How to Be a Great Investor, Part Three: Assess Strategy

This article is the third in a ten-part series loosely based on Michael J. Mauboussin’s white paper “Thirty Years: Reflections on the Ten Attributes of Great Investors.” See “How To Be A Great Investor, Part One: Be Numerate” and “How To Be A Great Investor, Part Two: Understand Value.” Please note: In this article, I’m departing from Mauboussin’s ideas at a number of junctures.

Part I: Assessing A Business Strategy

One obvious way to do so is to look at its numbers. Mauboussin primarily looks at the difference between a company’s CFROI, or cash flow return on investment (free cash flow divided by net operating assets), and its cost of capital, and compares that to other companies in its industry.

Every business has a strategy, a plan for beating its competitors. It’s a good idea for an investor to assess that strategy before investing in the company. But doing so is complicated.

Arriving at CFROI and cost of capital is not an easy job. I covered some of the pitfalls in cash flow and cost of capital measures in How To Be A Great Investor, Part Two: Understand Value, and also discussed how to get around them. (Also see my article on net operating assets: My Favorite Balance Sheet Ratio.) In addition, it’s probably best to use the cost of capital for the industry or industry group rather than for the firm in question.

So, for example, let’s look at two chemical companies. Celanese (CE) has about $1.5 billion in annual free cash flow and $6.7 billion in net operating assets, giving it a CFROI of 22%. Albemarle (ALB) has under $200 million in annual free cash flow and $5.6 billion in net operating assets, so its CFROI is 3%. Assuming the cost of capital for both companies is around 8.5%, Albemarle is what Mauboussin calls a “value destroyer” while Celanese is a “value creator.”

If you look only at this measure, the best “value creators” in the S&P 500 (excluding the financial and real estate sectors and excluding firms that are less than five years old) are VeriSign (VRSN), Qualcomm (QCOM), Fortinet (FTNT), Starbucks (SBUX), and Boeing (BA), while the worst “value destroyers” are Netflix (NFLX), GM (GM), CarMax (KMX), Alliant Energy (LNT), and Advanced Micro Devices (AMD).

And value creators do tend to outperform value destroyers: Over the past ten years, the top decile (value creators) in the S&P 500 have beaten the bottom decile (value destroyers) by 4.2% in annualized returns (if rebalancing monthly with no transaction costs), and in the past twenty years, that spread has been 7.0%. That’s quite a remarkable spread for a quality factor – the stock’s market price and its growth rate don’t come into the calculation.

But obviously, a business can change its strategy, and one number can’t tell you that much about a strategy’s future viability. Assessing strategy is a complicated and rich subject, and I can’t possibly give you better pointers than Mauboussin can. His papers on the subject are well worth reading, and can be found here and here. At the end of each of those papers is a checklist you can use to assess each company you investigate. There are close to a hundred useful questions in those checklists, and you can learn a lot about a company while trying to answer them.

Part II: Assessing An Investment Strategy

Mauboussin does not cover assessing your own investment strategy in his “Ten Attributes of Great Investors,” but I think it’s just as important as assessing the strategy of the companies you invest in – if not more so.

Before you can properly assess your strategy, you need to properly articulate it. You can begin doing so by asking yourself a number of questions. There are no right or wrong answers here, this is just a way to get to know what kind of strategy is right for you.

1. Are you interested in beating the market over the short term, investing wisely for long-term portfolio growth, or both?
2. Are you interested in maximizing your returns, minimizing your risk, or both?Are you interested in finding a single strategy that suits you or developing a number of different strategies for portions of your portfolio?
3. Are you interested in making money primarily from stock price appreciation, dividend income, or both?
4. Are you interested in stocks, ETFs, options, or all three?
5. Do you consider yourself a gambler, a trader, an investor, a speculator, or some combination of those?
6. Would you rather use a fully automated strategy or get stock ideas which you’d then accept or reject on a discretionary basis?
7. Do you believe that backtesting will guide you to better strategy development or do you believe that backtesting offers illusory results and that it’s best to limit its use?
8. Do you consider yourself financially skilled enough to come up with new, untried methods of beating the market, or do you think you’d do better to follow established paths?
9. What is most important to you when considering a stock purchase: the company’s quality, price, growth potential, or category (size, industry, etc.)?
10. Are you most comfortable with approaches to investing based on the ideas of professional investors such as Warren Buffett, Peter Lynch, James O’Shaughnessy, and Joel Stern, or do you prefer to take a scholastic approach, using sophisticated statistical analysis and keeping up with the latest academic research?
11. Do you place your faith primarily in fundamental analysis, technical analysis, or sentiment indicators?

