Portfolio Optimisation, Luck & Regret, François Rochon, & Running Money for the Long Term
Market Talk, Edition 70, March 5th 2023
Once every second Sunday I curate the most interesting things I have consumed during the previous two weeks; bucketed into 5x must-reads and honourable mentions. Investment Talk goes out to over 19,200 investors and is a reader-supported newsletter. If you enjoy the content and would like to support the newsletter, you can do so here.
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Comments from Me
Some big news… we hit the 19,000 reader mark. At the beginning of this year, I set a tentative goal of reaching 20,000 readers by year-end. I think I sandbagged that one; I would make a great CFO. I shared a quick update last week about some tweaks to the format of Investment Talk going forward. I won’t repeat myself here, but the response has been very warm, so thanks to everyone who reached out and offered their two cents and other words of encouragement. When I stopped paid subscriptions at the end of 2021 (can you see it on the chart?), I did so to relieve pressure and focus on quality & growth. I think I achieved some nice growth, and I’d like to think the quality of the newsletter has improved.
It was the right decision for that moment in time. Now I find myself back at ground zero, attempting to build it all back up again. Because the content matter and the way I structure the newsletter has changed in the last few years, it no longer feels like I am running a “service”, so the pressures which plagued me in the past, are no longer present. This is important when it comes to writing and creating an environment conducive to creative thought. You can’t force inspiration. You can only invite it.
If 2022 was a year focused on growing the newsletter, 2023 will be a year focused on refining it; improving its quality. To commemorate this, I finally decided to write an about page for the newsletter. In other news, later this month I will be returning to India. This time for ~2 months. Nothing will change on the cadence front, I’ll be working mostly, but will try to do a better job of documenting some of it this time around!
Recent Publications: Memos I have shared since the last Market Talk.
The (p) indicates a partially or fully paywalled post.
5x Must Reads
Here are 5 that I found particularly enjoyable or insightful. Note, that these articles are not listed in order of perceived value.
To access the suggested article, click the purple link after the source subheading.
1) Seven Thoughts On Running Big Money For the Long Term (2009)
Source: (AQR Capital Management)
A revised edition of AQR’s original (2007) memo on advice for running money for the long term. While the authors write with institutional money managers in mind, there are plenty of learnings that translate to that of the retail investor.
The memo is not overly verbose, but it does cover quite a lot of ground. So instead of commenting on each thought, I have provided a synopsis of each segment.
1. Embrace Risk: Being truly long-term is one potential advantage for investors because it allows them to bear more near-term risk than those with shorter horizons. Setting up your portfolio to take and withstand substantial volatility without changing course is likely the leading determinant of long-term success in investing.
2. To Survive LT, Brace for the ST: In general, you have to protect yourself from disaster. The way to do this is not by buying insurance, as that is almost always a sucker’s game long-term. Instead, stress-test your portfolio in advance. Statistically shocking events (“Black Swans” if you will) definitely occur. At the beta level, we all have to collectively bear them but what you can make sure of is that if it happens somewhere it does not kill you.
3. Diversify Market Risk: Market risk (beta) will drive the lion’s share of long-term returns. Unfortunately, many investors under-diversify as they focus on capital allocations rather than risk allocation. Shifting to a risk budgeting framework can improve results by more clearly highlighting the true degree of concentration in certain types of risk.
4. Seek Alpha in Beta: Alpha is incredibly powerful. It's also widely misunderstood. We think of alpha as source of long-term positive return with a low correlation to other available returns. We think all investors should look at the risk exposures in their portfolio and see where they can add new sources of risk for which they will be compensated. Even if these are a kind of "beta," in a portfolio context they look like (and behave like) alpha.
5. Manager Alpha: Not all that relevant to retail, but the idea is to stay flexible. I liked this though: "Basically, take alpha wherever you find it rather than targeting a certain amount".
6. Don’t Fear Contrarianism: Along with being contrarian, long-term investors should be able to earn a risk premium by providing liquidity when short-term opportunities present themselves. Remember that being a contrarian isn't easy. By definition, you will be going against conventional wisdom – and conventional wisdom is often based on logical judgments and real-world observations.
7. Be Innovative: We can basically just re-use the "take alpha wherever you find it rather than targeting a certain amount" quote here.
“Being truly long-term is one potential advantage for longlived institutions versus other investors, because it allows them to bear more near-term risk than those with shorter horizons. In fact, it’s probably the largest advantage for big institutional investors. Setting up your portfolio to take and withstand substantial volatility without changing course is likely the leading determinant of long-term success in investing. For example, Warren Buffett’s track record is more about having a decent Sharpe ratio and sticking with a high volatility process for the long-term, than it is about having a very high Sharpe ratio (he has had some harrowing streaks of disastrous years)”.
