Practical analysis for investment professionals
01 August 2017

The Active Equity Renaissance, A Case Study: Alpine Capital Research

C. Thomas Howard and I authored a series of posts entitled The Active Equity Renaissance earlier this year. We did so because we believe that it is hard but not impossible to “beat the market.” We outline many of the directions the investment management industry took over the last 15 years that have led active managers astray. Much of the blame for active managers’ failure to deliver value is on active managers themselves. Yet, we identify steps they can take to improve performance, and we support our contentions with data.

It is not surprising then that people and firms that follow our prescriptions succeed. Alpine Capital Research (ACR)’s founder and CIO Nicholas Tompras, CFA, offers a compelling example of how to do things the right way. Both the firm and the man serve as case studies of important tenets of effective active management. In the interview below, Tompras outlines some of the strategies that have contributed to ACR’s success.

CFA Institute: Do you believe active managers can outperform passive ones?

Nicholas Tompras, CFA: Yes. The main test for me is how I choose to invest my own capital. I would much rather own a basket of stocks today with an estimated earning power yield of 8.2% (ACR’s EQR portfolio cash earning power) versus the S&P 500 earnings yield of 3.4% (Shiller CAPE). However, criticism of active managers is clearly warranted. Active manager performance, in general, has been abysmal. The question is why.

I believe there are three reasons:

  1. Most active manager fees are too high relative to the risk-adjusted returns generated.
  2. Active portfolio construction, due to longstanding industry norms, is fundamentally flawed.
  3. Most active managers are high-turnover price speculators rather than long-term investors.

The high fee problem is self-evident. The solution is simple: Active managers should charge a lower fee that is in proper proportion to the excess return they generate. Active manager construction of fundamentally flawed portfolios and short-term speculation are more subtle problems. The good news is that there is a solution to these problems — a different framework and market structure for investing in stocks.

What are some of the things you have done to deliver outperformance at Alpine?

The first and probably most important thing we’ve done is to stick with our five core investment principles. One of them is directly related to your question: Above-average performance requires an above-average understanding of a security’s value. Our understanding begins with a thorough analysis of the financials and lots of data gathering. But quantitative methods only get us so far. Fundamental value investing (as distinct from trading smaller, short-term changes in value and/or price) demands an in-depth understanding of qualitative factors — the products, markets, management, and competitive dynamics — that produce long-term future cash flows.

Another key is the right structure. We combine wide mandates with concentrated portfolios while making sure that we remain fundamentally well diversified. Rather than managing tracking error relative to the market, we employ an absolute return framework and hold cash when returns are inadequate. Regarding time horizon, we think 10 years, not three or five years. Additionally, we close strategies at relatively low asset levels to protect our wide mandate. The upshot of all this is that we get to be incredibly picky. In EQR (Equity Quality Return) — our long-only, all-cap, domestic equity strategy — we have owned 61 securities over 17 years.

Moving beyond security selection, how do you structure a portfolio? Do you use asset allocation or factor models? Do you construct an efficient frontier?

We structure a portfolio with the cheapest quality securities we can find on a strictly bottom-up price/value basis. The only structural constraint to owning the lowest price/value securities, and it’s critically important, is to avoid investing too much in any one company, industry, or other type of common risk. For example, the adoption of a single-payer health care system in the US could impact several industries. We slice and dice each company across the portfolio to determine common portfolio risks. Understanding these risks determines whether we would impose a constraint on adding a security. For example, if the cheapest price/value securities are all in one industry, we will only buy the most attractive among them to mitigate industry concentration. Asset allocation, factor models, and efficient frontiers are useless constructs for us. Fundamental value and risk are all that matter to a value investor.

What is your selling discipline?

Price/value is the ultimate determinant of both the buy and sell decision. When price is higher than value, we sell. The best type of sale, of course, is when price and value both rise, but price rises faster. Unfortunately, value sometimes declines, or one’s assessment of value is wrong. The real discipline is actually not the sell decision. It is the discipline required to adjust value when the facts change or when you’re wrong. Hitting the sell button is easy. Knowing when a rough patch in corporate performance is really a permanent change in economics can be very difficult. All you can do is dig deep and stick with the facts.

What has been your success as an active manager?

We define success in three ways: capital protection, solid absolute returns, and beating the market. Capital protection means protecting against permanent losses during tough economic times. We did that in 2007–2009. It’s our foremost imperative. Regarding absolute and market-beating returns, we don’t care about results in the short term. Focusing on short-term results would require price speculation, the antithesis of what we do. We measure absolute and relative return success only over a full cycle. While we have handily beaten the S&P 500 over the two full cycles during our existence so far, I think our greatest success is how we have generated spendable absolute returns. Believe it or not, since we started in April of 2000, over five-year periods (rolling month-end), the S&P 500 has beaten 6% annualized only 49% of the time. Our EQR strategy has done it 93% of the time. The only time we didn’t beat 6% annualized over five years was in late 2008 and early 2009 when harvesting gains (if there were any) would have been a bad idea, and we were buying like mad. Absolute returns are important because you can’t spend relative returns.

