An institutional investor recently emailed me a list of 10 questions about Victori that I responded to this morning and share below.
Q: Are you of the opinion that in the current backdrop we have been at levels that favor accumulating stocks, especially for longer-term positioning, in contrast with waiting it out because of high uncertainty and expected volatility?
Our research focuses on studying the company’s culture and leadership, the quality of the business, and the secular growth narrative. I am not a macro analyst, and aside from understanding how our companies perform at different points in the business cycle, we refrain from relying on macro predictions. We look for stocks that get better over time. Such stocks tend to make the best investments because the market extrapolates linearly while the value compounds exponentially. When we lose conviction on a stock, it is typically a gradual process where we get out incrementally as our conviction erodes. We look for evidence that we were wrong about things like management quality, business model, and reinvestment opportunities. It is rare for us to go from believers to non-believers because of a change in the macro backdrop. Since we run a concentrated portfolio (between 15 and 25 names), there is little room for low-conviction names. And since we target, from the onset, narratives that don’t change with the cycle, our turnover has been relatively low, and our mistakes or changing views have been addressed gradually. That said, if you look at our portfolio today versus 5 or 7 years ago, you will see that it has changed over time. That’s because conditions are always changing, and we have corrected a few mistakes over the years.
It’s the expectation that there will always be high uncertainty and volatility that compels us to invest the way we do. Because our goal is to stay fully invested in the best companies for the long-term, we avoid adjusting for less-pronounced changes in the market backdrop. For instance, we rarely trade ahead of quarters, and we barely touched the portfolio last year. Raising cash and changing portfolio mix as we did recently is an exception, and it too was done gradually (over months). Putting the larger than usual cash back to work will also likely take months. We are doing deep dives on three new stocks, and I anticipate at least two of them will come into the portfolio this year, but not because of price. Appraisal analyses is part of our process, so price clearly matters, but we deliberately avoid buying or selling because of price. There have been times when we trimmed a stock because it got too expensive and harder to justify. As a rule, though, we let the market choose the trajectory and focus instead on the outcome five to ten years out. Our time horizon and target holding period is measured in decades, which is a tall order, but it’s the mentality that matters more than how long it takes to prove us wrong on any stock.
The current backdrop is not particularly favorable because the Fed is still raising rates, growth is slowing, and the market trend is down. As is typically the case when stocks fall sharply, the slope of the 150-day moving averages for the broader market indices, and especially for the growth indices, turned negative back in February, which by our definition, puts us in a bear market. The average growth fund has already drawn down 30% and recession and/or inflation fears are running high. So yes, I think these levels already favor accumulation for the investor with a long-term orientation. But I also think there will be even better opportunities to accumulate specific stocks before this bear market ends. I think it’s more likely to be a multi-month process as opposed to a sharp crash that induces the Fed to pivot away from tightening, but anything can happen. Again, our goal is to avoid having to react to price (up or down), while staying focused on the long-term. The “attractive opportunity” label applies only to a special group of stocks that we would accumulate anyway (but like even better lower), on the premise that they will keep working for us over time. This happens not because we bought them “cheap,” but because they will enjoy strong, profitable growth for longer than the market typically discounts. When high growth rates at incrementally higher returns plays out for decades, it doesn’t really matter that much where you bought it if you manage to stick with it for the long-term rewards. The bigger risk is not owning enough. So, while I keep a close eye on the market backdrop as the portfolio manager, our investment process is designed to allow us to downplay the “macro” swings and letting the outstanding companies to their work.
Q: Can you elaborate on a point I read from you “If the economy turns down, the Fed has our back”? Approximately how many more rate hikes do you expect until the Fed turns around and when do you expect this to happen?
The Fed’s creation in 1913 put a stop to the boom-bust pattern of the 1800s, and its abilities to smoothen cycles have only expanded over time. But as Keynes had argued in the 1930s when he warned against “animal spirits,” and Hyman Minsky repeated during the 1970s when he warned against the danger of too much stability (i.e., it leads to bigger, sudden crises, or what came to be called Minsky moments), the stakes go up proportionately with the degree of intervention. In his 2022 book Bernanke writes: “If the Fed’s willingness to accept more near-term instability reduces investor complacency, and thus the risk to destabilizing financial crisis, then the net result is an economy that, paradoxically, is more stable in the long term.” I read this to mean that the Fed is committed to fighting inflation even if it takes a recession. While Bernanke is not Powell, I think Powell was an upgrade. Born in D.C. into a family of prominent lawyers, Powell practiced law (1981-84), worked as an investment banker (1984-95), and was a partner at the Carlyle Group (1997-05) before entering the Fed in December 2011 and becoming Chairman in February 2018. Bernanke, by contrast, was a career academic with limited practical experience and business contacts, who quietly emerged from Greenspan’s shadow as a determined leader in the fight against deflation.
