry about them, heard their names come up unsolicited and of, course, met with them on a number of occasions in person in a formal interview setting.

The key person risk with investing in a micro-cap manager is huge, and it is very important to me that the people who are going to steward my family's capital for many years are credible, honest, with strong value systems and ethical standards.

Which means that, during my interviews with prospective managers, I upfront make no apology for directing questions which are likely to be quite personal; for example, their upbringing and background, personal ethos about life, their health, domestic circumstances, and family life, even stuff like how big their house is, what cars do they drive, what domestic duties they perform at home, what they do recreationally, the nature of interactions they have with service providers (cab drivers, wait staff, garbage removal people, tradespeople, bus drivers, super market staff etc.), even the state of their marriages, and the relationships they have with their children and parents (and parents-in-law!) [All in perfectly confidential terms of course.]

Clearly these are often sensitive matters for people to divulge to a total stranger, and I accept if people choose not to answer certain questions, but I struggle to see what they alternative is, given that I don't just view this as a normal commercial arrangement; instead, I view it as a long-term partnership - at least 7 or 8 years and probably longer than a decade, if the manager in question continues to exist and to remain true to label for that long.


"And is there a plan to add or withdraw over time?"

About 3 years ago, I set myself an objective to have between one-third and half of my family's capital externally managed. I'm not even at 10%, so I'm way behind where I wanted to be.

So I am keen looking to add, but the funds I have identified to date have been too small to be able to invest meaningfully (For risk management purposes, I don't want my capital to represent much more than 5% of a fund at the commencement point).


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