In this episode of The Acquirer’s Podcast Tobias chats with Daniel Grioli, the Managing Partner at Guisgard Capital. Daniel constructs his portfolios using the best ideas of a group of carefully selected fund managers. He distills the portfolios of up to twenty mutual funds, investment advisors and hedge funds investing across four different investment styles (quality, growth, value and small cap) into two portfolios. During the interview Daniel provided some great insights into:
– When You Put Four or Five Portfolio Managers Together You Get Mud!
– How To Construct A Successful 13F Portfolio Strategy
– Like Coca-Cola, The Best Portfolios Are Heavily Concentrated With Provision To Add Water
– Fantastic Backtests For 13F Strategies Are Totally Impractical
– Why Is it A Waste Of Time To Try To Replicate Firms Like Renaissance Technologies
– The Successful One Stock Portfolio
– Value Investing Works Best When You Have Nice Frequent Economic Cycles
– The Secret To An Outstanding Growth Strategy Is To Prune Out Those Growth Ideas That Are Not Working Out
– Investors Could Be Missing Out On Some Big Gains By Selling A Stock That Reaches Its ‘Target Price’
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Tobias Carlisle: All right. Take three.
Daniel Grioli: Cool.
Tobias Carlisle: I’m Tobias Carlisle. This is the Acquirers Podcast. My special guest today is Daniel Grioli of Guiscard. He’s a former allocator turned Fund manager. He’s learned some lessons and we want to talk to him about what they are right after this.
Speaker 3: Tobias Carlisle is the Founder and Principal of Acquires fund. For regulatory reasons, he will not discuss any of the Acquires Funds on this Podcast. All opinions expressed by Podcast participants are solely their own and do not reflect the opinions of Acquires Funds or affiliates. For more information, visit acquiresfunds.com
Tobias Carlisle: Hi Daniel. How are you?
Daniel Grioli: Good. Tobias, how are you?
Tobias Carlisle: Very well. In the interests of full disclosure, we should say we’ve had some technical difficulties trying to record this through fiber optic cable or multiple fiber optic cables connecting the US to Melbourne. But it seems to be working a little bit better now.
Daniel Grioli: It must be all those highway listing devices.
Tobias Carlisle: That’s right. So Guiscard, where does that come from?
Daniel Grioli: So it’s a Norman French word. It means crafty or cunning. It’s a title that’s been given to various people through history. But it’s anti-descendants, actually a lot older. It comes from two Norse words because the vikings invaded Normandy and the two Norse words are wise and brave. And I think that investors to be successful need to combine those two qualities. They need to be wise, but they also have to have the bravery to act. And it’s French. That sounds kind of sophisticated and cool. So[crosstalk 00:02:06].
Tobias Carlisle: You didn’t want to choose an Italian word.
Daniel Grioli: I guess. Well, in some ways it is kind of related to Italian history because one of the people that had that surname Guiscard, was actually quite prominent in Italian history. So an interesting adventure and military rader, if you were to look him up, his name’s Robert Guiscard.
Tobias Carlisle: I’ve recently finished a book on the history of Britain and I know that the Norman area is where William the conqueror, who was the first king to unite all of Great Britain or England at least. So, I’m happy to hear that there are some Norman Norse words that continue on. So you’ve got an interesting career because you started in Australia and then you moved to London where you worked in structuring at Deutsche. And then you came back to Australia to work in a superannuation fund which is like a pension fund in the states. So what was your role in the superannuation fund?
Daniel Grioli: So I started there as a bit of a generalist at a fund that at the time was about $5 billion Australian assets under management and then the financial crisis hit and we got to 4 billion pretty quickly. So that was an eye opening experience, losing 25% of our multi-asset, supposedly diversified portfolio very quickly. But at the time I was covering everything. So everything from the cash portfolios right through to illiquid unlisted portfolios, which had everything in them. I love the Mug.
Tobias Carlisle: It says I love Australia if you can’t see it at home.
Daniel Grioli: So, we covered everything from, we had a craft lacing, Agriculture funds, liquid Hedge funds, fund of funds, you name it. So it was a very broad experience. And then over time and through different roles, I started to focus primarily on the listed asset classes and then equities, but also on multi-asset strategy. So I spent a lot of time working on the fund strategic asset allocation, but also taking tilts around that. And some people call that dynamic asset allocation. Other people call it market timing. We draw the line between the two is kind of subjective.
Tobias Carlisle: As a manager. And I know I have other managers who listen to the Podcast. I’m always interested in how allocators think about managers. How does one manager stand out? So I’ve heard you discussed this before and we’ve discussed it before. You like to compare a manager to their own universe or the first part of their funnel.
Daniel Grioli: Yeah. So the underlying idea is that you’ve got to be looking for feedback into your process. So how can a fund manager look for feedback on what they do? Well, they can look at each decision that they make independently as if it was a portfolio and compare the next decision layer to that to see what it adds. So if you think about how most fund managers processes work, and I’ve seen millions of these inverted funnel diagrams where you start at the top with the whole universe and then you filter for liquidity. And then if you’re a value manager, some sort of price screen or growth manager, some sort of EPS growth screen. And then you have your team of analysts and they analyze the stocks that passed the screen and then the portfolio manager picks the portfolio as the last step.
