Dear Fellow Investors:
We have argued vociferously that active managers have given up their preferred position in the investing marketplace to passive indexes because of high turnover. A recent Wall Street Journal article referenced 78% turnover as being the average among large-cap US equity funds. Studies have shown that as much as 144 basis points each year in return is chewed up by trading costs. Explaining turnover and its impact is one thing, but it is more important to ask a question. How do you practice low turnover while seeking maximal long-term performance?
We at Smead Capital Management practice low turnover in the following ways. First, we like to buy at what John Templeton called, “the point of maximum pessimism”. If you follow an admirable company long enough, either the stock market, industry wide difficulties or an inner-company stumble of their own making will cheapen their shares to the lowest P/E quintile in the S & P 500 index. Valuation matters dearly to low turnover, because the original depressed price leaves a wonderful company plenty of upside potential at historically normal P/E ratios. If a stock has gone up markedly since you bought it and is a superior company in many ways, then you are in position to make attractive returns at a fair price. Warren Buffett reminds us of why below: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”
Second, owning high quality companies allows for long holding periods. In his 2005 study on quality aspects of a company which provide long-term alpha, Ben Inker of GMO, showed that low leverage, low earnings volatility, high and consistent profitability, and low stock price volatility (beta) contributed significant alpha over 24 years from 1980-2003. We use wide moats, long histories of high profitability, high and consistent free cash flow, and strong balance sheets as our qualitative aspects of stock selection. We believe that humans are unlikely to hold low quality securities through multiple cycles. We like to look at a company in their darkest hour and ask if we could have withstood the pressure to sell at that point before we buy it originally.
Third, we have what we consider a sensible sell discipline and appreciate the way your sell discipline can lead you to either high or low turnover. In our case, we sell for three reasons. 1) We sell if one of qualitative criteria get violated going forward. Did they lose their moat, permanently damage their balance sheet or cease to maintain historical profit margins? 2) We sell investments which we were wrong on. We sell a stock which declines 15-20% in the first three years we own it, if when re-analyzed, doesn’t motivate us to buy more. In other words, some companies are not meant for us to be a long-term holder (we have duds). 3) Sometimes the wonderful companies we are part owners of get maniacal pricing in the market place. This usually means a P/E ratio two times the norm for that company. Extremes of popularity must be avoided even for those of us who resist turnover.
Lastly, holding winners to a fault contributes to low turnover and maximal long-term portfolio performance. The math of common stock investing is very simple: generally stock performance tends to fall along a bell curve in the long run. Good stock picking and portfolio management seeks to find a few of the companies which make it to the best 5% of performance among all stocks on that bell curve. We argue that active managers have given up too much advantage to the index on the simple math. In the Bible, love covers a multitude of sins. In portfolio management, our theory is that a ten-fold increase or greater in a few stocks out of 20-30 covers a multitude of duds.
The S&P 500 holds its winners straight through without any effort to weed out maniacal securities. Therefore, they satisfy the bell curve. In our opinion, most active equity managers spend way too much time attempting to determine the top in a stock under the guise of price targets and intrinsic value calculations. We believe that the urge to smooth returns for short-term performance reasons and/or an effort to be smarter than anyone really expects them to be drives stock picking organizations that direction. When an equity manager research person asks us what our price target is for a certain company we cringe. The whole idea behind what we are doing is auditioning companies for use in our portfolio in hopes of finding multi-decade success stories! Other than maniacal pricing, we believe equity managers kill long-term performance by cutting off their best performers. The crime is the penalty to short-run performance coming from the trading costs associated with their impatience and attempts at perfection.
Think of it this way. If you were a producer of plays and movies, you would audition actors and actresses. If everything works well, you could find a Meryl Streep, George Clooney, Kevin Bacon, Reece Witherspoon, Bradley Cooper or Jack Nicholson. Think how depressed you’d be today if you had Meryl under contract in the 1970s and 1980s and let her go in the early 1990s because you thought she was “fully valued”. She is still cranking out hits in this decade, 20 years after a pretty actress like her is supposed to be left with supporting roles. I’m pretty sure that the “Devil Wears Prada” and a devil sits on the shoulder of active managers and begs them to sell out of their best performing securities.
In conclusion, we believe that low turnover is critical to outperforming the S&P 500 index. We also believe that every stock picking organization should consider establishing a discipline to promote low turnover to get at bell curve success and low trading costs. We believe that Michael Price, former manager of Mutual Shares said it best, “The fewer decisions I make, the smarter I am”.
Best Wishes,
William Smead
The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
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