2019 Annual Letter excerpt - LGF’s investment frameworks within the context of power laws

2/19/2020

II. 2019 Annual Letter excerpt - LGF’s investment frameworks within the context of power laws:

The axiom in the venture capital (VC) world is that investment returns follow a power law distribution, which means that a small number of winning VC investments generate the bulk of the overall return and offset copious losing investments. Put differently, the average VC investment has been a winner thanks to outsized contributions from early investments in firms like Google and Facebook, but the median VC investment has been mediocre. Venture capitalists plant many acorns, but seldom does one become an oak.

Although one rarely hears “power laws” with respect to the stock market, public equity returns also follow a power law distribution, albeit one less extreme than observed in VC. A 2017 paper from Arizona State’s Hendrik Bessembinder[1], as one example, found that from 1926 to 2016 “the best-performing 4% of listed companies explain the net gain for the entire US stock market.” We include Bessembinder’s exhibits on the next page and note that his finding makes intuitive sense to us because equity stakes, definitionally, have finite downside (-100%) and unbounded upside.

The (perhaps obvious) implications of this are clear: if one wishes to earn excess returns, concentrating one’s portfolio in the market’s few, disproportionate winners is paramount, as any investor who was zero-weight FAANMG (Facebook, Amazon, Apple, et al) last decade will tell you. On the flipside, having less concentration in the market’s long-term losers is important too—not just because the number one rule of investing is “avoid permanent capital impairment” but also because the opportunity cost of increased exposure to losers is reduced exposure to disproportionate winners.

As an aside, the latter point is partially why Long Game Financial (“LGF”) continues to maintain zero exposure to the energy sector. The opportunity cost of owning an oil major like Exxon Mobil—which we believe has little chance of being one of the market’s future disproportionate winners but continues to have an immense weight in the S&P 500—is owning less of a variety of businesses that we consider to be higher quality, faster-growing, better-managed, and more attractively-priced…with less exposure to longer-term macroeconomic risks like China. We believe our decision to tilt away from big, lower-potential index weightings, like Exxon, will continue to advantage LGF clients relative to the S&P 500.

Apart from portfolio concentration (the aforementioned “owning more of the good stuff”), there are only two other ways to generate a return in excess of the stock market: turnover and leverage. Concentration, however, will always be LGF’s primary lever for endeavoring to (continue to…) do so. Turnover—that is, buying and selling assets for short-term gains—is tricky and tax inefficient, and although leverage can magnify profits it cannot generate them.

Understanding that “stocks follow power laws so own the winners” and concentrating one’s portfolio ex-ante in future disproportionate winners are two completely different things, of course—but at LGF this is once again where our Four-Step Pattern and CAM frameworks assist us. We contend the market’s past disproportionate winners generally exhibited Four-Step Pattern and CAM characteristics, and we believe firmly that plain business logic suggests that our frameworks should continue to describe Planet Earth’s future corporate shareholder success stories.

Last, we do reiterate that our frameworks are about managing risk as well as capturing return. Per our CAM framework, LGF seeks to manage downside risk is by emphasizing business resilience: “[we] favor businesses that can thrive despite adversity. Key types of resilience include macroeconomic, competitive, managerial, operational, and financial.” LGF prioritizes owning businesses we consider resilient because while nobody can easily predict future disasters and their timing, one can estimate business resilience and durability, which can lessen the effects of disasters. Put simply, instead of attempting to forecast disasters, we strive to mitigate ex-ante the likely effects of potential disasters.

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[1] Bessembinder, Hendrik (Hank), Do Stocks Outperform Treasury Bills? (May 28, 2018). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2900447 or http://dx.doi.org/10.2139/ssrn.2900447