Daniel Grioli: What you want to do is you want to see the value that each layer is adding and in many cases the layer that the majority of the work is that screen. Because if you think about it, say this 10,000 stocks in the universe and then you take out the illiquid names, you’re probably left with 5,000 and then you screen and you’ve got a short list of 500 names. So you’ve just gone from 10,000 to 500 with screening. So it’s cut out 95% of the universe. Stand 95% of the work before the analysts have even looked at a balance sheet.
Daniel Grioli: So what does that screen do? And if you ran that just as a portfolio, how would it do? So what is your team below that point adding? So what are the analysts adding in terms of stock names and what is the portfolio manager adding in terms of risk management and position sizing? And I was always really interested in the founder managers that did that analysis. And what surprised me because I instituted a policy of asking everybody that question in every meeting I had for about a year to two years. I think I asked the question and 90% of the managers I asked hadn’t done the analysis and that shocked me no end because to me it’s the equivalent of a sports team not watching the game tape to see what they did right or wrong.
Tobias Carlisle: It’s funny. That’s exactly the process that I went through to go from being mostly discretionary to being mostly quantitative because I realized that the universe that I was drawing from was consistently outperforming. And whatever I was doing at that final stage was reducing returns pretty materially. So I’m happy to hear that that’s one of the things that you do. And that’s one of the things that I do track. So now you’re a manager at Guiscard and you manage, you have an investment management side to the business. one of those lessons when you’re an allocator, have you taken over, when you’re deciding how you construct a strategy and then how you market the strategy?
Daniel Grioli: I think the biggest lesson is there was a big disconnect between what the fund manager thought we as the allocator or the client was looking for and what we were looking for. And that disconnect in some ways informs what I do now. So I’ll give you an example. So the fund manager would come to me and say, well, look at my returns. There are fantastic. Have out performed. I’ve done it with these characteristics. I’ve delivered net alpha after fees, you should hire me.
Daniel Grioli: That’s not the problem as an allocator I was trying to solve because, yes, I can find a great manager that does a great job, but that’s not my problem. My problem is I need to find five or six or if I’m a really large pension fund, 10 or 15 of these managers, and not only do I have to find 10 or 15 which is hard, I have to play nicely together and that’s even harder.
Daniel Grioli: And what I learned over time was that once you start getting past three or four managers, the interaction effects really start to crowd out what the manager’s doing. And the way I’d explain it to a fund managers, it’s no different to their own portfolio. So when I look at, for example, adding a bank stock to their portfolio, they say, what exposures does this bring to my portfolio? It exposes me to the underlying economy, the housing market, net interest margins, bad debts, et cetera. Do I have those exposures already? Do I want more of them. They’re not just looking at all this bank’s a great bank. They’re looking at what it brings, what it adds to their overall portfolio.
Daniel Grioli: So I used to explain to managers that we try to think the same way. And yes, you may be a great manager and you might be good at what you do, but that’s not necessarily the problem that we’re trying to solve. We’re trying to solve a problem of creating an overall portfolio with more than one manager such as yourself.
Daniel Grioli: And so that disconnect just kept coming up. And that issue of the interaction affects the redundancy between managers, particularly with Australian shares. So, I used to say, for example, that … and I did the analysis once at an earlier job that I had where I had access to one of the big investment banks, quant model. The model that they’re quoting team at their transition management team used to analyze portfolios. And I ran all these different combinations of managers through it. And invariably what happened was once I added a third or a fourth manager, the redundancy effects just started to cancel out the good work that the managers did.
Tobias Carlisle: What does that mean? They own the same stocks?
Daniel Grioli: Well, one manager owned, the other one didn’t. So for example, a value manager might say, “Oh, you were at the bottom of the resources cycle. I want to go long BHP.” And then the growth manager says, “Oh, you know we’re at the bottom of the resource cycle. I want to be in a tech company. I want to be short BHP.”
Tobias Carlisle: Right.
Daniel Grioli: And because of the concentration in the benchmark, the stocks where you could be heavily under or overweight are few in number. So you end up with this really large redundancy effect. So what ends up happening as well is that most active equity managers in Australia, they really pay a play a bit of a benchmark arbitrage game. And the way the game works is you underweight the top 20 names and it’s those under weights that actually drive your tracking error or your variation from the benchmark. And then you spread the capital from those under weights across a few mid and small caps. And that’s actually where you generate your out performance.
Daniel Grioli: The problem is when you put four or five managers together doing that, you get mud. And the reason why I call it mud is, it’s like when you’re in kindergarten and you start painting and you put a bit of yellow on the canvas and then you put a bit of blue on top of the yellow and it goes to green and you think this is great. I can mix colors. If I put red on top of blue, I get purple. But whenever you add that third color, you get brown get mud. And it’s the same with multi-manager portfolios. The interaction effects, particularly in concentrated markets. So anybody who’s allocating in Australia, in Canada, in the Nordic countries would know exactly what I’m talking about because it’s a really big problem.
Daniel Grioli: Less so in emerging, but that’s still relatively concentrated and a bit less so in global because it’s a bit more diverse, but it’s still an issue.
Tobias Carlisle: So how does a manager avoid that or how do you avoid that problem?
Daniel Grioli: Well, the interesting thing about the manager is they are incentivized if an asset gathering manager to run a liquid portfolio. And that means staying fairly close to the benchmark.
