20th Anniversary of the Large Cap Model Portfolio. Some Reflections Over That Time and Lessons Learned.

The model portfolio was started on July 8th, 2000.

From the outset, the purpose of the portfolio was a real world test of a long held premise. It was my contention that one could bridge the gap between active management and passive management and, hopefully, earn an above index return. It was, and remains, my view that individual investors lack the necessary fortitude to maintain a portfolio of world class equities through the many unsettling times that make up a full economic cycle. Individuals become far too passionate about the current state of affairs and this makes it difficult, maybe almost impossible, for the public to hold investments for the sufficient time required to earn that above market return. Additionally, individuals are, in my view, pretty poor assemblers of equity portfolios. They hold poor investments for far too long, they sell great investments for relatively quick profits and this leads to result in less than optimal returns.

It is also my view that institutional investors are too conflicted or too obsessed with the need to earn at least what peers earn, to be able to hold investments through the periodic tough times that occur in equity investing. This would logically mean that most mutual funds and off the shelf accounts don’t achieve their stated aims over time.

The issues with passive indexing and peer return chasing have plagued institutional investors for decades and are well noted. Unfortunately, this awareness has led more than a few retail investors to conclude that they possess the nimbleness to beat institutional investors at what is truly an institutionally rigged market. Retail superiority bias is a false premise and can result in bad decisions that limit capital returns with a heavy dose of obstinance. Almost all studies in print indicate that retail investors, on the whole, do very badly indeed when it comes to assembling and managing investment portfolios.

These observations; that retail investors are crummy managers because they tend to trade when they need to hold, and that institutions are crummy investors due to the fact that they must buy and sell so as to, at a minimum, mirror peers for short term performance, are extremely sore points in the investment world. It seemed, at least to me, that there could be a middle way; something more than a buy and hold but less transactional than traditional portfolios, something less concerned with short term return but still endeavoring to outperform over time. That was the rational for the creation of the global large cap portfolio.

The aim was to identify important secular trends that would become evident to all over time. After identifying a secular trend underway, the step that logically followed was to find world class companies that would participate in those trends. Find a wave, buy a board, catch a wave, surf the wave. Investments chosen didn’t have to be early participants in any secular trends but they did need to possess the necessary scale to become a primary beneficiary of those trends. Potential investments would be relatively large and have limited competition. They were required to be dominant; the goal was to own horizontals, not verticals. Monopolies or oligopolies would, obviously, be preferable. Absent from the portfolio would be cyclical investments, industries with low barriers to entry and industries that earn low operating margins. The portfolio would be assembled, monitored, remarked upon and fussed over, but there would be very limited transactions. Dividends would be reinvested, the occasional takeover would need to be reinvested as funds were received and any new business that might be included in the portfolio would have to be superior, at the minimum, to the worst business presently held within the account. One critical determining factor for inclusion in the portfolio was that any investment had to earn a much higher than average EBITDA margin. A high EBITDA margin provides a cushion to offset a variety of ills, from both without and within. A company generating high EBITDA can bounce back from mismanagement, or from external shocks, far better than a company that generates a low margin.

Investments within the portfolio were to be reviewed regularly to ensure that their business was still at the top of the heap in its respective industry. Industries included within the portfolio were assessed regularly to ensure that they remained primary participants in a secular trend. And that was it. After the initial building of the account, it was left to its own devices, free of external meddling and unburdened by useless oversight.

The starting year, 2000, was a horrific time for investors and the portfolio took some years to move firmly into the black. Since that time, there have been several bubbles, numerous meaningful recessions, a number of market crashes and growing geopolitical tensions. Despite that, the account maintained its low turn philosophy. I missed out, completely, on the incredible wealth created for those who caught onto the growth of the FANGS, at the outset. My objections were purely financial, in the early years, none of the FANGS generated anything close to a respectable EBITDA margin.

Despite this glaring oversight on my part, the account was incredibly lucky in one respect. I was fortunate enough to capitalize upon the growth of financial processing via the public listing of several FinTechs. The trend towards global consumerism and the need for fast global payment processors has been, thus far, a clear and compelling trend. Due to the existence of Fintechs, consumers can purchase a product directly from a retailer almost anywhere in the world. That retailer can receive, for a reasonable charge by a FinTech, their sale price of that item and it is delivered, typically without incident, to the purchaser in a reasonable timeframe. Mastercard, Visa and PayPal were merely payment processors for almost a decade, until someone decided that they were FinTechs, so I truly wasn’t even an early participant in the trend, a number of my holdings were simply rebranded and got swept up in the trend. Nevertheless, payment processors were instrumental in laying the foundation for the success of Amazon and other online retailers; for without the ability of the customer to quickly pay for a product, and to have some assurance that their purchase would actually be completed, most online retailers would not have grown to the size that they are today.

