TOL - 22nd Jul, 2024
Why you should only focus on your best ideas (and 2 to get you started)
Plus, our guests share some of the major wins, lessons and learnings from following a high conviction approach.
Back in May, Livewire sat down with the chief investment officer of a family office - i.e. the steward of a billionaire client's wealth.
The main takeaway, for this anonymous writer at least, was that Australia's ultra-wealthy are on the hunt for concentrated, high-conviction funds - those that hold a smaller number of stocks, look very different from the benchmark, and generate returns far different from the index too.
So in this episode of Buy Hold Sell, we're hoping we can learn what sets these types of funds apart - and of course, whether investors at home can replicate these strategies too.
To do that, Livewire's Ally Selby was joined by Magellan's Alan Pullen and Loftus Peak's Alex Pollak. They share the case for concentrated strategies, how they identify the stocks that make their way into portfolios, the perfect number of holdings, ideal holding times and turnover.
They also provide an example of a stock that didn't perform as expected and what they learnt from that, their best-performing positions since their funds' inception, and their highest conviction ideas from their portfolio of best ideas for markets today.
Note: This episode of Buy Hold Sell was recorded on Wednesday, 17 July 2024. You can watch the video, listen to the podcast or read an edited transcript below.
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Edited Transcript
Ally Selby: Hello and welcome to Livewire's Buy Hold Sell, I'm Ally Selby. A few months ago I sat down with the CIO of a family office. One of the biggest takeaways, for me at least, was that he really loves concentrated, high-conviction funds, those that don't invest in that many stocks.
Alan Pullen: There is some evidence that portfolio managers and funds are actually better at picking high-conviction stocks. That's where they get their best performance. So, by having a portfolio of just high-conviction stocks, you maximise the opportunity for a knowledgeable manager to actually outperform over the long term.
So, today I'm really hoping we can learn what makes those types of funds so unique, so special. To do that, we're joined by two high-conviction portfolio managers - Alan Pullen from Magellan and Alex Pollak from Loftus Peak.
SPIVA data shows that most active managers actually underperform over the long term. What is it about concentrated, high-conviction strategies that help overcome that challenge? I might start with you, Alan.
The case for high conviction, concentrated strategies
Ally Selby: Over to you, Alex. Why do you think investors should consider high-conviction, concentrated strategies?
Alex Pollak: We have always said we don't want to generate index returns. And in order not to generate index returns, you should not be invested in companies in the index at index weights. That's obvious, right? If you want non-index returns, don't be in companies that form the index at those weights.The perfect number of holdings and investment strategy
Ally Selby: How do you identify stocks that make their way into the portfolio? And do you have a perfect number of holdings?
Alex Pollak: We're a disruption fund, so we identify stocks that make it into the portfolio on the basis that they are taking an existing business model and significantly changing it, disrupting it, in fact. So, that's an easy question for us. Because if you look at Amazon (NASDAQ: AMZN), so to speak, it disrupted traditional retailing, going back 15 years ago. And if you look at, for example, what Nvidia (NASDAQ: NVDA) has done in the last 12 months, they've disrupted the whole compute and the whole information processing universe. Those are the logical companies, as a disruption fund, for us to invest in. We find it easy to find them, but it's harder to price them.Ally Selby: And in terms of the number of holdings that you'd want in your fund, is there a perfect number of holdings?
Alex Pollak: We want around 26 to 28 holdings, because that is a manageable number of companies that we can do the work on, so to speak, and understand well enough. And it's sufficiently differentiated to not be an index fund at that point. You only really need 10-20 stocks to be a non-index, high-conviction portfolio. And if you can go a little bit above that, then it enables you to cover a little bit more ground and have a few more bets. I think that's one of the things that's helped underpin our return.Ally Selby: Alan, your fund holds quite a few less stocks than that. What is the magic number for you, and how do you identify the companies that make their way into the portfolio?