Daniel Grioli: The other incentive is that managers typically earn a percentage of assets under management based fee. So their incentive is to not lose assets under management. And the way that they do that is by trying to strike the right trade off between being active enough to be interesting to the client and not so active that you under perform and lose them. And when you’re running those kind of portfolios, those are long only tracking error three to five. They’re the ones where you get the interaction effects at their worst because you put a few of those together and you quickly, very quickly go to benchmark. But you’re paying active phase.
Daniel Grioli: So part of it is looking for managers that are willing to do something different. Part of it is by specifying different benchmarks. So for example, with one of our managers, we excluded the 20 largest stocks on the Australian index. We did some analysis of their returns and we found that we’re very good at buying mid cap and small cap names. So we just took that benchmark risk away from them. We said, “Look, you’re not going to get penalized if one of those big stocks does well because we were taking it out of your universe.”
Daniel Grioli: So sometimes it’s up to the allocator to define the universe. Sometimes it’s up to the allocator to find somebody that’s doing something different. Sometimes it’s up to the manager, but it’s something that you have to be very thoughtful of because it can dominate the good work that your individual managers do.
Tobias Carlisle: So at Guiscard, you run a best ideas portfolio, which is something like a 13F replication or am I missing describing that?
Daniel Grioli: It is 13F based. So the way I would describe it, it is a multi manager portfolio without the managers. So essentially what I’m trying to do is create a multi-manager portfolio, remove all the frictions and the complexity and the costs that 10 years of trying to do it at a pension fund taught me just doesn’t work. So I’m trying to create a more efficient version of a multi-manager portfolio.
Tobias Carlisle: And how do you go about doing that?
Daniel Grioli: So I identify a group of what I believed as skilled managers, these managers have high conviction. And it’s important to look for managers with high conviction because it’s quite interesting. So, at the moment I’m tracking 15 managers and I ran the analysis of what would happen if I just allocated to these 15 managers roughly in line with their contribution to my portfolio. What would the overall portfolio look like? And turns out it would have 490 stocks. So I’d get the S&P 500.
Daniel Grioli: And the interesting thing is these are very concentrated managers individually. So each one of them has at least 40% of their portfolio in their top 10 stocks. And yet, when I combine them together in a typical sort of multi manager, if you were to use the Morningstar style and got to fill the nine buckets, S&P 500.
Tobias Carlisle: Right.
Daniel Grioli: Even if you focus on the top 50 stocks that these 15 managers hold, the top 10 only account for 20% of the portfolio. So still individually highly active, put them together. It’s amazing how fast the active bets get diluted away.
Daniel Grioli: So the first step is identifying the universe of managers, but there’s not one universe I actually monitor four universes. So I have a group of Quality Managers, Growth Managers, Value Managers and Small cap Managers.
Daniel Grioli: And this is something I learnt investing in other 13F replication, strategies previously is that a lot of strategies focus on trying to find managers with great recent performance. And they’ll often use a lot of quantitative analysis to work out who has the best information ratio, whatever.
Daniel Grioli: What I found happens with that is that you get a lot of curve fitting. So you end up following a group of managers that has done well and what ends up happening, what happened in this strategy that I was invested in was the portfolio got heavy with growth oriented Hedge funds because they had done really, really well. And if you think about it, if you pay somebody two and 20 to pick stocks, you’re not paying them to buy you a T&T or Procter & Gamble. You want something sexy, you want to Carvana or you want to Zillow the next big whatever.
Daniel Grioli: So most Hedge funds have a growth bias and so all this quantitative sampling to find the best pool of managers to follow, gave the portfolio heavy growth bias. And what happened in 2016 was, the strategy was literally up by about 10% this manager strategy. And then early 2016 the market sold off, so up … sorry. Versus the S&P 500 it was down 10% versus the S&P 500 in a very short period of time. And then when the market recovered at the end of 2016 it was all the cyclicals that drove it higher. So it got totally whipsaw. It went from plus 10 minus 10 and then missed all the recovery because it was focused on a sampling of growth managers that had done well over the last two or three years.
Daniel Grioli: And so by ensuring that I’m looking at different universes and that the final portfolio is a combination of them, I help to manage those style and factor effects, which are very important in that in trying to create a more sustainable, robust return.
Tobias Carlisle: So you start out with four universes and then you look for managers in each of those universes. Are you equally weighting into the universes?
Daniel Grioli: No. So there is a bit of discretionary management. Actually there’s a lot of discretionary management. The reason why I don’t equally weight is because I’m trying to manage risk. So to give you an example, we were criticizing other fund managers for not doing the analysis versus at naive portfolio. I ran the analysis of my naive manage your portfolio.
Daniel Grioli: And the results were interesting, so it did slightly better than my actual portfolio. So I’m like you the simple quite beat me by a few basis points but that wasn’t telling the whole story. If you actually look after tax, my returns were better because I have a risk map [inaudible 00:20:14] I’m selling losing stocks. So the tax credit of that actually would have boosted my returns at a phase.
Daniel Grioli: But also in this recent period where we had the Trump tweet at the beginning of May about trying to tariffs and everything selling off and then the power press conference at the beginning of June and everything taking off again. During that volatility, the draw down of my portfolio was a lot less than the risk management characteristics were a lot better. So that’s another important part of it is the position sizing and the risk management.
