"Our philosophy and discipline work together to build in resilience at the individual company level and at the portfolio level as well."- Elise Hoffman, Marshfield Associates
[In the Institute for Innovation Development’s ongoing interviews with active asset managers, we are seeing a growing trend of portfolio construction exploration and experimentation driven by the aftermath of the 2008 financial crisis. Many have taken Modern Portfolio Theory and other traditional methodologies and have, in essence, blown them up, and are now reassembling the pieces into new types of investment strategies and risk management approaches.
To further explore this topic, we decided to reach out to 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 differs from the market in as many ways as possible, we decided to dig deeper from our previous interview to understand the firm’s perspective of risk management as architecture.]
“Form follows function – that has been misunderstood. Form and function should be one, joined in a spiritual union.” - Frank Lloyd Wright
Hortz: What does that quote from Frank Lloyd Wright say to you and how do you apply it to money management?
Hoffman: Frank Lloyd Wright, as a master architect, argues that a well-designed structure should seamlessly integrate both the form and the purpose of the structure so that the finished product incorporates both without any lack of continuity. We think his ethos expresses nicely our own approach to investing.
When we design and then construct our portfolio, we do so with an eye toward not only generating performance but also managing risk. In fact, the way Marshfield’s process works is that risk mitigation is an inherent part of company analysis and stock selection and not just an overlay thrown on top of those decisions. Our philosophy and discipline work together to build in resilience at the individual company level and at the portfolio level as well. We think it’s the joint impact of our largely independent decisions, as interwoven with our price discipline, that imbues our portfolio with a kind of tensile strength, resulting in an integrated whole that is greater than the sum of its parts.
Hortz: With that as a guiding principle, how do you start designing and then constructing your investment portfolios?
Hoffman: We rely on some basic tools of structural “engineering” at the outset with respect to such elements as number of stocks, position sizes, and the like. We don’t have too many rules, though, principally because we understand them to be somewhat arbitrary and we believe that piling rigid rules—even largely defensible ones—on top of one another only serves to amplify randomness. We intentionally limit our portfolios to around 20 stocks, based mostly on our experience, having tried smaller and larger numbers of holdings over time. Holding many more than 20 serves to diminish the impact of our best ideas and holding many fewer gives undue influence to our worst ideas. When we buy an opening position in a stock, we size it at 3% of the portfolio. It’s big enough to matter and focus our attention but not so big as to unduly harm the portfolio if we’ve made a mistake (which—spoiler alert!—happens from time to time). As we learn more about a new company, having lived with it for a while, we’re more comfortable adding to the investment if the price gets lower.
At the upper end of things, we have a per-stock limit of 15% of the stock portfolio. That gives the stock room to run but is a bright line buffer against allowing even our most successful investments to consume too much of the portfolio. That doesn’t prevent us from downsizing a holding before it reaches that upper limit when there is a clearly identifiable source of risk that causes us concern. Also, given the limitations inherent in the valuation process, while we have a hard-and-fast numerical rule dictating the point at which we will consider selling an overvalued stock, we don’t just pull the trigger willy-nilly; instead, we decide whether to sell some or all of our position, based on considerations such as our confidence in that particular valuation and the risks inherent in the business itself.
And that’s pretty much it as far as hard-and-fast rules of construction go.
Hortz: What about the top level design?
Hoffman: This is not something that we impose on our portfolio but something that happens organically as an output of our process. I analogize it to building structures in earthquake zones. Just as buildings along fault lines need to be resistant to both standard vertical forces as well as the lateral forces produced by quakes, our portfolios need to be constructed to withstand both the pressures on individual holdings as well as the kinds of exogenous shocks that can affect the portfolio more broadly. It’s here where the real strength of our price discipline comes to the fore. Due to the fact that we’re buying what’s cheap and selling what’s expensive, we’re continuously layering different economic and cyclical scenarios into the portfolio—and rotating out of them over time as well. Since our holding periods tend to be pretty lengthy—7-9 years, on average—we typically have a series of such cyclical stories built into the portfolio, resulting in a group of holdings that are likely to be favored in some economic circumstances but not others.
Hortz: How do you determine companies that add to the architectural design of the portfolio, that have as you say a certain ‘give ‘ built into them?
Hoffman: The ultimate architecture of the portfolio is determined by the brick-by-brick investment decisions we make. It’s our goal to invest in good, resilient companies at bargain prices and to own them until high price or a degradation in quality dictates their sale. At the individual company level, we look for firms with strong value creation opportunities that they are well-positioned to exploit, that have the ability to extract economic rents over time, and that have an excellent management team and a strong culture that is well suited to the industry.
