Calculating Return Rates

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In their recent episode of the VALUE: After Hours Podcast, Taylor, Mitchell, Brewster, and Carlisle discussed Calculating Return Rates. Here’s an excerpt from the episode:

Tobias: How do you set your personal return requirements? What are you basing that on?

Mike: For me?

Tobias: Yeah, or anybody but you raised it. So, I’m interested in you first.

Mike: Oh, yeah. It’s not more complicated. I just picked a number almost out of thin air. There wasn’t any science to it. I just thought, as I looked at the world and what I’ve done in the past, and when I retired in the end of 2018, early 2019, I just said, well, “What’s a very reasonable stretch target that’s very, but also very reasonable? If you’re into the game, you like security selection, what is the number at which you wouldn’t underwrite below?” For me, the number I wouldn’t underwrite below is 10%. If you do the math, and I’m not charging myself any fees– By the way, the 10% I have to– If I’m underwriting to 10%, I’ve got to feel extreme confidence in that 10%, because I don’t even think you get a ton of margin safety at 10%. When you start talking 20% IRR, and now, I’m like, “Okay, if it really doesn’t go well, I’ll probably still– even if the arrow lands, well, south of the bullseye, I’ll still hit a pretty good number.” That’s how I got there. As I said, “Well, I’m not underwriting anything under 10%. If it’s under 10%, I’m just going to hold cash.”

That how I got to 10%, and I’ve always felt very strongly that, I don’t want to compare my own returns to a benchmark like the S&P for example. As I watched other funds do that, and LPs of the funds more importantly do that, what I noticed was the portfolio managers and the analysts, everybody was complicit in this. They start managing to the benchmark, and that is not how I personally operate, not how I wanted to operate. The benchmark to me is irrelevant. If you want the benchmark, just go buy the benchmark. It’s not–

Tobias: When you say they manage to the benchmark, do you mean the portfolio starts looking like the benchmark, or do you mean that when the market gets very expensive, the hurdle rate goes way down?

Mike: No.

Tobias: -which all things being equal, you probably want it the other way around.

Mike: Yeah, it’s more of the former– The portfolio construction is discussed in context of the S&P 500. The issue that I– I’m not saying that’s wrong, in many cases, especially if you’re selling yourself as like, “Look, don’t give your money to the S&P 500. Give it to me, because I’m going to give you lower beta, or I’m going to give you less market risk, and I’ll give you the same, whatever.” You can come up with better Sharpe ratio. I’m not saying that’s bad. I’m just saying for me, if you look at the top components of the S&P 500, I have no view on them. That’s 25% of the index. 25% or some huge number, I don’t know if it’s that today or more or a little bit less, but it’s the vast majority of your money is wrapped up in five securities that I have no view on. You’re asking me to compare the next investment opportunity I get to those five companies when I don’t really know those companies, and by the way, not a knock on them, I’m sure they’re phenomenal. I don’t want to spend the time to learn those companies. It’s just not something I want to do with my time.

That to me, when we would get into meetings with portfolio managers, co-portfolio managers, they’d say, “Well, the index makeup now is, I don’t know, 40%, the 10% tech and 5% energy and 3% mining, and I’m like, “Guys, to be honest, I don’t give a flying fuck what the index is made up of. Who cares? What idea do you have? Walk me through a stock pitch that you like and why you think it’s going to work, and why you think we’re going to make good money on a risk adjusted basis. In my mind, it just got very cloudy. I’m a stock picker, I’m a business analyst, I’m not an index analyst. That’s not what I do.” I think if I really compared on a day-to-day basis, I looked at the S&P and I said, well, boy, the S&P is up 30% and I’m up 10%. That’s a disaster.” Actually, for my family being up 10% is pretty good. If I don’t outperform the S&P over time the conversation, we were having last week, if I’m not matching the S&P over five years, I’ll just go to the movies. Seriously, I’d rather play video games. I like picking stocks, but if I suck at it, it’s not a problem, I’ll just give my money to the S&P, pay 10 basis points or whatever the ETF charges.

Anyway, like I said, I’m getting over skis here pretty quick. I think that’s what most people should do candidly, and if I underperform for long enough, that’s exactly what I will do. But the comparison to the S&P, it makes no sense to me. What’s a good outcome? If I double my money every seven years, that’s a pretty good outcome. That’s not a terrible– If that happens, I’m going to die on a net jets that I will not have left for five years, I’ll just be in the air like that. What’s that movie contact, where the guy just lives in the air? That’ll be me. I’ll just be traveling between Tobias, and Jake, and Bill. I’ll just be in this constant loop of–

Tobias: I’ll come and get in that jet with you.

Mike: [crosstalk] coffee. [laughs] It’s not a bad outcome. But that’s how I got to 10%.

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