Q3 2023 Performance Review – Comment: “How High Should Your Hurdle Be?”

In the first 9 months of 2023, the Value & Opportunity portfolio gained +6.5% (including dividends, no tax) against profit +8.3% for Benchmark (Eurostoxx50 (25%), EuroStoxx small 200 (25%), DAX (30%), MDAX (20%), all TR indices).

Links to previous Performance reviews can be found at Performance page blog. Here’s how some other funds I track performed in the first 9 months of 2023:

Partners Fund TGV: -0.9% (as of September 15)
Profitlich/Schmidlin: +12.9%
Condemnation of European cooperatives 5.7%
Frankfurter Aktienfonds für Stiftungen +4.9%
Team Aguja Special Situation +2.4%

Paladin One -4.7%
Alphastars Europe +4.9%

Performance Assessment:

Year-to-date performance jumped from the tight end of the peer group to second place during the quarter. Looking at the monthly returns, it is not difficult to see that August and September in particular were very good in terms of indicators:

As noted in the Q2 report, the stocks in my portfolio carry very “idiosyncratic” risks that can lead to significant “tracking error” relative to the index. Therefore, quarterly or even annual returns can deviate widely from the benchmark in either direction. At some point in August, the portfolio was down more than -10% against the benchmark. But then luckily, my biggest position, Schaffner got a takeover offer out of the blue. Without it, my performance would be -5% lower.

2023 is a good reminder that many things are out of any investor’s control.

Another interesting thing to mention is that on a quarterly basis, Q3 2023 is a record for me, on a monthly basis, August was an all-time high.

Pretty incredible when you think we’ve had a pandemic, a ground war, pipeline busts, a return of inflation and massive interest rate hikes in Europe in the last 3 years. If I had a crystal ball that showed me these events 3 years ago and the fairy gave me the option to either stay invested or go 100% cash, I would happily take the cash. So another reminder: While you might be able to predict geopolitical and macro events, predicting what the stock market is doing is even more difficult.

3rd quarter transactions:

The current portfolio can be seen as always on the Portfolio page.

Q3 was quite an active quarter. I added 4 (!) new positions: Energy office, Italmobiliare, Laurent Perrier and Brother Hartman. I went all out Meier Toblera reduced Schaffner after an offer to finance new positions.

Meier & Tobler has clearly been one of the main drivers of performance over the past few years, not only did I realize 3x my initial investment (plus dividends), but it was also my largest position for some time.

The average portfolio holding time is around 4 years. The top 10 positions are around 50%. That’s a little low, so for Q4 I’ll favor raising positions with higher conviction.

Comment: How high should your hurdle be?

I strongly believe that in the long run, any investor or trader will only be successful if they are able to calculate the estimated return on a new investment before they invest, based on specific assumptions made. Why?

Because this is the only way to monitor whether your assumptions are valid and to be able to identify systematic errors in the investment process.

“I like this stock” or “this company has a great product” will not ultimately lead to a good result if that is the only basis of the investment.

In any case, when you calculate the expected rate of return, at some point you have to decide whether to invest or not. There are many ways to do this, but many investors use the “hurdle rate”, i.e. the minimum rate of return, to decide whether or not to buy a stock.

But how do you decide which hurdle speed to use?

First, a baseline needs to be established. What is the expected return on this asset class that you should get if you invest in a broad index. For stocks, a common approach is to look at the long-term risk-free rate (10 or 20 years) and add an “equity risk premium”. usually something like 5-7% pa on top for developed markets.

Now, if you want to outperform the market, you should aim higher. The question is: How high?

In theory you could say: I aim for 50% pa and I only invest in stocks that offer me an IRR of 50%, so why should I aim lower?

That sounds simple, right, aim higher, get higher returns. However, there are several implications to be understood here. If an investment offers an expected return well above the market, there is ALWAYS much more risk involved. This risk comes in many ways:

  1. The actual result is much wider around the expected return, often including the risk of total capital loss
  2. The price of such an investment is often much more volatile than the market
  3. A high return can only be available if some event etc happens quickly, so timing is important
  4. The company may have management problems or be in a very difficult jurisdiction
  5. The investment is in another currency with much higher base rates

On paper, a lot of investors often say, I don’t care about volatility, but in reality, high volatility often creates behavioral problems, even for seasoned capital market veterans.

Sometimes you even hear during a stock market event: Now there is downside, only upside. In my opinion it is pure BS like Monish Pabrai’s “Dhando investing” bogus head. If there is a potentially high return, there is always a corresponding risk in the stock market. If you think that a 30% expected return has no risks, then you most likely haven’t analyzed it very well.

Another important aspect is: How much volatility can you afford? For example, if you know that in a few years you will need to withdraw a larger amount to finance a large purchase, you should limit volatility and aim lower. If you are young and have inflows in your portfolio, you can afford much higher volatility.

If you’re running third-party money, another variable comes into play: How will your investors react? In many cases I’ve seen, investors react very differently to what they might have said at the beginning. Investors don’t like downside volatility and trying to pull money out at exactly the wrong time. There are many studies that investors on money weighted performance badly underperformed mutual funds eat due to poor timing.

It’s also a different experience if you experience downside volatility after making good turns before, or if you start on the downside.

It may also come as a surprise to investors who have only been in the market for the last few years that drawdowns and renewals are not always “V” shaped like they have been for the past 3 years or so, but that sometimes drawdowns can take much longer than that.

In general, stocks with very high expected value/high volatility generally offer lower returns. This is often called the “draw” effect. One of the most prominent examples is IPOs as a group. Yes, you’ll get a nice first day “pop” from time to time, but on average over the long term, IPOs significantly underperform. A similar pattern can be seen with “hot stocks” on social media such as Twitter.

To summarize, my advice would be the following:

To be successful over the long term, whether as a private investor or a fund manager, you need to be able to invest consistently well over a long period of time. But more importantly, you need to be in control of your behavior (and your investors) when things go wrong.

For new investors, my advice is not to start aiming too high. For experienced investors, you should really be sure that you can stomach draw downs as well as you think if you aim high.

The only exception would be if you are starting a hedge fund and don’t care about your investors and want to maximize the possibility of getting very rich in a short period of time. Then starting with a very high hurdle speed makes a lot of sense. If things go well, you’ll be able to manage a lot of money quickly and share in a significant portion of the growth. If things go wrong, your investors will be left holding the bag. Bill Hwang (Archegos) is a good example of this approach and it almost seemed to work for him, depending on the outcome of the upcoming trial.

Personally, as many readers know, I try to aim a little higher than the market, but not too much because (I think I know) my limits. Being able to stack up over the long term is more important to me than beating my peers in any given period.

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