Tobias Carlisle: Talk to us a little bit about how you size positions and how you think about each manager’s contribution to their own style.
Daniel Grioli: So in terms of sizing position, I don’t do it. I don’t care what the benchmark position is, but in most cases that don’t even look at it. And if I do, it’s usually after the fact. Just because I’m curious.
Daniel Grioli: How I size positions is, I’m looking at the risk of each docket, individual stock level, and then aggregating that up at the total portfolio level. And I’m doing it that way for a couple of reasons. So I assign the maximum amount of loss that I’m happy to make on an individual position. And the reason I do it that way is that when I aggregate all of those individual stock losses together to come up with what I think total portfolio loss will be, I’m assuming that every stock is perfectly correlated with each other, which I know is not the case.
Daniel Grioli: Now, why would I make that assumption that everything’s perfectly correlated? Well, because most of the time that’s not going to be the case. So I’m effectively assuming the worst and getting pleasantly surprised, 80 to 90% of the time. And that’s the opposite of how most people construct the portfolio. Most people will assume those correlations and try to optimize. And in that case they’re assuming the best and getting surprised, 20 to 30% of the time. And typically the surprise is very bad.
Daniel Grioli: So I kind of feel how I’m doing things is a bit more robust by assuming that every stock is perfectly correlated and if they all lose money and everything has to get managed down, what is my total portfolio loss? So I think of it in that way. And once you start to think of it in that way, your position size becomes a function of both the upside that you think you’ll get from that stock, but also the damage it will do to your overall portfolio if you’re wrong.
Tobias Carlisle: So for example, if you have a cyclical stock, how do you size something like that? What’s a maximum position size inception?
Daniel Grioli: So for something that’s deeply cyclical, maximum position size is probably about 3% of the portfolio.
Tobias Carlisle: And it’s something that’s more stable, compound?
Daniel Grioli: Maximum of 9%.
Tobias Carlisle: So that’s quite a large position size inception.
Daniel Grioli: Yes. And we can hold it as … we can let it double without having to sell. That’s another thing.
Tobias Carlisle: How many positions altogether?
Daniel Grioli: Between 15 and 30.
Tobias Carlisle: It’s very concentrated.
Daniel Grioli: It’s very concentrated. And the reason for that is the way I conceptualize what I’m trying to do is I’m creating cordial. And if you think about Coca-Cola, for example, if you go to the shop and you buy a bottle of coke, that’s premixed, you’re paying mostly for water. There’s that much syrup at the bottom, and the rest is water and you’re paying for water. Whereas at a restaurant, they will buy postmix, they’ll buy the concentrate and now add the water. So if they sell you a glass of coke, their cost is probably 5 cents and they’re charging you whatever for it.
Daniel Grioli: So by running a concentrated portfolio, what I’m trying to give my clients is that cordial is that concentrate. Where if you were to run a typical multi-manager portfolio and you had five or six active managers together, once you account for the redundancy and the interaction, there’s probably 15, 20 stocks that are driving all your risk and return. And yet you’re paying me six managers, all this money largely to manage risk. And the risk that they’re managing is, they are tracking error and they liquidity so that they can maintain their capacity and keep the farm. They’re not actually managing your risk, they’re managing their business risk.
Daniel Grioli: So if at the end of doing that, you’ve just got 15 to 20 stocks that are driving all your risk of return, why can’t I just give you those 15 to 20 stocks? That’s really what best ideas is. And to the extent that you are worried about tracking arrow underperforming the market, you add your own water going by the S&P 500 ETF, mix it in at whatever proportion you like. It’s a lot cheaper that way you’ll get the same overall outcome with less complexity and less cost.
Tobias Carlisle: So, when you’re looking at the managers, there a few things come to mind about the 13F tracking strategies. I know Mebane Faber has a book where he talks about, some of the research. So one of the things that Mebane points out is that you don’t want to hold the largest position because often that’s a position that a manager had conviction in and has allowed to run. And so the juice might be kind of gone from that idea. So how do you handle things like that?
Daniel Grioli: I think you’ve got to handle it by … this is where it’s actually a little bit difficult because it’s very hard to come up with one set of rules that you can apply to all managers to figure out what conviction is.
Daniel Grioli: So conviction can vary a lot from manager to manager, so there has to be some discretion in terms of how you figure out what a manager’s highest conviction ideas are. And the example I give people is Warren Buffet. So if you look in his top 10 stocks, Wells Fargo features pretty high up the list. Now does that mean that Buffet an enormous amount of conviction of Wells Fargo? Probably not. It’s probably more likely that he bought it a long time ago, which he did and is sitting on a massive capital gain. And therefore, the penalty for selling it is pretty large.
Daniel Grioli: And given that it’s delivering a return on capital that’s better than most of these alternatives, he’s probably happy to sit there.
Daniel Grioli: Conversely, you’ll often see Buffet selling Wells Fargo in his recent 13F filing. Does that mean he’s lost conviction in Australia, in Wells Fargo or not necessarily? He’s an insurer. And by law insurers aren’t allowed to earn more than 10% of a bank. So he’s trimming to maintain that 10% limit.
Daniel Grioli: So by understanding Buffet’s situation in his process, you can interpret his conviction level. That’s the example I give people. So with every manager, you need to have some understanding of the process. So at the end of the day, what I’m doing is I’m still investing in the multi-manager portfolio because I’m looking at these managers just as I would be if I was looking to give them a hundred or $200 million in a mandate.
