Robert. G. Kirby
Journal of portfolio management (1984)
In my initial drafts of writing this, I thought of giving you a long write-up about the author, but then almost decided otherwise considering how easy it is to find an assimilation of facts about anyone as a matter of fact. But as you can see if you click on the link, even after using major keywords, all you can find is his paper. So, I am also going to give you a brief outline of who he was so you can be at ease trying to understand his proposition.
“An avid sports car racer and a veteran investment manager, Kirby was a graduate from Stanford and Harvard. In 1951, he began to work for a stock brokerage although the entire idea was considered nuts back then by his MBA peers considering how depressed the securities industry had been from the 1930s. However, he soon resigned when asked to choose between the job and racing, because the latter was a potential concern to the firm’s clients. So, by 1965, he began working for the Capital Group. When Capital research decided to enter the investment advisory sector for individual high net worth clients (Institutional portfolio business didn’t become popular until the end of 1960’s), Kirby managed to convince his superiors to instead open up an investment trust company, citing concerns about creating more good faith in their clients. Thus, in 1968, began Capital Guardian Investment Trust which was an innovation from the very start. How? It was the first independent non-bank trust company since 1911. A fascinating fact that I read about the company, their office was initially set up in the Crocker Bank building in L.A. Naturally, since their company was also going to be competing with the crockers it was only right to ask the crockers management If it was okay to set up shop in their building. Funnily enough, Crockers deemed them too small to even be considered worthwhile and laughed it off. It took only 18 months for capital guardian to accumulate more assets than crockers ever had in 140 years.
However, Capital Guardian was built more on pension fund assets and not on individual assets as was originally planned, starting with General Mills which had a pension fund of $100 million and soon agreed to put in $50 million in capital guardian after one meeting. The trust company’s board was very well connected in the industry. Each board member would go to his company and suggest they put some portion of their pension money with capital guardian. Things then moved quickly from pension funds to college endowment funds.
Kirby avoided the so called nifty fifty stocks that dominated the market from 1970 to mid 1973, and the trusts performance lagged. However, Mr. Kirby’s investment results coming out of the 1973-’74 bear market and through most of the following three decades, were top-tier, except for periods like the Internet bubble. He was a firm believer in actively investing and was against the whole efficient markets hypothesis. He never got carried away with the madness of the crowd. After passing the administrative torch to younger executives in 1991, he concentrated on managing investment portfolios until his death. This passionate man died at his doing what he loved at par with racing, managing money in 2005.”
Published in the fall of 1984, almost 30 years into his career, the coffee can portfolio paper is still a relevant read today.
The primary point I’d like to put forward is the time period in which it was written. There’s going to be a significant variation in then and now. So, most of the facts in the paper is going to be vitiated by this element.
However, the premise of the paper is anything but obsolete.
As noted above, Kirby has always remained favorably disposed to active investing. However, he was not aggressively against passive investing. The quote at the start of the paper, “You can make more money by being passively active than by being actively passive.” reinforces this fact. Maintaining a broadly based unmanaged portfolio inevitably meant ending up investing in an index fund, the most popular being S&P5001.Why is this even an option? Michael C Jensen in his well-known PhD dissertation on the evaluation of Mutual Fund managers shattered the preconception of money managers’ ability to beat the market, considering the massive resources they were in possession of. His findings concluded that Money managers in aggregate underperformed the market. What does this mean? This meant that while some managers did consistently beat the market, most did not. There was a high likelihood of investors ending up with a bad money manager. According to Kirby, investing required perspective, patience and courage, qualities that still are not found in plenty today. It was only natural for clients to go looking at other options, as validated by the trend of index funds becoming more sought after in the wake of a period in which the index had been an excellent performer.
According to Kirby, there were only 2 valid reasons an investor should even look at an index fund.
- Do you believe in the Efficient market hypothesis? Do you think market return’s the best you can do? (Proponents of the EMT tend to disagree with the ability to generate alphas.)
- Do you think transaction costs are eating a huge chunk of your returns and that is the reason behind the supposed underperformance of money managers? (Kirby still does believe active management, if done right can provide you exceptional returns.)
It must be noted here that Kirby writes this paper in view of institutional investors. Hiring a private wealth manager is a big deal and expensive too, not something for the middleclass or the poor (Leading to them preferring passive investment.)
Let’s look at point 1 –
Suppose you do believe it’s virtually impossible to consistently overperform the market and this is the reason you prefer the index fund. Two ancillary questions that Kirby places are these :
Who told you that the index you prefer to invest in isn’t in reality actively managed? – This is a fair question in my opinion. Most index rebalancing isn’t based on some formula, but on the research and intuition of the index staff, just like portfolio managers we know. Even though the transaction costs aren’t as significant when compared to PMs, it does become pronounced when cumulated over time.
Does your index replicate the actual market ? – This makes sense, doesn’t it? Obviously, no index can truly represent the entire market but if our aim is to obtain market results, we should of course have a portfolio that is quite close to it, shouldn’t we? So, Kirby provides a solution for this. Go for an index that represents most of the highly traded stocks in the market or get something tailor made as proxy for “everything out there”, helping to obtain “True market results”.
Looking at point 2 –
Kirby has managed to write this article as a prospective answer to this question.
You can see how the idea of a “Coffee can portfolio” comes into the picture. Kirby has no worries of swift promulgation of this concept, due to its ability to change the entire structure of the investment industry which could be damaging to money managers.
