Confidence in Portfolio Strategy

To be a successful investor requires confidence in portfolio management – in particular, the strategy and companies which you have selected. This sounds like an obvious statement. After all, if you don’t believe in the performance of the companies then why would you invest in them?

Having confidence in your portfolio management strategy often requires you to take a contrarian stance. It’s easy to back a company when the price is going up but much harder to do so when the market is moving against you. You’re essentially saying that the combined wisdom of thousands of other investors is incorrect – they might be selling out of the company but you know best. You’ve seen some value that they’ve ignored – perhaps a new client or product, or a higher return on equity than their competitors. In time, you feel that the market will come to recognise this value – that the price trend will reverse; maybe even surpass previous highs.

When Confidence in Portfolio Strategy becomes Overconfidence

Over the weekend, I spent an hour re-watching the excellent webinar from Ed Croft and the Stockopedia team on Neil Woodford – the disgraced ex-fund manager who was forced out of managing his own funds after losing hundreds of millions of pounds of investor’s money. Clocking in at over an hour and twenty minutes, there’s a huge amount of material to digest – much of which will have been covered elsewhere in the many months since the webinar was released. Ed’s team did a fantastic job analysing Woodford’s portfolio strategy and breaking down some of the key mistakes he made. I’d recommend taking an hour or two and digesting it.

To cut a long story short, Woodford started out investing in a rather conservative style in keeping with his previous employer Invesco. He tended to invest in high quality companies trading at a significant discount to true value. When he initially went public in 2014, such companies included AstraZeneca, GlaxoSmithKline, British American Tobacco, BT, HSBC and Legal & General. These companies were steady, stable, blue-chip firms. Low risk and dependable.

Over the next five years however, Woodford then began to shift his portfolio away from these blue-chip companies and instead started to invest in smaller, riskier and less proven companies such as Prothena, Benevolent AI, and Oxford Nanopore. These firms were often unlisted, with little to no profits, and operated in highly speculative sectors such as drug development and technology. In theory, one of them might have turned out to be the next Google…but who knows how many decades that might take.

Having done a bit of reading into Woodford previously, I’m aware that he had a track record for attempting to make investments in these types of companies but was usually reigned in the compliance department of his employer. Once out from under their watchful gaze, he quickly set about backing his own preferred picks in the sector – clearly believing that he was right and that the rest of the world was incorrect.

The rest is history – the underlying companies failed to perform (in some cases collapsing entirely), investors lost confidence and Woodford was forced to realise enormous losses to pay back early requests for redemption before gating the fund entirely to buy time whilst he tried to recover investor’s money. The question is – should Woodford have taken a step back and considered that his portfolio strategy was grounded in overconfidence rather than sound analysis?

What if your investment analysis is incorrect?

For me, a good rule of thumb is conserving the consequences of being wrong. Let us say, for example, that you began buying shares in a biotech company at £3 a share – believing that they were vastly undervalued and actually worth as much as £10 each. You buy an initially small stake – say 0.5% of my portfolio, reflecting the risk of the company going bankrupt or failing to live up to its potential.

Over the next 24 months, the shares tick up to £4.50, £5 and then £6 a share, doubling your initial investment. Despite this, the company consistently fails to make a profit – every report has a sensible sounding reason for why, but the company burns through resources quarter after quarter without making money.

At this point, you must begin to ask yourself what the consequences are for being wrong. If you declined to add to your initial investment, it might be worth 1 or 1.5% of your portfolio after doubling in value – not enough to seriously damage it should the price trend reverse. Now, you a choice to make; if your initial investment thesis was correct, the company is still ludicrously undervalued, but if that’s the case, then why is the price not higher?

How would you react if that momentum began to reverse – the subsequent two years saw the price fall from £6 back down to £4, and then past your entry point to just £2.

If you continued to buy on the way back down doubling your position from 1.5% to 3% over the next year and again from 3% to 6% the year after, you continue to increase the risk exposure in your portfolio of being incorrect. The market clearly disagrees with your analysis that the company has potential and is moving on – you’re buying from those investors believing that you know better. If you get this wrong, the price could go all the way to zero – after all, they\’re still loss-making, remember? If you get this wrong now – 6% of your portfolio will be wiped out. Maybe more, depending on how aggressive you\’ve been. How confident do you feel now?

Defensive Portfolio Strategy

The thing that struck me about the Woodford analysis was how determined he was to back companies with no track record and negative price momentum on the grounds that he knew better. As a fund manager, Woodford would have been well aware that investors could request redemptions at any time and that those redemptions wouldn’t always neatly correlate with a rise in the market allowing him to sell of investments for a profit.

By asking himself “What if I’m wrong?”, I believe Woodford could have protected both himself and his investors from painful losses. The answer to the question is simple – if those speculative shares or those with negative price momentum failed to perform, Woodford would not have sufficient capital to repay investors and would be forced to sell positions, further depressing the prices of the companies he was invested in.

The price of his overconfidence would therefore be a catastrophic collapse of his entire fund; an outcome which sadly came to pass. There is a powerful lesson here for all investors. Have confidence in your portfolio strategy, but always ask the question; “what if I’m wrong?”.

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