Tobias Carlisle: So can you talk a little bit about the managers who you track? Is that for fraud trio? Can you share those names?
Daniel Grioli: I can talk a little bit about them in broad terms. I probably can’t give you the names, but with the quality managers, the quality defensive managers, they typically more concentrated, they’re also lower turnover. So they anchor the portfolio in a few ways. The lower turnover helps to reduce the turnover, the overall portfolio level, but they also act as a bit of a stabilizer compared to the other styles. With the growth managers, they’re interesting because they typically have a higher turnover. So you have to make a little bit of allowances for that in how you’re looking at managers. And with the small cap managers, they’re also interesting because they typically tend to be more diversified. They hold more stocks. So you have to think a bit differently about how you assess conviction for them. So it’s very much horses for courses.
Daniel Grioli: With the value managers, I tend not to buy managers that are just interested in cheap things. So there are a few managers that are looking for cheap stocks, but most of them are actually activists or some kind of special situation managers. And the reason for that is that I believe that, that looking for cheap stocks can largely be done with a factor based or quantitative approach because you’ve got all the information you’ve need. The price is a current piece of information, book value, earnings, cashflow, whatever it is, is a historical piece of information.
Daniel Grioli: So a quant process has all of the information it needs to calculate a value. Therefore I don’t see where humans have the advantage.
Tobias Carlisle: How are you making the determination that one manager is better than another? You’re looking for a long track record about performance and then near term under performance. Is that then capturing the main reversion to come?
Daniel Grioli: I’m actually not too bothered by performance. Obviously I want to see a long term sustained track record. What is more interesting to me is, this is one of the interesting things about this approach. So a lot of people get hung up on the ideas and they’re managers and they’re important and you’d expect that over time if you pick a sample of quality managers, the hit rate should be better than 50 50. But it’s not actually the main driver of the strategy’s returns. In many ways, the position sizing and the risk management is as important. And that is something that I’ve seen over and over again, both when I was looking at other managers do this and what I’m doing now.
Daniel Grioli: So for example, where I’ve seen a lot of 13F strategies, how they put together is your doll identify a pool of managers. They’ll equally white the stocks that these managers hold. So if there’s 50 stocks, they’ll get 2% each in a portfolio and they’ll rebalance quarterly and they’ll drive enormous turnover.
Daniel Grioli: So there’ll be enormous turnover at the manager level because often they’re choosing managers based on historical performance and trying to optimize that. So that manager level turnover will drive enormous portfolio turnover and then the rebalancing will drive even more turnover.
Daniel Grioli: So when you see these fantastic back tests for 30F and half strategies, they’re totally impractical because if a higher net worth investor had to invest in 50 or a hundred stocks with that kind of turnover and trading costs and taxes, not much of the out performance would survive that. So we’ve had to do things differently and we’re not necessarily trying to optimize the manager picks. This is early defined the best or to try and play a main reversion angle. What we’re looking for is people that have demonstrated skill over a very long period of time. And the complimentary to each other, and then the risk management and the portfolio construction adds to that.
Tobias Carlisle: Why do you think of small caps as being a category separate from say value or momentum or quality or growth, rather?
Daniel Grioli: I think they’re different mainly because, well, this is the interesting thing about the 13F data. So firms report at the firm level, so you can’t track fidelity because you’re getting the aggregated holdings of hundreds of strategies, it’s just garbage. For the same reason, you can’t track renaissance technologies. So I had a client say to me, why don’t you track renaissance? While it’s a quant Hedge fund that they track, they hold three and a half thousand stocks and they’re in and out of them daily. I have no confidence that what I’m buying today actually reflects their current thinking.
Daniel Grioli: So with small caps, in order to get reliable data, you need to look for firms that specialize on small stocks, either boutique, small cap managers, and that’s all that they do. Otherwise, the data that you get is just mixed in with everything else.
Tobias Carlisle: Right. So it’s a style, as you said it. When you’re looking at the small cap manager, are they small cap value or small cap growth or all small cap managers, growth managers.
Daniel Grioli: Interesting. Most of them tend to have a growth bias. But having said that, I’ve seen some research, I remember GMO did some research years ago that looked at the performance of fallen angels in small caps. So large docs that become small because they lose a lot of value and they don’t tend to come around all the time. They tend to come up largely in crisis when a lot of stocks are pushed into the small universe. But some of those fallen angels can do quite well.
Tobias Carlisle: This is possibly where they fall out of the index too. So they lose their index, the index investors support, and that can drive the price down very rapidly.
Daniel Grioli: Especially in Australia. Once something falls out of the ASX 200, it falls off a liquidity cliff.
Tobias Carlisle: So, when you’re looking for the value managers, you’re looking for that more traditional Buffet style with some growth factor in what they’re doing. Do you find there’s any overlap between the growth managers and the value managers and how do you deal with overlaps?
Daniel Grioli: Well, actually I’m not. So, for example, one of the managers that I have in my value portfolio has a very heavy tangible price to book focus. Very old school, very, very deep value.
