Frank Thoughts: Two Open "Secrets"
Frank Boland
September 10, 2020

To me an open secret is something known but not acknowledged. Years ago, a client, who was an executive of Coca-Cola, invited me to the company in Atlanta, Georgia. I was surprised by two things. Firstly, that Robert W. Woodruff – the entrepreneur who built the company – had an apartment in the building and secondly, the formula for Coca-Cola was a secret.  I’ve since learned many businesses have, if not a secret, some inner knowledge. In the investment business they’re open “secrets.”

Recently, the Wall Street Journal ran a story titled “And the No. 1 Stock-Fund Manager is …” The story went on to say his mutual fund had achieved a total return through June 30 of 56.2%. The portfolio manager’s comment about it was, “We go through periods where we look stupid compared to a lot of other people, or to the market.” As I read the story, I thought of what a young analyst had once said about his coverage of money management companies. “The business of managing money is not about managing money, but gathering assets.” In other words … performance!

The more money under management, the more profitable the business. The way to achieve this growth in assets is through great performance. It will always attract a crowd. What’s not realized by the “crowd,” however, is that there is almost a formulaic way of achieving it. We know the more risk undertaken, the higher the potential reward; the less risk, the less gain. Most of us do not deal well with personal or public failure and thus avoid risk. But in the investment business such fear is eased with the creation of “pooled” accounts, such as mutual funds and hedge funds.

The purpose of these funds is to perform. In pooled accounts the customer does not own individual stocks but shares in the fund’s structure. That’s very different from a separate account where an individual’s name is on the portfolio and the client has his own unique tax consequences. Typically, the portfolio manager and client know each other. In a mutual fund they do not. Such anonymity can give a manager greater risk tolerance. In his pursuit of performance, he can decide to focus on a “concentrated” portfolio. Such a portfolio will hold 20-25 stocks with half of it in 10 or fewer stocks. This concentrated structure can generate a lot of performance impact both up and down. Bill Miller, former manager of Value Trust, became famous for this approach.  

Miller established a 15 consecutive-year record of outperforming the S&P 500. But then came the bear market of 2000-2002. The same concentrated structure - that can work so well in a bull market -often becomes inverted in a bear market. The portfolio axiom, of down 50% requires up 100% to break even, comes into play. Such downside becomes even more “deadly” if it’s heavily weighted in one or two sectors, industries or current Wall Street “concepts” such as unprofitable Unicorns.

The real open “secret” in achieving outperformance is to own entrepreneurially run companies as core holdings. Value Trust had owned such stocks as Yahoo, Dell Computer, AOL, Google and Amazon over its 15 year record performance. All were entrepreneurially managed. The advantage: a founder is driven by his dream, not caring about current macro-economic realities. Two Bain & Co executives, Chris Zook and James Allen, wrote a book about this passion titled The Founders Mentality. In it, they disclosed that over the past 30 years founder-led stocks have outperformed the S&P 500 by 3.1 times! Some founders will even stay overnight in their corporate office, as I had discovered years ago.

-Francis Patrick Boland

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