Todd: How are you doing, Roger? Do you have time for a chat?
Roger: Yes, of course. Found a new idea and discuss it together?
T: No, since I am new here, I was told to report a concentrated portfolio with a high conviction investing approach. I have read various materials, and I do not feel I am getting organized.
R: OK, what questions do you have in your mind?
T: There seem to be many variations of the high conviction approach. Moreover, the investment criteria applied to high conviction investing do not look much different from the normally-diversified portfolio.
T: What is the best way to describe it?
R: I would contrast it against short-term trading strategy on diverse securities. It stands at the opposite end.
T: What do you mean?
R: When you take the diversification approach, you implicitly assume that investments include mid-low conviction ideas with a probable positive return, and they are not highly correlated. So as a group, it should deliver, but individual investments are not so sure. A game of a probability using a group.
T: A diversified mid-low conviction ideas? So, the level of diversification is inversely proportional to the level of conviction?
R: In general, yes. I have not seen a concentrated portfolio of low conviction ideas.
T: OK. Then short term and long term. Does it have something to do with the high conviction strategy?
R: Here comes the ambiguity of high-conviction, right? Everyone says we do high conviction something, even including a commodity trader.
R: In the financial industry, you should be carefully looking at the name and the contents. The link between the two is often loosely defined. In the case of high-conviction investing, the point is that it does not precisely specify the conviction of “WHAT.”
T: What do you mean?
R: There are a couple of aspects. First, as a high conviction investing strategy does not use diversification to reduce the portfolio’s total risk while keeping or improving the expected return, you have to own individual investment with risk-return ratios, such as Sharpe ratio, above the benchmark. A large mutual fund with a high conviction strategy tends to be the case, and it is suited for an active core portfolio. Another type of high conviction investment fund is a fund that intentionally aims to differentiate return and make alpha as idiosyncratic as possible rather than as high as possible. It is typically small but uniquely & differently performing well. The latter is useful for large institutional investors, which need a wide variety of small-size strategies to optimize the entire portfolio. The mix of individually optimized funds as a standalone basis is not the same as the portfolio that is optimized as a whole portfolio.
T: So you are saying that an institutional or family office portfolio is an exception. In general, a high conviction of an outstanding expected risk-return profile at an individual security level should be “WHAT”?
R: That is correct. Secondly, the duration of the strategy is critical.
T: Most say long term high conviction investing?
R: But traders can do high conviction trades as long as his approach suits it and delivers results. Even portfolio managers of mutual funds do not only research and invest for clients but also give considerations to AUM of the managed portfolios and external fund rating consultants. So the funds would not immune from getting rebalancing adjustment to smooth the short term price volatility.
T: So, the time horizon is not always long term?
R: Again, the issue is that the term “long term” does not have a unified definition. It is not either good or bad, but precisely speaking, different managers have a different context.
T: OK, why then the duration of strategy is essential and how it relates to high conviction investing?
R: We have talked about price and value, and you remember that price is an exchange mechanism that balances short term demand-supply, and value is defined entirely differently. There is no certainty as to how long it takes for the gap to narrow, right?
R: So, if you go for a short duration, focus your entire skill on predicting price movement in the near term. Anticipating newsflows, positive or negative surprise, and a chain of reactions, i.e., reactions of other market participants’ reactions. A classic case of Keyne’s beauty voting and higher differentiation.
T: What about a strategy with a long duration?
R: So, it focuses on value, and typically it invests in the companies for which the manager has a high conviction for them to meet the investment criteria such as:
- An understandable business with reasonably predictable future cash flows
- A business with limited external threats and an ability to withstand uncontrollable events
- A business that generates enough excess cash flow
- A business run by strong management and governance with minority shareholders as partners
- A business that is attractive from the business owner’s perspective
Simply put, the key is whether the visibility of certainty of excess cash flow is high enough. The strategy buys the stock when the market price is not too high.
T: Had thought value investing is a strategy to invest in low price multiples such as PER or discounted by DCF. Why does it look more like a low volatility and stable companies fund?
R: That type of low price contrarian strategy has not performed well in the last decade. It is due to a systematic shift in the environment. An enterprising investment management company has an article on it. It should be useful for you. While it is functioning OK, the low volatility strategy even started to show less and less alpha because the companies to the industries that meet the criteria tend to be legacy incumbents, which see a faster depreciation of assets, including intellectual properties. After all, valuation is one of the acts of expression of subjective judgment, and the margin of error is always high. Also, the remaining challenging economic environment will leave little room for error for the companies categorized as value.
T: Thanks, Roger. It looks like I still need to learn more from hands-on investment experience. I have to go—nice speaking with you.
R: You got it, Todd. There is no end in learning in investing, as things in the world of investment evolve persistently. Foresight is what is required to be successful in high conviction investing, but hindsight guides the foundation of ideas. It is not easy to discern these two in practice.