Hortz: Can you further explain your concept of resilience and give us some examples of companies that exhibit this?
Hoffman: Sure. Resilience is an important through-line for our companies, the attribute that more than any other allows the portfolio as a whole to retain some stability during turbulent times while also maintaining the ability to take advantage of opportunities to grow and thrive. We believe that resilience exists independent of what one might think of as a good business. While its building blocks are similar: strategy, management, and culture, it represents a fusing of those attributes specifically in the service of addressing crises (or even just hiccups) of both internal and external origin. It invokes flexibility, the capacity to adjust course midstream, as well as a certain toughness of spirit. Most critically, it means that a company is built not only to survive disruptions but ideally to affirmatively succeed when circumstances are less than perfect.
I’ll give you a few examples. NVR is a homebuilder that is not in the business of speculating on the price of land; in fact, it foregoes the opportunity to benefit from appreciation in land prices in favor of the flexibility conferred by owning options on land rather than the land itself. Since a predecessor company went into bankruptcy in the early 1990s due to excessive land holdings, NVR clearly prepares for a world in which periodic financial and housing crises can arise, even if that means leaving some return on the table during the good times.
The case is much the same in property casualty insurance, where resilience means strong and effective cycle management, a practice that allows an insurer to move capital from one line of business to another depending on the point in the insurance cycle. Arch Capital, for example, pursues a strategy of shifting capital to those areas where fear predominates and away from those where complacency has set in. One of its current cash cows, mortgage insurance, benefitted from dislocations in the marketplace following the housing crash; yet Arch foresees a day, perhaps not too far down the road, when market conditions are too benign to justify continuing to write that business as enthusiastically.
The real common denominator for companies like this is the pulled punch: namely, the willingness to forego that last dollar of revenue or margin. Much as we at Marshfield look to sell a stock before—sometimes frustratingly long before—a stock reaches its pinnacle price, these kinds of companies understand that designing a strategy for the full cycle (and in anticipation of potential threats) means leaving some money on the table in the form of lost revenue or seemingly non-optimized operations.
Hortz: How does looking at investment risk from so many levels, from both the individual company level and at the portfolio level as well, best serve the portfolio and investors?
Hoffman: Portfolio design for us is less about following a detailed blueprint and more about an organic process of analyzing individual companies and deciding whether we should buy (or sell) them and if so, when. While, in theory, these independent decisions could result in a portfolio overly beholden to a particular economic environment or to the success of a particular industry or sector, in practice, this has rarely if ever proved to be the case for us. The interaction of our company quality requirements with our price discipline has over time tended to yield a portfolio embodying a balanced series of economic scenarios, where periodic shocks are not equally borne by every holding.
The bottom line is that if you specifically focus on finding companies that embody strength and resiliency and you buy them at prices that reflect a series of reasonably uncorrelated negative scenarios, you are making your portfolio as a whole more resilient.
Hortz: How is this risk management approach different from other predominant risk management approaches? What risks are they not addressing?
Hoffman: One thing we really like about our approach is that often when risk in a portfolio is reduced, performance is reduced as well. But in Marshfield’s case, we believe that it is the very attributes that support our good performance—namely, company quality, including resilience, and good price—that produce risk mitigation at the broader portfolio level. We don’t have to introduce new rules or metrics or dilute our philosophy in order to achieve that outcome. We can follow our discipline by being patient and holding cash until we see a great opportunity, and we can ignore what other investors do and what stocks and industries comprise the S & P 500—and in the end produce a product that we believe offers both good reward potential as well as capital preservation. It’s not clear to us that many other approaches can deliver the same.
Hortz: What is your best advice to advisors worried about the growing volatility and risk perceived in the markets today, in a business environment of accelerating change and growing uncertainty?
Hoffman: Changing one’s approach mid-stream to account for “heightened” uncertainty would only exacerbate such uncertainty, as it would introduce a new variable into one’s investment discipline, so we would really caution against doing that. Similarly, managing toward a particular apocalyptic outcome presumes the ability to predict not only that outcome and its timing but also its ramifications and the market’s complex reaction thereto. And finally, running for what seems to be cover by retreating from the market altogether might relieve anxiety in the short run, but it both assumes the ability to predict the market and begs the question of when to emerge from hiding should that prediction actually prove correct.
For us, the only approach—both logical and, we think, reasonable—is to accept volatility as a gift and to continue to look for and invest in good, resilient, high return companies just as we always have.
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