2) Portfolio Optimisation: A General Framework for Portfolio Choice
Source: (Resolve Asset Management)
The idea of portfolio optimization has been described as having “compelling theoretical merit” but not being useful in practice. The author of this paper seeks to dispel that notion. Even critics agree that optimisation is the “only mechanism to make best use of all the information available to investors”. Despite this widely held view, the author contends that many investors default to naive methods of portfolio construction, which typically take three forms:
Conviction weight: investments are held in proportion to the portfolio manager’s conviction in the investments’ relative prospects
Market cap weight: investments are held in proportion to their market capitalisation
Equal weight: investments are held in equal weight
If investors are seeking to achieve the highest returns relative to a maximum threshold for risk, then portfolios constructed using the above heuristics express strong views about market inefficiency.
In this paper, the authors seek to dispel some of the myths of financial theory, surmising that many do not hold up to empirical scrutiny, and offering up optimal (their words) ways to construct a portfolio. The primary focus of the paper is on ways investors can make the best use of opportunities for diversification, without relying on active return estimates. It’s quite dense, some of it borders on the overly technical, but there are some great nuggets throughout that are shared in an educational manner. Picking great stocks is one part of generating amicable lifetime returns, but sizing those investments correctly is equally, if not more, important. Particularly as it relates to maximising gains and minimising painful losses.
“Managers who form portfolios on capitalization weights are expressing the strict view that the chosen investments should produce returns that are a linear function of their beta to the portfolio. While this assumption is consistent with CAPM, it is grossly inconsistent with the empirical evidence. Equal weight portfolios express a view that market returns are entirely random, so that nothing can be known about the investments’ relative risks, correlations, or expected returns. Additionally, an equal weight portfolio is only optimal when the expected returns on the underlying investments have no relationship with their respective risks whatsoever, or in the unlikely case that all assets have equal expected returns, volatilities, and homogeneous correlations. Conviction weighting expresses strong active views on relative returns”.
3) Back to Basics: Six Questions to Consider Before Investing
Source: (Ben Inker, GMO)
Scribbed in 2010, Inker kicks off by illustrating how sentiment had shifted amongst money managers between 2000 and 2010. Managers who said things like “we are long-term investors, so we should have an equity-dominated portfolio” in 2000 would later say things like “equities will play a smaller role in our portfolio going forward”. The crisis of 2008 would bring us “closer to the fundamental truths of finance”, as Ben puts it, and these shifting sentiments were really just a sign of the times. A story which repeats itself many times over. A pig touches the stove. It hurts. It smells a bit like bacon. He learns not to touch the stove. The wound heals. The pain is forgotten. He touches the stove again years later. It smells like bacon again. And repeat. Fun fact, as I am editing this on Sunday morning, I am actually cooking bacon.
The preface of the memo is this; Wall Street will never change, so how can investors avoid doing what they did in 2000 (getting drunk on speculation) in future? By asking themselves the hard questions before they start investing, that’s how. While a number of the examples in this paper are now dated, it is the onslaught of questions posed that is the value-add to the reader. The paper was designed to be a way for investors to look at asset classes and related strategies and make reasonable conclusions about what kind of long-term returns to expect from them. In that respect, it’s worthy food for thought.
“Would investors rationally buy equities if they did not believe they would give returns above cash? The answer to this seems unambiguously no. There is no obvious argument for holding stocks without an equity risk premium. Equities are volatile, they have no legally mandated cash flows associated with them, and they are the lowest rung in the capital structure in the event a company gets into trouble. While it is true that in a period of high or uncertain inflation equities provide a degree of protection against the loss of real purchasing power, the behavior of equities in inflation is not consistent and there are other, less volatile, assets that can be held for infl ation protection – not least cash itself, as cash rates tend to mirror infl ation rates except in cases of severe fi nancial repression”.
4) A Conversation with François Rochon
Source: (Best Anchor Stocks)
François Rochon is the founder of Giverny Capital, an asset management firm that has generated a cool mid-double-digit CAGR performance over the last three decades. Rochon started in the early 90s; originally managing a family portfolio based on an investment style synthesised from the likes of Graham, Buffett, Lynch, Fisher, and Templeton. Before the turn of the millennium, he would open Giverny’s services to the public.
Despite the impressive performance, Rochon is not as widely discussed, and Leandro’s interview with him highlights why he ought to be. With an hour set aside for some good old fashion brain picking, the pair discuss François’ journey, valuation, how to identify high-quality businesses, competitive advantage, managerial ownership, position sizing, and a whole lot more. There is even discussion around a lucky escape from Valeant Pharmaceuticalsand François’ candid learnings from that ordeal. I particularly enjoyed his interpretation of his own theory, the "tribal gene" as it relates to the inability of most investors to beat the market. A caveat is that this is a theory, not fact. But it still poses interesting food for thought.
This was a truly engaging and educational discussion and I enjoyed it immensely.
“Probably in my younger years I was more confident in my decisions. So probably I could start with 4 or 5 or 6% in that company very rapidly. Today I've seen my share of, you know, disappointments. So I'm much more prudent. I usually start with 1 or 2% with a new investment, and as I get more confident in my decision, I will increase it. And the goal is to have something like 20 to 25 names with an average weight of about 4%. So if everything goes well an investment, it will become something like 4% weight.
