Beating the Market or Winning the Loser’s Game?

As we come into the end of 2015, volatility is back in the equity markets and near-panic conditions exist in some parts of the high yield market.  Active managers are likely to under-perform again this year.  With this confluence of factors, it seemed appropriate to look back at Charles Ellis’s seminal work , Winning the Loser’s Game,

Ellis, a long time investment consultant, and an excellent author dives deeply into the market and whether or not it is even possible to achieve market beating performance.

Here are a few snapshots from his work:

  • Four possible ways to beat market:
    • market timing
    • asset selection
    • changes in portfolio structure/strategy
    • long-term investment philosophy
  • For most investors the most important thing is to be invested.  
  • Paradox – Funds are often being managed with their purpose and objectives being misaligned on the time dimension
  • Appropriate investment policy can therefore be the most important way to achieve superior investment results
  • 6 questions any investor should ask before selecting a manager
    • What are the risks of an adverse outcome?
    • What are the emotional reactions to an adverse outcome?
    • How knowledgeable is the investor?
    • How important is the portfolio to the overall financial position?
    • Legal restrictions?
    • Any unanticipated consequences that could arise from fluctuation of value?
  • “time is archimedes’ lever in investing.”
  • the real risks in the long run are the risks of inflation and excessive caution
  • the great secret for success in long term investing is to avoid serious losses
    • policy is the most effective antidote to panic
    • Policy is to establish useful guidelines that are appropriate for your objectives and the realities of the markets
  • First understanding of your objectives and tolerance for risk
  • spending decisions should most definitely be governed by investment results
  • problem definition and problem solving should not be delegated to investment managers
  • “don’t confuse brains with a bull market”
  • a few simple tests of investment policy
    • Is the policy carefully designed to meet your real needs and objectives?
    • is the policy written so clearly and explicitly that a competent stranger could manage the portfolio and conform to your intentions
    • would you have been able to sustain commitment to the policies during the markets we have experienced over last 15, 20, 30, 50 years?
    • would the manager have been able to maintain fidelity over the same periods
    • would the policy have achieved our objectives?
  • Managing managers
    • believes in concentrating with 1-2 managers
    • know your objectives
    • do not expect more than they can deliver
    • select based on competence


Know When to Walk Away, Know When to Run – Part 5 – Investment Process

“You cannot always sell out when you wish or when you think it wise. You have to get out when you can; when you have a market that will absorb your entire line. Failure to grasp the opportunity to get out may cost you millions. You cannot hesitate”
– Edwin LeFevre – Author, Reminiscences of a Stock Operator

“There have been cases where we own say, 1 million shares and we think we want to sell, but we can only sell 25,000 shares right away. You could say ‘why bother it’s only 25,000 shares?’ but our feeling is that’s silly – it might only help solve 2.5 percent of the problem, but the problem is now 2.5 percent smaller than it was.”
– David Einhorn – Greenlight Capital

We conclude our series on the investment process by looking at the final step, the art of sell discipline, or knowing when to exit an investment. As we noted previously in ‘Go, No-Go – Making the Decision,’  the actual process of “making the decision to invest” is largely brushed over analytically. In our experience, the process to follow when exiting a position is also given little consideration by investors.

From our time in investment banking, we often heard the common-sense wisdom of “You never go broke taking a profit,” or “Pigs get fat, but hogs get slaughtered.” The implication being that if you have made a profit, it almost always makes sense to exit your investment. The saying attributed to George Soros that “it takes courage to be a pig” may have been tossed around as a contrarian retort to these sentiments. Rather than make intuition based decisions using such common-sense refrains, we find it much more prudent to make decisions using a framework that has been thoroughly constructed in advance.

We believe the best place to begin evaluating the end of the investment (i.e., exit) is at the beginning (i.e., well-before you have invested). Prudent investing, if it is to be more than gambling or a coin toss, involves first articulating a specific investment thesis. This thesis clearly describes what the investor believes will happen to the investment being evaluated. It should define in advance what catalysts are going to move shares, an approximate time frame, and the risks and rewards present.

The well-defined investment thesis protects you from stumbling into Alice’s quandary when she encounters the Cheshire Cat.