Daniel Grioli: The other one is more of a Buffet style, good company to reasonable price, but probably still more to the value than Buffet. The other three are all activists. So, well, sorry. The other one is a Hedge fund that can be an activist, but the other two are activists. So one is actively engaged in the one and only company that he owns in his portfolio. So that might be a clue as to who it is. He’s on the board of that company. And I think that’s really interesting. When a fund manager raises over $1 billion to create a fund with only one stock and then proceeds to take a seat on the board of that company. I think that’s a really interesting signal.
Tobias Carlisle: You have to give us the name that save us going and googling that name.
Daniel Grioli: I can tell you this one. It’s Paul Hilal’s mantle Ridge.
Tobias Carlisle: He takes $1 billion in, invested in a single stock at a time and sits on the boards?
Daniel Grioli: CSX. Yeah, the Railroad company.
Tobias Carlisle: And how’s this performance since he initiated that position?
Daniel Grioli: Fantastic. Look at the chart since 2017, its upward and onward.
Tobias Carlisle: So how long is he likely to be in that position? How long has he typically held positions for in the past?
Daniel Grioli: Well, I actually … this is where it’s interesting how you sort of pull on different threads. So how I heard of Paul Hilal’s was back in 2017, sorry, 2018. I went to the Columbia Business School Student Conference and I had several investors there that had Seth Klarman at Joel Greenblatt present. And then they had Paul Hilal’s. And Paul spent a lot of his time working with Bill Ackman.
Daniel Grioli: And one of the stocks that Paul was very involved with was Canadian Pacific. And he was instrumental in getting Hunter Harrison to come on as CEO and implement precision railroad scheduling, which turned Canadian Pacific around. And that’s what he’s doing at CSX. He again brought Hunter Harrison to CSX. Unfortunately, he passed away, but one of his Canadian Pacific associates is now CEO of CSX. And it’s all about this roll out of precision railroad scheduling, which most of the other railroads, with the exception of Burlington Northern Santa Fe, which is owned by Warren Buffett in Berkshire Hathaway, most of the other railroads are also trying to take this approach.
Daniel Grioli: And it was interesting hearing him speak at the Columbia conference because one of the things that came out of that was that in the 15 or 20 years that he’s been investing, he’s only invested in about five or 10 companies.
Tobias Carlisle: He’s taking that Buffet Punch card suggestion, 20 hole punch card very seriously?
Daniel Grioli: Very seriously, very literally. And I think that’s an interesting signal. Now what I put 100% of my portfolio or a client’s portfolio into a single stock. No, but I would be silly to ignore somebody with that track record when he goes and does it. And especially when he as an activist has the capacity to be a catalyst for change. So do I want some exposure to that in my portfolio? Yes. And even having 3% in my portfolio, I think the benchmark weight in the S&P 500 for CSX is something like half a percent. So it’s six times if you want to think of it in benchmark relative terms, it’s six times market weight.
Tobias Carlisle: It’s remarkable that he had such a close association with Bill Ackman who had the famous target fund, which was the one stock that I think it was, he used a lot of options as well, but he ended up vaporizing the very vast majority of the capital in that. And he was still, Hilal’s still wanted to go ahead with that strategy.
Daniel Grioli: Yeah, I think their relationship dates back to college. I think.
Tobias Carlisle: Do you think … you said before that there’s a bias towards growth in the Hedge funds. Do you think that that’s a product of the time we are in the cycle? It’s been a very rough run for valley for the last five years, particularly 10 years before that. So that the value managers who are there just aren’t very many value managers who are outperforming. And so there’s a lot of survivorship bias in that they’ve gone away. And the ones who are there are growth style investors.
Daniel Grioli: I think that’s definitely an issue. I think it’s also an issue that value is easier to replicate. As I was saying before, you’ve got the data there, so if you think of a quantitative process, what does a quantitative process need? It needs break. So you need to be able to take lots of little individual bets because in most cases you’ve got a low signal strength. So you need both. You need the data, actually need information to analyze. And if you think of growth investing, growth happens largely in the future. So yes, you can try and find proxies for what you think is going to grow such as momentum and other things, but it hasn’t happened yet. So it’s unsure.
Daniel Grioli: But value is priced relative to something that you know. So there’s a lot of data there and I think investors have become more sophisticated in doing it systematically and quantitatively. And I think that’s eaten the lunch of a lot of value managers. A lot of them were basically you’re running factor portfolios and they didn’t even know it and now that people are consciously doing that and more money is invested in those opportunities, that’s making it harder.
Daniel Grioli: I think the other thing for value managers is value typically did work well when you had these nice frequent economic cycles, sort of bust cycle and you in the recovery stage valued as well. And we haven’t really had that. And I think that’s partly to do with unprecedented central bank intervention. We’ve had these very long pronounced cycles with the expansion that we’re in now, the economic expansion I think is now the longest on record, hasn’t necessarily shot the lights out in terms of the rate of growth, but it’s just been this long slow grinding.
Daniel Grioli: And in that environment I think it’s a lot harder for value managers that actually suits growth managers because as a fund manager once told me markets by scarcity. So, when prices are very, very high, what scarce is value. Conversely, when earnings growth, when economic growth is slow or moderate, what scarce is growth? And so people are willing to pay up for that.
Daniel Grioli: So you’ve had this goldilocks, not too hot, not too cold growth. And that environment has really suited the growth managers. And I think it’s partly driven by central banks and interest rates. And at what point that changes, I’m not sure, but I think that’s definitely be a head with being a headwind for value managers as well. It’s sort of having to deal with that constant, a lower rate environment.
