Hiring an investment manager is somewhat like hiring a fishing guide. You’re looking for someone whose knowledge, experience and judgment can lead you through an otherwise mystifying set of variables. As with fishing guides, some money managers are much better than others, and this improves the likelihood of good results over time. Below is a discussion of the strengths that have underpinned our success.
We eat our own cooking. Our portfolio manager has invested all of his personal long-term investments according to Kopion's Model Portfolio. He thus owns the same stocks in the same proportions as our clients’ portfolios. This aligns our interests with our clients’, and it also serves as a natural governor on the amount of risk taken in the portfolios.
Kopion is a value investor which means that we research the businesses we are considering for investment, develop an estimate of those businesses’ underlying values, and use the resulting appraisals to drive our buying and selling decisions. Benjamin Graham said that “investment is most intelligent when it is most businesslike,”1 and value investing uses due diligence and valuation exercises to squeeze emotion out of the decision process.
Humans are pattern-seeking creatures, so when a stock’s price declines, most of us feel like it is becoming riskier because we intuitively extrapolate the decline. In truth, however, as a stock’s price falls, it has progressively less downside risk and more upside potential—the “risk vs. reward” proposition is actually improving. Consequently, buying at lower prices simultaneously reduces risk and increases the potential return. Taking advantage of these opportunities, however, requires detailed analysis at the beginning of the process in order to characterize the businesses under consideration and estimate their underlying values. For an expanded discussion of this, please refer to our client letter, Competing Realities.
Certain parts of the stock market are more prospective than others, just like certain lakes and rivers are more likely to provide a good day of fishing. Kopion focuses on these areas.
Among value investors, Kopion is somewhat unique in that we focus on high quality companies that are likely to grow their earnings well into the future. We refer to these as “compounders.” Capitalism is designed to foster competition among businesses which is great for consumers, but makes it difficult for companies to grow since they are constantly having to battle competitive threats. Some firms, however, have unique advantages that insulate them from these competitive pressures and allow them to build upon their growth over time. Warren Buffet summarized this by saying that “time is the friend of the wonderful business, the enemy of the mediocre.”2 Kopion thus focuses companies with defensible competitive advantages in growing markets. For an expanded discussion of this, please refer to our client letter, No Rain, No Rainbows .
Kopion is also differentiated by focusing on firms that are relatively early in their commercial lifecycles and thus have abundant opportunity for growth. Ironically, many of these firms have been in business for a few decades, but their growth has historically been constrained by various barriers that have prevented the broader adoption of their products. As these barriers are overcome, however, the companies (and their stocks) often progress into their halcyon days.
Many investors, by contrast, gravitate towards “Blue Chips”—large, well established companies whose size and familiarity confers a sense of security. Unfortunately, this approach ignores the fact that companies have lifecycles, just like people. Most Fortune 500 companies take 25-30 years to earn a place on that list, but their average life expectancies are only 40-50 years. This is analogous to how successful businesspeople usually attain prominence in the later stages of their careers. Corporate lifecycles are such that many of the companies in the Fortune 500 cease to exist within 20 years of their initial appearance on that list.3 We thus believe that Blue Chips’ perceived stability is illusory because their advanced age makes it harder for them to grow and places them closer to their decline. The list of former Blue Chips is a long one that includes names such as Hewlett Packard, Motorola, AIG, Citigroup, Pfizer, Eastman Kodak, Xerox, Sears Roebuck, Woolworth, Bethlehem Steel, International Harvester, American Can, American Smelting, Studebaker, American Locomotive and others. (Many of the companies named here were once so prominent that they were included in the Dow Jones Industrial Average.)
In his 1989 book, One Up on Wall Street, Peter Lynch explained that there are institutional pressures that encourage portfolio managers to buy well known companies. He wrote:
With survival at stake, it's the rare professional who has the guts to traffic in an unknown La Quinta. In fact, between the chance of making an unusually large profit on an unknown company and the assurance of losing only a small amount on an established company, the normal mutual-fund manager, pension-fund manager, or corporate-portfolio manager would jump at the latter. Success is one thing, but it's more important not to look bad if you fail. There's an unwritten rule on Wall Street: "You'll never lose your job losing your client's money in IBM."
If IBM goes bad and you bought it, the clients and the bosses will ask: "What's wrong with that damn IBM lately?" But if La Quinta Motor Inns goes bad, they'll ask: "What's wrong with you?"4
John Maynard Keynes observed the same phenomenon when he said,
Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.
Besides institutional pressures, many portfolio managers oversee large funds whose sheer size prevents them from investing in small companies, regardless of how attractive they might be. Revisiting the fishing analogy used earlier, large funds are like fishing guides with large boats that can accommodate many customers. While this arrangement is lucrative for the guide, it also restricts him to large bodies of water. Furthermore, the attractiveness of this business model draws many large boats, so those areas tend to be over-fished. Small money managers, by contrast, are like fishing guides with small boats who can access small lakes and rivers. This gives them access to best water which improves their likelihood of catching fish.
Kopion’s portfolio manager spends most of his time performing first-hand research. This means that the person conducting the research is the same person making the investment decisions. This is extremely beneficial since all of the facts are brought to bear on each decision. This arrangement is also relatively uncommon.
In the most common arrangement, analysts conduct research and report to a portfolio manager who makes the actual investment decisions. This decoupling of research and decision making is problematic because the decision maker is never making full use of all the facts, and he is less confident of the information that he does have because it is second-hand. The most important decisions are made after stocks have declined sharply, and this is the exact moment when the portfolio manager’s confidence in his analysts is most strained. This can compromise the decision making process. This dynamic can occur when a firm has an internal research department, and it is magnified when a portfolio manager uses third party research because the degree of separation is wider.
A fuller discussion of this is available in our client letter, The Kopion Manifesto
Investing always involves an element of chance which makes it impossible to directly control the outcome. What can be controlled, however, is the investment process, and this process has a strong influence on results over the long term. Kopion focuses on executing against a well-defined investment process that is academically, logically, and historically sound. Poker legend Amarillo Slim expressed a similar approach when he said that,
The result of one particular game doesn't mean a damn thing, and that's why one of my mantras has always been "Decisions, not results." Do the right thing enough times and the results will take care of themselves in the long run. (Emphasis ours.)A fuller discussion of this is available in our client letter, Process vs. Outcome.