Business

Say It Like It Is – How to Manage Your Family’s Fortune

Generational wealth should be properly structured with trusts[i], but after the money is placed where it should be, I believe that this is how you should approach investing your family’s fortune.

The Mindset

  1. Adopt a capital preservation focus. Preserving capital is the first step towards growing it. A focus on absolute return, not relative return, is key to achieving this goal.
  2. Avoid permanent losses. Define risk as the likelihood of permanent impairment of capital, as opposed to price volatility, and make every effort to avoid large losses so that your wealth can compound at attractive rates over time. The power of compounding wealth is enormous.
  3. Value orientation. Investing with a margin of safety, that is to say invest at a discount to intrinsic value, is key. When valuations are high, don’t underestimate the value of holding cash, despite the short-term drag on performance. Cash gives a host of choices.
  4. Fundamentals count. Finding great businesses at the right price is rare, but when found, you want to own them in size. It is hard to own too much of a great company, except when value unexpectedly drops.
  5. Diversification. Once you achieve wealth, the goal typically is to stay wealthy. Owning an array of assets minimizes the risk of unexpected events damaging your life style and future prospects. Stocks, bonds, cash and real estate are the core four. Within each category, especially stocks, diversify further. However, diversification does not guarantee a profit or protect against a loss.
  6. Ownership orientation. Long-term investors who can withstand interim volatility should maintain an ownership posture. That is to say, buy stocks. Over time, stocks are a better hedge against inflation than bonds and provide a greater opportunity to achieve attractive absolute returns.
  7. Long-term view. Short-term performance is unpredictable. I believe the surest path to generating attractive investment returns is to maintain a long-term focus. This may allow one to patiently wait for the realization of value without being swayed by market volatility. It also reduces unnecessary portfolio turnover, which can detract from returns.
  8. Partnerships and aligned interests. Seek out situations where the principals are invested along-side you and pay the same fees. In my opinion, if it is good for the goose, it should be good for the gander.

Assets You Want to Own

I believe that you should look for companies with all, or most, of the following business and financial attributes:

  1. Essential products and services. It is exciting to buy stock in the next blockbuster drug or disruptive technology company, but they don’t always work out as well as planned. I prefer to recommend companies that sell products and services people need in both good and bad economic times.
  2. Loyal customers. Great companies have loyal customers that are not lured away by a temporarily discounted price. Loyal customers know they will get value.
  3. Leadership in an attractive market niche or industry. Most people do what other people do, assuming the wisdom of crowds. When an industry expands, the leaders often enjoy a disproportionate share, and when it shrinks the smaller players are at greater risk of going out of business.[ii]
  4. Sustainable competitive advantages. Lower costs, better technology, patent protection, as well as reputation for service and quality are all reasons why great franchises have staying power.
  5. High returns on invested capital. Industries that do not require continual capital investments in order to grow are where the greatest earnings compounding opportunities exist[iii].
  6. Strong free cash flow. Companies that can generate high free cash flow have flexibility to make investments to improve service, quality, lower cost and access to capital to make attractive acquisitions.
  7. Great people. In addition, seek to invest in companies whose managers have high levels of integrity, are excellent operators, and are good capital allocators.
  8. When to buy. When a company meets these criteria, establish a position to buy when its market price reaches 75% or less of the normalized, long-term value. As long as the company passes these tests, and is cheap, I think you should own it.
  9. When to sell. This is probably the most difficult question. Since no one can predict which company will become the next Google or Amazon, prudence dictates systematically reducing risk. When a stock significantly exceeds its intrinsic value, or becomes twice the size of the average holding, in my opinion you should sell some.

Should I Just Buy an Index Fund?

Proponents of index funds and exchange traded funds (ETFs) are quick to point out that passively managed portfolios have historically outperformed two thirds of actively managed U.S. equity portfolios[iv]. Given this record, how can you be confident that the approach described above can outperform passive products over a full market cycle?

The answer is fourfold: diversification, valuation, and investment criteria and process. Look closely at the results experienced by index investors and those who do not adhere to a disciplined process.

Index Investing’s Little Secret

Most investors claim to be long-term oriented, but their actual behavior suggests otherwise. Investors tend to pour more money into index funds and ETFs (as well as other equity products) after several years of strong equity performance. Investors then typically lose confidence when markets decline and withdraw capital near market bottoms[v]. Legendary investor Stan Druckenmiller observed a “buy and hold strategy beats trying to time the market because “85% of people do worse than random.”

The problem is people just don’t stick to it.

As a result, the return for the average investor in an index fund has historically been much worse than the published time-weighted returns. Dalbar studies over the last 20 years show the average mutual fund investor earns about 40% of the index. The reality the study shows is most people don’t have the stomach to be responsible for making global economic decisions when the market sells off 20-30%. 

