Outcast Beta Blog

[jfan]

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This is a interesting blog that Corey Hoffstein supported on his podcast. He interviewed the author. 

 

I read through some of his articles and there are some interesting insights on portfolio management. 

 

He discusses the interaction between portfolio concentration, investment styles, & time and their effect on geometric outcomes and minimum threshold of required alpha.

 

Long-story short:

1) more concentration portfolios (<=5 (concentrated), 6-10, <20, >20) requires more alpha and increases risk of portfolio drag

2) probability of loss is less as time goes by but the magnitude of loss increases

3) probability of loss is less than expected < 5 years, but the magnitude of loss is greater than expected in < 5 year time frame according to real world data

4) microcap, high valuation, non-profitable companies, low momentum require much more alpha whereas as large cap, low valuation (E/B, E/P), profitable, high momentum require much less alpha

 

So Buffett's punch card of 20 stocks of profitable, value strategy is quite rationale, but with his concentrated approach, it makes alot of sense to keep lots of cash for opportunities. 

 

For an investor that likes to be fully invested all the time, it would be rational to take more of a diversified approach > 15-20 stocks and consider diversifying across styles to avoid any portfolio drag when a particular strategy is not in fashion. 

 

The author also mentions alpha consistency is a hard to measure variable but will contribute to portfolio drag, hence focusing on a repeatable process to optimize investment decisions tilts the table in your favor over the long-term.

 

I'm not a quant, but I did find the articles helpful in quantifying what I felt over time were key decisions in portfolio construction. 

 

The web address to the blog is above, and I've attached the author's thesis for those braver than I to dissect the mathematics behind it. 

 

Portfolio concentration, style, and alpha needed (thesis).pdf

[jfan]

Outcast Beta Blog + Ergodicity, and their implication to portfolio construction

 

The conventional wisdom among value investors is that:

1) invest with a mindset of holding a company's stock for 5 - 10 years,

2) concentrate on your best ideas where you have an edge/circle of competence/unique contrarian insight that is highly probable that you are right,

3) buy below intrinsic value (especially if market implied expectations are particularly extreme) and sell above it.

 

The problem with this conventional wisdom, is that I feel it is incomplete and potentially dangerous to the goal of building wealth especially for the everyday retail investor. This is because it does not take into account the repeatability of a particular strategy in the long-term, nor the fact that long-term, really means one's life expectancy (not the planned holding period of a stock), for a specific individual. Buffett concentrating his portfolio in Coke was a big winner. Other value investors concentrating in Sears was a big loser. Miller riding Amazon was a big winner. Other value investors shorting Tesla was a big loser. Why did it work from some and blow-up others?

 

After reading Outcast Beta's blog and learning about the concept of ergodicity, it gave me a bit of insight on how to think about this a bit more deeply as it pertains to myself as I learn how to construct a portfolio. 

 

The first lesson I learned is that survival is more important than performance, and the only way to survive is to have a strategy that I can live with and reproduce in a consistent manner. This strategy will depend on the game that I choose to play, which in turn depends on my own skillset, knowledge base, and temperament (or in the case of professional investors, their clients). This coupled with one's own personal time frame (ie months - years - decades), will govern the interplay between the number of stocks and the degree of leverage (% of stocks in a portfolio of stocks & cash equivalents). 

 

The second lesson I learned is that greater the deviance of portfolio from a well diversified index, the wider the distribution of outcomes I will be exposed to in terms of geometric returns, total wealth accumulated, and probability of losing as compared to a benchmark index. The most practical way to minimize this deviance is from diversification. Where I was surprised, was the degree of diversification necessary especially as one's time frame lengthens. In fact, over a 40+ year investing time frame, a randomly-selected portfolio could require > 25 - 100+ stocks to reduce this drag. 

 

   

Interestingly, but not surprising, is that selecting stocks > 20th percentile in market size, cheap, profitable stocks, and having a lower % of stocks in the portfolio reduces the degree of diversification necessary to reduce the variance drag in a less than perfectly diversified portfolio compared to the benchmark.

