“Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years.”
- Warren Buffett
Imagine two portfolio managers, Jack and John, who are both responsible for Australian equity portfolios for large funds management businesses. They both have offices overlooking Sydney Harbour, and are supported by large teams of analysts. John manages three billion, Jack about four billion. For 20 years, both have arrived in the office by 7:30 am to prepare for the first meeting of the day, having already read their emails and checked Bloomberg and Reuters at home. They are well known in the market and are often interviewed on television to give their market views.
Which style do you prefer?
They are both Masters of the Universe, and to the casual observer, they seem to be doing the same job. But they have completely different styles.
John markets himself as index agnostic, and he is not active in terms of portfolio turnover. He prefers to hold a relatively concentrated portfolio of less than 25 stocks, backing his judgement and not owning a bit of everything. For the majority of the time, he is happy with the way his portfolio is set, he has a good understanding of the investee companies’ long term prospects, and there’s usually little which suggests to him that he needs to change his portfolio. On most days he does not do a single trade, although it has taken him the best part of 20 years to learn this discipline. His portfolio turnover is only 15% annually. In the last decade, he has beaten the index by 3% per annum, making him a top quartile manager. As a younger man, he found he was often trading just to look busy, and it was only when he had nothing to prove that he felt confident doing nothing. In fact, he now has time to spend some mornings with his wife, and he tries to amaze her and leave early to cook dinner.
Jack’s portfolio includes 70 of the ASX100, with most large companies close to their index weight. He is continually rebalancing back to index, selling companies which have risen and buying companies which have fallen. He has also delivered good results over the last decade, about 2% over the index. He finds outperformance, or alpha, through intimate relationships with the major brokers in town. They tell him whenever they hear anything, and he quickly buys or sells a stock before the story is on the street. He often reverses his trade a few hours later. He rarely claims to have any great insights into a company’s long term prospects, but he just stays a step ahead of the market. His portfolio turnover is over 200% a year. He stays close to the screens and phones all day, and demands any broker with news contact him first or face a black ban. He pays handsome brokerage, with the large firms earning $5 million a year from him. He does not know or care how long he has held any individual stock. He’s never home early.
How do you manage your portfolio?
Who do you want to manage your money? If you are a direct investor, where do you stand on active trading? Both Jack and John have their strengths and weaknesses, and in my career, I have worked with both types and they’ve done well. In reality, most investors are somewhere between these two extremes, with elements of ‘buy and hold’ and ‘trade opportunistically’.
Personally, for my own investing, I’m more in John’s camp of ‘buy and hold’. In fact, I find it much easier to recommend changes to other people's portfolios than my own. Maybe I’m less emotive when it comes to other people's money and can see other opportunities, but some of the benefits of John’s approach include:
- More likely to detach himself from market emotion and not be spooked by short term movements in share prices
- Low turnover means lower costs and he takes advantage of the capital gains tax (CGT) discount on shares held for longer than 12 months
- Smaller portfolio may mean a more intimate knowledge of the investments.
But it’s not all plain sailing. A ‘buy and hold’ strategy may ignore how poorly some sectors and stocks can perform over time, and fails to recognise the need to change at certain points of inflexion. Few if any businesses are immune from challenging conditions. Just ask the executives and investors in companies like Kodak, destroyed by digital processing, or Blockbuster, impaired by online movie downloading.
It’s easy to think BHP must have been a good long-term investment, but as Ashley Owen wrote in October 2013, its share price in real terms had moved little over 125 years.
“BHP shares peaked at £413 in February 1888 at the top of the late 1880s/early 1890s silver and lead mining boom. That’s $34.70 in today’s dollars in real terms after CPI inflation and after accounting for all of the splits and changes in capital structure over the years. People who bought BHP shares at the top of the 1888 mining boom had to wait 75 years for the share price to recover in real terms after inflation. BHP is still only $36 today as I write this in October 2013, some 125 years later!”
Why do I resist over-trading?
No doubt there were good trading opportunities in BHP along the way, so what other reasons cause me to resist over-trading?
- transaction costs
- the paperwork (which I dread)
- taxation leakage (if I have made a profit)
- loss aversion (if I am carrying an unrealised loss then, rightly or wrongly, I often just want to ‘stay in there’ to prove it will come good)
- not wanting to become a ‘trader’ where gains are taxed on income account rather than capital account (although this is a fuzzy piece of tax law)
- not having carry forward losses that gains could be offset against
- the reported experience of traders, who often seem to lose money by being too flighty in their positions and opinions.
I believe taxation leakage is one of the more important considerations when selling a stock. A portfolio manager may be happier to actively trade on behalf of a tax exempt fund (though always watching the 45-day rule to avoid losing franking credits) but should be more hesitant about realising a gain where they are a taxpayer (whether 15%, 30% or 45%). The time value of money paid to the ATO becomes an important calculation.
On the other hand, some experienced fund managers believe tax is a secondary issue, and sell decisions should always be made on investment principles. I understand this view, but I’m not impressed if a portfolio manager generates a capital gain by selling a share after owning it for 11 months and three weeks (and losing the lower CGT concessional rate).
There’s no right answer
Investment is more art than science, and I find these trade-offs a real dilemma in practice. Sometimes I think I have finally got my portfolio ‘set’ and then something happens that makes me feel I should change it (yet again!) but deep down this is an uncomfortable move.
I’ve often thought we need a formula that takes into account our tax rate, our concessional CGT rate, transaction costs, the value of carried forward losses, an estimated valuation on the stock versus its market price (an inexact task at the best of times), etc etc … and, hey presto, the formula would spit out whether selling is a good strategy. And by the way, this issue applies equally to changing asset allocation as it does to changing securities within a specific asset class.
I personally manage an investment portfolio for a not-for-profit, tax exempt organisation that has nil brokerage fees thanks to the generosity of a community-minded stockbroker. I find myself regularly adjusting the portfolio both in terms of security selection and asset allocation (between Aussie shares, international shares, property, infrastructure and various fixed income securities). I find this rewarding (the portfolio performance has been very good, even if I do say so myself!), but at the same time challenging and somewhat tiring, like I am on a never-ending marathon.
But when it comes to my own personal affairs where I am definitely a taxpayer, until someone gives me a black box to work through the myriad of variables, I am much more of a ‘buy and hold’ investor, unless I need to sell for cash flow reasons. That said, there have been many times where I have kicked myself for not reducing exposure to particular stocks or asset classes when it looked obvious they were stretched in value.
Chris Cuffe was co-founder of Cuffelinks, the former name of Firstlinks. He is Portfolio Manager of the charitable trust, Third Link Growth Fund, Chairman of Australian Philanthropic Services and sits on the boards or advisory committees of many listed and unlisted companies. The views expressed are his own and they are not personal financial advice.