Hedge Funds and Private Equity

Fortunes have been made by concentrating risk, using leverage and being right. However, the explosion in the number of alternative investment options has made it much more difficult than in the past. Keep in mind that most hedge funds close within five years of launch due to poor performance.[vi]

Private equity has the potential advantage of taking a long-term view, improving management and providing guidance as well as capital. This too has become a crowded industry and understanding how returns are calculated takes an advanced math degree. Caveat emptor, or as the wise carpenter says, ‘measure twice before you cut.’

It Takes High Conviction, Steadfastness

In order to capture the higher returns associated with equity investing, investors need to have conviction in their strategy so they can remain invested through the inevitable downturns.

If you have what it takes, do it yourself. If you don’t, hire a firm or an advisor who meets the criteria and will do it for you.

Is this all there is?

Successful investing is not easy. A body of knowledge has been acquired through thousands of interactions with employees, managers, and executives.

Christopher F. Poch

 

Mr. Poch advises private clients and family offices.

christopher.f.poch@morganstanleypwm.com
1850 K St. NW, Suite 900
Washington, DC 20006
w. 202-862-2861
m.202-557-8801

Christopher F. Poch webpage

The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Wealth Management or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results.

This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material may not be suitable for all investors. Morgan Stanley Wealth Management recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

Investing in stock securities involves volatility risk, market risk, business risk, and industry risk. The prices of stocks fluctuate. Volatility risk is the chance that the value of a stock will fall. Market risk is the chance that the prices of all stocks will fall due to conditions in the economic environment. Business risk is the chance that a specific company’s stock will fall because of issues affecting it such as the way the company is managed. Industry risk is the chance that a set of factors particular to an industry group will adversely affect stock prices within the industry.

Alternative investments often are speculative and include a high degree of risk. Investors could lose all or a substantial amount of their investment. Alternative investments are suitable only for eligible, long-term investors who are willing to forgo liquidity and put capital at risk for an indefinite period of time. They may be highly illiquid and can engage in leverage and other speculative practices that may increase the volatility and risk of loss. Alternative Investments typically have higher fees than traditional investments. Investors should carefully review and consider potential risks before investing.

Private equity funds typically invest in securities, instruments, and assets that are not, and are not expected to become, publicly traded and therefore may require a substantial length of time to realize a return or fully liquidate. They typically have high management, performance and placement fees which can lower the returns achieved by investors. They are often speculative and include a high degree of risk. Investors can lose all or a substantial amount of their investment. They may be highly illiquid with significant lock-up periods and no secondary market, can engage in leverage and other speculative practices that may increase volatility and the risk of loss, and may be subject to large investment minimums.

The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Principal value and return of an investment will fluctuate with changes in market conditions.

Investors should carefully consider the investment objectives and risks as well as charges and expenses of exchange traded funds (ETFs) before investing. To obtain a prospectus, contact your Financial Advisor or visit the fund company’s website. The prospectus contains this and other important information about the ETFs. Read the prospectus carefully before investing.

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[i] “Why Rich Kids Don’t Pay Taxes”, Brian Luster, Forbes, February 26, 2014

[ii]Competitive Dynamics And Early Mover Advantages Under Economic Recessions”, Vassolo, Garcia-Sanchez, Mesquita, February 2017, “In light of the recent macroeconomic instability in global markets, we examine the evolution of competitive dynamics and firm profitability when industries are subject to recessions. Although ordinary intuition leads most to view recessions as harmful, we highlight conditions under which they enhance the relative value of industry-level supply-side isolating mechanisms, thereby affording early movers significant and sustainable profit advantages vis-à-vis laggards. We observe that the distribution of firm size within the industry switches from a bi-modal distribution (i.e., one dominated by both small and large firms) to a right-skewed one (i.e., dominated mostly by large firms) in these contexts, thereby signaling the rise of important opportunities in the form of less rivalrous competitive contexts for survivors of recessions. We derive our results from formal modeling and multiple simulation runs.”

[iii] Warren Buffett, Berkshire Hathaway 1992 Shareholder letter “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.”

[iv]66% of fund managers can’t match S&P results

Adam Shell , USA TODAY Published 7:06 a.m. ET March 14, 2016

[v]Why Average Investors Earn Below Average Market Returns: Investor overreactions cause poor historical returns

Retirement Decisions, By Dana Anspach August 28, 2016

[vi]Most hedge funds fail” Financial Times, July 31, 2014, By: Dan McCrum, “Most hedge funds fail: their average life span is about five years. Out of an estimated seventy-two hundred hedge funds in existence at the end of 2010, seven hundred and seventy-five failed or closed in 2011, as did eight hundred and seventy-three in 2012, and nine hundred and four in 2013. This implies that, within three years, around a third of all funds disappeared. The over-all number did not decrease, however, because hope springs eternal, and new funds are constantly being launched.”

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