Bob Rodriguez’s Diversification Experiment

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.”

Consequences of Contrarian Actions

Below are excerpts from a speech Bob Rodriguez of First Pacific Advisors gave in May 2009. Quite a few interesting lessons derived from his previous trials and tribulations in dealing with clients and redemptions during periods of contrarian actions and underperformance. Psychology

“I believe I have found success because I have been deeply aware of the need to balance the human emotions of greed and fear. In a word, DISCIPLINE…is a key attribute to becoming a successful investor. I stress that, without a strong set of fundamental rules or a core philosophy, they will be sailing a course through the treacherous investment seas without a compass or a rudder.”

AUM, Clients, Redemptions, Patience

“It seems as though it was a lifetime ago in 1986, when I had few assets under management, and the consultant to my largest account insisted that, if I wanted to continue the relationship, I had to pay to play. I was shocked, dismayed and speechless. Though this would probably have never become public, if I had agreed, how would I have ever lived with myself? By not agreeing, it meant that I would lose nearly 40% of my business. When I was fired shortly thereafter, this termination compromised my efforts in the raising of new money for nearly six years because I could not say why. Despite pain and humiliation, there was no price high enough for me to compromise my integrity. With the subsequent disclosure of improprieties at this municipal pension plan, the cloud of suspicion over me ultimately lifted. I not only survived, I prospered.”

“While technology and growth stock investing hysteria were running wild, we did not participate in this madness. Instead, we sold most of our technology stocks. Our ‘reward’ for this discipline was to watch FPA Capital Fund’s assets decline from over $700 million to just above $300 million, through net redemptions, while not losing any money for this period. We were willing to pay this price of asset outflow because we knew that, no matter what, our investment discipline would eventually be recognized. With our reputation intact, we then had a solid foundation on which we could rebuild our business. This cannot be said for many growth managers, or firms, who violated their clients’ trust.”

“Having the courage to be different comes at a steep price, but I believe it can result in deep satisfaction and personal reward. As an example, FPA Capital Fund has experienced heavy net redemptions since the beginning of 2007, totaling more than $700 million on a base of $2.1 billion. My strong conviction that an elevated level of liquidity was necessary, at one point reaching 45%, placed me at odds with many of our shareholders. I estimate that approximately 60% left because of this strategy…We have been penalized for taking precautionary measures leading up to and during a period of extraordinary risk. Though frustrating, in our hearts, we know that our long-term investment focus serves our clients well. I believe the words of John Maynard Keynes…‘Investment based on genuine long-term expectations is so difficult today as to be scarcely practicable,’ and ‘It is the long-term investor, he who most promotes the public interest, who will in practice come in for the most criticism wherever investment funds are managed by committees or boards or banks. For it is the essence of his behavior that he should be eccentric, unconventional, and rash in the eyes of average opinion.’”

“I believe superior long-term performance is a function of a manager’s willingness to accept periods of short-term underperformance. This requires the fortitude and willingness to allow one’s business to shrink while deploying an unpopular strategy.”

As I write this, the world’s smallest violin is playing in the background, yet it must be said: what about clients violating a fund’s trust by redeeming capital at inopportune times to chase performance elsewhere? The trust concept flows both ways.

There will be times in every fund manager’s career when doing what you believe is right will trigger negative consequences. The key is anticipation, preparation, and patience.

Historical Performance Analysis, Luck, Process Over Outcome, Mistakes

“Let’s be frank about last year’s performance, it was a terrible one for the market averages as well as for mutual fund active portfolio managers. It did not matter the style, asset class or geographic region. In a word, we stunk. We managers did not deliver the goods and we must explain why. In upcoming shareholder letters, will this failure be chalked up to bad luck, an inability to identify a changing governmental environment or to some other excuse? We owe our shareholders more than simple platitudes, if we expect to regain their confidence.”

“If they do not reflect upon what they have done wrong in this cycle and attempt to correct their errors, why should their investors expect a different outcome the next time?”

Examine your historical performance not only to provide an explanation to your clients, but also to yourself. For example, was there anything that you could have done to avoid the “stink”?

Rodriquez mentions “bad luck.” During this reflective process (which ideally should occur during times of good and bad performance) it’s important to understand whether the returns resulted due to luck or to skill. See Michael Mauboussin & James Montier’s commentary on Process Over Outcome & Luck.

Psychology, When To Sell, When To Buy

“Investors have long memories, especially when they lose money. As an example, prior to FPA’s acquisition of FPA Capital Fund in July 1984, the predecessor fund was a poster child for bad performance from the 1960s era. Each time the fund hit a $10 NAV, it would get a raft of redemptions since this was its original issue price and investors thought they were now finally even and just wanted out.”

Anchoring is a powerful psychological bias that can compel investors to buy and sell for the wrong reasons, as well as to allow those who recognize the phenomenon to take advantage of the bad decisions of others.

Is the opposite true: investors have short memories when they’re make money?

Far from the Madding Crowd

Investing is full of paradoxes. For example, in this zero-sum game, everyday we walk a fine line between arrogance (conviction that we are right) and humility (possibility that we may be wrong). We’ve written in the past about the importance of self-awareness. Self-aware of our mental weakness(es). Self-aware of our (perceived) strengths. Self-aware of how we stack up relative to the competition. But is there a point when we are too self-aware, such that it becomes our enemy?

In a 2011 Fortune article about Bob Rodriguez of First Pacific Advisors (many thanks to my good friend and former colleague Robert Terrell of Karlin Asset Management for sharing this with PM Jar), there’s a part that talks about how Bob was teased as a child and didn't care.

"When Rodriguez was 12, he had a major operation on his teeth that, for two years, left him with a heavy speech impediment. Classmates teased him -- so he gave a speech on the topic of elocution to show that he could make fun of himself. ‘Most people, when they're different, they become self-conscious,’ says Dick [his brother]. ‘Bob hasn't been one to sacrifice his ethics or his intellect to fit in.’"  

Ignoring negativity would definitely be easier if one lacked the self-awareness to realize that others were hurling it in your direction. Whether this is through naiveté or deliberate choice, in terms of investing, is it easier to stick to a contrarian strategy and sustain creativity when you are far away from the madding crowd, either mentally or physically?