Portfolio Management - A Few Thoughts about Major Gains and Losses

Preface

A passage from Skin in the Game: Hidden Asymmetries in Daily Life by Nassim Nicholas Taleb caught my interest early one morning.

I personally know rich horrible poor forecasters and poor "'good" forecasters.  Because what matters in life isn't how frequently one is "right" about outcomes, but how much one makes when one is right.  Being wrong, when it  isn't costly, doesn't count - in a way it's similar to the trial-and-error mechanisms of research. 

In an earlier incarnation, I wrote a graduate thesis based on the "analysis of extremes", a method of understanding a phenomenon lacking parameters with a normal distribution of data.  It led to insights that would not have been possible through the use of methods dependent on parametric data.  I wondered if I could apply it to analyzing the performance of my portfolios. 

Instead of looking at annual returns and averages over the longer term (a little more than 10 percent over 20 years without accounting for periodic withdrawals), I looked to discern the sources of major losses and gains.

Here is what I discovered.

1. Major gains in the value of the portfolios were due largely to the outstanding performance of a few investments.
2. Major losses were attributable to a general decline in the market as a whole - not outsized losses due to the poor performance of a few individual investments.

This was eye-opening.  It led me to question previous assumptions about the basics of portfolio management; namely,

• the benefits of diversification in order to distribute risk more evenly
• and correspondingly, the optimum number of holdings in a portfolio (20 to 30 are often cited as being ideal) 
• the dictum of buying and holding through thick and thin (the thesis is that long-term trend in the market, when measured over decades, is always "up")
• the convention that one should limit the size of an individual holding to no more than 5 percent of a portfolio and then "rebalance" 

The academic literature and convention that I had accepted as gospel simply did not hold up in the light of my practical experience.

A few other considerations that may have influenced the review:

• In recent years, the composition of the portfolio has been biased in favour of companies in the early stages of development and other small to medium cap stocks.  
• Since the major portfolio is not tax sheltered, there is a bias to investing for capital gains.  
• The number of holdings has declined steadily.
• In the last two years, my strategy of heeding market cycles may have influenced performance but it's still to soon to determine its impact on performance over the longer term. 

Observations About Major Contributors

For the purpose of this review, I defined "major contributors" as companies which increased in value by at least 250 percent.  I paid no attention to the time period for the gain as at the end of the day, I am only interested in the final size of my stash.  

1.   Catching the Trend - The Strategic Sweet Spot

Virtually all of the major gainers were companies that operated in a strategic sweet spot - a sector experiencing significant growth.

The first major gains were associated with precious metals.  As a result of investing in a few companies and letting gainers run, some portfolios experienced gains of almost 40 percent and 30 percent in two consecutive years.  

The second set of investments which produced major gains were in the oil and gas sector at a time when commodity prices were increasing significantly.  

2.   Portfolio Concentration

During the periods when I invested in "sweet spot" companies, the portfolios were concentrated.  As to the risk associated with this, I reasoned that when things started to go south, I would exit my positions.  I didn't worry too much about trying to time the exits as I had the cushion of healthy profits.  (I remember showing one of the portfolios to a tax expert and he expressed the view that it was "risky" and unorthodox, ignoring the reason that it was brought to his attention because of the gains it had made. )

3.  Innovative Business Models

Many of the companies had innovative business models which gave them a competitive edge.  The foray into Silver Wheaton, one of the first precious metals streaming companies, alerted me to the possibilities of investing in companies with new business models.  Abitibi Royalties is another company with an interesting model - a perpetual lottery based on bets on properties associated with major gold camps.  

4.  Great Balance Sheets

For the most part the companies had sound financials.  Most of the companies had very low or no debt.  Some did not have cash flows from operations in the initial going but were able to secure financing through a variety of means because the business was attractive.  

5.  Patience on my Part

Questor Technologies was a great learning experience.  Following my initial investment, the price declined by more than 50 percent.  However, I had faith in the company's management - truly outstanding - and the state of its finances.  I also felt that the company was in a strategic sweet spot.  I added to my stake as the company achieved various milestones - a lesson that I applied ever since - most recently to CO2 GROW and Abitibi Royalties and Clean Seed Capital.  

