Features | Education | 16 Mins Read | by AG Latto
Whether private investors can outperform investment funds (active or passive) is up for debate. But they do have one key advantage - the ability to only invest in their best ideas. This is the most powerful advantage that exists.
What's nice about investing is that you don't have to swing at pitches...You can wait for the pitch you want. - Warren Buffett
Or to put it another way:
Only invest in stocks when you have great stock ideas to invest in
The logic of the above quotes is compelling. How can we carry out this approach in practice?
The easiest method is to adopt an investment default - an approach we turn to when we don’t have great stock ideas.
Funds are the easiest default strategy - passive or active - because they require relatively little thought. On this basis the investment approach becomes:
Invest in funds unless you have great stock ideas to invest in.
There tends to be some investor push back on funds. If active funds aren’t your thing, there are plenty of passive funds to choose from.
The point is not that funds will perform well. The point is that they allow investors to perform well.
It is, of course, advantageous to pick good funds. But the crux is that funds allow an investor to focus on their best ideas.
The approach is known as the core/satellite approach. The core is a default strategy and the satellite is made up of the best ideas.
The size of the satellite varies according to the number of good ideas. There is no pressure to find ideas.
There may be lots of good ideas one year and few good ideas the following year. That is the nature of markets.
How does core/satellite compare to running a stock portfolio?
The core/satellite approach should generate better results with less work. Or to use management jargon: “work smarter, not harder.”
The key advantages of the core/satellite approach are:
1) It should generate stronger returns
2) It reduces risk
3) It requires less effort
4) It is less stressful
In short, what’s not to like?
Stock picking is hard
The top 10 ideas an investor has will be much better than the next 20 ideas. But a diversified portfolio requires at least 20 holdings -in practice, most portfolios have at least 25 stocks.
We need diversification to reduce risk. But we are unlikely to have 25 good ideas. Unless we spend a huge amount of time researching stocks.
Many private investors focus on small caps. In this area, you may need at least 50 stocks for sufficient diversification. Small companies can go kaput in short measure, as we learnt with Patisserie Valerie.
We are highly unlikely to have 50 good ideas.
The investor's dilemma is this: we need 20 or more stocks to be diversified but we are unlikely to have 20 great stock ideas. The core/satellite investment approach solves this dilemma.
Under the core/satellite approach, we can invest in 5 good ideas or even just one great idea.
Having a good fund as the investment default also creates a quality threshold for new ideas.
I personally use the Fundsmith Equity Fund as my investment default. When I am looking at a new stock I ask myself the question: is it better than the companies in the Fundsmith Equity Fund portfolio?
The opportunity cost of investing in a share is having less money in the Fundsmith Equity Fund - a top performing and low-risk fund.
Everyone can choose his or her own investment default. One option is the S&P 500 tracker fund, which doesn’t involve monitoring a fund manager. Another might be a conservative fund with a high bond weighting.
Focus drives success
Warren Buffett and Bill Gates were once sitting around a dinner table and asked why they had been so successful. They both answered: focus.
The core/satellite approach allows an investor to focus on a few good ideas. This offers the scope to get ahead of the curve.
An investor who had spent a few weeks analysing Greggs or Games Workshop a few years ago would have been richly rewarded. Focus helps drive returns and core/satellite allows investors to be focused.
A focused approach has made Bill Gates and Warren Buffett incredibly successful. We are likely to be more successful when our investment approach is focused.
AJ Bell and Fundsmith case study
Theory is one thing, but how does core/satellite work in practice?
A fellow investor informed me that in mid-2018 they had 100% of their AJ Bell account in the Fundsmith Equity Fund. They remain invested in the fund unless there are attractive investments.
The IPO of AJ Bell appeared to be a great idea. They, therefore, sold all of the Fundsmith Equity Fund and applied for AJ Bell shares.
Their allocation was 25% of the shares they applied for. They reinvested the remaining 75% back into the Fundsmith Equity Fund.
AJ Bell has worked out well with the shares up about 100% on the IPO price (listed at 160p and recently 320p).
AJ Bell highlights the core/satellite approach in action: waiting until a great idea comes along.
AJ Bell hits a lot of investment criteria. Why compromise with a mediocre investment?
We should not equate activity with effectiveness. Activity without effectiveness equals “a busy fool.”
What counts is what works when it comes to markets. Investing in mediocre ideas will lead to mediocre results.
I wrote three articles on AJ Bell for Cube.Investments that can be found here.
AJ Bell since the IPO at 160p
Source: SharePad
Stock challenge 2019
Another example is the annual www.stockchallenge.co.uk. It involves selecting five stocks at the start of the year. My five stocks for 2019 have performed reasonably well. The average gain of 20% at 26 March.
I wrote a short article on the five picks. If I had been forced to pick 10 ideas or 20 ideas my results would have been mediocre - I didn't have that many good ideas.
