Supreme Industries, Cera Sanitaryware, Page Industries, HEG India, Thirumalai Chemicals, APL Apollo Tubes…
We see/hear about them all the time. On Twitter, in blog posts and in conversations. Investors or Investment Managers talk of a stock they identified, a few months or years ago that has since several ‘X’d its initial price. When they explain their rationale for why they felt it was massively undervalued, it seems obvious, in hindsight.
Let’s temporarily suspend cynicism and appreciate the investors’ skill in identifying multibagger stocks. Now how do you decide whether you should give them your money to manage or take their advice to do your own investments? i.e. Does evidence of one or even several multibaggers reliably indicate an excellent investor?
If you do your own investing, it’s important that you be able to measure your own investment performance. But looking only at overall return is of limited utility if you’re looking to improve as an investor.
If someone manages your money or advises you on your investments, first, they should be able to pass the “what’s in it for you test“, next you need to be able to assess how good they are, and what makes them good.
Ehren Stanhope of O’Shaughnessy Asset Management recently tweeted an excellent thread on the importance of portfolio construction for investment managers
1/Few professional managers understand the power of portfolio construction, fewer still can quantify the impact on performance.
— Ehren Stanhope (@FactorInvestor) May 10, 2018
Ehren writes of going beyond an overarching assessment of “skill” based on absolute returns by breaking an investor’s performance into three aspects:
- Consistency – How often positions win
- Magnitude – Win by more than losers lose
- Conviction – Playing to strengths
Let’s look at how this might translate to assessing the potential strengths and weaknesses of different investors.
Consistency is the most intuitive of the three performance measures. Percentage of winners.
The investor with the higher percentage of positive returns on their portfolio is more consistent. Note this comparison assumes equal-weighting across all the stocks and only focused on the basic percentage of positive picks. In hindsight, you would be indifferent between the two portfolio managers above but as an indicator of future performance, all else being equal, you should be picking the more consistent stock picker.
Magnitude represents the average size of an investor’s wins and losses.
Is an investor who delivers small but consistent wins and the odd sizable loss better than one who delivers the rare but massive win but lots of total losses?
Unlike when we considered consistency alone, real-world investment performance is driven by the size of wins and losses in combination with consistency. The table above is illustrative only which means instead of anchoring on the returns shown, think about the likelihood and impact of minor changes to the magnitude of returns and the consistency to outcomes.
For instance, A drop in consistency (win-rate) for Investor F from 6% to 5% means a drop in portfolio return from 26% to 5% (80% decline) while a drop in returns per win for Investor C from 10% to 8% (20% decline) results in a portfolio return of 7.4% (down 21% from 9.4%).
Conviction represents position weighting or portfolio allocation.
Conviction is the joker in the pack driving investor performance. Given two investors with equal intellectual ability to pick stocks, the willingness to throw more weight behind a high-conviction pick while reducing exposure to others can have a telling impact on out or underperformance. In the table above, more than the outcomes, consider the potential scenarios comparing an investor who having identified her picks sticks with the original allocation versus one who is willing to write-off some of those picks while doubling down on others.
What it means for investors
Take a look at your past performance to break down the contribution to your outcomes from consistency, magnitude and conviction.
If your consistency is low, your average return per win is mediocre but your portfolio did well because of one or two high-conviction picks, maybe it means you should reduce your universe of stocks to consider and go deep in the ones that pass the first few filters to develop conviction. On the other hand, if your consistency is high but your returns are negatively skewed, then you might improve your outcomes by making your initial screening process more rigorous. The best course of action for you might be to improve where you’re particularly weak. Or it could be about modifying your investment process to exploit your strength.
Apply the same framework to assess investors you follow. Are their returns courtesy high consistency and magnitude or from conviction inspite of mediocre consistency? Plot them on an imaginary three-dimensional grid. Next ask yourself in what style are you most comfortable with seeing your money managed. The answer could even be an allocation to multiple styles as long as the bulk of your money is managed to a style that enables you to sleep at night.
How do you review your investment performance? Strengths and weaknesses? Comment or email me at thecalminvestor [at] gmail [dot] com.
You can find the full paper ‘Dimensions of Return’ by Ehren Stanhope here