And we have the attitude of letting our winners run. So as a company does well, it will become a bigger part of the portfolio. And once it reaches 10%, we'll trim it. We don't want any position to be more than 10%. In the first years probably there were some securities that went up to 15 or 20%. I think that probably the highest was 20%”.
5) Luck, Regret, and Good Investing
Source: (Morgan Housel, Ensemble Capital)
I wanted to share these two short articles (both centred around luck & regret) because they build on something that I wanted to dive further into in my recent post, ‘valuing the unknowable’. There, I talked about how there are unknown unknowns, there are people who obsess over noise at the expense of signal, and that the best use of time would be to acquire businesses that create environments conducive to benefiting from these strokes of luck that are so critical to long-term returns; whether we admit it or not. Even Buffett himself said as much in his Berkshire letter last week.
“Our satisfactory results have been the product of about a dozen truly good decisions - about one every five years - and a sometimes-forgotten advantage that favors long-term investors” - Warren Buffett
Housel’s piece observes the differences in how people process bad experiences and good experiences. When most people experience bad times they tend to think of it as having been a risk. He suggests the logic is seldom reversed; where people attribute good times to luck; the opposite of risk. I suspect they, instead, allow it to inflate their ego; “I did that, that was all me”. But neither luck nor risk is permanent.
“Nothing too good or too bad stays that way forever, because great times plant the seeds of their own destruction through complacency and leverage, and bad times plant the seeds of their own turnaround through opportunity and panic-driven problem-solving” - Morgan Housel
This quote reminded me of creative destruction in some ways. It also left me with a deeper sense of appreciation for those humble enough to admit when they were simply the benefactor of luck. And then we have the Ensemble Capital memo, which takes a look at how luck, good and bad, always play a role in investment outcomes (but this is applicable to life, too).
“Investing is a decision-making business. Letting outcome-driven regret seep into your process grinds the machine to a halt, rendering it useless or destructive to value creation. At Ensemble, we’ll continue prioritizing process over outcome and think that’s the healthiest approach investors can take. In the end, results are what matters. But to reach the intended results, you must follow a process that works” - Ensemble Capital
The piece focuses on regret and why we should use mistakes as learning opportunities. Following a mistake, you have two options; regret or learn. To regret is like slicing yourself with both sides of a double-edged sword, afflicting twice the pain. To learn from a mistale is a method of healing and will make you wiser.
Morgan Housel: The Luckier You Are The Nicer You Should Be
Ensemble Capital: Why Regret & Good Investing Don’t Mix
• The Prism: 10 Ways to Avoid Being Fooled
• Morgan Housel: The Three Sides of Risk
• Phronesis Fund: Power Laws Rule the World
• Laconia: Enmeshment in Venture
• Woodlock House: Footnotes to Phelps
• Neckar: The Forgotten Lesson of Ben Graham's Life
• Lewis Enterprises: Intolerably Boring
• Bain: Global Private Equity Report 2023
• Rational Walk: Falling in Love With Investments
• Musings on Markets: The Upside and Downside of Debt!
Company Related Write-Ups
• Leveling Up (UMG): Universal’s Push for Higher Streaming Payouts
• AGB (INTU): Intuit write-up
• Invariant (CARR): Carrier, people need our products
• Fairway Research (TVK): TerraVest Industries Deep Dive
• Kyla Scanlon: Why the Data Makes No Sense
• Wealth of Common Sense: History of Interest Rate Cycles
• Wealth of Common Sense: Why Aren’t Housing Prices Crashing?
• Investor Amnesia: History of Market Panics
• Of Dollars & Data: The 7 Greatest Bubbles of All Time
• Apricitas: ChatGPT, Please Take My Job!
Please be sure to visit the publications of the mentioned writers!
These are opinions only of the individual author. The contents of this piece do not contain investment advice and the information provided is for educational purposes only and no discussions constitute an offer to sell or the solicitation of an offer to buy any securities of any company. All content is purely subjective and you should do your own due diligence.
Occasio Capital Ltd makes no representation, warranty or undertaking, express or implied, as to the accuracy, reliability, completeness or reasonableness of the information contained in the piece. Any assumptions, opinions and estimates expressed in the piece constitute judgments of the author as of the date thereof and are subject to change without notice. Any projections contained in the Information are based on a number of assumptions as to market conditions and there can be no guarantee that any projected outcomes will be achieved. Occasio Capital Ltd does not accept any liability for any direct, consequential or other loss arising from reliance on the contents of this presentation. Occasio Capital Ltd is not acting as your financial, legal, accounting, tax or other adviser or in any fiduciary capacity.
Valeant Pharmaceuticals, now known as Bausch Health, was a business that began to engage in unhealthy M&A to reduce R&D expenditure. They would acquire smaller companies and hike up the prices of their drugs. There were also allegations of fraud via multi-million dollar kickbacks and various other nefarious activities. There is a great Netflix documentary that covers the ordeal in a series titled “Dirty Money” with the episode called “Drug Short”.
Respect Conor! 😁✊🏽