Targeting the Exact Exposure…

Investment Selection is the choice of the right security or fund to best use to take a particular exposure to the targeted risk, or asset.

The decision to take a particular risk or market exposure should be done FIRST (hence the position of asset allocation in the investment process) and the choice of investment to take that exposure comes SECOND.

This does not make it any less of a decision but many investors see an investment that they like and buy it without assessing the impact of that product and how it can enhance the whole portfolio.  Some portfolios end up like a bucket of unrelated assets, which loses the very power of Portfolio Construction.

The narrower an investor focuses on a particular investment specialisation, the more he can focus on bottom-up investment selection, rather than asset allocation and portfolio construction.  If you are investing in Asian equities, stock selection is likely to be your main differentiator.   Investment Selection is the bottom-up part of the process.  Even completely bottom-up investment philosophies still have an element of top-down allocation and construction embedded in their investment process.

At Port Shelter, we look at the whole investment spectrum and our investment comments are in essence a combination of top-down and bottom-up, seeking the best of breed in both areas in order to construct our portfolio.  In that case asset allocation and portfolio construction, the more top-down parts of the Investment Process are more dominant factors in determining overall performance.

The Investment Selection process is perhaps the most interesting and intellectual part of Investment Management.  The ability to choose just the right investment / company after due research is most rewarding partly because it is close to people and the real economy.  The process used to be one of simple bond and stock selection but in recent years the emergence of strategies and slightly more formalisation in the private equity arena have led to a plethora of funds.   A new generation of fund selection professionals have grown up becoming an increasingly important part of investment management, although too few of those professionals have ever traded a share in anger.

Many investors believe that Investment Selection is the main part of the investment process.  It is not; but diligent investment research should add a good component of excess return to your portfolio.

Selection mantras

Research is fundamental to the Investment Selection process.  We very much like research as that is the way that our imperfect knowledge can get al little better.  Research is hard as it is not work or time dependent – smart research is better than hard research and well-interpreted research is the best.  Research adds conviction to our investment decisions.

The answer does not lie in front of a Bloomberg screen, it lies in the FIELD.  All those engineers who taught me that the answer lies in the field and not in the office taught me something.  The answers lie in reading widely, in walking around with your eyes open, in visiting companies and talking to management, in speaking to friends or contacts at cocktail parties or in taking an interest in what your kids are excited in.  That is true, empirical, grass roots research which needs to be interpreted with an open and cynical mind.

Our research and selection philosophy is dependent on a number of investment mantras which we have observed in the marketplace.

For equities, our natural inclination is to go for growth – Growth at Reasonable Risk.  This targets companies with good product lines in strong areas of demand, which tends to shade the cyclical side of the growth spectrum. Value companies are also of interest if they fit the growth tilt, but not if they are ex-growth.  Growth is so important because growth leads to added value – which is why we invest.

As noted above, we start with the market sector but of course other key factors are the corporate business model, the quality of management, competition, balance sheet strength.  This kind of analysis relates not only to listed but also unlisted investment analysis.   There are a myriad of lesser factors any of which might be individually significant in any particular case, which is why for successful investment selection, detailed and honest research and due diligence is critical.

On the fund side, the criteria for review are likewise endless but the mantras here are a clearly articulated investment philosophy, a disciplined research process, explanations for the inevitable spikes or dips in performance, the likelihood of ‘investment style drift’ and the quality and tenure of the investment team.

If past performance looks too good, it always is. Past Performance is no guide to future Performance – although it can write off investments, it should never write them in. .  This mantra is perhaps the most forgotten during times of greed.   Anyone offering to provide over 15% per annum on a sustainable basis is clearly worth considerable due diligence – and still don’t believe it.   There is no doubt that some investments can produce double digits more than three years in a row but without leverage, inflation and until fees start coming down for alternative investments, few investments are going to make more than single digits for the next few years on a multi-annum basis. Except perhaps old fashioned, boring and low cost long-only equities…..?