Alan Pullen: We're running it more like 10 to 20 stocks. But typically we sit in the middle of that, at around the 15 number. Which, again, gives you an average position size, which is pretty concentrated, and you're going to look a lot different to the overall benchmark, the overall market. As Alex said, if you don't want index performance, you've got to have a portfolio that looks very different to the index. That's exactly what this is aiming to deliver.We're a quality manager, so we're really looking for a combination of high-quality companies, and we go back to the Warren Buffett economic moat. But we also look at other characteristics like reinvestment potential, business risk, and agency risk. So, we actually assess them on a number of quality metrics. And the other big factor that you've got to consider is valuation. We really need both quality and valuation to come together to be a high-conviction position, in our opinion. And we also think about, of course, the risk that those stocks bring to the portfolio. Those would be the three factors.
Turnover and holding times
Alan Pullen: If a company remains attractively valued and can compound over time, I'm happy to hold it forever. However, most companies don't. Things change over time, either their quality deteriorates over time, or the valuation reaches a point where it's no longer attractively valued. But typically, we'll often hold companies for three or four years, so quite low turnover, as it takes some time to deliver those compound returns. And some companies we've held for more than 10 years within the portfolio.
Ally Selby: Alex, how often are you turning over stocks in the portfolio, and do you have an ideal holding time?Alex Pollak: We break the portfolio into two separate buckets, a core bucket and a non-core bucket. The core bucket is 80% of the holdings. We expect to hold those companies, subject to DCF valuations because we don't use P/Es, for between three and five years. We will hold them longer than that if we need to, and they continue to return. But if they don't make the returns that we want, we will turn them out earlier than that, if we don't think there's any hope that they'll be able to grow into that DCF valuation.
Everything that Alan said about companies' quality of management, franchise, etc, we take all that into consideration. But we don't deal with single-period measures like P/E ratios. We are much more focused on long-term DCF valuations where we consider the company's future over a period of 10 years. That's been enormously helpful in being able to get the pricing of these companies right.
How to deal with poor-performing positions
Alex Pollak: There's been a couple, not that many, frankly, but one of them was Volkswagen (ETR: VOW3). We held Volkswagen on the basis that as the largest producer of cars in the world, with 10 million units, they had the largest base of cars on which they could strike the new electric car platform. So, they could amortise the cost base, not just over one brand, but over 10 or 15 different car brands. That's the reason we held Volkswagen, and that failed. The Volkswagen bet failed.
The reason that it failed is that we did not sufficiently take notice of the impact of the production hikes that were coming out of China in terms of electric cars. And you see them on the roads today, the BYDs, SAICs and Havals. You've got a stack of them. We did not readily understand how quickly the Chinese EVs would come up to being a credible alternative as far as the car companies globally. And that, as it were, was the end of the Volkswagen bet.
Alan Pullen: I think it's important to try and identify why the stock might not be performing as you hoped. And really, here I want to differentiate between cyclical factors and structural factors. Alex just talked about a structural factor - a reason you would exit the position even if you're at a loss, if the position has changed, the quality of that stock has changed, then you should exit the position and transition to something more attractive.
But I'll go through an example that was much more cyclical in nature. It's important to identify the reason for the underperformance. In 2022, Amazon (NASDAQ: AMZN) halved. They overbuilt their logistic network during the GFC. They thought there were going to be a lot more volumes coming through. They didn't come through at first, and so their profitability was impacted, and their stock underperformed pretty significantly, as I said, it halved.
But we knew this was a cyclical impact, that they would get those volumes coming through, and they'd make the network more efficient. They've done that multiple times in the past. So, that was one we were comfortable to lean into because we're confident it was cyclical and actually top up the position, and of course, it came out and doubled in the next year.
Top performers since inception
Alan Pullen: I went back and ran the numbers, and it's actually one that's been in there since inception, which is Microsoft (NASDAQ: MSFT). We all know that's the largest company in the world now, but back then it was actually struggling a little bit in terms of the market's perception of its quality. It was considered lagging in the personal computing era, which was coming to an end under pressure. But we recognised that the company had an enormous moat in enterprise users, and that's where it actually makes all of its money.