I would therefore probably have underperformed the UK benchmark indices. However, five ideas cannot form a sufficiently diversified portfolio.
The solution would have been to put 25% of a portfolio in five ideas and the remaining 75% in a default investment fund.
If the stock challenge was for 20 stocks it would have required a lot more effort. I would also have been less familiar with the stock picks which would have resulted in more risk.
Monitoring 20 positions would also be a lot more stress. If I didn't have 20 good ideas to start with it is unlikely I would have outperformed the benchmark.
In short, the core/satellite approach resulted in less work, lower risk, stronger returns and less stress.
UK Stockchallenge stocks performance so far
Source: SharePad
The key advantage that active funds won’t use
If core/satellite offers such a great advantage then why don’t active funds use it?
An active manager needs to justify the fee on the whole of an investment portfolio. This would be harder to do if 75% of the portfolio was allocated to passive funds.
An approach that is likely to generate higher returns is therefore ignored.
There is some irony here. Active managers are charging more for an approach that is less likely to perform well.
What about funds with no external clients? One example is a pension fund that manages its money internally.
A pension fund manager I used to work with told me that they used the core/satellite approach. This is only anecdotal evidence.
But it does suggest that the core/satellite approach is adopted when there aren’t conflicts of interest.
Stocks and funds are not an either/or
There is another explanation as to why core/satellite isn’t adopted. Investments funds and stocks are viewed as an either/or equation.
But this is not the case - it is likely to pay dividends to own both.
Funds allow you to invest in stocks only when you have good stock ideas to invest in.
Private investors may want to outperform investment funds using the same approach. This means building a portfolio of 30 stocks.
The challenge is to “beat the professionals” using the same approach that they use. This is an interesting challenge but it isn’t necessarily an optimal approach.
I would suggest using a fantasy portfolio for the challenge. If it isn’t the optimal approach then why use it in practice?
Private investors are able to use an approach that active managers cannot use. It is the main advantage they have over the professionals.
If you are after the best results you should use the best available approach.
An additional reason why core/satellite may not be adopted is due to conditioning.
We see active funds run portfolios that are only in stocks. We, therefore, believe the best option is to run portfolios only with stocks.
But active funds don't have the luxury of investing only when they have great ideas. Private investors are free to act as they see fit.
Running a stock portfolio
Running a stock portfolio is very time-intensive. I believe that you need the following attributes: 1) the right temperament 2) sufficient experience 3) the right skill set and 4) sufficient free time.
I liken running a 100% stock portfolio to gardening. It involves three key steps:
1) Cutting positions that are too large is the same as pruning trees 2) Finding new positions is the same as seeking out new plants 3) Monitoring the portfolio is the same as cutting weeds as they develop.
You need the time to monitor existing positions. This means analyzing company results and changing competitive dynamics.
If you own a company it is best practice to go through its annual report and interim reports in depth. This is one of the ways to spot blowups before they happen.
You also need to research potential new positions and you need to cut successful positions that are becoming too large.
Not everyone likes or has time for gardening. You may spend so much time taking care of the existing garden that you miss out on attractive new plants.
This leads us onto the key drawback of running a large stock portfolio.
Wood for the trees
A key reason that core/satellite can deliver strong results is that it frees up time. This can be used to find the best ideas that are out there.
A portfolio of 30 or more stocks is time intensive to run. You need to spend a lot of time monitoring new positions and managing portfolio risk.
Not many companies have the ability to create value over the long-term. There are few investments that are truly special and they take a lot of effort to identify.
When they come along they are worth grabbing with both hands. This was the case, in my view, with AJ Bell.
A core/satellite approach frees up time to identify attractive new positions. In short, you are playing attack instead of defence.
I personally mentioned AJ Bell to a few investors. They generally didn’t follow it up as they were so engrossed in their existing portfolios.
Another example is Fever Tree. This wasn’t too hard to identify as a potential winner. The crux was prioritizing research time to do so.
Stock research is qualitative to some extent and is, therefore, time intensive. To have figured out Fever Tree you would have had to look beyond the numbers at the IPO.
I have personally missed out on great investment opportunities by not following a core/satellite approach. It pays to focus on the best potential opportunities.
Core/satellite also frees up time to monitor your existing positions. It is very time-consuming to monitor 30 stocks but 5-10 stocks won't take up too much time.
Very few investors closely look at annual reports. Owning fewer stocks create more time to do so.
The best stocks
This probably begs the question of what are the best stocks to invest in? This is best left for another article. But in short, we want stocks to compound value. I think that there are three criteria needed to achieve this:
1) Generate high returns
2) Maintain high returns
3) Realize high-return growth
Fever Tree and AJ Bell have the three attributes in spades. The three attributes demonstrate why stock research is time intensive.
We can identify companies generating high returns from basic stock screens. Finding companies that are not generating high returns today but will do so in future takes more time (i.e. companies like Amazon).
