Seeking Alpha: Researching Investments Longer

Spending more time in researching each investment increases the possibility of above-average alpha returns.

This is because the majority of investment managers do not or even cannot spend as much time for diligent research.

A large part of global wealth invested is managed by professional portfolio managers on behalf of their clients – be it a discretionary mandate for one client or fund managers.

For safety concerns they almost always must maintain well diversified portfolios. That includes for most actively managed portfolios anywhere from 30 to 50 about equally weighted investments.

Let’s for the following assume a portfolio with 40 positions, and that each investment stays in the portfolio for 6 years. That means for a portfolio with 40 positions an average of 7 new positions must be added each year to compensate for the sold positions. That amounts to a portfolio turnover per year of 17% (100%/6), which is not uncommon in professional portfolios.

The portfolio manager must spend his time during the year following the positions he has in the portfolio, to make sure he is aware of important changes. Depending on how serious the portfolio manager is about following and understanding the companies, that will likely take anywhere from 2 to 5 working days per year for each investment. Why not more than 5 days will become obvious later in the article.

Only reading the yearly shareholders report and not just skimming it, will take half a day – not to even talking about quarterly reports. If it is a larger company with global sales, then getting to know how the business is going in each country will take time. Additionally identifying rising competitors and identifying shifts in the industry structure will also take a lot more time.

If the portfolio has 40 positions and assuming 4 days are spent each year on staying up-to-date, then that is already 160 working days. The year has a total of 260 working days (excluding Saturday and Sunday). This leaves 100 days for finding the new investments for replacing sold positions. With 7 new positions a year, a new investment must be found for each 14 days of searching. If only every 5th prospective investment researched makes it into the portfolio, then a maximum of 3 days can be spend on researching each new prospective investment. But wait a second, 4 days on maintaining an investment and 3 days for the initial analysis to make it into the portfolio? Certainly not, the initial research must take much longer than the time spent on keeping up-to-date. That means that the assumed 4 days of time spent on following the investments are not realistic.

Making the same calculation with only 2 days of work for staying up-to-date leaves 180 days for searching new investments. In 180 days, 7 new investments must be identified, that is on average a new investment for every 25 days spent on research. If again only every 5th prospective investment makes it into the portfolio, then the time available for researching each prospective investment is on average 5 days.

2 days per year per investment for staying up-to-date is very short. 5 days for scrutinizing a new investment is also extremely short.

Due to this constraints, almost all institutional portfolio managers can only be very superficial in their research activities.

This opens up the possibility to uncover hidden rewards and risks in investments by spending more time on research and looking deeply into the investment’s individual characteristics. What can be seen by spending a few hours is probably recognized by most investment professionals and hence priced into the market. But very few people spend a long time with an individual investment and here possibilities for uncovering opportunities exist.

Also, by not spending so much time with each investment, these managers will have to rely on industry averages, e.g. ratios and average opinions for growth etc., and by doing so can introduce pricing inefficiencies, that also give rise to opportunities (see article on using averages for pricing individual assets). That is because they think a company should, as a very simple example, trade at the industry average PE (price-to-earnings-ratio) and buy or sell accordingly, but the different PE was in fact justified.

What can be done about it? This is one of the pitching points of many hedge fund managers. They have concentrated portfolios. The time available for searching and keeping up with individual investments is much better then. I personally do not think one should go below 8-10 uncorrelated positions (this is no investment advise!). The uncorrelated (actually it should read independent) becomes important to balance the higher volatility of a concentrated portfolio.

However, even then it is for most investment managers impossible, as a concentrated portfolio will fluctuate much more out of line with the general market. Than can get an institutional manager fired, even if it were the best possible portfolio in the world.

As a middle ground, it could be considered to have 8-10 uncorrelated core investments with a weighting of each 4%, resulting in 40% portfolio allocation to core investments, and filling up the remaining portfolio with more or less random picks from the benchmark investment universe.

However, a concentrated portfolio only magnifies the skills of the investment professional. If his skills are below average or only average, then a concentrated portfolio will be worse than a well diversified one.

 
Have you ever seen it working or not working in practice, what I described here?


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