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Actively Passive, A Hack for Short-Termism

August 22, 2019

By Joe Zappia, Co-CIO, LVW Advisors

I am a curious investor always looking for hacks to be better.  I recently stumbled upon a white paper called “The Coffee Can Portfolio,” written in 1984 by a former portfolio manager of a Los Angeles-based investment manager, Robert G. Rigby. Rigby presents a unique and interesting approach to investing for the long term—the very long term. This paper is just as relevant today as it was 35 years ago.  The main takeaway is that the power of equity investing lies in holding ownership shares of operating businesses that grow and benefit from the power of compound returns over decades, not in buying and selling stocks at the right times.

The very same day I read a Bloomberg article titled “Most Stocks are Duds: A Stock Picker’s Lament.” The title conveys the main idea: Only a handful of stocks produce strong long-term returns, and the rest probably aren’t worth owning.

The lesson of those observations isn’t rocket science: The best way to invest in equities is to buy shares of great companies and not sell them. Yet few investors—and hardly any portfolio managers—invest this way. Most of us shoot ourselves in the feet by fussing and fiddling with our portfolios or reacting to short-term events. We make changes based on the short term and wind up worse off in the long term. Rigby’s coffee-can concept offers an alternative idea.

What to do when most stocks stink

Two years ago, an Arizona University professor named Hendrik Bessembinder made waves with a study that proved something shocking: The vast majority of stocks aren’t worth owning. Besseminder looked at the returns of more than 62,000 stocks and found that all of the wealth they created came from gains in a weirdly small group of companies.

During the 28-year period between 1990 and 2018, three-quarters of global net wealth creation came from gains in just 306 of those 62,000 stocks—about 0.5% of them. Apple, Microsoft, Alphabet, Amazon and Exxon Mobil alone accounted for 8% of global net wealth creation. About 60% of stocks were so lame that they underperformed one-month U.S. Treasury bills.

How do you find the minority of stocks that can create wealth over time? Investment newsletter editor Chris Mayer authored a book titled 100 Baggers: Stocks that return 100-1 and how to find them, building on work done by analyst, advisor and author Thomas Phelps in the 1970s. Mayer and Phelps’ research aimed to identify the characteristics of stocks that returned 100 times an investor’s original investment, focusing on the nearly 50-year period between 1962 and 2014. With 100-to-1 stock an initial $10,000 investment would have grown to $1 million, for a 10,000% return.

Mayer discovered that about 300 stocks qualified as 100-baggers. These tended to be companies that invested capital at a high rate of return and then reinvested that return again and again and again and again and again.

But creating wealth takes more than identifying future winners, it takes compounding over a very long time—25 years, on average, among the companies Mayer found. To capitalize on the mathematics of compounding, investors need the fortitude and discipline to hold on to stocks through periods of volatility, including gut-wrenching losses.

Take Amazon, a classic 100-plus bagger. AMZN has gained more than 38,000% since going public in 1997. But the ride has been bumpy, including declines greater than 10% every year and drawdowns of at least 20% in all but three of the last 20 years. In fact, Amazon had downturns of 30% or more in 10 calendar years since 1997. The chart below illustrates Amazon’s largest loss each year since 1997.

The chart below from Michael Batnick provides a reference point of just how insane this is. AMZN share price is in red, the Dow Jone average in black. You’ll notice that Amazon had far deeper drawdowns in every year but 2009 and 2015.

Source: The Irrelevant Investor, 1/4/2017

To realize Amazon’s 38,000% return, an investor not only would have had to recognize the company’s potential and invest at the IPO, they also would have had to hold on through 22 years of extreme turbulence. That’s very, very hard to do.

In the words of Warren Buffett’s partner, Charlie Munger, “Investing is simple, not easy.”