Due to the participation of the account in just this one trend, and despite the recent balkanization of the world into “pro-China” vs “anti-China” camps, as well as the current economic misery wrought on the world by a global pandemic, the portfolio has succeeded in generating an above market return for the first twenty years of its existence. A $1 million dollar investment in the account on the inception date and held through August 7th 2020, had grown to $39.24 million US, net. In no year, over the past twenty, was the turn ratio greater than 5%. In some years, the only investment transactions were dividend reinvestments.

My resolve has been tested, time and time again throughout the past two decades and this year is certainly another year where being resolute has seemed, at times, imprudent. What has been noted is that simply letting a large, well run company do its thing without being caught up in unbridled enthusiasm or abject terror has been highly profitable.

There have been almost a mind-numbing number of incredibly successful investments over the 20 years that I have failed to purchase in this account. No doubt, I will continue to miss out on innumerable highly successful trends to come in the coming two decades. However, to have earned a compounded annual return of 20.12% over 20 years suggests that one doesn’t have to even get a lot right, so long as one gets SOMETHING right and persists on holding a few successful investments through the valleys.

Over the last two decades, despite rigorous balance sheet evaluation, careful appraisal of all competition and through patient development of understanding just what a company, or industries, place is in the global economy, the butterflies have never left my stomach and accordingly I seek out investments that minimize the wear and tear of investment media on my psyche. I have avoided most investment pitfalls due to a sustaining and healthy skepticism of the investment media, of mainline investment firms in general and of the retail public at large, who all wear their confirmation bias with as much aplomb as do national military personnel. I don’t read external research, I troll through SEC filings or the equivalent filings to the SEC in foreign jurisdictions. I don’t listen in to shareholder communication conferences. I don’t talk to management of companies that I own; management is clearly biased and cannot, for legal reasons, tell me what I need to know. So, I do my own workups for each and every company within my portfolio and look for the flaws in my own judgement. As I do not believe that I am the “smartest guy in the room”, it makes critiquing my own work quite interesting at times. The risks of owning ALL equity investments is far higher that the public is led to believe and that remains uppermost in my mind at all times. Secular trends can be derailed; they can be squashed by political whims or by geopolitical events. Avaricious governments often seek to confiscate abnormal profits, in the belief that such levels of profitability are ill-earned. Rent-seekers in countries, foreign and domestic, attempt to extract their pound of flesh. All of this requires that one remain constantly vigilant. Thus far, I have not had to make key judgements about when a secular trend unravels on a permanent basis. Identifying the end of a trend, that might be the true test of investment success for this account.

My critical eye, and persistent fretting about both the big picture and the small picture, the macro and the micro, on more than one occasion leads readers to conclude that I am more a bear than a bull. Categorizing my investment process is not to be simplified into a false choice. I am not a Warren Buffett acolyte in the slightest. I take a world view and am determined to own the best company in its class, wherever it may be found. I don’t buy turnarounds, I don’t own cyclicals, I don’t own industries that are in terminal decline in the hope of scraping out some pennies on the corpse. I refuse to buy indexes or ETF products due to the fact that in order to hold a few great investments within them, one must hold an enormous amount of profit limiting detritus. I don’t buy fallen angels. In truth, I don’t buy much and I don’t own a lot of industries that are present within broadly based indexes. I don’t go short or use arcane hedges. I won’t own investments simply because everyone else does.

I intend, and am determined to own, the very best investments in a highly profitable industry, no matter what country that investment is listed in. I own companies, not economies. When it comes to most industries and all companies, I represent a skeptic and that differs completely from a bear; a skeptic is truly an optimist, because a skeptic wants to believe. Apparently, I am somewhat on the “spectrum” in the category of skeptic, because my investment view skews towards the jaded, less the “trust but verify” type, more so the “identify, don’t trust and DO verify”.

Over a twenty year span, the returns earned have been somewhat life-altering, for both myself and, I have to believe, for those who were fortuitous enough to participate alongside me. In the coming decades, it will be fortunate, indeed, if I am able to identify and capture just one more important secular trend that will help to reframe the global economy. I look forward to continuing that search.