"We try to be different only in ways that we think give us an edge over the intrinsic architecture of the market." Elise Hoffmann, Marshfield Associates
[The Institute for Innovation Development recently talked with Elise Hoffmann, Principal and Co-Chair of Research for Marshfield Associates, a value money management firm based in Washington, DC and advisor to the Marshfield Concentrated Opportunity Fund (ticker: MRFOX). With a core investment tenet that the only way to beat the market is to have an investment strategy that deviates from the market in as many ways as possible, it sets up a number of complex questions: How does an investor balance being “different”, protecting capital, and shooting for out-performing the market all at the same time? What is the mindset and approach that allows you to implement that kind of strategy? ]
Hortz: As a money manager with a strategic goal of outperforming the market, how do you know what investment strategies are sufficiently different? What are the main differences you determined in your approach and have they evolved over time?
Hoffmann: It’s surprising how hard it is for active managers to get away from closet indexing. Anyone who strives to replicate all or even most sectors of the market, who diversifies well beyond what’s minimally necessary for the sake of risk management, who stays fully invested at all times, and who feels compelled to participate in the “must have” names of the day like the FANG stocks risks replicating the market’s performance, minus fees. We approach things totally differently. We specifically look at where the market does things that we think are suboptimal for good performance. So for example, we’re happy to hold cash—not as a tactical matter but as an output of our valuation and company analysis. As our names decline in price, we add more; the stock market implicitly adds more to the highest priced names. We’re concentrated—we hold about 20 stocks. We couldn’t care less about what sectors we’re in so long as we like the industry structure and the company in question.
But we’re not different for the sake of being rebellious or oppositional. We try to be different only in ways that we think give us an edge over the intrinsic architecture of the market. We’ve been doing things this way since our inception back in 1989, with maybe a few tweaks along the way but no major changes. At bottom, we’re trying to address the central paradox of public equity investing, which is that in order to outperform the market you have to be different from it but in order to be paid for being different, you have to submit to the market’s ultimate verdict on the value of your holdings.
Hortz: Since you are equally looking to preserve principal, where do you see the boundary between the right kind of different and the wrong kind of different? Why do you state that your approach has “an inherent risk-mitigating value”?
Hoffmann: There are lots of ways of being different that don’t necessarily add value and lots of ways of being different that layer on risk. So the trick—especially if, like us, you want to provide downside protection for people’s capital investment—is to find ways to be different that add value on a risk-adjusted basis. We actually don’t find there to be much, if any, conflict between preserving principal and attaining above-market returns. The things we look for in a good investment are also those things that tend to be protective of capital: resiliency; a coherent, strong, and appropriate culture; good management; a good valuation that can help buffer shocks; and an industry structure that is stable or improving. That’s what we think makes our approach inherently risk-mitigating.
Hortz: In the active vs. passive debate, you feel that active management can have strong analytical advantages over passive investing. Can you walk through those with us?
Hoffmann: The way we see it, an active manager needs to have a meaningful analytical advantage: an information advantage, an intellectual/perceptual advantage, or a process/discipline advantage in order to earn his or her keep. Not many of us have an information advantage in this Reg FD world, and I would argue that a lot of what passes for useful information, like minutely detailing foot traffic in stores, is really just informational noise. The real trick here is for a manager to understand what matters and what doesn’t.
But it’s really two analytical advantages that can set a manager apart from the crowd and justify active management. An intellectual or perceptual advantage can be an algorithm or it can be the way a stock picker approaches understanding an industry or a particular company. For us, we spend a lot of time focused on company culture, among other things. While culture is dismissed by most investors as “soft” and kind of hard to pin down, it’s quite real and extremely important. Look at it this way: a strong and resilient culture is critical to surviving things like management succession, something that’s actually among the most dangerous events in a company’s life cycle. So the ability to understand culture, developed in part through repetition and experience, is impossible if you don’t deeply believe in its importance and if you don’t have the right set of perceptual tools. Another analytical advantage to look for is a process or discipline advantage. This has to do with the methodology around buy and sell decisions. Using a well-constructed process that flushes out inconsistencies and anomalies and that surfaces emotional biases allows you to make better and more reliable decisions. If a manager doesn’t have any of these advantages over the crowd, it’s really hard to justify using him or her.
