Lisa Rapuano Interview Highlights - Part 3

Part 3 of highlights from an insightful interview with Lisa Rapuano, who worked with Bill Miller for many years, and currently runs Lane Five Capital Management. Selectivity, Hurdle Rate, Opportunity Cost, Sizing

“We do not own many stocks, and anything we buy has to improve the overall portfolio and/or be better than something else we already own…I’ll go into portfolio construction in a bit, but the short answer here is that it has to be better than something we already own, or improve the overall risk profile of the portfolio to make it in.”

“The actual position sizing we choose will be based on…the return profile of the name relative to other things in the portfolio as well as on an absolute basis…”

There are a few concepts here – selectivity, opportunity cost, and hurdle rate – all interrelated in the delicate web that is portfolio management.

Selectivity – not all investments reviewed makes it into the portfolio. They are judged against existing positions and other potential candidates.

Opportunity Cost – should I put capital into this idea? How much capital? If I do this, what is the cost of foregoing future opportunities? Calculating this “cost” is a whole other can of worms. See what other investors have to say about opportunity cost. Jim Leitner has some especially interesting thoughts.

Hurdle Rate – based on the quotes above, the hurdle rate could be a return figure or a risk-related figure since whether or not an idea makes it into the portfolio is dependent upon its merits compared to the expected returns and risk of existing portfolio positions.

Curiously, does this mean that an investor’s hurdle rate can be extracted from the expected return profile of his/her current portfolio? In the spirit of bursting gaskets, how then does this “hurdle rate” figure reconcile with the “discount rate” concept that’s frequently used by investors to value companies?

When To Buy, Sizing

“Value investors like I am are usually a bit too early, both on the buy and the sell side. It’s just part of our process…we’ll be buying long before any catalyst is evident (and thus discounted)…we try to mitigate the impact of being early on the buy side, just by recognizing who may be selling…and controlling our position sizing so that as the stock continues to fall we can confidently buy more.”

Important concept: the relationship between sizing decisions and ability/willingness to buy more if the price of a security continues to decline.

When To Sell

“On the sell side, we learned long ago that holding on to terrific businesses a bit longer than our original value might have indicated is usually a good idea. That being said, there are not that many truly terrific businesses, so most should be sold as they approach value.”

Creativity

“Our philosophy remains static but we pride ourselves on being adaptive in process and tactics.”

“…one of our Core Values at Lane Five is to Adapt and Evolve Actively. The tools change and people get smarter and information flows more quickly. To maintain a competitive advantage we have to evolve ahead of the market.”

Lisa Rapuano Interview Highlights - Part 2

Part 2 of highlights from an insightful interview with Lisa Rapuano, who worked with Bill Miller for many years, and currently runs Lane Five Capital Management. The interview touches upon a number of relevant portfolio management topics. Rapuano has obviously spent hours reflecting and contemplating these topics. A worthwhile read!

Fee Structure

“…I launched my fund [November 2006] with an innovative fee structure – wait three years and then charge only on the positive return over the market…three-year lock up…given the changes in the marketplace we simply did not think a three-year lock-up was a tenable proposition under any circumstances. So…we had to abandon our three-year free structure as well…What I was extraordinary surprised by however, was how little this mattered to many potential investors. There is an institutional imperative that has evolved in hedge funds that is very similar to that which has evolved in long-only funds. Being different, no matter how right it may be, doesn’t help.”

Given my family office background, the fee structure topic has come up frequently especially as it relates to fundraising. One would think that fee discounts should garner more investor interest. Unfortunately, my advice is the same as Rapuano’s: “being different, no matter how right it may be, doesn’t help.”

The average retail investor is usually not sophisticated enough to care about the difference between 1% (management fee) & 15% (incentive fee) versus 2% & 20%. The average institutional investor is merely going through the motions of checking boxes with a “cover your behind” mentality before presenting to committee. So with the exception of sophisticated investors (fewer in number than the unsophisticated), the fee discount really doesn’t make much difference.

In fact, it could potentially hurt fundraising because it begs the additional question: why are you different? With only 60 minutes or so per meeting, it’s likely best to not waste time having to answer this additional question.

