In the third quarter the portfolio gained 6.4% while the benchmark gained 8.2%. YTD the portfolio increased by 9.0% while the benchmark added 2.8%. Since inception in January 2014, the portfolio grew by 28.8% while the benchmark grew by 31.4%.
Largest contributors to performance during the quarter were Brainjuicer (+1.5%), A&O Johansen (+1.1%), a basket of Italian real estate funds or REIFs (+1.0%) and City of London Investment Group (+0.8%). Largest detractors were Dundee Corp. (-0.5%) and Sports Direct (-0.5%).
An overview of the portfolio’s ten largest investments ex cash is outlined in the table below:
Some thoughts about portfolio management in the current market environment
At quarter end, cash made up 25.5% of the portfolio. Since inception cash holdings averaged 34.2%. Cash holdings have come with relatively high opportunity costs so far. However, I believe that at some point over this market cycle financial flexibility will be a very valuable asset. I am aware that timing the market is controversial and that for many investors it is mandatory to be fully invested. Holding large portions of cash is not en vogue, but it might turn out as an edge.
Of course, I could reduce my current cash holding by increasing the weight of my existing investments or by adding new investments to the portfolio.
For me the weighting of an investment within the portfolio is a function of (i) liquidity, (ii) complexity versus simplicity and (iii) price versus value.
The first criteria – how fast I can trade and what is the impact on price when I trade the security – has been constrained since passive investing has become so popular. As Horizon Kinetics has proclaimed for a couple of years, mostly large cap corporates with high free float were the beneficiaries of strong and consistent inflows in ETF / passive investment strategies. In contrast to active investing, passive or index investing does not consider the underlying fundamentals of the securities but reproduces an index / basket of securities just based on the (free float) market capitalization (e.g. the weighting in an index). As fees are only a couple of basis points, asset managers need to attract sufficient capital to conduct their operations in an economically efficient manner. Consequently, most of the assets under management flow into large cap securities reproducing the most important indices to generate the highest margins for asset managers. This results in an “ETF divide”, where part of the financial market is neglected by passive investing. At the same time, active fundamentally based investing has witnessed substantial outflows over the last decade. Consequently, the question arises whether a group of large cap securities is decoupling from their fundamentals while prices of these securities correlate with capital flows in and out of passive strategies only. If that is the case, putting too much weight on liquidity as a criteria for portfolio weighting will sooner or later produce dire consequences.
Currently, the portfolio consists of 24 positions (when accounting for the Italian funds as a basket) with an average weighting of 3.1%.
To be fully invested, I could just proportionally increase the average weighting to 4%. However, this would ignore the individual life cycle of each investment. Prices of some portfolio components have soared and have been approaching intrinsic value (e.g. A&O Johansen, Lectra, BrainJuicer, Italian funds, et alia). Consequently, also their weighting within the portfolio has increased. Therefore, it would not make sense to increase the weighting again when the return potential has declined. Other investments are in an early phase and it will take time for them to play out (e.g. Rolls Royce, Houston Wire & Cable, Sports Direct, et alia). There might be back steps on the way ahead leading to attractive entry points. So here I just want to wait and see whether I can increase my bets at some point in time.
I could also add more investments to the portfolio. However, I believe that a portfolio consisting of around 25 investments is already providing enough diversification. In addition, the more investments I have the less time I have to spend on each of them (not to mention the companies on my watch list). I am not inclined to own an extremely concentrated portfolio with 10 or less investments due to the large impact of single investment failure. At the same time, the art of active portfolio management becomes obsolete with an increasing number of investments. So for me the truth is somewhere in the middle and I feel comfortable with a portfolio of about 25 investments.
However, what I can do is reducing the number of investments with limited impact on portfolio performance due to their low weightings (e.g. Passat, UMS and AG Bad Neuenahr will take care of themselves due to liquidation and bankruptcy). Replacing these investments with my average 3% starting position will contribute to reducing cash holdings over the next quarters.
From a macro perspective, I do believe that the time to be greedy has not come yet. The unprecedented interest environment is already delivering unintended consequences. Currently, there are some temporary winners (e.g. large corporates being paid to borrow capital, emerging market issuers and zombie companies) but many losers are just emerging (e.g. banks, insurance companies and people trying to save for retirement). I do not know what the future will provide – (i) more expansive central bank measures combined with fiscal spending or (ii) increasing interest rates with the Fed starting in December this year. However, I believe that the former (i) will if at all only provide a short term boost to financial markets while the later (ii) will lead to short term disruption. Over the mid to long term the dislocations in the world economy / financial markets will need to be solved. The question is just how – I assume that it will be the market putting things right as politics is not leading / just reacting and central banks cannot do that. The funny thing is that almost everybody I talk to or read about seems to be aware of that. At the same time, almost everybody tries to stay on board and to profit from the addictive gift made by central banks as long as possible.
Consequently, I do focus on controversial, unloved / uncrowded, misunderstood, long term, small to micro-cap investment opportunities. And I am holding cash not forever but for the time being.
The following table provides an detailed overview of the current portfolio:
During the quarter I added to my existing positions in Par Pacific Holdings via capital increase. I reduced my position in Europa Immobiliare and Brainjuicer. I also stopped accounting for interest payments on cash given non-existent interest on cash in the financial markets. A detailed overview of the portfolio’s quarterly cash flows can be found below:
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