 

 

 

Although not precise, inspecting the graphs in Outcast's blog, it seems that selecting stocks > 50th percentile in mkt cap will reduce the # of stocks by 50%, and selecting cheap, or profitable, or stocks > 20th percentile market cap will reduce the # of stocks by 30%. 

 

Starting with the assumption of a 100% stock portfolio, it would seem that ~ 120 - 150 stocks get you close to a well-diversified portfolio. By using the above selection criteria (ie big, cheap, profitable), I would be looking at ~ 18 - 22 stock positions over a 40+ year investing life-time, which is remarkably close to Buffett's punch card rule of thumb for the buy & hold investor. It may also be consistent with Munger's 3 stock portfolio with ~ 5 year holding periods over a ~ 40 year investing life (ie 24 stock positions over a lifetime). 

 

In either case, a significant factor contributing to Buffett and Munger's success, is creating ergodicity. This can be done both in measurable and  philosophical ways (qualitative). It can be, as shown in Outcast's blog, through diversification in the number and styles of stocks. But diversification can also be done through time, such as a buying a full position of 1 in 20 punch card positions every 2 years when you can find them at a decent price or alternatively accumulating small amounts of your evolving list of 20+ favored businesses over time. Core to this, is avoid the potential of zeros or extremely negative outcomes in a manner than does not cause permanent irreversible damage to your overall portfolio (taking into account future certain cash flows from other sources such as employment). Furthermore, reducing the % of your portfolio that is comprised of VC-like bets, as you age and get closer to the fixed income stage of life also helps, because recovery from future certain employment cash flows is much less likely to rescue you and your portfolio.

 

The other way to create ergodicity is act like a true long-term owner by thinking like one or actually have significant influence in the business. As an outside passive minority shareholder, we have neither the influence or clout to vote away poor board decisions, we can only ride along with management's decisions and choose to accept them at their word or not. Buffett and Munger can take equity positions and by the nature of their reputation, have significant sway in management. Along the theme of ergodicity, is playing games that we can reproduce and games where there are many winners. Copying Buffett and Munger in this regard, doesn't work. So as an OPMI, it behooves us to have a higher level of diversification (# of & through time) than these investing giants. As it comes to "stock-picking", it is more valuable to think about this endeavor more similar to searching and owning a participation in a collection of durable assets/businesses with a historical track record of surviving many different harsh economic realities (quality businesses). 

 

As Cliff Asness wrote recently in his paper "The Less-Efficient Market Hypothesis", the markets have become less efficient (so finding opportunities for the skilled investor) has become easier but sticking with what is right is getting much harder (longer to time for the market to realize this value). This got me thinking that being highly concentrated in a small cap value in a foreign market for example, will require significant patience and will very likely cause a long-term drag on your portfolio. It will also require you to ensure that the underlying business is of high quality (highly profitable with a long re-investment runway) and/or management is actively working at returning capital to shareholders. These positions may need to be smaller so that you and your stakeholders don't run out of patience waiting for the re-valuation event.  

 

 I'll end of this post with some examples of how I would apply the above:

1) Costco/Hermes - punch-card high quality at a stretched valuation - accumulate slowly over time (time diversification for a better price)

2) Fairfax India - owns some highly durable assets in a vehicle that is not particular shareholder friendly at a very cheap price that will have a long-reinvestment runway - own in quantities directly proportional to your degree of patience

3) Stellantis - not a 100-year business that a monkey can run (although founded in 1899), available at a cheap price that is actively returning capital to shareholders hoping for an inflection point of a successful EV transition - own in quantities that won't permanently damage your portfolio if it fails and reduce your time frame of holding on it (not a buy-hold candidate)

4) Fairfax Financial - punch-card quality if the culture stays the same over time available at a very reasonable valuation - having a > 5-10% position is very rational with a 10+ year time frame (large, cheap, profitable)

 

 

Edited September 15 by jfan