Portfolio Turnover – A Vastly Misunderstood Concept by John Huber, Base Hit Investing
A while back I wrote a post about how the gap between 52 week high and low prices presents an opportunity for investors in public markets.
I mentioned that this simple observation (the huge gap between yearly highs and lows) is all the evidence you need to debunk the theory that markets are efficiently priced all the time. I think the market generally does a good job at valuing companies within a range of reasonableness, but there is absolutely no way that the intrinsic values of these multibillion dollar organizations fluctuate by 50%, 80%, 120%, 150% or more during the span of just 52 weeks.
The market is constantly serving up opportunities. I just checked a screener and there are 375 stocks in the US that are 50% higher than they were 1 year ago today.
This leads me to a thought that I think, for some reason, is not really discussed in investing circles—at least not in value investing circles: and that is the concept of portfolio “turnover”.
To think about portfolio turnover, let’s first take a look at a concept that security analysts and value investors think about more often: asset turnover.
Asset turnover basically measures how efficient a company is at using the resources it has to generate revenue. It’s simply a company’s revenue in a given period divided by its assets. Generally speaking, asset turnover is a good thing—the higher the better. If two companies have the same asset base, the company with the higher level of sales is doing a better job at employing those assets.
Coke and Pepsi are somewhat similar businesses, but it isn’t necessary to compare their business models when it comes to understanding the math of turnover. Just look at how Coke’s profit margins are almost double the margins at Pepsi, but Pepsi is about equally profitable (produces similar returns on assets) because Pepsi is more efficient than Coke is at using the assets it has.
Let’s glance at two homebuilders:
NVR has a different business model than Lennar as it uses less capital (it employs a smaller asset base). This allows NVR to be almost three times more efficient with its resources than Lennar, and although Lennar has a higher profit margin, NVR produced a much better return on assets.
We can compare two businesses in different industries to see how their business models and operating results affect their profitability:
Coke and Whole Foods produce roughly the same ROA, but got there in very different ways… Coke has very high profit margins but takes nearly 2 years to produce $1 of revenue for every $1 of assets. Meanwhile, Whole Foods’ profit margin is less than 1/4th the size of Coke’s, but it turns over its asset base nearly 5 times faster, yielding roughly the same return on the resources it has to deploy.
These examples aren’t to say one business or one measurement is better than the other–it’s really just to point out the importance of turnover.
Inventory turnover is a similar ratio. A grocery store is a very low margin business, but in some cases grocers can produce adequate (or sometimes better than adequate) returns on capital if they are able to turn their inventory (merchandise on the shelves) faster than competitors. Two competitors with identically low profit margins might have vastly different profitability because one grocer might be producing much higher ROA due to its ability to turn its inventory over faster.
So in business, it is clear that asset turnover (and inventory turnover) is a good thing. The higher the turnover, the higher the returns.
I once mentioned I have put together notes on investors who have achieved exceptional (20-30% annual returns or better) over a long period of time (say 10-15 years minimum). There are a variety of strategies and tactics employed, but there are a few common denominators. In addition to the expected commonalities (most are value investors), there is one common denominator that isn’t talked about much: portfolio turnover.
Portfolio turnover is a phrase that I’m using—I don’t like using phrases and words that you might find in a CFA textbook, but this is the easiest way to refer to the concept. Basically, think of portfolio turnover as asset turnover.
The capital you have in your account might consists of stocks, bonds, cash, etc… these are your assets. The faster you turn these assets over (at any given level of profit), the better.
It’s simple math. I think a lot of value investors get hung up on the Buffett 3.0 version. Let Seth Klarman explain this… Klarman once said that Buffett’s career has evolved a few different times and can be categorized generally as follows:
- Stage 1: Classic Graham and Dodd deep value and arbitrage (special situations)
- Stage 2: Great businesses at really cheap prices (think American Express after Salad Oil Scandal, Washington Post, Disney—the first time at 10 times earnings in the 60’s)
- Stage 3: Great businesses at so-so prices
Now, if we look at Buffett’s results, even lately, some might take issue with Klarman calling them “so-so” prices. But nevertheless, I think Klarman is basically correct in his assessment of Buffett’s career, and I actually think Buffett himself would agree with this. As Buffett’s capital base expanded, he had to begin to begrudgingly adjust the investment hurdle rate that he required. He mentions this in his 1992 letter to shareholders, replacing his demand for “a very attractive price” with simply “an attractive price”.
This description by Klarman took place during an interview with Charlie Rose, and Klarman jokes that he (Klarman) is still in Stage 1, scavenging for bargains. What’s interesting about this comment, is Klarman has been able to produce really solid returns on a very large amount of capital, and I think it’s in large part because of the simple math of asset turnover—Klarman buys bargains, waits for them to be valued at a more reasonable level, sells them, and repeats.
Walter Schloss was another master at turning over his portfolio that was filled with bargains. Schloss actually ran his portfolio like a grocery store. I’d say on balance, his stocks produced relative small profits (I’d venture Schloss had many 20-50% gainers, but very few 5-10 baggers), but collectively, he produced 20% annual returns for nearly 50 years because he was able to adequately turn over his “inventory” (i.e. his stocks) fast enough. This isn’t to say that you have to look for activity, or actively trade—Schloss said he kept his stocks an average of 3-4 years. But it just means that he would not have produced anywhere near the results he did if he held his stocks “forever”, or for 10 years instead of 4, etc…
Walter Schloss was akin to the low margin grocery store that didn’t produce exciting margins on any one product, but collectively across the store it was able to effectively turn over the merchandise fast enough to make exceptional returns on the assets it employed.
Some other investors might be more akin to