The Powell Fed has demonstrated that it “has our back” when really bad things (such as a global pandemic) strike. The COVID response was easier to justify because it couldn’t be blamed on greed and animal spirits. When inflation is being attributed to an overheating economy and complacency, achieving a balanced outcome tends to require more pain before the “Fed put” kicks in. So, while they have our backs, maybe it’s not as much as people think right now. While its less popular and therefore harder to sustain, they prefer to deal with overheating than secular stagnation. In that sense, the current bout with inflation is an opportunity to make the system more stable over the long term. So, when I write that they “have our back,” I mean they will stay focused on maintaining their credibility by promoting long-term stability, even if that means inducing a mild recession or a bear market with the goal of taming inflation. I don’t have a strong opinion on how many more rate hikes the Fed will do, but I think it’s clear that they are not going to stop soon. I suspect at some point the market will start pricing the end of the campaign and a more stable future – probably in the Fall or early next year. In the 1994 hiking campaign, as an example, the Greenspan Fed started raising in February of that year and kept raising through February 1995, but the market bottomed in December and never looked back. They tried the same approach to cool the housing market in 2006 and that time it did not work as well. Every time is different, but our companies have thrived over the decades despite the economy and how the Fed reacts.
Q: Do you think we may already be in a recession given the varying definitions of it, or do you think it will happen later this year or next year? Do you think a recession is already priced in?
I think the market is pricing a recession that has yet to happen. The technical definitions of a recession are not as important as the industries and players that get impacted. A recession in real estate (including housing), or in banking, would be more serious because that’s where much of the financial leverage resides. But I don’t think that’s where the recession will play out – or at least that is not where I think it will start. The US economy is driven largely by consumer spending, which will likely be the first to respond to the inflationary backdrop and higher rates. The industrial complex continues to be strong, but it typically lags the rest of the economy and is also more global in nature. Trying to time cycles or determine to what degree today’s macro news is priced in, is futile. Some things just can’t be known, no matter how much resources and brain power one devotes. It’s easier and more rewarding to focus on the outstanding companies and how they will keep growing and improving. None of our companies rely on discretionary consumer spending, and neither are their fortunes tied to commodities, rates, or currencies. This is by design as opposed to being a reaction to the current backdrop. We favor “all-weather” businesses that outperform during recessions. Our research process includes a close study of how a company performed during prior downturns, with the aim of avoiding stocks that prove more cyclical than they appear on the surface during an upturn. We are careful in separating what’s cyclical from secular, and while we will accept some degree of cyclical risk, we do so lucidly and only when the secular is underappreciated.
Q: Do you see a scenario where in a few months we find out from NBER that we already reached recession with potentially also the Fed decelerating and sounding less hawkish, which would lead to risk assets going up?
Yes. I think that is the most likely scenario, but that there are other factors that could create other plausible scenarios. The war could also end, or China lockdowns could also ease, or not.
Q: How much of your process is fundamental vs technical analysis?
Our process and philosophy are anchored on fundamentals. While I look at technicals as part of my risk-management surveillance work, this plays a very minor role (if any) in the research we perform and the decisions we make, since we aim to invest in such a way that timing the market, especially through technical analysis, is unimportant. We avoid market timing, but our risk management overlay invariably brings timing into the picture because it allows for a change in risk posture depending on the backdrop. During periods of heightened risk, and/or transitions from bull markets to bear markets, we can and have shifted to a more defensive posture aimed at reducing the risk of outsized drawdowns, as well as benefitting from having dry powder when our favorite stocks get unusually cheap. Aside from this exception, our aim is to stay fully invested and let our companies do the work. But all told, buying low and selling high is not the objective, so we downplay market timing in our decision-making framework.
Q: Do you apply any sense of timing, or do you focus only on the quality of the company?
