As part of the initial investing activities the Fund established a position in Target1 (the US listed retailer). By the end of June, Urban Outfitters, which is another US listed retail business appeared more attractive (according to our internal ranking process) and holding both would have breached our portfolio diversification rules.
In an ideal world void of trading costs, taxes and labour costs, and with definitive accuracy of stock rankings, rational investment managers would constantly “upgrade” their portfolio to their top ranked stocks that fit within their investment criteria.
However, that is not reality. There are real costs incurred in trading. And let’s not over-estimate the utility of a ranking system. A ranking system is merely a tool. We feel it is best used with due regard to the philosophy often attributed to John Meynard Keynes:
“It is better to be vaguely right than exactly wrong.” – Carveth Read2
So, in order to limit trading costs and taxes we have rules in place which do not simply allow for “portfolio upgrades”. Businesses are generally only sold to address breaches of the portfolio construction rules, or if underlying business fundamentals or changing share prices cause the company to fail the valuation, quality or financial distress criteria. However, we do have a rule that allows the sale of a holding irrespective of those requirements if the ranking falls beyond a threshold.
We call this part the “common sense” overlay:
“Organized common (or uncommon) sense — very basic knowledge — is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little.” – Charlie Munger
By early July, our ranking of Target had fallen to a level which, according to our rules, allowed it to be sold. And indeed we did choose to divest it, because Urban Outfitters, which was cheaper and which we deemed to be of superior quality (lower likelihood of financial distress, higher returns on capital), could serve as its replacement.
Let’s fast forward a few weeks to mid-August. Urban Outfitters had just released results which were clearly well liked by market participants – they viewed the business to be suddenly worth 20% more! As a result, based on our systems, its stock ranking fell. And, there was a higher ranked alternative US retailer, Wal-Mart.
So the new question was: Do we realise the short term capital gain in Urban Outfitters and purchase shares in Wal-Mart? The rule is discretionary. Just as it allowed and did not require the sale of Target to purchase Urban Outfitters, it allows but does not require the sale of Urban Outfitters and the purchase of Wal-Mart. Time again for the “common sense” overlay.
Again we chose to implement the trade. Although we recognised at the time that Urban Outfitters posted a great result (it further demonstrated impressive returns on invested capital and very low likelihood of financial distress) we could not help but be concerned that its share price reflected lofty expectations which may fail to eventuate. Ultimately our view was that by implementing the trade, the benefit of lower risk would be more than sufficient to offset the costs incurred by realising a short term capital gain (unfortunately, or perhaps fortunately, there were insufficient losses to offset that gain).
Why discuss this? Because many industry participants have indicated they would categorise the Fund’s strategy as “Quant”. We suggest that although the Fund does have some typical “Quant” attributes it is not appropriate to categorise it as a “Quant Fund” (not that there’s anything wrong with “Quant”!), and we feel these US retailers “trading machinations” serve as an illustration as to why.
Hope this makes sense,
Stuart and Alexis
1 Company names have been abbreviated throughout this document in the interests of readability. Should readers wish for more detailed information, please feel free to contact Alluvium.
2 British Philosopher and logician, 1848 – 1931, https://en.wikipedia.org/wiki/Carveth_Read
This article has been prepared solely for the purpose of providing general information about Alluvium Asset Management Pty Ltd (ABN 69 143 914 930) which holds an Australian Financial Services Licence Number 476067 (“Alluvium”), and the Alluvium Global Fund, which is managed by Alluvium. The article has been compiled in good faith in relation to the activities of Alluvium. Alluvium believes the statements contained are reliable, however no representation is made as to the completeness or accuracy of the information it contains. In particular, you should be aware that this information may be incomplete, may contain errors or may have become out of date. Use of this article is entirely at your sole risk. Reproduction or distribution of this article without written permission is prohibited. The information is general in nature and does not take into account your personal circumstances, financial needs or objectives. Statements contained are not general advice or personal advice and should not be considered as a recommendation in relation to an investment in the Fund or any company referred to, or that an investment in the Fund or any company named in the article is a suitable investment for any specific person. Further, it is likely that at the time this article is published, Alluvium’s and/or the Fund’s position or opinion in any identified company may well be different to that at the time of writing. You should seek independent financial advice and read the relevant disclosure document prior to acquiring a financial product. Alluvium, its directors and employees do not accept any liability for the results of any actions taken or not taken on the basis of information contained in this article, or for any negligent misstatements, errors or omissions.