The cost of short-termism

Holding on through thick and thin is tough enough for individuals, who are bombarded with real-time returns, headlines and other noise. It’s practically impossible for most portfolio managers, who are judged and rewarded (or penalized) based on their performance during the last one- and three-year periods. Think about it: 100-baggers often lag the market over short periods—sometimes by a lot—and managers get fired for underperforming the market over short periods. There just isn’t much incentive for managers to buy stocks they think are potential 100-baggers and then hold them for the long term. Managers get rewarded for being traders and capturing a short-term profit, so they become traders, not investors.

When you add investors’ tendency to add money to recent leaders and take money from recent laggards, you all-but guarantee mediocre returns for the overwhelming majority of investors. This kind of short-termism may be costing investors billions of dollars.

I spend a lot of time thinking about hacks to keep us from doing dumb stuff as investors—tricks to help us get out of the way so that compounding can do its work. Enter the coffee can portfolio.

Kirby based the idea on a realization he had while working as an investment counselor in the 1950s. He was managing a married woman’s money; when her husband died, she turned over his accounts to Kirby’s management. Looking over the investments, Kirby discovered something interesting. The husband had piggybacked on all the buy recommendations he had made to the wife but ignored all the sell recommendations. Instead he threw the stock certificates into a safe deposit box and left them there.

Kirby was amazed to see that the husband’s account had far outstripped the wife’s. Some stocks had fizzled, but others had grown to jumbo proportions, more than making up for the duds. He realized that the work he had done while hovering over the portfolio—adding, trimming and doing all the things portfolio managers do—had been counterproductive.

Hence the coffee can concept. The idea, in Kirby’s words: “I suggest that you find the best investment research organization you can and ask them to select a diversified portfolio of the best businesses with the knowledge that the portfolio will not be reevaluated or re-examined for a period of at least 10 years.”

The coffee can approach is designed to protect an investor from himself. It forces the investor to extend his time horizon to 10 years. It makes him think carefully about what he’s putting in the coffee can. It saves transaction cost and prevents selling during volatile market conditions, so the investor can benefit from the math of compounding returns.

When passive is active and active is passive

Why not just invest in an S&P 500 index fund? Wouldn’t that have roughly the same effect as the coffee can portfolio, with greater diversification?

The short answer: No. Although the S&P 500’s turnover is low compared to that of most active money managers, even modest activity year after year produces large changes in the portfolio over time, potentially hundreds over a 10-year period. Further, the changes are not the result of a consistent, predictable formula; they’re the product of individual judgements made by the Standard & Poor’s staff, just as old-fashioned active portfolio managers do it.

If you believe that a market return is the best an investor can hope for, you should invest in a market index such as the Russell 1000, not the ever-changing S&P 500. But if you believe, as I do, that the main determinants to superior long-term investment results are capturing compound growth, managing investment expenses and taxes and rejecting “short term-ism,” then why not have a portion of your equity portfolio hold the best possible stocks for the long term—one with companies positioned to produce compound growth over long periods of time—and just hold them, rather than buy a broad market index or an active fund with high expenses and managers incentivized to produce short-term results?

I am a believer in being actively passive by selecting great operating businesses that can produce superior investment results over 10, 15 or 20 years and holding them forever. Most active managers today are sophisticated traders with misaligned incentives, not long-term investors. Our industry needs to encourage investment and long-term thinking.  Though a bit gimmicky, the coffee can portfolio is one potential hack to help investors benefit from the next 100-bagger investments and the wealth they will create.


The Coffee Can Portfolio

“100 Baggers: Stocks That Return 100-to-1 and How To Find Them”

A Stock Pickers Lament: Most of the Worlds Companies are Duds by Vikdana Hajric


This information is provided by LVW Advisors for general information and educational purposes based upon publicly available information from sources believed to be reliable – LVW Advisors cannot assure the accuracy or completeness of these materials.  The information presented here is not specific to any individual’s personal circumstances.  To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.  The information in these materials may change at any time and without notice.  Past performance is not a guarantee of future returns.



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