Designing the ‘perfect stock picker’

At Firetrail Investments, we believe that high-quality, high-conviction investment managers can outperform the index over the medium to long term. Over the short term, however, even an investor with perfect foresight will have periods of underperformance.

In the article below, we explain the findings from an experiment we conducted to assess the risk and return profile of a high-conviction stock picker with perfect foresight. The amazing excess returns generated over the long term may not surprise you. What might surprise you, is the conviction and long-term thinking required to stay the course and reap the rewards from our ‘perfect stock picker’.

The Warren Experiment: Designing the ‘perfect stock picker’

For our experiment, we wanted to assess the performance of a perfect high-conviction stock picker over the short, medium and long term. To be clear, in order to conduct this experiment our ‘perfect stock picker’ is required to have perfect foresight. That is, they know which stocks will win prior to investing. For fun, we named our perfect stock picker Warren, after one of the greatest stock pickers of our time, Warren Buffett.

For the Warren Experiment, we selected parameters that reflect the Firetrail high-conviction investment strategy and style. The key inputs for Warren’s portfolio are summarised below:

1. Investment universe and benchmark: S&P/ASX 200 Accumulation Index
2. # of positions held: The top 20 performing stocks in the universe over the period, equally weighted at the beginning of the period
3. Holding period/rebalance: three years, to reflect our own medium-term forecasting and holding period
4. Time period: 31st December 2000 to 31st December 2018

How did Warren’s portfolio perform over the long term?

The long-term results of Warren’s stock selection are unsurprisingly impressive. As the table below highlights, Warren generated 32.8% per annum above the benchmark over the 18-year period. If you had invested just $10,000 in Warren’s high-conviction portfolio, you would have over $4.5m at the end of the experiment. If you invested the same amount in the market, which still provided a solid return of 7.7% per annum over the same period, your investment would be worth $38,000. Due to the power of compounding, excess returns can have a significant impact on return outcomes for investors over the long term.

The Warren Experiment: Return Statistics

Source: Firetrail Research

Of course, Warren has perfect foresight in our experiment and the portfolio returns are theoretical. So, the incredible performance result is to be expected. In reality, the risk required to generate the above returns would make Warren’s strategy ‘uninvestable’ for the typical investor.

The Warren Experiment: Risk Characteristics

Source: Firetrail Research

The table above highlights the risk characteristics of Warren’s portfolio. To put this into context, an average high-conviction manager would expect to have a tracking error of 3% to 5%. Under normal conditions, the investor would expect to out/underperform the benchmark by approximately the same range of 3-5% p.a. over the long term. Warren’s portfolio had a tracking error almost three times the average high-conviction manager. The portfolio volatility is also higher than the market. While the theoretical returns in the Warren Experiment are high, so is the active risk taken to achieve those returns.

Long-term vs short-term performance

To outperform the index, your portfolio needs to be different to the index. High-conviction investors typically differentiate their portfolios through:

1. Portfolio concentration: Typically investing in 20 to 40 of their best ideas
2. Position sizing: Position sizing generally reflects the conviction the investor has in the underlying stock. Higher conviction = larger position size
3. Risk management: Which differs among investors. Our approach aims for the risk and returns of the portfolio to be driven predominantly by stock selection, where we believe we have an edge (as opposed to macroeconomic factors which we believe are largely binary and unpredictable)

Due to the differences in a high-conviction portfolio’s positioning, the performance outcomes can vary significantly from the index and the average investor. Put simply, if a high-conviction investor gets more stock calls right than wrong, they will outperform. Conversely, if they get more stock calls wrong than right, then they will underperform.

In our view, a high-quality, high-conviction investor should get 60% or more of their stock calls right over the medium to long term. After all, even Warren Buffett (arguably one of the greatest investors in our history), doesn’t get every stock call right. But an investor who gets 60% or more of their stock calls right should generate meaningful outperformance over the long term.

However, in the short term, even an investor with perfect foresight will experience performance volatility. The below chart highlights the significant drawdowns experienced by Warren in our perfect stock picker experiment over multiple short-term periods. Despite getting 100% of stock calls right over the medium term, Warren experienced 17 significant short-term underperformance periods of 5% or more under the benchmark.

The Warren Experiment: Short-term underperformance of 5% or more below the benchmark

Source: Firetrail Research

The largest drawdown Warren experienced was 26% below the benchmark between June 2008 to October 2008. This drawdown took almost two years to recover and raises the question as to whether Warren would have survived as an investment manager post the GFC?

The second largest drawdown was over 12% and occurred during December quarter of 2018, a period where many active Australian equity managers, including Firetrail, underperformed. Interestingly, despite the underperformance, Warren’s theoretical portfolio still delivered 45.3% pa over the three years to 31 December 2018, 38.6% per annum above the benchmark return over the same period. An impressive result if you were able to maintain conviction and stay the course.

Conclusion: High-conviction investing requires a long-term mindset

Finding a high conviction manager that can deliver excess returns can have a material impact on your returns over the long term. However, a high-conviction approach is not for everyone. It requires a long-term mindset and a belief that your investment manager will get more of their stock calls right than wrong over the medium to long term.

As our Warren Experiment shows, even an investor with perfect foresight will experience short-term periods of underperformance. These periods of short-term underperformance are painful for investors and investment managers alike. In our experience, high-conviction investors that maintain conviction, stay true to their approach and focus on the longer term will be rewarded over time.

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