“Would you tell me, please, which way I ought to go from here?”
“That depends a good deal on where you want to get to.”
“I don’t much care where –”
“Then it doesn’t matter which way you go.”
― Lewis Carroll, Alice in Wonderland

That is to say, if you never bother to define a specific investment thesis in advance of investing, you risk not knowing what the correct path forward is as circumstances develop. A well-defined investment thesis constructs a sell-discipline in advance, and is prescriptive about how to manage the investment as time progresses and circumstances develop.

Investment Scenarios

At the risk of stating the obvious, there are four potential outcomes to an actively-managed investment:

• The thesis is correct and the stock rises – “Correct Decision
• The thesis is incorrect and the stock falls – “Incorrect Decision
• The thesis is incorrect and yet the stock rises (for unexpected reasons) – “Lucky Decision
• The thesis is correct and yet the stock falls – “Unlucky Decision

Or graphically, we can represent this as a simple 2 x 2 matrix, as seen below.


Below we walk through each scenario and offer a few thoughts about how best to handle each.

Scenario 1 – Exiting the Correct Decision

This may be the clearest of all the scenarios in that the stock performance has corroborated your thesis based on the specific catalysts you described in advance. The exit from a successful position is a process that occurs in stages.

As part of an investment thesis, we define what we think the upside potential is (reward) to a downside case assessment of where the stock could go (risk). At the beginning of an investment, we want to see at least 2-3x upside to downside (reward over risk), or even higher. The reason for this is that we want to be compensated greater than 1 for 1 for each unit of ‘risk’ we are assuming. By insisting on this scenario, we hopefully are skewing the return potential of each idea and the portfolio itself in an asymmetric fashion (i.e., this deliberate skewing of the portfolio is designed to disproportionately reward the investor vs. the risk assumed). For example, why would we accept 50% upside potential vs. 50% downside risk (i.e., 1.0x upside to downside), if there is another investment offering 50% upside, but only 25% downside (i.e., 2.0x upside to downside)?

This asymmetry disappears as the stock approaches our target of intrinsic value (i.e., less upside remains, vs. the same/greater downside risk), and as such we begin harvesting gains / trimming the position. Our target is to be largely complete with our exit within 10% above/below est. intrinsic value.

As the stock nears fair value, the size of the position decreases

What if the intrinsic value has actually increased? This is a challenging scenario because when you purchased shares originally, you had a clear estimation of what you felt like the shares were worth. Over time, because the stock has performed (and generally this means that the company has as well), your estimation of the intrinsic value may begin to rise (and perhaps rightfully so).

The problem here is that the position has increased in size and you are more likely to regard the business more favorably from a pure psychological perspective (anchoring / recency biases). Our rule of thumb in this scenario is that whenever we increase our intrinsic value estimate, we need to re-evaluate the upside / downside relationship and resize the position accordingly (often back towards the initial size when the idea was first placed in the portfolio).

Scenario 2 – Exiting the Incorrect Decision

“Learn how to take losses quickly and cleanly. Don’t expect to be right all the time. If you have a mistake, cut your losses as quickly as possible.”
– Bernard Baruch – Famous investor of the 1920s

“Market losses are external, objective losses. It’s only when you internalize the loss that it becomes subjective. This involves your ego and causes you to view it in a negative way, as a failure, something that is wrong or bad. Since psychology deals with your ego, if you can eliminate ego from the decision-making process, you can begin to control the losses caused by psychological factors.’
– Jim Paul – Trader – Author – What I Learned Losing a Million Dollars

As an investment develops, circumstances may arise which contradict the drivers of the investment thesis. When this occurs, we believe that an incorrect decision has been made. When your thesis is incorrect and the stock reflects this, we believe the best course of action is a quick and speedy exit. In this situation, your reasons for being involved are no longer valid.

Many investors who do not define a specific investment thesis in advance have fallen victim to ‘thesis creep’ – a debilitating affliction whereby the ‘thesis’ for the investment is changing day-by-day with the direction of the market (‘Of course we bought Netflix because we saw the growth potential in Europe!’).

While it is certainly fatalistic to joke about ‘how much worse’ something could get, we have seen that when companies begin to struggle that the near-term ‘downside’ case can always be greater than anticipated. As such, it is best and prudent to exit and move on.

All good investors will be wrong on occasion and have losses, otherwise you likely are not taking enough risk. More importantly, is what is done after the loss that determines long-term investment success. We engage in a post-mortem analysis after each investment to assess what went right and wrong, with an eye to where we could improve our decision making.