Shorting, Team Management, Exposure

“On the short side, we only short for alpha – we do not use shorts to control exposure explicitly or to hedge or control monthly volatility…This model has been chosen very specifically to suit the skills of me and my team. We think being able to short makes us better analysts, it keeps us more honest.”

“We also like the flexibility to hold a lot of cash or be a bit more short when we think there are no great values lying around…we think eliminating the pressure to stay low-exposure (and to therefore often put on very poor shorts) is a good match for our style…”

Rapuano highlights a very important distinction: shorting for alpha vs. shorting to control exposure. I would add a third category: shorting to justify the incentive fee.

Also, it’s an interesting idea to build an investment process that works with the behavioral tendencies of the investment team. I guess the flip-side is to recruit for talent that fits a specific type of investment process.

Making Mistakes, Process Over Outcome

“Then there are the mistake where you just misjudged the situation in your analysis…I thought something was low probability but then it happens…we analyze these types of mistakes, but it’s not a focus on what happened, but simply to make sure we did all the work we could have been expected to do, our judgments were based on sound analysis, and well, sometimes you’re just wrong. There are other mistakes, however, that you can try to eliminate, or at least not repeat.”

“For me, my worst ones have been when I strayed from either my core values or my process. So, when we’ve done something as a ‘trade’ (it just seemed too easy) and not subjected it to the rigors of the process it usually doesn’t work out.”

Mistakes are not just situations when the outcomes are bad (i.e., ideas don’t work out). Do we make a mistake each time we stray from our investment process?

Lisa Rapuano Interview Highlights - Part 1

Recently, I was lamenting the lack of female representation in investment management. Then in conversation, a friend reminded me of this insightful interview with Lisa Rapuano, who worked with Bill Miller for many years, and currently runs Lane Five Capital Management. The interview touches upon a number of relevant portfolio management topics. Rapuano has obviously spent hours reflecting and contemplating these topics. A worthwhile read!

Portfolio Management

“I think that most investors spend way too much time talking about stocks and way too little talking about portfolio construction.”

Expected Return, Diversification, Sizing

“I’ve learned that you have to have a lot of different risk-reward profiles in your portfolio. You’ll have some things you think can go up 25% but you don’t think can go down very much. You’ll have things that can go up 50% but might go down 30%. Others can go up ten times, but may go down 75%. I try to manage the proper mix of all those. You just can’t have a portfolio where you say everything is priced to have 25% upside with little downside. What’s going to happen is that you’re going to be wrong about two of them and they go down 50% and you’re screwed because nothing else has enough upside to make it up.”

“A word on concentration. You can take it too far. I know there are manager out there who get enthralled with the Kelly Formula and start putting out 25% or 50% positions because this one is REALLY the best. That just defies common sense. Anyone can be wrong, and any outcome can happen, even if it seems low probability. Keeping a minimum 20 name portfolio with about 5% as a normal position keeps you from making those kinds of mistakes.”

I thought the idea of maintaining a variety of expected returns in one’s portfolio was particularly interesting. People frequently discuss diversification in types of ideas/assets, but not often diversification in expected return profiles.

Also, there is wisdom in her caution against blindly using the Kelly Formula (even if you don’t agree with her advice for a 20 position portfolio). Blindly following any rule is simply a bad idea. Putting 25-50% of your portfolio into one security can be pretty painful if/when you are wrong (which happens occasionally even to the best investors).

However, that doesn’t mean one should never put 25-50% of the portfolio into one position. The important takeaway here is maintaining flexibility, being prepared (especially mentally) for the possibility that you could be wrong, and having a “break the glass” contingency plan just in case the worst materializes.

Correlation, Leverage

“We tend to run about 70-100% net long, with a maximum of 100% gross long. Since we run a very concentrated long-term fund on the long side, we believe that going over 100% gross long isn’t prudent.”

Concentration (and thus high portfolio asset correlation) and leverage is a potent combination – the result is likely in the extremes of (1) homerun good or (2) disastrously bad.

Time Management, Sizing

“A new position has to be compelling enough to put at least 3% of the fund in, or it’s not worth dabbling in.”