Anthony Doyle's highest conviction idea

Ally Selby

Livewire Markets

Following the poor performance that many active investment managers experienced during the tech bubble and bust of the late 1990s, many shifted to focus on portfolios made up of their "best ideas", or what has come to be known as a "high conviction" approach.

So why high conviction? Well, a lot of ink has been spilled on the topic. 

For example, US-based Quantitative researcher Antti Petajisto found that the majority of active stock pickers outperform their benchmarks after fees, while "closet" indexers underperform. In fact, fund managers with "high active share" (or low overlap with the benchmark), beat their index by 1.26% per annum after fees and expenses.

Similarly, Firetrail's Anthony Doyle believes that if investors seek better than benchmark returns, their portfolios need to look entirely different to a said benchmark. And with 35 years' experience investing with a high conviction approach, Firetrail has found a portfolio made up of 30 to 40 stocks to be the sweet spot. 

In this Expert Insights video, Doyle shares his two cents on a high conviction approach, as well as why he believes that high conviction does not mean high risk. 

Plus, he also shares one of the S3 Global Opportunities Fund's highest conviction holdings right now. 

Note: This interview took place on Wednesday, April 13th 2022. You can watch the video or read an edited transcript below.


Edited transcript 

Why do you believe a high conviction approach can outperform?

Anthony Doyle: At Firetrail, we invest with conviction. And the way to invest with conviction is to do a lot of work, particularly from the ground up. So, our analysts conduct around 200 hours of research on one single company, and it might not even make it into the portfolio.

One other thing that we do when an analyst presents their research to our investment committee is we have a blind vote. Everyone is involved, but the reason we conduct a blind vote and score it on a zero to four scale, four being the best, is that we don't want members of the team to be anchored by more senior individuals. So, it's a team-based collaborative approach built on a bedrock of fundamental analysis that our analysts conduct.

The question is why are we doing that? Well, the reason is that if you want to outperform an index, you have to be very different to that index. 

We look at something called "active share" - what's our overlap with the corresponding benchmark? How many holdings do we have that are the same in the benchmark? In the Firetrail S3 global opportunities fund, we have a very high active share, meaning we have a very low overlap with the index. Our active share's around 95%. Only 5% of our portfolio is represented in the index. This means we have the ability to significantly outperform the index.

There are many funds out there that have a high number of holdings. They'll tend to replicate how the index is performing. 
If you want to take a high conviction approach, there will be periods where you underperform. But over the long run, we think core bottom-up fundamental analysis and investing with conviction translates to a good probability of outperforming over time. 

So, it is important when you're building portfolios with a high conviction approach to diversify appropriately. But our fund is style-agnostic, not beholden to growth or to value, 30 to 40 of our best ideas globally, from an opportunity set of over 20,000 companies.

What is the ideal number of holdings in a high conviction portfolio?

Academic research suggests that you can diversify appropriately across regions, countries, and sectors with as few as 12 to 16 stocks. Over our experience - which is 35 years of high conviction investing - we've found 30 to 40 stocks within a portfolio to be the sweet spot.

That said, a high conviction approach with fewer stocks than in the index doesn't necessarily mean higher volatility or higher risk. It's very important that you have a strong risk framework around your portfolio construction process. We can build portfolios that actually experience lower volatility than the index.

Now, some portfolio managers will have a high number of holdings, and they will have generally a low tracking area, relative to the benchmark that they're trying to outperform. So, they have very low volatility relative to the index. 

We think that if investors are going to pay an active manager higher fees than they will experience on an ETF fund or a tracker, then they should also have the ability to outperform an index significantly and be rewarded for taking that risk.

But it's important to recognise that high conviction does not mean higher risk. Indeed, you can take greater risk investing in a passive vehicle or a thematic vehicle. It's charging lower fees, but there are a lot of unintended consequences or unintended embedded risks within many of those exposures as well. Even the best investors in the world underperform, even Warren Buffett or those investors that are held up as market leaders.

We think, as high conviction investors, if we can get 60% of our calls right, and weight those opportunities accordingly, we stand a very good chance of delivering long-term outperformance to our clients and to our investors.

Now, every fund, every investor, will go through a period of underperformance in the short term. Equities, particularly global equities, are generally a riskier asset class. But it is very important that investors identify themselves as investors rather than short-term speculators.

Long-term patient capital stands a very good chance of being rewarded by a higher performance over the long run, particularly from a high conviction approach, as many of the investment theses that we run on our companies will take time to play out and will take time for the market to recognise. 

Particularly when you consider companies going on a journey of positive change and moving up a transition from being a sustainability laggard, to a sustainability future leader, to becoming a sustainability current leader.

What is one of the fund's highest conviction holdings right now?

So, one of the highest conviction positions in the Firetrail S3 global opportunities fund at the moment is a timber REIT called Weyerhaeuser Co (NYSE: WY). So, many investors in Australia wouldn't have heard of this company before, but it's actually one of the largest private landowners in North America. Its forest assets are equivalent, and even larger, than the size of Tasmania, for example.

Weyerhaeuser produces materials like lumber. Lumber is up over 125% over the course of the last year, responding to higher house prices and higher housing demand in the US in particular. But we think the great opportunity, apart from the strong housing demand and run-up in lumber prices and demand for wood products, is actually in carbon credits. 

So, as the carbon market in the US develops, and the US has been a laggard relative to Europe in particular in terms of the development of its carbon market, Weyerhaeuser will actually be incentivized to sell high-quality carbon credits into the market, and retain its vast array of forest assets. So, we think that this is a fantastic opportunity. It's only a small part of Weyerhaeuser's revenues at the moment but is likely to grow significantly, particularly over the course of the next five to 10 years.

Given it benefits from a strong housing market, what consequences would rising rates have on this stock?

So, the Fed obviously is behind the curve at the moment. Inflation is running hot, over 7% per annum, and you also have a very strong labour market, with unemployment under 4%. So, market expectations are for a rapid increase in the Fed funds rate over the course of the next 12 to 24 months. 

Now, it's extremely difficult to see how the Fed will be able to hike interest rates to the same extent as the market is pricing in without forcing a recession. You've seen how Powell has pivoted from inflation being transitory, and you've seen some of the more dovish central bankers also become a lot more hawkish.

If we do start to see a growth slow down, it suggests that the Fed will start to potentially move away from some of those tightening signals. Additionally, if you think that we are starting to approach peak inflation at the moment, and inflation does start to return to a range that the Fed is comfortable with, I would suggest that the Fed may be a lot less heavy-handed in terms of hiking those interest rates.

We're really at the apex of inflation fears at the moment. But when you look at year-on-year calculations, it does suggest that the peak in inflation may be around about now, and we may start to see more reasonable levels of inflation going forward. 

Again, it's very difficult to forecast, but one thing we do know is that there is an undersupply of housing in the United States, and so we expect that there will still continue to be strong demand over the course of the next 24 months. Unemployment rates are low, mortgage rates are rising but you still see that the average American continues to service their mortgage given the high rate of fixed-rate mortgages that exist in the United States housing market.

Introducing a high conviction portfolio with a sustainable edge

The Firetrail S3 Global Opportunities Fund is a concentrated portfolio (approximately 30 companies) of Firetrail’s best global equity ideas. The investment process employs fundamental analysis to identify the most attractive investment opportunities with sustainable characteristics. Click here to find out more. 

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Ally Selby
Content Editor
Livewire Markets

Ally Selby is a content editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian Group, Your...

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