Performance will disappear and fade no matter how long it has gone on for.  No one is that good – they usually have a good sector or have latched onto a new strategy before everybody else ruins it.   It is best to take the view that all investment managers have feet of clay and will one day fail you.  Markets change, managers change; the same manager changes over time.   But some managers are very clever over periods of time that may be lengthy ( five years or more), often in a market niche.  The mistake most investors make is to become over-exposed to just the one manager.

It is a combination of asset allocation, based on study of macro-economic factors, and the investment selection approach that seeks to understands managers, which defines quite how good they really are .   In general be very afraid of performance as a sole indicator of skill and regard it as more of a trend of how lucky they are at present.  For an investment manager it is better to be lucky than to be good.  Nothing works forever.

What is important is the Investment Philosophy, the consistency of the Investment Process and the likely repeatability of results. We NEVER chase historical performance or “Alpha”,which can disappear like the snow in springtime.

More lessons

Recent experience has led to some further lessons in understanding individual investments:

Sectors and strategies always rotate so that if one particular company or investment strategy has a good run they will inevitably disappoint at some time. There have been extraordinary stories of success – Reckitt and Coleman’s positive 20 years earnings record was enviable in its time. However eventually all good things come to an end.

Successful investments draw in capital and eventually the weight of capital will finally subsume the investment opportunity.  This is the principle of the efficient market.  But markets overshoot and undershoot and can be inefficient over long and variable periods of time.  This is when skill in investment timing comes in.  Sometimes you have to suspend disbelief and at other times be brutal.

Run the winners and cut the losers. The tendency is for most investors to do the opposite.

Their careers always end in failure …. Fund Managers, politicians and football managers share this one thing. Be careful being too faithful. Never trust a manager past your level of credibility, cynicism or naivety. If you don’t understand the investment or it can not be clearly explained then stay away. If you don’t get good, clear answers to your questions, stay away. Madoff would not give clear answers about his investment process, stay away.

Don’t confuse cyclical with secular returns. The flurry of new instruments, derivative combinations and strategies have produced some excellent investment returns over the last few years, well in excess of those of traditional assets. Many of these investments have deeply disappointed over late 2008 as their bull market strategies were exposed by falling markets. Investors should always remember that Return is always associated with Risk.

Over the last 10 years, alternative assets have outperformed traditional assets by some margin.  Special factors such as lack of competition, good investment background and above all the liberal use of borrowings, other people’s money, allowed the new, alternative assets to outperform their ‘normalised’ return envelopes.  We are now seeing the returns move back in line with the returns that they would have otherwise have delivered.

It is therefore impossible to detrimentally compare hedge funds and private equity against traditional investments.  Private equity is highly leveraged  if you did that with equity returns, the returns would be more comparable. Hedge fund composite returns have been in decline for four or five years now and although they have outperformed equities, equities will soon right themselves .  Hedge funds are lower volatility and lower return assets.  Equities are higher risk higher return.  Equities will always provide higher returns – but at the cost of higher volatility.

Traditional assets have followed more of a long-term return profile. Stock markets have been learning from crises like 2008 for over 200 years and many of the basic schoolboy errors made by the alternatives have been avoided by traditional investors.  As the new investments become more regulated and become more comparable in terms of leverage and competitions, returns will normalise more into line and with perceived risk levels.  In that case returns will increase from bonds to hedge funds to equities to private equities, each asset being a good investment within its own risk parameters and each should for m a part of a broad diversified portfolio.

Finally management selection is a numbers game.  The more investments that you look at and review, the more good investments you are likely to find.

Investment Mantras

Various gurus have presented rules of investment that are worth reproducing here, such as:

Sir John Templeton, Founder of Templeton Investment Management, and said to be one of the three greatest investors of the twentieth century.

Dennis Gartman, no title but Founder of the eponymous newsletter [www.thegartmanletter.com]

David Judice, Managing Director of the Consulting Group, part of Citi and one of the best Manager Research specialists in the business

And, of course: Richard Harris, Founder of Port Shelter – your source for safe haven investment ideas

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