In the Institute for Innovation Development’s ongoing interviews with active asset managers, we are seeing a growing trend of portfolio construction exploration and experimentation driven by the aftermath of the 2008 financial crisis. Many have taken Modern Portfolio Theory and other traditional methodologies and have, in essence, blown them up, and are now reassembling the pieces into new types of investment strategies and risk management approaches.
The Institute for Innovation Development recently talked with Elise Hoffmann, principal and co-chair of research at Marshfield Associates, a value money management firm based in Washington, D.C. and advisor to the Marshfield Concentrated Opportunity Fund (ticker: MRFOX). With a core investment tenet that the only way to beat the market is to have an investment strategy that differs from the market in as many ways as possible, we decided to dig deeper from our previous interview to understand the firm’s perspective of risk management as architecture.
“Form follows function—that has been misunderstood. Form and function should be one, joined in a spiritual union.” — Frank Lloyd Wright
Bill Hortz: What does that quote from Frank Lloyd Wright say to you and how do you apply it to money management?
Elise Hoffman: Frank Lloyd Wright, as a master architect, argues that a well-designed structure should seamlessly integrate both the form and the purpose of the structure so that the finished product incorporates both without any lack of continuity. We think his ethos expresses nicely our own approach to investing.
When we design and then construct our portfolio, we do so with an eye toward not only generating performance but also managing risk. In fact, the way Marshfield’s process works is that risk mitigation is an inherent part of company analysis and stock selection and not just an overlay thrown on top of those decisions. Our philosophy and discipline work together to build in resilience at the individual company level and at the portfolio level as well. We think it’s the joint impact of our largely independent decisions, as interwoven with our price discipline, that imbues our portfolio with a kind of tensile strength, resulting in an integrated whole that is greater than the sum of its parts.
Hortz: With that as a guiding principle, how do you start designing and then constructing your investment portfolios?
Hoffman: We rely on some basic tools of structural “engineering” at the outset with respect to such elements as number of stocks, position sizes, and the like. We don’t have too many rules, though, principally because we understand them to be somewhat arbitrary and we believe that piling rigid rules—even largely defensible ones—on top of one another only serves to amplify randomness. We intentionally limit our portfolios to around 20 stocks, based mostly on our experience, having tried smaller and larger numbers of holdings over time. Holding many more than 20 serves to diminish the impact of our best ideas and holding many fewer gives undue influence to our worst ideas. When we buy an opening position in a stock, we size it at 3 percent of the portfolio. It’s big enough to matter and focus our attention but not so big as to unduly harm the portfolio if we’ve made a mistake (which—spoiler alert!—happens from time to time). As we learn more about a new company, having lived with it for a while, we’re more comfortable adding to the investment if the price gets lower.
At the upper end of things, we have a per-stock limit of 15 percent of the stock portfolio. That gives the stock room to run but is a bright line buffer against allowing even our most successful investments to consume too much of the portfolio. That doesn’t prevent us from downsizing a holding before it reaches that upper limit when there is a clearly identifiable source of risk that causes us concern. Also, given the limitations inherent in the valuation process, while we have a hard-and-fast numerical rule dictating the point at which we will consider selling an overvalued stock, we don’t just pull the trigger willy-nilly; instead, we decide whether to sell some or all of our position, based on considerations such as our confidence in that particular valuation and the risks inherent in the business itself.
And that’s pretty much it as far as hard-and-fast rules of construction go.