That enormous moat, that quality was there, the valuation was very attractive at the time, and it had a structural growth tailwind. Which is really still going today in terms of increasing IT spending, the transition to the cloud, and AI now. It's been a really solid performer over that period.
What are we looking for? It's really when that quality and value come together that you do get that compounding return, which tends to be your better long-term performance over time.
Alex Pollak: The strongest, absolute return we had was actually from Nvidia (NASDAQ: NVDA) because we bought our first share at, I think it was 70 US cents, in 2016. And it's now US$130-odd. We held it for a long time. We understood the AI implications of what they were doing, and we held it for a very long time, and it performed for us very well.
There are other companies that we held as well that have created similar or better contributions to total return. Those are companies, for example, like Amazon (NASDAQ: AMZN), (Apple NASDAQ: AAPL), and Microsoft (NASDAQ: MSFT). We had a much higher conviction in them, and so we held them at greater weights, and so their actual contribution to the performance was also very strong. But it's a combination of companies like Nvidia, and also Amazon, Microsoft, and Apple to some degree.
Now really, you've got Qualcomm (NASDAQ: QCOM) and TSMC (NYSE: TSM) in the background as well, which are our highest-conviction and biggest positions in the fund. They're already performing incredibly well, and we imagine that will continue for a while.
2 high conviction picks for the next year
Alex Pollak: It is Qualcomm and Taiwan Semiconductor. I guess you want to know why?
Ally Selby: I want to know one. If you could only choose one?Alex Pollak: It's Qualcomm because Qualcomm has been the central brain, so to speak, of smartphones for 15 years now. And they've done a great job, and it's always been priced as such. What they are now doing that's so radical is that they are really on the way to kicking the x86 architecture, Intel if you like, and possibly some AMD as well. They're about to kick those things out of the PC and laptop market, and their offering into those markets is going to be an ARM chip that supports a long battery life. We have bench-tested it at 17 hours, very much comparable to the Apple machine.
They're about to go from one important business line in phones to a second, equally important business line, which is in laptops - both of which are happening at the beginning of a cyclical upturn. That's why we hold it to such a high conviction.
Alan Pullen: We have a lot of high-conviction picks and a lot of tech companies in there. But I want to talk about something a bit different today, which is Brookfield Corporation (NYSE: BN). They're a Canadian asset manager and an investor in alternative assets. What we like is their structural tailwinds. Investors are increasingly allocating to alternative investments. And they are one of the largest alternative investment managers in the world.
They're very well placed in infrastructure, things like renewables, so you've got investment demands for these assets. They've got a lot of supply of renewables coming on, so there's a real tailwind to that business. And what we really like is they've got co-investments, an investor alongside all of their clients in those assets, so you get income from both the investment and the asset management income, and they're very attractively valued. We're expecting mid-teens returns from that company.
What's your highest conviction stock pick right now?
Our guests have named Qualcomm and Brookfield Corporation as their top picks for today's markets, but we'd love to know what you think. Let us know what your highest conviction idea is in the comments section below.
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Buy Hold Sell is a weekly video series exclusive to Livewire. In each episode two fund managers give their views 'Buy, Hold or Sell' on five ASX listed companies. Not recommendations, please read the disclaimer and seek advice where appropriate.
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Livewire Markets
Buy Hold Sell is a weekly video series exclusive to Livewire. In each episode two fund managers give their views 'Buy, Hold or Sell' on five ASX listed companies. Not recommendations, please read the disclaimer and seek advice where appropriate.
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Livewire Markets
Buy Hold Sell is a weekly video series exclusive to Livewire. In each episode two fund managers give their views 'Buy, Hold or Sell' on five ASX listed companies. Not recommendations, please read the disclaimer and seek advice where appropriate.
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