Quality is not the only factor we consider, but it is core to our philosophy since we aim to own only the most outstanding companies. While we downplay timing, there are some very high-quality companies that don’t make it through our filter because of timing. Not market timing, but because of where they are in their own growth cycle. If a company is growing too fast, we might wait for the growth to settle down to a more durable state, which could take years. Other examples of what might give us pause are transformational acquisitions, management changes, or new products and verticals. Sometimes we prefer to wait for more evidence of success, or risk of failure, before we buy or sell. How much we wait depends on many factors, including the market backdrop and market expectations, but the predominant selection factor is quality. More specifically, we look for improving quality.
Q: I read from you the term “exponential dominance”. Can you please elaborate on that? Is it about the compounding effect, e.g. Buffett’s approach?
Yes, it is about the impact that sustained, above-average compounding has over longer stretches of time. I borrowed the term from Peter Thiel’s book, Zero to One (2014), where he writes: “Most of the differences that investors and entrepreneurs perceive every day are between relative levels of success, not between exponential dominance and failure.” The bottom line is that when a stock compounds at a higher rate for a long time, its value will dominate. If left undisturbed for long enough, a portfolio of 20 stocks will not be divided between winners and losers, but split between one or two dominant investments and everything else. We want to have as many stocks as possible that achieve exponential dominance, but we accept that very few will achieve this over time. It’s a rule of nature.
Q: What are your favorite indicators to pick stocks in your process, e.g. price, return, debt ratios?
It’s a mosaic that focuses on the quality of the people, the company, and the secular growth narrative. With people, we like to see a long track record of successful execution, a strong culture of continuous improvement, innovation, and growth, and a candid communication style. With the companies, we tend to favor asset light models with strong network effects and the ability to expand margins and financial returns with growth. For the secular narrative, we favor the stronger trends, but focus more on durability than absolute levels. In fact, we tend to shy away from trends that are too strong because they tend to be less sustainable. We prefer evergreen growth at relatively high levels. In our appraisal models, we boil it down to growth in operating profits and return on invested capital. When growth accelerates and ROIC expands, the outcome tends to be especially rewarding.
Q: Do you have any thoughts on the Elliott Wave Theory? Is it something you have ever incorporated in your analysis?
I went through a period earlier in my career where I read everything I could get my hands on regarding Elliott Wave Theory, including subscribing to Robert Prechtor’s service (link) and studying Ralph Elliott and Hamilton Bolton’s original works. The approach worked well in the 2008 crash, but it has otherwise been useless in the much longer bull market that ensued. As our investment philosophy crystalized over time, these market-timing techniques have faded in importance, even if I did not unlearn them. When animal spirits take hold and emotion overtakes reason, Elliott Wave Theory becomes more relevant, but if I ever did apply it, this would be more on the short side, where we have not operated in any material fashion for years. Conditions are always changing, so I avoid saying never to short selling, but in the current backdrop of heightened monetary intervention, things that used to work well (such as short selling), no longer make sense.
Q: How does your rebalancing process look like?
Every day we wake up asking if we have made a mistake in the portfolio. These mistakes can take several forms, such as owning the wrong stock or being too exposed to a particular end market or type of company. As I mention above, we try to interfere as little as possible with the work that our companies do for us, but this does not mean that we refrain from making any changes. The changes are typically minor and incremental, and they don’t tend to flip directions from month to month or even quarter to quarter. When the fundamental risk/reward we perceive with any given stock changes materially, we consider trimming or increasing the position, which in turn may require we buy or sell other names to remain fully invested. We think of the portfolio as consisting of four boxes: (1) Top 5; (2) Next 5; (3) Not Top 10; and (4) Workbench, which is anything below 3% weight. If the investment narrative for a top 5 position erodes, for instance, we might take it down to Next 5. The goal is to have the highest weights in the names that work best, and this has been the outcome over time. Sometimes a stock that does not deserve to be in Top 5 gets there through appreciation. At times we have allowed this to happen by doing nothing, while at other times we have interfered by trimming it back to Next 5.
We have never subscribed to rote rebalancing because we believe in Pareto’s Law and the notion that over the long term, the best stocks will dominate the portfolio, just like the best companies dominate their industries. If our top picks do best, then the concentration goes up, and while we monitor the weight of the Top 5 and Top 10 closely, we accept this natural phenomenon and only interfere when it gets too lopsided or the backdrop changes, such as occurred this year.