Scenario 3 – Exiting the Lucky Decision

“Better to be lucky than good”

Exiting the Lucky Decision is actually worse than Exiting the Incorrect Decision in which your thesis was wrong and the stock went down. In scenario 3, you were just as wrong about your thesis, but you made money, which provides a tremendous psychological reward. Lest the surge of dopamine lead you to become over confident about your abilities, a quick and timely exit is in order here as well. Again, this is another scenario in which an analysis after the investment will help you determine the underlying drivers of your success or failure.

Scenario 4 – The Unlucky Decision

Handling the “Unlucky Decision” is the hardest of the four to navigate accurately. Inevitably in any investing, and especially value investing, you are going to experience wide swings in a stock’s price. In looking at the moves between the 52-week highs and lows for stocks, it is quite common to see share price swings of 40% or more.

The point being, it can be tough to tell at the time whether or not the investment decision was a bad one, or if it was just poorly timed (i.e., “unlucky”). The recently reissued book, What I Learned Losing a Million Dollars, summarizes this situation well.

Authors Paul and Moynihan note that the stock market is unique in that there is typically “no predetermined ending point” when making an investment. If you were to look at a betting scenario, for example on a sports event, it is clear when the game is over and the balance is to be settled. Conversely, a purchased stock can be held for years or in perpetuity with no determination necessarily being made with regards to the success or failure of the decision.

So what can be done? Paul and Moynihan offer some thoughts we believe to be instructive. Note, they use the term ‘speculation’ here to mean any purchase made where you do not tend to hold till maturity (or for stocks, hold indefinitely).

‘Speculation is forethought. And thought before action implies reasoning before a decision is made about what, whether, and when to buy or sell. That means the speculator develops several possible scenarios of future events and determines what his actions will be under each scenario. He thinks before he acts…Before you decide to get into the market you have to decide where (price) or when (time) or why (new information) you will no longer want the position.

As part of the initial analysis, Paul and Moynihan recommend specifying in advance when you want to sell. This ex ante decision unlocks the key to knowing how to handle the stock that goes down but has not given a sign that your investment thesis is incorrect. Defining in advance the rubric by which the stock is going to be judged against whether it is right or wrong, allows the investor to dispassionately evaluate the stock in the event of an unfortunate decline, instead of reacting emotionally to the pullback in shares.

As the stock moves around due to new information and changes in the business, the investor can engage in a sensible re-underwrite process which compares the new information and changes to the original thesis and catalysts and determine if the ‘exit thresholds’ have been breached. If they have not, a pullback in value may present a wonderful buying opportunity.

So for the “Unlucky Decision”, there is no hard and fast rule about when to exit. Instead, it is going to be defined in advance and is particular to each individual company.

Concluding Thoughts

As we have written previously, “The end result of these steps is an investment process that is self-reinforcing in nature… The investment process itself becomes iterative (i.e., it ‘learns’ and ‘grows’ over time) and we are able to improve over time by cultivating best practices from successful investments and learning from mistakes made.”

A well-defined investment thesis and a well-constructed, carefully applied sell discipline allow the investor to capture the well-earned upside from a stock that performs, and hopefully mitigate the downside risk that can occur when a stock moves unfavorably.

How to Not Lose Money – Protecting Against Downside Risk – Investment Process Part 4


“Here’s the paradox: the odds are overwhelming I will end up richer by aiming for a good return rather than a brilliant return – and sleep better en route. Folks who seek a killing usually get killed… Consistency is the key. It is close to impossible to get a good, long-term, rate of return if you suffer serious negative numbers en route. It’s the math. A single year that is down 30% means you have to get 30% per year positive returns for the next four years to get back on track for a 15% annual average. Or, if you score 20% annually for four years, and then suffer a 30% decline, your five-year average return is only 7%.”
– Ken Fisher, Forbes, 1989

The task of investing is generally separated into two distinct functions – investment idea generation (finding securities that should generate returns) and asset allocation (determining the appropriate mix and weighting between all the various asset classes). Intuitively this makes sense, each of us has to decide how much of our portfolio is going to be exposed to stocks, bonds, etc. (the allocation decision). Having made that choice, the next logical step is figuring out what specific investments we should make. Should we pick individual stocks, index funds, or invest with a manager who will do the ‘picking’ on our behalf?

In general, most investors, individual and institutional for that matter, delegate the ‘picking’ to a professional manager. A bold few will try to pick individual investments on their own, relying on personal research, reading, and stock idea sources like Barron’s or CNBC.