Hortz: How do you develop and deploy what you call “guardrails of process”?
Hoffmann: One of the most important things process can do is to help eliminate some of the typical sources of bad decision-making, like pro-cyclical emotional bias. If you do everything ad hoc, you’ll find that it’s hard to replicate what you do well and also difficult to keep yourself from doing stupid things repeatedly. Basically, everything you do, as well as how you do it, should be undergirded by process. And I think that every investor needs to come up with a process that suits its style and discipline. We’re really protective of capital, so we have conservatism built into our process in myriad overlapping ways. We’re happy to hold cash, and that gives us the freedom to uncouple buy decisions from sell decisions. We never consider them together. This works for us but might not work for a growth manager who has to stay fully invested at all times. And while we’re willing to tweak our process—and honestly, we’re pretty ruthlessly self-critical—there’s a pretty high burden of proof to meet before we do that.
I’m not advocating rigidity, though. You need to stay flexible in your thinking and opportunistic in your actions. I’m just saying that you should have “guardrails” that guide you and keep you from running off the road. For example, we’ve developed a couple of checklists to make sure we don’t forget critical components of our analysis. It’s easier to forget stuff like that than you think. Adhering to these principles is especially critical when the world turns scary. There’s no place for impulsive behavior in investing, least of all when the world looks super uncertain. While it might work out from time to time, emotion is an unreliable ally. So when the tails get fat, and bad things look like they’re just around the corner, that’s when the rubber really meets the road and your guardrails can keep you from going over the cliff.
Hortz: What have you found are the characteristics of the kind of singular “lone wolf” companies you look for? Do they tend to have more innovative managements and company culture?
Hoffmann: One of the ways we strive to be different from the market is to avoid the kinds of consensus stocks that everyone else owns. And to those who say you can’t beat the market unless you own Apple or something, I say that’s just flat-out wrong. Your best chance to beat the market is to own singular stocks that represent good businesses and have good management and culture—but that the market isn’t celebrating with champagne and roses. While Apple may be singular, it sure seems to be priced for perfection.
We like companies that have an internal compass that steers them and that are not constantly looking over their shoulder at what everyone else is doing. They tend to be willing to think independently and not care about what the analyst community wants to see. We love it when a company refuses to provide guidance or doesn’t have earnings calls. Lone wolves tend to really know their customers and be able to provide the value those customers want. Since they’re not burdened with a business design cobbled together from the blueprints of others, they also tend to have the kind of resilience that allows them to respond well when the inevitable curve ball comes. This sometimes means that these companies are more innovative and it sometimes means that they were just dealt a better hand when they began so they don’t struggle with the kinds of lock-in that their competitors might have. Maybe another way to put it is that the management of a lone wolf tends to have the courage of its convictions and the support of its culture and employees—and so they’re better able to execute on their strategies. You may have to wait awhile for the market to understand and reward these companies, but that just means you can buy them all day long while the market’s looking the other way.
Hortz: What is your best advice to advisors concerned about investing for their clients in a business environment of accelerating change and growing uncertainty?
Hoffmann: In our experience, bad things will happen. Just count on it. Not always the particular bad things you think are going to happen, though. You have to be ready for the bad stuff but you can’t get too scenario-dependent in your planning. Stay nimble, own companies that themselves are resilient and able to do well across a variety of environments, and that have a management and culture that allow them to be resourceful and tough. And prepare for volatility in advance by having cash and a shopping list. You’ll get through it and, with any luck, you’ll come out the other end with a better portfolio than you started with.
This article was previously posted on Financial Advisor Magazine Online.
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