Below are some portfolio management highlights from a recent interview (July 2013) with Bob Rodriguez and Dennis Bryan of First Pacific Advisors in Value Investor Insight. Especially intriguing is Bob’s description of his ongoing experiment related to the effects of diversification on portfolio returns.
Diversification, Sizing, Volatility
“Your portfolio today has fewer than 30 positions. Is that typical?
DB: Generally speaking, we have 20 to 40 positions, with 40-50% of the portfolio in the top ten. That level of concentration is simply a function of wanting every position to potentially be a difference maker. Philosophically we would have no problem with concentrating even more, but clients often have a problem with the volatility that comes with having fewer holdings.
RR: I actually have an experiment going on this front since June 30, 1984. I have an IRA account that was set up then and over that period has only been invested in stocks that the Capital Fund has owned, but with never more than five holdings at a time. I’ll buy a stock only after the fund buys it and sell only after the fund sells it. From June 30, 1984 to December 31, 2009, when I stepped down from lead management, the Capital Fund had compounded at approximately 15% per year. But this IRA account had a compound rate of return of 24%. I attribute that premium to the higher concentration and to the fact that at no point has this account been affected by the inflows and outflows resulting from others’ emotional decision making. I was the only investor.”
Turnover
“Does the effort to avoid emotional decision-making explain the Capital Fund’s relatively low turnover?
RR: The turnover ratio has averaged 20% since 1986. Part of that is a function of investing with a long time horizon in companies that don’t get better or realize hidden value overnight. Sticking with your conviction in such cases can certainly require patience and discipline that many investors might not have. Low turnover is also related to the fact that we’re slow to transition from companies we own and know intimately to those whose stocks we’re looking to buy and don’t know as well. There’s a transition risk there that we usually address by taking a long time to both scale into something as well as to scale out of it.”
Cash, Liquidity
“Right now we believe the stimulus of lower interest rates has propped up the economy, which props up profits, which props up stock prices. So in our modeling work we’re not taking today as “normal” and going from there. We’re building in the potential impact of interest rates rising, say, and the resulting lower level of economic activity. That type of conservatism in setting our intrinsic values explains why we have 30% of the portfolio today in cash.
RR: You don’t know the value of liquidity until you need it and don’t have it. That’s when people are selling what they can, not what they want to…People today say, “I can’t afford to earn zero return on my cash.” But if you’re a contrarian value investor, you should be used to deploying capital into an area that no one loves and where the consensus can’t understand why anyone in his or her right mind would invest. I would argue that is how people are thinking about holding cash today, which makes us glad we have it.”