Daniel Grioli: The other thing that higher rates do is they shake out good companies from bed. Over leveraged companies blow up and when rates are very low and zero and negative in many parts of the world, those companies get a free ride.
Tobias Carlisle: Let’s talk about growth manager evaluation. Earlier you were saying it’s common for a growth manager in their inverted funnel. One of the first steps is to look for EPS growth. So that’s earnings per share growth. And I know from various research that I’ve undertaken, some of which we featured in quantitative value, that that’s a terrible screen. If you’re screening for EPS growth, you’re not going to do very well unless you are some stock picking genius and you’re able to find the ones in there that are sustainable because it’s highly main reverting.
Daniel Grioli: That’s right. So the way I think of that, and this is where the position sizing and the risk management actually are what add value. So you’re right, on average, if you buy stocks with high EPS growth, the results of disappointing and rob on it. At research affiliate did some great research on this. And what he found was investors are spot on in terms of picking the stocks with high growth. They get that equation correct. They can spot the superior company with the superior prospects. They’re just massively overpay for it. And that over paying just overshadows all the benefits and the growth.
Daniel Grioli: And then there’s obviously the risk that you have with growth stocks where some disappoint, you think the growth is going to happen and it doesn’t in the market punishes it and there’s the cost of that on your portfolio. So the way I think about growth investing is a little bit like fishing.
Daniel Grioli: So if you think about fishing, if you know what you want to catch, you know what sort of fish you have some idea of its habits, you know what its habitat is, you know the time of day when it’s active and the title conditions when it’s more likely to be searching for food and things like that.
Daniel Grioli: So you go out fishing and you’re not necessarily … you can’t guarantee that you’ll catch a fish, but you’re trying to look for a certain set of conditions. But then you have a choice, if the fish aren’t budding in that place, what you should do is move on to another spot or another time. And I think with growth investing, it’s kind of the same. You can look for a set of conditions, whether it’s APS growth or whatever. The secret to making it work is actually then pruning out the growth ideas that don’t pan out.
Daniel Grioli: And I think when you look at a lot of these quantitative analysis, what happens is, they’re creating a portfolio of growth stocks that equally rating it and rebalancing it periodically. I would never do that. I would come up with a group of growth ideas and as they don’t pan out, as I try fishing in that spot and I’m not catching anything, I’ll move on. And I think it’s that process of cutting the things that don’t work early before they hurt you. That actually allows you to capture the winners and create an asymmetry between the winners and the losers.
Daniel Grioli: So when a lot of the research happens, that rebalancing, that portfolio construction doesn’t get captured in the way the research question is asked and answered. And I think that’s the secret to making growth work. It’s being very quick to say, well, I thought this company might grow. It isn’t out next fishing spot.
Tobias Carlisle: So that’s the famous sold wall streets so what they say you should pull your weeds and water your flowers rather than the other way around. As in let the winners run, but then keep going and anything that’s not performing, pull it out. Replant something else and see how that goes. And you think that that’s a better strategy for if you’ve seen that work for a growth investor.
Daniel Grioli: Yes. And even for a value investor, this is interesting because all too often value investors said, all right, reach my target price or we have a discipline when it hits 90% of target price. How do you know what the target prices? Just think logically. The fact that this company has become so cheap is because somebody has overestimated the problems with it generally. So if people got that wrong, what makes you that people are going to get it right when it’s … the present situations better, what makes you think it’s going to be any better understanding the target price in that situation? So, all too often I’ve seen value managers sell stocks too early and I’m thinking of a conversation with a global equity manager where I actually said to them, why don’t you allow us stock to remain in a portfolio a little longer?
Daniel Grioli: So for example, you buy with a value mindset, but then in terms of when to sell, you adopt more of a trend following momentum approach and you let the stock tell you when it’s time to sell. And mismanage actually had done the work on that. They had researched that question and they found that in most cases on average that would have boosted returns. They would have done a lot better had they not sold as early as they did. They were systematically selling too early. And I said, [demaco 00:48:29] that’s great. You’ve done the work. Why aren’t you doing that in your portfolio? And they said, well a couple of reasons. The first reason is the consultants and the rating agencies would see that the weighted average P/E ratio of our portfolio would rise because of that, because we’re holding these stocks longer. And that would question whether we’re value managers and they might change their research on us.
Daniel Grioli: And I was shocked because I literally said to the manager, who’s running the portfolio, you are the consultant. If you know this works, if you know this is a creative to your process, why do you care what they think?
Tobias Carlisle: It’s sounds like it’s a pretty good recommendation for that Phil Fisher, Warren Buffet style value. Because that seems to me that avoids the problem of the growth manager over paying for growth avoids the problem that the value guy has. Where it’s easy to screen it away. So you find that happy medium where you’re buying, you’re trying to find high growth stocks, but then you’re trying to pay not necessarily a value price, but you’re trying to pay at some discount to what the DCF might tell you that their worth. Is that a fair assessment?
Daniel Grioli: Definitely. So, I’ll add a couple more points on this. The first thing I’ll say, there’s a great thing that Gerald Loeb wrote in his book, The Battle For Investment Survival. I think it was written during the Great Depression. It’s an investment classic and he makes the point that when it comes to buy decisions, if you don’t like something, you don’t buy it. And so therefore your hit rate, all things being equal is going to be much higher because you can wait for the Buffet fat pitch. No, no, no. Okay.