6.   The Over-Riding Importance of Great Management with Muddy Boots

All of the major gainers had management with the following characteristics: a strong sense of ethics, mindful of the interests of shareowners, adaptability to meet changing circumstances, and a careful hand to company finances.  

Most important, however, was that leadership was provided by management with the direct experience of managing business activities within the sector - an understanding of how things work and a great network used to get things done efficiently.  Clean fingernails maybe.  Muddy boots always.  

I always checked the pedigrees of management to assess their previous performance.  Surprisingly, many of them came up through the ranks of their sector.  (More on pedigrees later on.)

The profitability of some companies (e.g. Questor) rose significantly when adjustments were made to the business model.  It is a credit to management's agility and its approach to astute risk taking in addressing business challenges.  

7.   Hard Work and a Bit of Luck on My Part

All of the major contributors were found by extensive reading.  Hardly any of the reading involved the financial media.  Instead, I read local and regional newspapers, and trade journals, and the output of a few well-regarded think tanks - this in addition to technical papers in order to gain an understanding of the sector.

Lady Luck played a role ... I'll never know the contribution of LL to the performance of the portfolio.  Always nice to have as a partner.  

Observations About Major Losses

For the purpose of this discussion, I define the category as positions that lost more than 75 percent of their value from the time of purchase.  The one exception is point #4 below.

1.   Management Not up to the Task of Running the Business

One company had on its board, a person who was convicted of doing bad things.  What sort of a company would associate with characters like this?  You are known by the company you keep. How was this reflected in the way the company conducted its business?  A lesson learned.

Another company had a serial failure artist as its leader - a person who managed to move on to the next company by virtue of his connections.  He engaged in questionable business practices and orchestrated things to ensure that he was paid beyond reason ... to the detriment of the company and its shareowners.

Both of the aforementioned companies were led by people without muddy boots - individuals lacking a practical knowledge of the "trade" and the subtleties of competing successfully by delivering meaningful products and services at good prices.

2.   Weak Finances

You cannot run a company on the fumes of lit candles and censers.  The devil is in the details ... in this case .... cash.

Two of the companies ran out of cash and were constrained in their efforts by the difficulty of securing additional funding.  Others were burdened by heavy debt loads which left them vulnerable to the inevitable setbacks that plague all companies from time to time.

3.   Poor Strategic Positioning

I lost almost all of my stake in a few companies in the oil and gas sector in Canada.  I failed to account for the rise of fracking and the lack of capacity to move products to distant refineries.  It was akin to the "boiling frog" syndrome:  external factors gradually exerted more and more influence.  I succumbed to the temptation to downplay them with the thought that "my" companies could adjust.  They didn't - the frog was "done".

It was a lesson learned.  That is why I exited from agricultural machinery manufacturers and distributors over the past two years.  An important fact: farm incomes in the US are about half of what they were in 2013.  No wonder that farmers are reluctant to buy new machinery.

4.   General Downturn in the Market 

This was THE major reason for significant losses.  All holdings, regardless of their merits, headed south in 2008.  It was painful - a combined loss of more than 30 percent.

I resolved to make every effort to avoid this in the future.  As a result, the most recent downturn in 2018 restricted losses to 2 percent across of our portfolios.

I have a special place in my heart for Howard Marks.  Mastering the Market Cycle has pride of place on my bookshelf.  (The row has been winnowed to only five books.)

Contrary to the advice proffered by academics and money managers, my experience has been that it is possible to time the market within reason.  We do it every day.  When it rains, we go inside or put up our umbrellas.  Why should it be any different with investments?  As professional money managers would have it, we should tolerate getting wet in the occasional shower with the rationale that we will eventually dry out ... and they still collect their fees while watching us get soaked or while hanging us out to dry. 

5.   Following the Herd

A few of the losses were generated by investments that I made on the basis of suggestions from others - tips.  In some instances, I did not understand the business or take the time to undertake due diligence.  I relied on the credentials of the source.  Never again.  I prefer to take responsibility for my mistakes and to have a greater chance of learning from them.

Concluding Remarks

1. It is useful to look at portfolio performance with a new perspective - one that goes beyond the usual monthly, yearly outlook.  
2. I was able to detect some identifiable patterns and hope that I will incorporate the lessons learning in future investment activity.