Lumpy, In a Good Way…
Framing expectations is essential to life. Strong relationships are built upon a foundation of understanding what to expect from the other party. Whether business related or personal, this holds true as negative surprises are unwanted. While we spend a lot of time with prospective clients talking about our philosophy, process and individual holdings, we probably don’t spend enough time talking about what an investor should expect from our strategy.
We have a friend who asks “are you beating the S&P 500?” whenever he sees us. He is a bit of a do-it-yourselfer and has been trained by investing magazines to believe all managers are focused on this benchmark. It would be a valid question if our objective were to “beat the S&P 500”, but it’s not. The objective at Linde Hansen is to build wealth. We seek to accomplish this by achieving returns ten percentage points in excess of the rate of inflation through investing in common stocks. In this context we don’t really see how beating the S&P 500, or any broadly recognized benchmark, is pertinent to achieving our goal.
Unfortunately, the business strategy of many money managers has evolved to just “beat the market”. Managers that have done well versus a benchmark are likely to attract assets when asset allocators seek to increase their exposure to equities. So, in the quest to grow, many have adopted highly benchmark sensitive strategies and become “portfolio constructionists”. They own many names and weight positions close to that of the benchmark with the goal of beating the benchmark by a small amount but, above all, never straying too far from it. Whether the customer makes money or loses money is irrelevant as the focus is on relative performance.
We have never invested in the manner described above. We have built our portfolios one position at a time based upon the underlying merits of the individual company. And, our portfolios have been more concentrated than most. Nevertheless, despite having the fortitude to stick to our strategy, we do feel the pain when we trail the performance of the benchmarks and our peers. But a meeting with a client several years back helped put it all in perspective.
We were managing our strategy as a sub-advisor for a large and sophisticated insurance company. Despite being up for the year we were underperforming the chosen benchmark and their analysts were grilling us pretty hard, challenging our process and wondering what changes we would be making. After a thorough review during which we remained committed to our process we were surprised when one analyst said something to the effect of “OK, good, we just wanted to be sure you were sticking to your strategy. Given your process and style we expect your returns to be LUMPY “.
Ah ha! We are lumpy! They fully understood what we were trying to achieve. Since we don’t manage to the benchmark, the portfolio is concentrated and the returns for the portfolio are driven disproportionately by the success the companies we own, it makes sense that our return profile should be lumpy. It fit like a glove.
Our lumpiness comes from our process. Many of the companies we buy are beaten-up, low expectation situations that are often out of sync with the market. They become attractively valued because their profitability is depressed and few believe they can recover. But when signs of improvement materialize the stock price can recover very rapidly. The road to salvation for these companies is never straight and often bumpy. These stocks can and will react meaningfully to both good and bad news.
So we now tell prospective clients to expect our returns to be lumpy. There will be periods where we look like geniuses and periods where we look not so smart. If our batting average is solid we believe we will achieve our return objectives over time. On a rolling three year basis, we expect there will be two unremarkable years joined by one exceptional year but we can’t time or forecast when they will fall. So, if you understand our strategy and are aligned with our philosophy you should expect our returns to be lumpy…in a good way.
The material provided herein has been provided by Linde Hansen & Co. and is for informational purposes only. Linde Hansen & Co. serves as investment adviser to one or more mutual funds distributed through Northern Lights Distributors, LLC member FINRA. Northern Lights Distributors, LLC and Linde Hansen & Co. are not affiliated entities. 1336-NLD-06/06/2013This entry was posted in Contrarian Thoughts. Bookmark the permalink.