Is there a difference to your firm if an additional dollar of assets under management (AUM) comes from marketing or from portfolio management?

I have never stopped to consider that difference, so I would say no. We don’t spend meaningful amounts of money on marketing. We have two individuals who function in both business development and client relations out of 25 total, and we have nine in investments. I always say that if we generate solid investment results, everything else will fall into place.

How is your firm structured internally for success?

We outline structural issues for the investment team in a document we call our “strategic process.” It includes everything from core values, to key principles, as well as defining how we work together. For example, we define core values like accountability and meritocracy, and then specify performance measurement and compensation structures to make sure we are practicing what we preach. Organizationally, we make sure the investment team remains focused on investments. We have a fantastic president, COO, and operations team who focus on running our business, and excellent client relations associates who can answer complex investment questions. Last, we are 100% employee owned, and everyone who has proven themselves has the chance to own equity in the firm.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, is a content director at CFA Institute, where he tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor. Jason also ran a successful blog titled What My Intuition Tells Me Now. Previously, Voss was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund. He holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason.voss@cfainstitute.org

7 thoughts on “The Active Equity Renaissance, A Case Study: Alpine Capital Research”

  1. Fung C.F. says:

    Hi Jason, thank you for adding another interesting piece into your The Active Equity Renaissance series.

    ACR certainly has a good investment and philosophy and process — value approach, buy quality bargains for long term, boring but sensible. However, after some examinations on their flagship fund EQR via its fact sheets, I notice few shortcomings of ACR as an active investment manager (I hope I’m not overly cynical).

    One of the main observations I found about ACR is that they are “down”-market specialist (as most value investors are). They protected the downside well over the years (outperformed the index 4 out of 4 down years). However, ACR did not do a great job in adding value to investors during the up years. EQR has only outperformed the index (net 1% fees) in 4 out of 14 “up” years since inception. I point this out because investors don’t often get into a fund at right timing (often during the up years). An active manager should add value to the otherwise passive investors at most times, if not all times. That being said, smart investors should always knock on ACR’s door in any bear market for their speciality in capital protection. (Note: I do understand that value investors are typically bad bull performers, as Seth Klarman once said “I must remind you that value investing is not designed to outperform in a bull market. In a bull market, anyone, with any investment strategy or none at all, can do well, often better than value investors.”)

    I think ACR is also a victim of larger fund size. EQR had a terrific head start in 2000-2002, gaining 71% vs the index losing 39%. However, since then till today, EQR has slightly underperformed the index (net of fees 9.1% p.a. vs 9.5% index p.a.), mainly due to their inability to add much value during the up years. I’d speculate that the fund has attracted significant sum of inflows after the first few phenomenal years, leading to a too-much-money-to-deploy problem.

    ACR brand themselves as an absolute-return investor but I see a meaningful correlation between their performance to the index returns (0.71x beta as per its factsheet). Other than the first 3 years, EQR has been trending in line with the S&P 500. With due respect, I think the objective of absolute return has not been well achieved.

    Also, Nicholas mentioned “we combine wide mandates with concentrated portfolios while making sure that we remain fundamentally well diversified.” but I do not see a concentrated portfolio via EQR’s fact sheet. Its largest position (Microsoft) consists only 6% of the NAV, far from the conventional definition of a concentrated portfolio. If anything, there are certainly some elements of index hugging in the portfolio.

    I may be too critical but the reality of the investment world is equally harsh. As Warren Buffett has been preaching all these years, investors are better off investing in index unless the active manager can add meaningful amount of value.

    1. Hello Fung,

      Thank you, as always, for your comment, and in this case for an extended comment.

      Regarding your point about the timing of investors into a fund…I have answered this question before in other venues. To me, as a former portfolio manager, the timing of my shareholders in and out of my fund was not my concern. My job was to manage money in accordance with my strategy. My contract with my investors was put forward in two venues: my prospectus and via my marketing team. As I have written about before, it is extremely important for investment managers to have firms that are structured in accord with the investment philosophy of the managers to avoid the problems to which you are alluding. Likewise a board of directors, and the other staff at a fund need to do the same: understand the philosophy and make decisions in service to that philosophy. This is not an argument that the board give management a free pass, but that they serve shareholders’ interests relative to the investment philosophy outline in the contract. If advisers and investment consultants feel otherwise they are free to direct funds to shops that are committed to outperforming on a quarterly basis.

