One of my favorite questions to ask other stock pickers is: How many stocks have you owned over the last five years and how many of those do you still own today? I don’t believe there is a right or wrong answer. It is just a great question that cuts to the core of several discussion topics like turnover, buy/sell discipline, position sizing, etc. Portfolio turnover is a topic that has always intrigued me.
Portfolio Turnover – Investopedia describes portfolio turnover as a measure of how frequently assets within a fund are bought and sold by the managers. Portfolio turnover is calculated by taking either the total amount of new securities purchased, or the number of securities sold (whichever is less) over a particular period, divided by the total net asset value (NAV) of the fund. The measurement is usually reported for a 12-month time period.
This week I was looking at the portfolio turnover in my IFCM MicroCap strategy where I manage my personal capital in addition to capital from several outside investors. I noticed the portfolio turnover since inception (22-month period) was >100%. Per the definition above this doesn’t mean I haven’t held positions for the duration; it means I’m rather active in the positions I’m not holding. When I was a full-time private investor managing my own capital, I never bothered to look at such metrics. But when I was preparing my Q3 2020 letter I printed off the portfolio analysis report and the turnover percentage was staring back at me. I immediately began thinking what the other investors might be thinking:
- Are we investing or trading?
- Isn’t this supposed to be a buy and hold strategy?
- Don’t you do enough initial due diligence to hold for at least a year?
I would like to provide some context to portfolio turnover. I believe there is an over-glorification of buy and hold investing among active managers. With the rise of private equity and venture capital, everyone is trying to invest in public markets with the same permanent capital mantra. The lower the turnover, the more cerebral and thoughtful you appear to be with initial investment decisions. Nothing looks better than being right from the very beginning. More often than not, a low turnover is shown as a badge of honor. Many investors feel great pride and joy being a loyal shareholder of a company. It feels good to say you’ve held a company for 5-10-20 years. But in reality, what really matters is performance.
Peter Lynch had 300% turnover per year in the early years of the Magellan Fund. Joel Greenblatt had similar turnover at Gotham Capital. Even Warren Buffett’s public company portfolio ranged between 50-100% turnover per year during his first three decades. In fact, contrary to what most believe, many of the greatest long-only investors had their best performance when they had higher rates of turnover in their portfolios. And these were investors that invested in larger, more established businesses where low turnover is much more achievable.
A big part of what made these investors great was spotting when they were wrong quicker. Successful stock picking isn’t just picking winners. It also means picking out the losers in your portfolio. The greatest advantage in public markets is “You can sell”. But you have to know when to sell.
We normally sell a position for three main reasons:
- Sell when the story changes for the worse
- Sell when we find something better
- Sell when a company gets very overvalued
We invest in small emerging companies. Microcap companies evolve in different ways. Not all of them are good ways. We can’t say at the beginning, “I’m going to hold this stock for 1-5-10-40 years”. No, we are going to hold it as long as management executes and constantly compare them against other opportunities. We might hold them 3 months, or it could be 10 years. If I’m being honest, often times companies only deserve to be rented. Ownership is earned. The quickest way to go broke in microcap is buy and forget. Buy and hold forever only works if management executes forever.
We aren’t going to be right all the time. Acknowledging this fact isn’t a justification for not doing upfront due diligence. What we do acknowledge is that we are willing to accept a degree of uncertainty for the sake of speed – getting in early. Often times, an opportunity is an opportunity because the conditions aren’t perfect yet. The price of certainty can be expensive as it relates to discovery and valuation. When we find a business that aligns with what we like – speed is more important than certainty. Here is a wonderful quote that perfectly describes successful microcap investing:
“Most decisions should probably be made with somewhere around 70% of the information you wish you had. If you wait for 90%, in most cases, you’re probably being slow. Plus, either way, you need to be good at quickly recognizing and correcting bad decisions. If you’re good at course correcting, being wrong may be less costly than you think, whereas being slow is going to be expensive for sure.”Jeff Bezos
Our initial due diligence might get us into a position, but it is our maintenance due diligence that will keep us invested and/or save us from big losses. Our future returns are based on our ability to course correct and adapt to new information. We are going to have turnover, because turnover is the price of progress.
Sometimes when you sell you have gains and sometimes you have losses. I learned a long time ago to not let small losses bother me. A big part of being a successful investor is your ability to admit when you are wrong on a company while not letting it crush your confidence and slow you down.
“If you’re extremely confident in yourself, taking a loss doesn’t bother you.”Stanley Druckenmiller
“To others, being wrong is a source of shame; to me, recognizing my mistakes is a source of pride. Once we realize that imperfect understanding is the human condition, there is no shame in being wrong, only in failing to correct our mistakes.”George Soros
I view portfolio management like running an NFL football team. In a football game, each team is allowed 11 players on the field. Coincidentally, our IFCM portfolio is currently holding 11 investments. It is my job to strategize how to win and to identify the best 11 players to start on game day. Some of the players are veterans and some are rookies. The veterans you trust because they’ve proven themselves in various situations. Rookies aren’t proven but you can get them/sign them cheap and they could mature into greatness. Often times you have to give the rookies some playing time to see how they will perform. At any moment a player can go down due to injury, so you have to develop your bench. You have to be vigilant and watch your players to make sure their skillsets are developing and not declining. If a starting player is losing a step you have to be unemotional and replace them with someone on the rise. You can be more lenient when the veterans trip up. But in the end, the players you win with in five years might be different than the players you win with today.
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