Nandu Patel guides charities through the discipline of holding investments.
Because buying and selling activity captures attention, the role of patient holding is often neglected. Inactivity doesn’t get the attention it deserves. But there is great importance to taking a long-term perspective, of managing emotions, and of basing decisions on fundamentals rather than market movements.
Buy to hold
With one or two exceptions, we buy investments with the intention of keeping them for the long haul. The main exceptions would be options bought to protect portfolios and short-dated bonds, held as a substitute for cash. To that end, we spend a lot of time thinking about what, if and when to buy, before committing a charity’s capital. Once we have assembled an attractive portfolio of assets, we seek to limit our buying and selling, as frequent trading incurs costs, eroding returns. We believe it would also reduce chances of success.
Identifying and buying shares in an excellent company is hard enough to do once. As one fund manager put it, buying, selling and buying back these shares all at the right time, would involve “winning a trifecta of difficult investment decisions”, where the odds are “overwhelmingly against you winning”. History and experience show that market timing is almost impossible to get right.
Improving the odds
If trading in and out stacks the odds of success against you, we believe holding the right investments for the long-term helps set the odds in your favour.
Consider these numbers from the US stock market, calculated using data from Robert Shiller and Bloomberg. The daily series begins in December 1927 (the earliest available data) and shows nominal price returns. Over this period, if you invested in the market for just one day, you would have made a positive return 52 per cent of the time. If you had increased your holding period to three months, you would have made a positive real return 62 per cent of the time. This number is similar for a year.
However, if you had raised your holding period to five years or more, the numbers would have improved dramatically – to 80 per cent for five-year periods, 88 per cent for ten years, and 95 per cent for 15 years. For 20- and 30-year holding periods, you would have made a positive real return 99.9 per cent and 100 per cent of the time respectively.
We recognise that even one year of falling markets can feel like a lot to endure, let alone five or more years of performance that fails to keep pace with inflation. And yet we are willing to risk causing irritation by quoting this performance study, because we believe these numbers provide a healthy perspective.
We live in a world of 24-hour news. Investment headlines are often dominated by fleeting events, by things that lose their significance within hours or days. Even when nothing happens, there is instant publicity. Molehills can be confused with mountains.
Holding can be hard
Selling securities requires no more effort than ordering a book from Amazon. Not selling them at times can be harder, in part because it involves managing emotions.
Every investor, no matter how experienced, can get caught on an emotional rollercoaster that climbs from optimism to excitement to euphoria (on the way up) through to anxiety, regret and despair (on the way down). At low points, despair can morph into panic, denial or capitulation. Faced with these emotions, doing something – anything! – can seem better than patiently holding on.
After a security has fallen heavily in price, selling it will give an investor some certainty – a definite end to his or her losses, and the comforting stability of cash. However, when considering a sale, it is important to look not only at the certainty gained, but also at the opportunity surrendered. This might be ownership of an undervalued investment, and the ability to share in its future profits and returns.
Buying and holding can also be hard after an investment has performed well. In 1938, an article in Fortune magazine reported that “weighty and serious” investors were regretfully concluding that it was too late to invest in Coca-Cola. However, $100 invested in the stock at the end of 1938 would be worth $193,913 today. That figure excludes dividends. Such an investor, unable to overcome feelings of regret about not buying sooner, would have missed out on exceptional returns.
For the businesses we invest in, one of the ways we manage emotions is by assuming we own the whole company. We think of investments as family businesses. We’ve found this helps us hold assets for the long term, through favourable and unfavourable markets.
If Ryanair or Unilever were entirely ours, would we sell them to someone for 14 or 20 times this year’s forecast earnings? These are their valuations today and, at this level, our answer is no. At much higher valuation multiples we might consider selling some or perhaps all of our stake. But we are unlikely to sell just because a business seems temporarily overvalued, or trades at a premium to the rest of the market.
What if the price offered to us was to drop by 10 per cent – would that prompt us to sell? Again, all else being equal, our answer is no. As in every other area of life, a lower price will make us less, rather than more, likely to part with an asset. A fall in price is not in itself a good reason to sell.
While we go into a position intending to hold it for the long haul, this does not mean we will therefore hold it forever. For an individual company, a weaker outlook for longer-term profits or expected future returns might cause our assessment to change, prompting us to sell. Equally, if a company’s valuation has risen to a level that seems detached from its fundamentals, we may decide to sell.
For our fund holdings, there might be a change in the fund or in our relationship with the fund manager. We see the funds we partner with as an extension of our own investment team and trust is paramount. Ignoring investment guidelines, poor risk management, inconsistent reporting, less transparency, inadequate communication – these are all red flags that may prompt us to end a relationship with a fund manager.
Aside from fundamental changes in a company or fund, we may sell a position because we believe we have found something better elsewhere. Based on long-term considerations, that could mean switching to an investment with a better outlook for risk-adjusted returns, or to one that we believe is a better fit in the context of our portfolios.
When managing money, we want there to be a healthy ongoing competition for the charity’s capital. That is part of the reason why we combine both funds and directly-held positions in a portfolio – it helps set demanding standards for capital allocation. In turn, this should improve the overall quality and performance of the portfolio over time.
Our decisions here are usually gradual, and rarely dramatic. For example, in the summer of 2015, we sold Franchise Partners Global Equity fund. There had been no changes in the fund’s organisation or strategy. The team remains excellent, and we regard them highly. Performance had been great, with annualised returns since inception of more than 17 per cent. Crucially, the fund’s philosophy and approach were also unchanged. Franchise looks for companies that generate a sustainably high operating return on capital employed. These businesses must have resilient and recurring revenue, organic growth potential and high free cashflow. We still believe that investing in companies like these, at reasonable valuations, will provide excellent compounding of shareholder wealth over the long term.
What could be better? Why not continue to hold? In this case, it was because of a change in the investment climate. The team at Franchise had twice raised a yellow flag with us, highlighting that the valuation of its portfolio was looking rich. This is something we had noted ourselves, and so we discussed it with them. In the end, we decided to sell because of the expected free cashflow yield from the companies in its portfolio. The Franchise team forecast this to be just 4.5 per cent after fees. We concluded we could better allocate capital elsewhere.
When managing portfolios, we like to keep buying and selling to a minimum. Where we do sell an investment, it will be because of long-term fundamentals, not short-term news or performance. We believe managing money in this way, and holding investments for the long haul, will ultimately lead to better returns.
Nandu Patel is head of charities and managing director at Rothschild
Civil Society Media wishes to thank Rothschild for its support with this article