Value Investing

Wedgewood Partners Q2 Letter: The Spectrum of Conviction

Wedgewood Partners 2nd Quarter 2014 Client Letter – The Spectrum of Conviction

Review and Outlook

Our Composite (net-of-fees) gained approximately +1.5% during the second quarReview and Outlook

Our Composite (net-of-fees) gained approximately +1.5% during the second quarter of 2014. This tiny gain is below both the gain in the Standard & Poor’s 500 Index of +5.2% and the gain of +5.1% in the Russell 1000 Growth Index.

Our worst performers during the second quarter were Coach (-30.6%), Express Scripts (-7.7%) and Perrigo (-5.7%). Our best performers during the quarter were Apple (+21.9%), Schlumberger (+21.4%) and National Oilwell Varco (+18.0%).

The foundation of our investment philosophy is that investing in the stock is most successful when its most business like. Investing through the prism of a “successful business owner” requires the right combination of temperament and behavior. Specifically, success requires, no, demands, the temperament to view booming stock prices as increasing risk and crushing stock price declines as increasing opportunity. Many professional and lay investors profess to possess a contrarian element to their investment behavior and attitude, but far fewer are able to repeatedly execute when the chips of extreme fear or greed are on the table. Furthermore, successful stock market investing requires the preparation and execution of a marathoner, not a sprinter. At Wedgewood we attempt to amplify this “business owner” edge through significantly higher conviction by means of a focused portfolio of just twenty stocks. Such high conviction investing is quite the exception, rather than the norm in the world of institutional investing.

Our “marathon” goal, as it were, is to outperform both the stock market – and our peers – over the course of multiyear investment cycles, and without taking imprudent risk. Lofty goals indeed. Nonetheless, that is our mission at Wedgewood. Critical to our mission ends is the means to which we construct our twenty stock portfolio that by investment process definition must look very different than stock market indices, any related style benchmarks – and the portfolios of our peers. Said another way, the successful focused investor must accept the reality that the return set from a high conviction portfolio will by definition look very different over the sprinted course of a month, quarter, as well as over a year or two. In our view, the most critical attribute of a successful focused investor is not to go wobbly when oneter of 2014. This tiny gain is below both the gain in the Standard & Poor’s 500 Index of +5.2% and the gain of +5.1% in the Russell 1000 Growth Index.

Our worst performers during the second quarter were Coach (COH) (-30.6%), Express Scripts (ESRX) (-7.7%) and Perrigo (PRGO) (-5.7%). Our best performers during the quarter were Apple (AAPL) (+21.9%), Schlumberger (SLB) (+21.4%) and National Oilwell Varco (NOV) (+18.0%).

The foundation of our investment philosophy is that investing in the stock is most successful when its most business like. Investing through the prism of a “successful business owner” requires the right combination of temperament and behavior. Specifically, success requires, no, demands, the temperament to view booming stock prices as increasing risk and crushing stock price declines as increasing opportunity. Many professional and lay investors profess to possess a contrarian element to their investment behavior and attitude, but far fewer are able to repeatedly execute when the chips of extreme fear or greed are on the table. Furthermore, successful stock market investing requires the preparation and execution of a marathoner, not a sprinter. At Wedgewood Partners we attempt to amplify this “business owner” edge through significantly higher conviction by means of a focused portfolio of just twenty stocks. Such high conviction investing is quite the exception, rather than the norm in the world of institutional investing.

Our “marathon” goal, as it were, is to outperform both the stock market – and our peers – over the course of multiyear investment cycles, and without taking imprudent risk. Lofty goals indeed. Nonetheless, that is our mission at Wedgewood. Critical to our mission ends is the means to which we construct our twenty stock portfolio that by investment process definition must look very different than stock market indices, any related style benchmarks – and the portfolios of our peers. Said another way, the successful focused investor must accept the reality that the return set from a high conviction portfolio will by definition look very different over the sprinted course of a month, quarter, as well as over a year or two.

…………………………..

John Templeton once said that if your portfolio looks like everyone else’s, your returns also will look the same. The great (and I truly mean great) value investor Howard Marks of Oaktree Capital puts it somewhat differently but equally succinctly. Here I am paraphrasing but, if you want to make outsized returns than you have to construct a portfolio that is different than that held by most other investors. Sounds easy right?

 

But think about it. In large investment organizations, unconventional behavior is generally not rewarded. If anything, the distinction between the investors and the consultant intermediaries increasingly becomes blurred in terms of who really is the client to whom the fiduciary obligation is owed. Unconventional thinking loses out to job security. It may be sugar coated in terms of the wording you hear, with all the wonderful catch phrases about increased diversification, focus on generating a higher alpha with less beta, avoiding dispersion of investment results across accounts, etc., etc.

 

But the reality is that if 90% of the client assets were invested in an idea that went to zero or the equivalent of zero and 10% of them did not because the idea was avoided by some portfolio 

managers, the ongoing discussion in that organization will not be about lessons learned relative to the investment mistake. Rather it will be about the management and organizational problems caused by the 10% managers not being “team players.”

 

The motto of the Special Air Service in Great Britain is, “He who dares, wins.” And once you spend some time around those people, you understand that the organization did not mold that behavior into them, but rather they were born with it and found the right place where they could use those talents (and the organization gave them a home) . Superior long-term investment performance requires similar willingness to assess and take risks, and to be different than the consensus. It requires a willingness to be different, and a willingness to be uncomfortable with your investments. That requires both a certain type of portfolio manager, as well as a certain type of investor.

 

I have written before about some of the post-2008 changes we have seen in portfolio management behavior, such as limiting position sizes to a certain number of days trading volume, and increasing the number of securities held in a portfolio (sixty really is not concentrated, no matter what the propaganda from marketing says). But by the same token, many investors will not be comfortable with a very different portfolio. They will also not be comfortable investing when the market is declining. And they will definitely not be comfortable with short-term underperformance by a manager, even when the long-term record trashes the indices.

 

From that perspective, I again say that if you as an investor can’t sleep at night with funds off the beaten path or if you don’t want to do the work to monitor funds off the beaten path, then focus your attention on asset-allocation, risk and time horizon, and construct a portfolio of low-cost index funds.

 

At least you will sleep at night knowing that over time you will earn market returns. But if you know yourself, and can tolerate being different – than look for the managers where the portfolio is truly different, with the potential returns that are different.

 

But don’t think that any of this is easy. To quote Charlie Munger, “It’s not supposed to be easy. Anyone who finds it easy is stupid.” You have to be prepared to make mistakes, in both making investments and assessing managers. You also have to be willing to look different than the consensus. One other thing you have to be willing to do, especially in mutual fund investing, is look away from the larger fund organizations for your investment choices (with the exception of index funds, where size will drive down costs) for by their very nature, they will not attract and retain the kind of talent that will give you outlier returns (and as we are seeing with one large European-owned organization, the parent may not be astute enough to know when decay has set in).

 

Finally, you have to be in a position to be patient when you are wrong, and not be forced to sell, either by reason of not having a long-term view or long-term resources, or in the case of a manager, not having the ability to weather redemptions while maintaining organizational and institutional support for the philosophy.

wedgewood partners second quarter 2014 client letter HERE

Via Wedgewood partners

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