Consistency Beats Intensity: Excerpt From Our Latest Letter
This is an excerpt from Eagle Point Capital’s Fall 2022 letter to clients. Every six months, EPC writes to clients to explain what they own and why they own it. The portfolio-specific portion of each letter is for clients and prospective clients only. If you’d like to read EPC’s entire letter, please contact us.
“The most important investing question is not, ‘What are the highest returns I can earn?’ It’s, ‘What are the best returns I can sustain for the longest period of time?”
— Morgan Housel
On September 25, 1990 the Wall Street Journal wrote an article about a New York money manager that dramatically outperformed the S&P 500 in 1989 but drastically underperformed the following year.
“A year ago, the big New York money-management firm, which runs about $9.5 billion of stock portfolios, was coming off a winning streak. Then, in typically bold fashion, it gambled two-thirds or more of clients' money on a rebound of cyclical companies that are highly dependent on the economy's fortunes — raising its stakes massively in financial, technology and auto stocks.
But the rebound was delayed and the bets didn't work out.
In the 12 months through August, Bernstein's stock portfolios have fallen by 23.4% and were a stunning 18.4 percentage points behind the market.”
The Wall Street Journal could easily run this story today, swapping Bernstein's name for any number of firms. The hype around unprofitable tech stocks, meme stocks, and crypto produced stratospheric returns for many investors in 2020 and 2021. Their fortunes have reversed in 2022. Many have given up all of their gains and then some.
In the Journal's 1990 article Lewis Sanders, Bernstein's president, rebutted:
“If you want to be in the top 5% of money managers, you have to be willing to be in the bottom 5%, too.”
We couldn't disagree more.
Our philosophy is consistency beats intensity. We aim to do a little bit better than average each year, through thick and thin. We do not ask ourselves, "What stock offers the highest returns?" Instead, we ask, "What stock offers good returns with little to no downside risk."
Our focus on protecting the downside means we’d prefer to outperform during “thin” years, like 2022, than “thick” years, like 2021. If we succeed, we will steadily inch ahead of the averages and dramatically outperform over the long term.
Aesop immortalized our philosophy in “The Tortoise And The Hare.” Though schools teach this fable to our kids, few investors embrace it. We shouldn’t be surprised. In The Mind of the Market, F.J. Chu says, "The history of the stock market is the history of forgetting."
We don't think it’s realistic to try to string together a series of years of top-decile performance. That requires making consistently bold, concentrated bets that are as likely to succeed as to backfire. Swinging for the fences every day is likely to lead to more strikeouts than home runs.
A combination of far above-average and far below-average years is a recipe for a volatile and mediocre long-term record. The mathematics of compounding makes digging yourself out of a hole difficult — a 50% drawdown requires a 100% return to break even.
We want to avoid digging ourselves into a hole in the first place — to win by not losing. We worry about a return of our capital before we worry about a return on our capital. If we can avoid losing money, most of the alternatives are good. Our approach isn’t flashy, but we think it is effective.
How do we implement this?
First, we prefer simple, predictable, and profitable businesses drowning in cash. Businesses with lots of cash are unlikely to get into serious trouble. We want to own businesses that are like cockroaches — very hardy and almost impossible to kill. We don’t care if they’re ugly so long as they’re resilient.
Second, we pay reasonable prices which afford a margin of safety. We like to buy stocks mired in a cloud of pessimism that face short-term headwinds but enjoy long-term tailwinds. Low prices and low expectations create a low bar for investment success. Investing awards no points for difficulty so we avoid stocks priced for perfection.
Third, we prefer businesses in replication mode whose future is likely to resemble their past. Rather than make bold forecasts about how the world might change, we look for areas where change is unlikely.
Fourth, we use a 10x10 framework to build our portfolio. We buy roughly 10 stocks, each with about 10% of our capital. The 10x10 framework minimizes damage from mistakes, which are inevitable. A mistake or two should never sink our ship. We want to be as resilient as possible to any future state of the world.
Finally, we focus on a sustainable lifestyle. Frantic decision-making, high turnover, and volatile returns are a recipe for burnout for clients and managers alike. The best strategy is the one you can stick with, and we truly enjoy our lifestyle. We avoid stocks that keep us awake at night.
Perhaps counterintuitively, we believe that we will maximize our long-term investment returns if we avoid trying to maximize any single year’s return. We will maximize our lifetime investment returns by earning merely good returns consistently. Just as the tortoise beats the hare, consistency beats intensity. While other managers swing for the fences, we are content to hit singles and doubles.
That’s not to say there won’t be volatility. Although we are pleased by our significant outperformance this year relative to the market averages, bouts of short-term underperformance are inevitable. We cannot affect how the market prices our investments.
Equity investors must be willing to accept that the quoted value of their portfolio will decline significantly, perhaps 50% or more, on occasion. While we will do all we can to avoid these periods, they will occur. Volatility is the price of earning superior returns. All we can do is pay reasonable prices for businesses with stable earnings power that is increasing over time. If our business’s earnings march higher, so too will the value of our investments.
If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com. You can also find more information on our website. We recommend starting with Fundamentals. Thank you for reading!
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.