Because investor focus generally revolves around these two tasks of asset allocation and idea selection, we believe investors in general neglect to consider an important line of inquiry, how does a professional manager go about constructing an effective single asset class portfolio? This is important because investors, in their diversified portfolios of various asset classes, will select managers to make specific investments on their behalf. How that manager takes a group of individual investment ideas and combines them into a portfolio that generates the largest possible return for the risk incurred will determine whether or not the investor views their selection of a particular manager favorably.

Constructing an effective single asset class portfolio is a key function in investing and an area to which we have devoted a significant amount of time and contemplation.  We thought it worthwhile to discuss a few thoughts on the matter.

Protecting Against Downside Risk – The Core of Portfolio Management. All active investors want to generate outperformance vs. the market over the long-term (otherwise you would choose passive, index-like funds). Accomplishing this goal is the function of choosing individual investments that can grow capital and avoiding investments that lead to capital losses.

As the Fisher quote we opened with alludes to, incurring losses is perhaps the single greatest inhibitor to delivering long-term investment outperformance. In fact, the simple math of it is, making money is not the hardest part of investing; not losing money is.

As stock markets consistently trend positively over time, there is a decent foundation for some positive investment return. For example, the S&P 500 from 1993-2012 has delivered annualized returns of ~8.2%, even despite the bursting of the Internet Bubble and the global Credit Crisis of 2008. Assuming no active management (i.e., the active selection of specific stocks), stocks have generated a decent rate of return.
But natural cycles of euphoria and fear set the stage for staggering pullbacks in values. Over the same period of time as the average 8.2% return highlighted above, the market saw years in which the S&P 500 fell, 10%, 13%, 23.4% and 38.5%. Adequately weathering these storms is what protects the investor. Because of the toxicity of losses, proper portfolio management must first begin with insulation from losses. We split this task into several key functions: investing with a margin of safety, improving your process to minimize mistakes, diversifying adequately, sizing positions appropriately, and remaining patient.

Our first protection against losses is from investing with a margin of safety. Margin of safety is an investment concept first expounded upon by Ben Graham in his classic The Intelligent Investor, wherein Graham alludes to this as the “central concept of investment.” Margin of safety is the cushion that an investor builds into the evaluation of a stock to provide protection against being wrong. First, we approach margin of safety by looking to buy cheap, unloved stocks. This is the proverbial buying a dollar of value for 50 cents. Even if ultimately it isn’t worth the full dollar, but only 60 cents, the investor’s downside is protected. We call these situations ‘businesses that are in transition.’ By nature, because of their inherent uncertainty and unloved character, these businesses are naturally less popular from the rest of Wall Street (stocks everyone loves are never cheap).

On to these situations, we look to layer an additional margin of safety through a conservative estimate of the earnings power of the business. We approach our analysis of the growth and return prospects of the business with a healthy level of skepticism. Next, we apply a conservative valuation multiple onto our estimation of the earnings potential of the business. Finally, we look to see downside protection in the form of easily monetizable assets, conservatively positioned balance sheets, etc. On the whole, by the time an idea makes it into our portfolio, we work to have constructed a multi-faceted margin of safety.

The second way we protect ourselves against losses is by improving our process to minimize mistakes.

“Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome”
-Robert Rubin

As former Treasury Secretary Rubin emphasizes, it is process, not just outcome that drives long-term success in investment decision making. Working to minimize mistakes in investment decisions is an iterative process. For several years, we have been compiling a check-list of investment mistakes that we and other investors have made. This list forms a core element of our investment process as it pushes us to look in all the dark corners where risk could be hiding. Each step of our investment process is documented and logged to allow us to go back and evaluate the quality of the decisions we made.

The next step of loss mitigation is through adequate diversification of the portfolio. The oft-remarked refrain for some investors is to ‘Have all your eggs in one basket, and then watch that basket!’ While we would agree that concentration is an important driver of returns, the investor must retain a base line level of diversification. The reason for this being that even the greatest of business have missteps along the way. The classic refrain being that of the 6 foot man who died crossing the river that was 5 feet deep on average. Survivability is more important than returns and undue concentration can put that at risk.

A few key studies illustrate that diversification exhibits a declining marginal benefit, meaning there is a point where further diversification (adding additional investments to the portfolio) does little to further insulate the portfolio from risk and only serves to lower returns. Our view (which is supported by the literature) is that portfolios of 15-20 stocks adequately balance the needs for diversification, but maintain the possibility for performance beyond the index.

