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:
- Most active manager fees are too high relative to the risk-adjusted returns generated.
- Active portfolio construction, due to longstanding industry norms, is fundamentally flawed.
- 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.
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