      Separately, if you do believe managers are beholden to such concerns let’s extend your argument a bit. Why not demand of them that every minute of every day they be outperforming “just in case” the index is a basis point ahead of the manager at that very moment? There really isn’t a logical end to your argument.

      Regarding your statistics about correlation…frankly, correlation and causality are not the same thing. Also, most funds that are long-only are going to show correlation with an index that has gone up and up and up and up. To me this is a meaningless criticism. It is the sort of argument – i.e. that managers should care about this sort of thing – that ends up hurting performance. These were some of the very points made in the other articles in the Active Equity Renaissance series, as well as in my Alpha Wounds series. I am going to put you on the defensive, in what way does it help end clients to track correlations in that way that you are? In what way does it enable investment managers to possibly outperform an index?

      Also, and I am not an ACR apologist, there are SEC mandated rules in the Investment Company Act of 1940 that enforce diversification on portfolios. For example, if memory serves, your top five largest holdings cannot constitute more than 25% of your portfolio. Your top 20 cannot constitute more than 40% of the portfolio. So your complaint should be direct at the authors of that legislation in 1940.

      Yours, in service,

      Jason

  2. Fung C.F. says:

    Thanks Jason for your equally long feedback.

    I wasn’t nitpicking on their quarterly or monthly performance, we are talking about 16 years of track record and a statistically significant pattern. I imagine myself being their client, I really need great timing ability in order to really enjoy the value added by EQR, i.e. putting in money in 2000, 2001, 2002 & 2008 (4 out of 16 years or 25% of the time). If I’m a dollar-averaging client of theirs, I don’t get much out of it (especially if I only discover them after 2002).

    I need to add that my comments have nothing to do with their investment process but rather purely from the angle of results. I understand that fund managers should always focus on process, not results, but over time results are products of process and the pattern could tell us a lot about the managers. I actually respect, or in fact admire ACR’s process (based on the article), but if their long term results don’t add significant value to their clients, something must be wrong somewhere.

    There might be many definitions of absolute return. I’m personally influenced by David Swensen’s way of approaching absolute return. At Yale, they seek to generate absolute returns with low correlation to the market. In other words, they actually don’t mind lower returns compared to the index, but they seek consistency with very little market risk. As how Paul Singer put it in to words, “We try to make money all the time.”

    If I’m a potential client who seeks out absolute returns, I wouldn’t want to put money with them because (1) EQR hasn’t been meaningfully beating the market since 2003; and (2) their performance has been reasonably correlating to the market, hence exposing to market downturn that might destroy my absolute returns. I must give credit to them for their terrific performance in the first 3 years as those were absolutely absolute returns, i.e. gaining 71% while the market losing 39% = enormous outperformance and no correlation to the market whatsoever, but that’s no longer the case since 2003.

    On portfolio concentration/diversification, if rules don’t allow, they should market themselves as a concentrated portfolio manager.

    1. Fung C.F. says:

      Correction on last paragraph:
      On portfolio concentration/diversification, if rules don’t allow, they *shouldn’t market themselves as a concentrated portfolio manager.

    2. Hello again,

      Thank you for your detailed explanation. I really like your thinking on performance evaluation.

      Yours, in service,

      Jason

  3. marvin menzin says:

    As an investor seeking advisors following CFA fee rules, that have a long term full cycle active outperformsnce risk adjusted ,I would like to see many more
    articles of this type which show performance data of active advisors

    The main financial media features and touts advisors and funds often without any snalysis of long term performance . They list advisors by annual revenue . instead of performance .This is like making McDonalds a top restaurant to dine in because of its huge revnue

    almost all the press offers endless repetition about passives and low cost etc
    but almost nothing on the performance of really good active managers and funds with long term outperformance .yes they are scarce….all the more reason to help investors find and evaluate them .

    please do these articles more often . the critique you offered is also very welcome to investors .
    thanks Marvin

    1. Hello Marvin,

      Thank you very much for your comment. Both C. Thomas Howard and I believe that the investment consultants of the world need to conduct more in-depth studies to identify what techniques in active management work. If it turns out that there are criteria, that when met, lead to consistent outperformance then the consulting industry could better identify active managers. Instead, the norm is to use techniques that actually place passive management at the center of the equation, and managers that deviate too far from a prescribed strategy are punished. The base assumption is that an index is the standard of performance. Unintentionally this overemphasis has, in our opinion, led to an active management industry that looks like an expensive version of passive investing. In our series, the Active Equity Renaissance we shared research done by Tom that identifies four simple criteria, that when followed, reliably identify quality active management. Especially noteworthy is that the criteria are predictive of consistent outperformance. This changes the screening problem significantly.

      Again, thank you for your comments.

      Yours, in service,

      Jason

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