"The zebra can lie down with the lions, but had better keep one eye open."
—Anonymous
“Zebras have the same problem as institutional portfolio managers. First, both seek profits. For portfolio managers, above average performance; for zebras, fresh grass. Secondly, both dislike risk. Portfolio managers can get fired; zebras can get eaten by lions. Third, both move in herds. They look alike, think alike and stick close together.
If you are a zebra, and live in a herd, the key decision you have to make is where to stand in relation to the rest of the herd. When you think that conditions are safe, the outside of the herd is the best, for there the grass is fresh, while the middle sees only grass which is half-eaten or trampled down. The aggressive zebras, on the outside of the herd, eat much better. On the other hand – or other hoof – there comes a time when lions approach. The outside zebras end up as lion lunch, and the skinny zebras in the middle of the pack may eat less well, but they are still alive.”
—Acorn Fund’s founder and portfolio manager, Ralph Wanger
So last Friday I attended a meeting with Myron Scholes. That would be the Nobel Prize winning Ph.D. and economist famous for the option pricing model, termed the Black-Scholes Pricing Model (Black Scholes). He is currently associated with Janus as a strategist and portfolio manager. In our discussion he referenced elephants, not zebras. He opined that the “trick” to investing outperformance is to decide which way the elephants are going to go. He stated too many portfolio managers (PMs) are constrained by having to “hug” their respective bench marks. But recall, according to Wanger, “alpha” (excess return) is found by the aggressive zebras, on the outside of the herd, [that] eat much better – which is the key to outperformance if you manage the risk. He also noted thematic investors tend not to worry as much about which way the “elephants are going,” but rather the expertise they have in a particular field like water. Further, you can ride the elephant in the same spot, or you can ride the elephant in a safer spot when the terrain is rough; or in a more causal spot when the terrain is smooth. Importantly, investment returns over the long-cycle are dependent on compounded returns, and cross-sectional allocations. His strategy is to give investors the least volatile returns with the best long-term compounded returns over the long cycle with the mantra of “keeping the risks constant.”
Myron’s attention to managing “risks” is consistent with the Benjamin Graham quote I use in just about every presentation I make. To wit, “The essence of portfolio management is the management of risks, not the management of returns. All good portfolio management begins and ends with this premise. Given that Myron’s Black-Scholes model is the gold standard for the pricing of options, he gleans a lot of forward risk information by studying the options market. When it suggests risks are high, he de-risks the portfolio and raises cash. When risks are low, he adds risk back to the portfolio. My main takeaway from the meeting was that Myron manages risk, which is the key to successful investing. This is why Andrew and I attempt to “call” some of the short/intermediate market moves, albeit within the construct of an ongoing secular bull market that has years left to run.