Beyond the benchmark
It’s no secret that in order to outperform a benchmark, one must differ from it. We believe that letting benchmark sector weights influence decision making can hinder success. A concentrated, benchmark agnostic portfolio allows capital to be focused in the highest conviction ideas, with portfolio returns driven by stock selection. However, differing from the benchmark exposes investors to risks. And as such, an active investor needs a disciplined process for identifying benchmark agnostic opportunities, and a process for risk management.
Benchmark agnosticism is not just about holding non-benchmark securities. As we often say, relative performance is tied not only to what you own, but to what you don’t own. Investors should be willing to consider having limited or no exposure in areas where they believe valuations are unjustified. For example, during much of 2014, 2015 and even large parts of 2016, investors concerned about the global economic trajectory amid a low-yielding, low-interest rate backdrop had increasingly favored areas they perceived to be “stable,” e.g., health care, utilities, consumer staples, telecom. While it makes sense to like stability—and a more stable business with high returns should be worth more— it doesn’t mean that stability can’t be priced too richly or that there isn’t an appropriate price for a cyclical business. For investors beholden to an index, that would have meant remaining exposed to these areas even as valuations appeared, to us, stretched at best, if not downright expensive—and certainly not supported by fundamentals. That approach to value investing doesn’t make sense to us.
Our efforts are geared toward weeding out poor investment choices—by that we mean we want to invest in companies with attractive business economics in sound financial condition that are selling at attractive valuations. If we cannot find that, we are comfortable having well below benchmark or even nil exposure—which is reflected in our interest in these perceived “stable” areas.
Conversely, just as active investors should be willing to consider having no or minimal exposure to unattractive areas of the market, they should be willing to consider having materially higher exposure in areas of the market that line up with their process. For example, over the past few years, our process has led us to a number of energy names. We tend to seek out areas of the market that are unloved, and prior to 2016, there were few areas that were more unloved. If stability and exposure to the energy sector are important, the majors are where many investors focus—they are more diversified, have the strongest balance sheets and dominate the index. However, we observed these companies held up a lot better in the downturn, and were concerned that meant they would lag on the way back up (which they have done). When examining energy companies for Artisan Value Equity Strategy, we looked past the majors to energy exploration and production companies Devon, Apache and Hess—high-quality businesses in strong financial condition selling at, in our view, more undemanding valuations than the majors. These names are also in the Russell 1000 Value Index, but their weights are minimal. In fact, over the past year or so, our overall energy sector exposure hasn’t been much higher than the index, but we believe our energy exposure—excuse the bad pun—has a lot more octane to it.
An investment approach built on a portfolio free from benchmark limitations can give investors the potential to add material value. However, what’s true to the upside is true to the downside, and deviations from the benchmark create risk. There are times when even the most disciplined agnostic strategy will be out of sync with markets. This is why investors need a disciplined, repeatable framework. That is why we emphasize companies with attractive business economics in sound financial condition that are selling at attractive valuations. We refer to our criteria as our three “margin of safety” characteristics, and in our view investing in companies with these characteristics helps tilt the risk/reward in our favor over the long term.
George Sertl is managing director, portfolio manager – Artisan US Value Team