The second stage is to determine if high returns can be sustained. We can use history as a guide but what matters if the future. Things change - local newspapers were an attractive investment at one point.
The final stage is to see if companies can realize high-return growth. This also requires a view on the future. The past also offers only a guide.
It is best to buy these opportunities early on. This means buying Fever Tree at £1.70 rather than at £20.
The core/satellite approach frees up time to research companies with significant potential.
The best funds
Core/satellite is generally focused on investing in funds and stocks. We can also use it for investing in core funds and a satellite of high-return funds.
The S&P 500, for example, is considered to be one of the hardest equity markets to beat. One approach would be to invest in the S&P 500 sectors that are well placed to perform well.
The S&P 500 IT sector has driven the market for a number of years. Investing in the S&P 500 IT sector ETF (IITU) would have been the easiest way to beat the market.
There are also sectors that occasionally experience strong bull markets such as biotechnology.
Fewer decisions mean better decisions
When our brain gets overwhelmed with information we tend to make bad decisions. It is similar to sale shopping with hundreds of offers and products available.
Very smart people can be overwhelmed and make bad decisions. When it comes to investing it is more important to avoid losing money than it is to make money.
Core/satellite helps you to make fewer, and therefore better, decisions.
The Zulu principle and circle of competence
The growth investor Jim Slater advocated knowing a small number of companies very well. He referred to this as the Zulu principle.
Warren Buffett's circle of competence is a similar concept. The idea is to know what you understand and focus on that. This helps to make better decisions.
The fund manager Keith Ashworth-Lord has stated that:
I don’t go near business models that I don’t understand. My circle of competence is an inch wide and a mile deep. That fences off large areas of the stock market such as miners, oil exploration, blue-sky pharmaceutical firms and banks.
Detailed investment research on a company is time intensive. It involves looking through annual reports, evaluating products and attending meetings.
The core/satellite approach frees an investor to do the required research. One example might be spending a few week's evaluating whether Games Workshop had improved its offering a few year's ago.
By knowing a small number of companies well it is possible to have an edge over other investors.
Summary
The nub of the core/satellite system is this:
Only invest in stocks if you have great stock ideas to invest in.
It is hard to argue with the logic of the above statement. But it pays to identify good companies before the crowd.
The core/satellite approach frees up investors’ time to find great stock ideas.
You don’t need to play defence in terms of spending all your time monitoring existing stocks. You can play attack by finding great stocks ideas to invest in.
An investor will also have more time to monitor the stocks that they do own. This should help in cutting positions before there are any major blowups.
The core/satellite idea is incredibly simple and incredibly powerful. It is the key advantage that private investors have over active funds.
It is an advantage that may enable private investors to outperform active funds. Why not use it.
Core/satellite and Fund Hunter
Core/satellite and Fund Hunter
The core/satellite principle is part of the inspiration for Fund Hunter.
If the core of a portfolio should be in funds then it pays to find good funds.
Analyzing stocks also tells us if the funds are still investing well. A good fund will be full of good stocks.
We can also learn how the best investors invest.
When it comes to the satellite component we can use this knowledge for ideas: whether they are stocks or niche funds.
In short, Fund Hunter seeks to solve the “investment problem” in the simplest and most robust way.
Opportunity cost
Opportunity cost
The article briefly touched on the opportunity cost concept. In case of interest, there are few further thoughts on it here.
In my view, it is one of the best concepts from economics. The idea is that you identify the next best alternative to a course of action: this helps focus minds.
The opportunity cost in the article was the cost of buying stocks - the core fund in a portfolio that needs to be sold down to free up capital.
For me it was selling out of Fundsmith and betting that I had found something better. This is a high threshold given the performance of the Fundsmith Equity Fund.
We can think of it this way. Investors are successful if they are disciplined. This means only investing in the best opportunities.
Core/satellite forces an investor to only invest in the best opportunities. It forces the investor to be disciplined.
The opportunity cost concept can be applied to other areas to make better decisions.
I don’t have a strong view on the high-speed rail project in the UK.
It is expected to cost £56 billion and will reduce the journey time from London to the North and Scotland. The argument put forward is that we must have high-speed rail as France, Japan and China have it.
This seems not a good way of justifying the project. The best case for the project is to find the next best alternative for the money. If the project is better then that it may be worthwhile.
The next best alternative for the £56 billion expenditure is probably to improve the existing railway network in the UK. This includes electrification, reopening closed lines and investing in more rolling stock.
This is a much tougher challenge for the high-speed railway line. It makes more sense than simply saying: France has a high-speed rail so we must have it to.
The opportunity cost concept forces us to make better decisions. It is a powerful tool to use when it comes to investing.
1) Buffett's baseball analogy
CNBC: Warren Buffett simplifies investing with a baseball analogy
