‘Safety-First’ Investing and Capital Allocation
Concentration and Portfolio Management
One of the most common mistakes I have seen in the investment industry is betting big on risky investments. Whilst this is quite fine if you are in your 20’s and have decades of future savings ahead of you, the older you get, the less time you have to make up for your mistakes.
Many have used the Kelly formula concept without really thinking about the permanence of the capital.
If you add in the complication of capital additions and withdrawals, the maths for the Kelly formula should change.
If you have permanent capital, then I think that the Kelly formula works. If you are adding to your savings over a very long period of time, then I think the Kelly formula is perhaps not aggressive enough!
The converse is true. If you have fickle capital, then the Kelly formula simply doesn’t make sense as large drawdowns on your portfolio will further complicate decisions as capital will be withdrawn during the inevitable weak periods involved with concentrated bets. You become forced to sell at lower prices. Add in illiquidity and you have a one-way ticket to the fund graveyard.
If you have a need to draw down from your capital, such as retirement needs, then the Kelly formula is not appropriate.
In the investment industry, there is often a disconnect between investment managers and the end clients, which are often retirees. Retirees have less ability to handle large drawdowns.
The Core Satellite Approach
A common approach to reduce risk is to use diversification. Many advisers use a core satellite approach where they have index funds as the core and add in some stocks or funds for some hopeful alpha.
In a world where everything is overpriced, does diversification work like it did in previous generations? If most assets are returning -1% to 3% a year, diversification probably won’t work that well if you need 5% net returns to live. If many of the global markets trade at 3 times the price of where they have been during periods of weakness in the past, then diversification may not help.
Others use unlisted assets to attempt to manage volatility. The main issue we have with unlisted assets is the transparency is very limited and leverage is often higher than what we are comfortable with. In a rising rate environment (something that hasn’t happened in many decades) are these vehicles able to maintain their returns? Are elevated prices for these assets riskier than their short-term volatility suggests? Are managers marking assets to reality? Has Brisbane Airport been marked properly to its fair value during Covid-19? Are new investors coming in at elevated valuations?
We live in a low return world where the future average portfolio return will likely be well below averages of the past. Doing what everyone else is doing probably won’t get most clients acceptable returns. This leads to the likely need for some concentration in assets which are either significantly better value or significantly better quality, or both. The question then becomes, how do you manage this concentration in a rational manner that doesn’t materially increase the probability of permanent loss?
Our Core Satellite Approach
Our Core Positions
Valor has developed a unique “Safety-First” investment philosophy. This philosophy is derived from the aviation principles. Aviation is the safest form of transport due to a philosophy that puts safety before anything else. This concept is foreign to most investment professionals who regularly commit unsafe acts in markets on a daily basis.
At the core of these principles is the certainty levels of different investments. The idea that Coke has a less risky business than a car company is not a difficult one to conceptualise. Coke sells cans of coke. A car company needs to almost reinvent the wheel every 3 years to remain relevant. The certainty levels over a 10-year period are far higher for Coke than a car company.
Valor ranks our investments with a certainty rating. We call it the “Safety Ranking List”. When we know with near absolute certainty that a company will sell more of what it does at higher prices in 10 to 20 years, the company moves up the list. The list changes at a glacial pace. The best companies in the world when rated by certainty are very close to the best companies on the list from 10 years ago. A few have moved up the list such as Amazon, Microsoft, Facebook and Alphabet, however Berkshire, Coke, Pepsi, McDonalds and Costco haven’t changed in many years.
Valor believes that you can concentrate far more into companies that are “safer” using our certainty comparison tool.
A second, yet equally important consideration of concentration is the balance sheet of a company. Some companies are far riskier than others due to their balance sheet. McDonalds may be one of the safest businesses in the world, but if they keep borrowing to pay dividends and share buybacks, then their safety degrades. This would move them down the list.
Valor has a capital independent investment philosophy. A company that is extremely unlikely to be forced to raise capital under duress is our preferred investment style. Berkshire with $138.9 Billion in cash is far safer than a company with debt. You can concentrate more in a capital independent company.
Thirdly, the fundamentals of the business are critical. The return on the businesses equity and the ability to reinvest capital are enormous considerations for safety. Higher growth and a long runway for this growth can actually build safety into an operation. A company that is growing at 20% per annum and is likely to continue doing so for many years can grow out of a number of mistakes. Whether you paid $300 or $350 a share for Alphabet all those years ago is less important due to its growth over the many years.
The slower the growth of the company, the more important valuation becomes.
Obviously, the management need to be outstanding for a company to be considered safe. Even great companies can be destroyed by terrible management.
Our Satellite Positions
At the other end of the spectrum are the riskier, yet likely higher returning businesses. You are highly unlikely to triple your money on Berkshire in a short period, however buying smaller risker businesses you can have significantly higher returns. We made 1350% return buying Magellan Financial Group. This is not a stock you can put large amounts of your portfolio in, however a 1% or 2% position is fine. A few dozen of these positions and you will likely do fine on average. Due to the asymmetric upside versus downside of stocks (you can make many times your money, yet the most you can lose is 100%), some allocation to these positions is rational.
Less certainty requires significant diversification.
Valor is also highly aware of previous periods of global history where markets have taken decades to return to previous highs. Thus, we have a few satellite positions that are likely to be fine under most conditions, yet provide asymmetric returns under difficult conditions protecting our clients from multi-decade market drawdowns. We own a few small positions in gold stocks for this reason. The current levels of global debt, particularly Chinese corporate debt and Australian household debt, zero to negative rates with structurally flawed fiscal and banking systems in Europe could lead to outcomes that are far worse than most expect. We believe having a few very small satellite positions in a portfolio to protect against this is not irrational.
Where most go wrong is concentrating into companies that should only ever be satellite positions.
Key Take Away
Be wary of managers that concentrate capital in open ended structures. Be further worried if a manager concentrates capital in an open-ended structure in companies that are not “safe” (high certainty and capital independent).
It is not uncommon to see managers with 7- 15% of their fund in a company like AfterPay or Tesla. They may be right and be praised for their gamble. We view these types of risky bets as irresponsible and are more likely to cause effects such as the Valeant debacle at some point in time. Whilst cowboy managers in high flying stocks may temporarily receive praise for their guesses, if you analyse the risks they are taking, they are acting like untrained crop dusting pilots flying past telegraph poles at 10 feet.