Once you’ve articulated your strategy, try to think of what chance it has to succeed. Everybody overestimates their chances. It’s very rare to encounter someone who estimates her chances of success at a particular endeavor as below average.

To avoid this pitfall, the first thing to consider is your base rate. In other words, try to assess not your own skill at achieving your strategy goal but the average skill. Pretend you come across another investor with exactly the same strategy, and you have no idea whether she’s good or not. You know nothing about her except her articulated plan. What chance would you give her of success? That’s your base rate.

So, for example, my own strategy is to use an automated system based on fundamentals (primarily quality, secondarily value and growth) to choose stocks, trading frequently, concentrating primarily on microcaps, doing a lot of backtesting, placing big bets, and trying to beat the market every year. If I were to meet someone else implementing this strategy, knowing nothing about her particular skill set, I would give her a 40% chance of beating the market. That’s my base rate, and I need to acknowledge that my own chances aren’t a whole lot better, even if my performance so far has been quite good.

Speaking of performance, the standard way to assess an investor’s past strategy is to look at her alpha. Some would prefer to look at her Sharpe ratio, or use another risk-adjusted return measure, but in my opinion, of all the conventional measures of strategy performance, alpha is the best. Here’s why:

1. It shows the relationship of an investor’s performance to the performance of the market as a whole; CAGR and certain other performance measures are market neutral.
2. The Sharpe ratio, Sortino ratio, and information ratio divide average performance/outperformance by the standard deviation of the returns. But standard deviation is a flawed measure of volatility that has little persistence and – in the final analysis – makes little difference in terms of out-of-sample performance.
3. High alpha correlates with low beta, and a low-beta strategy is less subject to market-induced volatility than a high-beta strategy.

Estimating the future alpha of a strategy is a very tricky business. Even measuring past alpha is tricky. The first thing to do is to choose the right benchmark. If you have access to good research tools, you can construct your own benchmark made up of the type of stocks that you’re likely to invest in (look at size, industry, minimum price, and, if you have other requirements, such as limiting yourself to stocks listed on the major exchanges, include those). But there are also a wide variety of ETFs available that may be suitable benchmarks.

The conventional way of measuring alpha is extraordinarily susceptible to outliers. There are lots of ways around this – you could Winsorize your returns, for example. I calculate beta by using the Theil-Sen estimation (this is the median slope of all pairs of points) and then calculate the median difference between my returns and the product of that beta and the benchmark returns. (I subtract the risk-free rate from both my returns and those of the benchmark before calculating any of this.) By this measure, and using the microcap ETF IWC as my benchmark, my strategy has gotten an annualized alpha of 26% since its inception in November 2015, which is 3% lower than if I’d used the conventional calculation.

Once you have past alpha – or even if you don’t – estimating future alpha has certain pitfalls you should be aware of. First, if your strategy is successful and you don’t make regular withdrawals, your assets will grow, and the more assets you have, the harder it will be to maintain a good alpha, because either the market impact of your trades will be greater or you’ll be investing in more stocks and thus underweighting your best ideas compared to what you used to do. Second, if you use backtests to optimize your strategy, reduce your backtested returns by at least a third in order to compensate for the fact that out-of-sample returns are almost never as good as optimized backtested returns.

If your strategy has certain inherent advantages over other folks’ strategies and you’re getting high alpha, you’re likely doing a good job. If, however, your strategy is just one out of many, with few or no inherent advantages over that of others, then a high performance may indicate a low performance in the future simply due to the axiom of regression to the mean (uncorrelated performance has, by definition, a high probability of relative reversal; if that weren’t the case, the performance would be correlated).

Even if your base rate is high, your skill set is strong, and your performance is exemplary, ask yourself some additional questions about your strategy.

1. Are you willing to stick with your strategy, making only minor tweaks, even if you underperform for an extended period? If so, give yourself a point.
2. Are you liable to change your strategy radically during a market downturn? If not, give yourself a point.
3. Are you juggling several different equal but uncorrelated strategies, and are you choosing those that have performed the best in the recent past? If not, give yourself a point; if so, regression to the mean will doom you.
4. Pretend your strategy has utterly failed and you have lost not only a good portion of your savings but all faith in your strategy. What will you do then? If you have a good answer, give yourself a point; if you have no idea, try to come up with one.
5. How much research is involved in your strategy? If a lot, give yourself a point. Doing your homework should be an essential part of your investment strategy.

This last point is perhaps the most important part of assessing your strategy. A strategy that involves little to no research is doomed to eventually fail. And that brings us back to the first part of this article. Assessment is at the very core of successful investment: assessing the investments themselves, and assessing your ability to take advantage of them. Without spending the time and effort to assess, your investment success will be no better than that of a dart-throwing monkey.