CIO Blog: Long Story Short

Investment Strategy – May 2019

Seven years ago, shareholders in Netflix – the S&P 500 listed provider of online movies and shows – suffered a crushing loss as it disastrously attempted to raise prices and restructure. Roughly one-million customers cancelled their subscriptions; Netflix’s share price plummeted to less than $53 from $300* in a matter of weeks, a loss of 83%.

During this tumultuous period, billionaire investor Carl Icahn – a legend in investment circles – did not even initially have Netflix on his radar but was convinced by his son, Brett to take a position in the disruptive company against all the odds and the slew of investors dumping the stock. Icahn’s fund was persuaded, and eventually took a 10% stake in the company during this period.

Brett’s instinct was right. Netflix cast aside its flawed strategy, and painstakingly started to rebuild its brand and customer relationships. The following year Icahn sold half his stake in the company at multiples of his purchase price reaping a staggering profit of $825 million – any investor would be pleased. However, his Brett son was most displeased! He believed that the company was undervalued still. Nonetheless, Mr. Icahn was not to be moved: the following year, he sold the rest of his position, profiting to the tune of about $2 billion. 

While it is hard to call a $2 billion profit a mistake, it has likely caused some frosty moment at the Icahn family holidays. With the benefit of hindsight, we know Netflix has continued to grow and expand even beyond Brett’s imagination. Had the senior Mr. Icahn held his original position of around 5.5 million shares (38.5 million shares if adjusting for a subsequent 7-to-1 stock split), his profit would have been $13.9 billion. With a story so compelling, maybe they’ll make a movie about it!

Despite the huge gain from Netflix investment, the holding formed less than 2% of the Icahn fund’s holdings11. The fund had larger positions at the time in Ebay, Federal-Mogul, Hertz, Chesapeake Energy, Nuance Communications and American Railcar; these summed up to 25% of the fund. Most of these performed poorly in that year. Therefore, in spite of the windfall gains from Netflix, the fund posted a loss of -7% in 2014 vs. a +14% total return for the S&P 500.

Mr. Icahn is considered a master of picking the right investments, and indeed, his track record is amongst the best. However, as the above illustrates, picking the right “stocks” is difficult – and often winners occur by chance, while losses come despite overwhelming analysis, due-diligence and conviction. Even more precarious is timing the optimum entry and exit point, as the above example shows. Indeed, while security selection decisions are important, larger asset allocation decisions are always more important. 

United we fall

To illustrate why, take the 2018 returns amongst the FTSE100 constituents. The top 10 performing stocks returned 32%, on average; the bottom 10 returned -40%. Intuitively, one can surmise that with such dispersion, picking the right securities is the way to go. 

But most investors would never hold as few as 10 securities; the concentration risk – or lack of diversity – would be too high. In fact, most research states that a minimum of 30 stocks is required to maximise a portfolio’s diversification benefits. However, even a portfolio of 30 stocks, selected from the FTSE 100 at random, would likely result in returns closer to that of the index itself. Trying to “pick the winners”, as Mr. Icahn does, can add more risk. Furthermore, since stocks tend to be quite correlated in bear markets – there tends to be indiscriminate selling during sell-offs – even holding 30 stocks offers little diversification benefits. For example, in 2008, only 10 companies in the FTSE 100 delivered a positive return! 

This correlation effect is largely isolated to securities within an asset class. Stocks tend to rise and fall together, as do bonds, as do real estate holdings. But the correlation between asset classes tends to be far less, and even negatively correlated at times. In other words, when one moves up, the other could move down. And therein lays the crux of why asset allocation matters more.
Dr. Raghavendra Rau, a finance professor at Cambridge, following on from the logic above, proved that asset allocation is more important than security selection on an empirical basis22. Conducting a rigorous simulation exercise using 21-years of data (Jan. 1991 – Dec. 2011), he showed that the average monthly difference between portfolios that allocate assets well (i.e. top 5%) versus those that do it poorly is (i.e. bottom 5%) is 2.02% per month. On the other hand, the difference between good and bad security selection is 1.56% per month.

More importantly, at times of genuine geopolitical or financial stress – when the risk of losing money is at its highest – the importance of asset allocation soars. During the first Gulf War (Feb. 1991), the Asian crisis (Aug. 1998), the dotcom crash (Mar. 2000) and the crash of Lehman Brothers (Sep. 2008), the monthly difference between portfolios that allocated assets well versus those that did it poorly was 6.05%, 5.53%, 4.78% and 5.36%, respectively. The difference due to security selection stayed stable, around its long-term average (approximately 1.5%), regardless of market conditions. 

The key here is that both asset allocation and security selection are important and both must be done well, but getting asset allocation right is far more important, particularly at times of great market stress.

1 On 31 March 2012 (pre-stock split prices)
2 Raghavendra, Dr. Rau, Asset Allocation vs. Stock Selection: A Simulation Exercise, Global Financial Institute (2013)
*Before the 7-1 Stock Split - 2015



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