JUNE 2019

Developing an Approach to Portfolio Management That Is “Great by Choice”

Category: Investment Research, Portfolio Management

By Erick Rawlings, Managing Director, Research

I recently finished reading Great by Choice (GBC) by Jim Collins, which follows his previous books Good to Great, Built to Last, and How the Mighty Fall. In GBC, Collins and his co-author Morten T. Hansen review five sets of companies in the same industries, operating at the same time and facing the same uncertainties.

Yet, in each of the industries, one of the companies goes “10X” while another ends up an also-ran. Collins and Hansen attempt to systematically understand what factors led to these two disparate outcomes. Luck? Visionary leaders? Big strategy shifts?

What they found is 10X companies exhibit variations of the following three characteristics:

1. Fanatic Discipline
2. Empirical Creativity
3. Productive Paranoia

As I made my way through the research and anecdotes, it seemed to me that these sound principals could also be applied to portfolio management.

Fanatic Discipline:
The 10X companies in GBC exhibited a high degree of discipline, hitting specific performance markers in good and adverse periods over a long period of time. Collins equates this to the first race to the South Pole in 1911 between Roald Amundsen and Robert Scott. Amundsen was methodical and consistent and stayed to a 20-mile daily advance regardless of the weather conditions. In contrast, Scott was brash and cavalier, using untested equipment and moving fast in favorable weather, and hunkering down when the weather was unfavorable. Amundsen’s consistent approach got him to the South Pole first. Scott made it, but after Amundsen, and tragically didn’t make it back. The concept also has parallels to the old Aesop fable of the tortoise and the hare: to be a 10X-er, it is about patient consistency, it is not about ebbs and flows of whipsawing bursts of energy.

The Amundsen 20-mile march in investing is akin to proper planning ex ante and then sticking to that plan via rebalancing through nearly all market environments. Overtime there will be no shortage of promised returns with no risk, plenty of opinions of why now the economy is on the brink of recession, and, of course, actual recessions and expansions. Could one do better by dynamically moving tactical allocations as market views shift? Possibly, but if you do so excessively you might merely be increasing the risk of underperforming the ex ante stated objective, particularly once transaction costs and taxes are considered.

Empirical Creativity:
“Fire bullets, then cannonballs” was perhaps one of my favorite concepts from the book. The idea ties back to fanatic discipline as well as to the concept, “In God we trust, all others bring data.”
What Collins and his team found was that 10X companies adjust strategy and try new things, products, offerings, etc., but they do so in a calibrated manner. They stay disciplined to their 20-mile march, but augment, adjust, and evolve as needed gradually. When they found something that showed promise, they went for it in size.

The parable in the book goes something like this:
It’s the early 18th century, you’re on a merchant ship and you have a finite amount of gunpowder (this represents a company and its finite resources). You see a pirate ship approaching. You could rush to fire the cannonballs, but the cost in terms of powder is high and your shots are limited. So, what do you do? You realize you have some time to react; you take your time and fire bullets first. The bullets use less powder and allow you to calibrate the cannons (i.e., get data in a lower cost manner). Once your bullets are hitting the pirate ship you then load the cannonballs and fire.

Likewise, new investments are not funded at maximum size at the outset, they earn their way there through performance and our growing familiarity with them. These ‘bullets’ give us a chance to test our ex ante thesis: We expected X. Is that true? We expect Z when Y occurs. Did that happen? And when we do find that our bullets are hitting we shouldn’t shy from making them cannonballs.

Productive Paranoia:
“You can’t predict the future, but you can prepare for the unexpected.” The 10X-ers in GBC had the following characteristics:

• Available cash and limited leverage: this allowed the companies to deal with the unpredictable future. By having limited debt, it allowed them to be in control of decisions and long-term shifts.

• Risk-Bound: the companies fired bullets, then cannonballs, but even at the cannonball level the risk was bounded—i.e., they didn’t just have one cannonball. And if they fired a cannonball and it missed, they viewed that as expensive tuition. They did not, as the also-rans tended to do, go out and fire another cannon ball right away to try and make up for the miss.

• Exceptional use of time: the companies were mindful of the changing nature of risk and would always maximize the time allotted to them to think through their reaction. Think of it as a dynamic clock in a game of chess. Sometimes you have a lot of time before you need to make your move, sometimes less, but in all instances you maximize the time allotted.

In portfolio management, a strategic asset allocation is in effect a strategic business plan. With this plan in hand it is important to remain vigilant to changing conditions, but not react to every perceived change. This can be achieved by:

• Approaching opportunities and risks with the same “bullets then cannonball” mentality and bound the risks taken.

• Staying wary of leverage at a portfolio level, and on a look-through basis to fund managers

• Challenging your strategic allocation and its process each year to get better; to ensure it is rigorous, realistic, and aligned with forward expectations

When markets are falling or rising at an exceptional rate, do not abandon discipline but do increase intensity. Zoom out, gain perspective and form a view, then zoom in to the portfolio line items and fund managers and adjust if needed.
In summary, developing a long-term approach to portfolio management can be great by choice by following these basic principles:

1. Fanatic Discipline: Set a clear portfolio performance goal ex ante, and stick to it
• Set a clear performance goal that is aligned with your objectives, based on conservative estimates, and achievable over a reasonable timeframe
• Stick to it through good times and bad

2. Empirical Creativity: Gradually grow managers and execute portfolio shifts based on growing data-driven conviction
• Fire bullets then cannonballs: Don’t start with full-sized positions or execute big shifts at the outset; instead, let the position/shift earn its place with data-driven conviction
• Don’t be afraid to fire cannonballs after calibration

3. Productive Paranoia: Be vigilant to changing market dynamics, but approach them by maintaining discipline and increasing intensity
• Strategic allocations should be robust to reasonable outcomes: “We cannot predict the future, but we can prepare for the unexpected.”
• Understand the risks being taken: limit asymmetric risk