Our general opinion has always been that at the 40th / 60th/ 100th idea in the portfolio, the idea quality is simply not as good, and even if the idea is a home run, at 1% of total capital, the impact is likely to be muted on the total portfolio.
One additional point to consider on being overly diversified. The average mutual fund holds ~100 positions in their portfolio and averages 80-100% annualized turnover (i.e. sells every stock holding every 9-12 months). With those statistics, the average fund will need to find close to 100 new investment ideas a year to replace positions that are exited. This translates to almost 2 ideas per week! At that pace, we question the depth of research that can actually be done on a position.

Once the portfolio is sufficiently diverse, the task is of sizing. The slicing of the pie amongst competing alternatives not only insulates the portfolio from additional downside risk in the case of a bad investment, but also sets the portfolio up to deliver the greatest possible return. There are several schools of thought on the slicing of the pie. We will summarize each below and offer some thoughts.

1. 10×10 portfolio (“Ten by ten”) – This portfolio is composed of 10 positions that each represent 10% of assets. While there are several extremely smart investors who run similar portfolios, our view is that this is an outsized amount of downside risk (i.e., losing 10% of capital in one investment mistake can be a difficult error to recover from).

2. Strict 20×5 portfolio – This portfolio is relatively formulaic like a 10×10 portfolio, but allocates capital over 20 ideas at 5% size. In this strategy, 5% positions can contribute meaningful performance, but a total loss would have only half the impact as in a 10×10.

3. Flexible 20×5 – While similar to #2 above, some positions may skew larger than 5% for exceptionally high quality ideas, or smaller than 5% for ideas that while compelling may have other risk factors that warrant a smaller overall position size. Our portfolio management approach is more similar to #3. We look to have ~20 ideas, but are comfortable allowing some variance in the number of positions and in the size of each position.

The task of the ‘slicing the pie’ is a combination of both art and science. At a core level, we believe the investor is managing the relationship of upside to downside risk. We are looking to find opportunities where the amount of upside return potential significantly exceeds the downside loss potential. This is governed more broadly by the maximum dollar amount we would be comfortable losing under our bear case scenario vs. the maximum amount we stand to gain in our base/bull cases.

Once we have a general sense of the upside/downside potential for an opportunity, we have built a proprietary model which allows us to adjust our standard position size (5%) upwards or downwards based on things like business quality, valuation, time frame, and catalyst set. The end goal being of course to be largest in our best ideas and smallest in our less-compelling ideas.

The final key to loss minimization is the ability to be patient. Investor psychology what it is, the average investor typically adds capital to the market at the top (when stocks are most expensive/overvalued), and pulls capital out at the bottom (when stocks are cheapest/ most undervalued). Over time, this backwards psychological propensity is what leads the average investor to significantly under-perform the market. A J.P. Morgan study highlights this performance discrepancy: over the past 20 years (1993-2012), the S&P 500 has delivered an average +8.2% annualized rate of return, while the average investor saw a +2.3% (that is not a typo!) average annualized rate of return.

Fund flows, or the level of dollars flowing in and out of certain asset classes, further reinforce this observation of psychology blinding investors. Mutual funds domestically average ~$5 Trillion in assets under management. Equity funds saw investors pulling out capital in 2009, 2010, 2011, 2012 – almost $400 Billion dollars worth! This is despite a stock market that has now rallied almost 173% from its March 2009 nadir.

As Pascal so aptly noted, “All of human unhappiness comes from one single thing: not knowing how to remain at rest in a room.” Our style of investing requires patience, as “businesses in transition” are not home-runs over night. Despite Wall Street’s quarterly expectations game, change occurs over multiple quarters and multiple years. Because we generally avoid technology stocks, most of the businesses we look at typically see low levels of creative destruction. As such, mean reversion is a powerful force in any company, when managed by a strong, appropriately compensated team.

The great temptation of investment (and speculation of any sort) is to focus solely on the upside potential. While I have made money several times on the craps table, the odds are simply stacked against me in the long haul (as my wife is keen to remind me!) The greater challenge is to focus on downside mitigation. We believe this is done through investing with a margin of safety, improving your process to minimize mistakes, diversifying adequately (but not excessively), sizing positions appropriately, and remaining patient.