Daniel Grioli: With the sell decision, you can’t actually avoid the decision. Every day that portfolio sits in your portfolio. You’re either holder or a renewed buyer or seller. And so because you’re being forced to make, so decisions, which you are at some point you have to sell. He should expect that your hit rate is going to be lower.
Daniel Grioli: And I’ve noticed that pattern across the hundreds of fund managers that I’ve worked with and met and research is they all find selling harder. And so what everybody ends up invariably doing is coming up with some kind of rule that works for them. And I know it’s not going to be right in every circumstance, but it should be right on average over time and it works for them. And I think that’s about the best you can do when it comes to sell discipline.
Tobias Carlisle: I liked those rules were, and I think that this works particularly well for the Buffet style investors where you’re sizing your best ideas, the largest when they’re first in the portfolio and then as they rise and they come closer to your estimate of intrinsic value, trimming them back as they become risky. And that way you’re harvesting some return as you go. And if the stock comes back, then you’re in a position to buy some more and you don’t have to learn a new stock. You know that particular name pretty intimately. You can become very familiar with the way that they work. So and I think that there’s some pretty good quantitative recommendations to that. As a strategy of gathering some value and holding onto it as the stock grows. Do you work that way? Do you trim as it goes?
Daniel Grioli: I do sometimes. I’ll tell you an interesting story about that because it really illustrates. And I know this is an anecdote and anecdotes are not data, but it really illustrates the problem with thinking in terms of target prices and the uncertainty that you have with selling. So in my personal portfolio, a few years ago, I bought a small cap stock called Blackmores and Blackmore’s makes vitamins and health products. And at the time the stock had been quite beaten down because most of its products were sold to three retailers, the two large supermarkets and a chemist, or a pharmacy chain here in Australia. And they were really squeezing on price. They were trying to get the most they could out of Blackmores and now forcing it to do a lot of cost cutting, a lot of promotions.
Daniel Grioli: It had a small but quickly growing business in Asia. And as the Asian middle class is getting wealthier, they’re more focused on health. And as I found out talking to some people from China, they described to me the dynamics of a four two one family. So four grandparents, two parents, one child. So you’ve got this funnel where the child is seen as a very important investment because you’ve got four grandparents, two parents, and they’re all trying to make sure that this child has the best start in life. So, vitamins, health. And then particularly when you had the issues in China where they were putting melon wine into baby formula and children were dying, very conscious and Australian and New Zealand products were seen as healthy and safe. So they commanded a premium, but that all came later. At the time Blackmores was beaten down because these three suppliers were gouging it.
Daniel Grioli: So I purchased some of the stock and it traded up slightly from where I bought it. I think I bought it around about $24 and then I sold some about $28 I did another valuation, I looked at it, I did a free cashflow evaluation. I actually used the template that professor Damodaran puts on his website at NYU Stern, which is great resource for anybody doing their evaluations.
Daniel Grioli: And after a while I took a look at it again and I actually realized that I’d made a mistake in selling it. So I bought it back at 28 I bought it back roughly where I sold it, kept it, and it got to mid 70s and I revalued it again at the mid 70s. This time, the Chinese growth story, it started to emerge and so people were getting behind the stock. It’s a very small company. The son of the founder owns a large block of stock. He’s still the chairman, so there’s very tight float.
Daniel Grioli: So as people started to buy this, it was getting ramped up. Now I valued it at about $56, it was trading at $74. If I was a traditional value manager, I should’ve sold. But understanding the dynamics of the Australian market, I knew that it was just outside the 200, to top 200 stocks and was very close to getting reclassified into the index and given the tight float out there and the forced buying from index funds, that’s what’s going to go further.
Daniel Grioli: So I actually let it run to about $80 and then it experienced a bit of a pullback. So I sold half my position and then the index effect happened. According got included in the 100 I think. It ran onto $130 so way above any kind of fundamental number I could come up with, it experienced another pullback.
Daniel Grioli: So I sold all of the position at that point from buying at 28 to 130, that was a great gain. And then I felt like an idiot when I saw it go all the way to $220.
Tobias Carlisle: So where is a wave?
Daniel Grioli: But I later felt a lot better. And you know what cheered me up immensely. There was an article in the paper that the chairman and largest shareholder, Marcus Blackmore sold the large block of his stock at $48 I think to purchase a new boat.
Tobias Carlisle: It’s an expensive purchase.
Daniel Grioli: And that cheered me up immensely because I thought if the chairman, the son of the founder, the person within the firm, if he can’t understand what the target price for the stock is, if he’s got no idea that this Chinese growth is coming, how does anybody know?
Tobias Carlisle: Yeah. 100%. That’s coming up on time for us, Dan. If folks want to get in contact with you, what’s the best way of doing that?
Daniel Grioli: So you can find me on Twitter? My handle is @Market Fox. You can also find my blog, www.marketfox.org. And you can see what I’m up to with Guiscard Capital at www.guiscardcapital.com.au G-U-I-S-C-A-R-D capital.com.
Tobias Carlisle: We’ll put those links in the show notes. Daniel Grioli thank you for your time.
Daniel Grioli: Thanks, Tobias. It’s been a pleasure.
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