Although he links the provenance of the name to the old west, it seems quite familiar, does it not? After all, every child has had a piggy bank. In the olden days, before the advance of savings accounts, fixed deposits and such, people saved all the possessions they held dear by storing them in an obscure place to be able to access them whenever the need arose. The triumph of this process is owed only to the wisdom and foresight of the possessions chosen.
Transaction costs were supposedly high and rising in 1984, but now although present, its a given fact that developing markets’ transaction costs are drastically higher than the former. Even otherwise, transaction costs if can be minimized significantly can help us earn a higher return. These costs have been held widely to be the primary reason why activity of the investor is negatively correlated to returns. (Less active, higher returns)
WHY? Ask yourselves an honest question. How many times have you brought a stock and after coming across some detrimental news decided against the worth of it? How many times has loss aversion and other external circumstances cause you to dump your holdings? Even if you start off with the purpose of investing, in the end is it not just trading? Constantly keeping track of your portfolio’s value, fearing a fall in any sector and consequently having to lose out on the goal of high returns is a rational response in investors, be it individuals or professional wealth managers. Intensifying this reaction in money managers is the focus on month to month & quarter to quarter results. Since these returns end up constituting the trackrecord, the pressure to show optimal performance in such short time horizons is quite troubling however rewarding it can be. (This has also been a major argument against a company going public). This shortening of time horizons end up leading to erroneous decisios. Kirby keeps reiterating this fact, arguing that transaction costs created as a consequence of wanting to prove superior returns in such short time horizons have repeatedly undermined the ability of money managers to produce favorable outcomes.
Most money managers who do beat the market consistently over a 10 year period have had a qualifying circumstances – Typically due to lower AUM/Capital.2
How can a coffee can portfolio beat a similar actively managed portfolio?
For explanation, Kirby gives a simple example. I have scaled it down for easier comprehension. Suppose you give your money manager $100 to invest in common stocks. An average orthodox professional money manager would probably build a portfolio of 50 $2 commitment, each 2% of the fund. If the portfolio were then forgotten for a while what happens? The most that would be lost in any one holding is 2% ; The most that would be gained from any one holding would be unlimited. Why? Because who’s there to apply principles of diversification or concentration in the portfolio.
Kirby further purveys a personal experience that occurred years back. An aged female client of his had come to him soliciting his help in adding her husband’s portfolio of securities to her’s upon his sudden death. When he eventually received the husband’s list of assets and its values, he was aghast. Over the years, the husband had been covertly “piggy-backing” on the recommendations for his wife’s portfolio. Except, he had only heeded the ‘Buy’ recommendations. He simply put about $5000 in every purchase recommendation. Then he’d toss the certificate in his safe deposit and forget about it. Needless to say, he had an odd-looking portfolio. He owned a number of small holdings with values of less than $2,000. He had several large holdings with values in excess of $100,000. There was one jumbo holding worth over $800,000 that exceeded the total value of his wife’s portfolio and came from a small commitment in a company called Haloid; this later turned out to be a zillion shares of Xerox.
I believe what the coffee can portfolio is driving home is what is popularly known as the ‘Buy and hold’ strategy.
This strategy has been widely employed to earn generous returns by a large number of investors.
Fidelity investments once conducted an internal accounts review, only to end up concluding that the “Best investors are either dead or Inactive”. The fact lies that the bad days aren’t in our control but staying invested is. Did you know even Albert Einstein considered compounding to be the 8th wonder of the world? Staying invested leads to this very compounding of investments, even during the bad times as historically, many of the strongest rallies have occurred in corrections or bear markets.
There has been another fidelity study claiming that those who stayed invested in 2008 (Financial crisis that rocked the world), saw their investments and additional contributions jump a whopping 147% in 2017, twice the average of 74% return for those who got out of the market due to fear. More than 25% of those who sold out of stocks never got back into the market and missed the gains due to the ascent that followed.
The key point here is to, never invest any money you cannot afford to lose. If not, adjust your investments to properly reflect your risk tolerance.
I’d like to use the example of Rajiv Khanna, veteran Indian self-proclaimed “accidental investor” who corroborates this fact and attributes his wealth to this strategy. It all started when Khanna was looking for a flat in Delhi in 2003-2004, he wandered into the offices of Unitech, a realty company. Amazed by their luxurious spaces, he decided to look into the company. On liking the numbers, he decided to invest 5-7 lakhs in the stock. However, he soon forgot about it. In 2008 as the realty boom came, his petty investment turned into 25 crores. Khanna believes this strategy is the most effective way of furnishing mega multibagger gains. Do not tinker with your investments and there is a high probability you could do better than the supposed “Active” investors. However, there is no guarantee and the same thing could go in the opposite way too.
Warren buffett, with a networth of $71.8b earned solely through investing endorses the same. He expressly advises to never buy anything that you wouldn’t be comfortable owning for 10 years. Strong management, consistent earnings, competitive advantage, are quality indicators of a good company. As Peter Lynch advocated Buy only what you know and what you believe in, to ward against the risk of a steep descent. If you aren’t comfortable, you’re most likely dealing on price appreciation. Much of what you hear in the short term is pure noise.
It is worthwhile to mention Terence Odean, Behavioural economist slash professor in the University of California whose paper published in 1997, titled ‘Why Do Investors Trade Too Much?’ provided insightful answers. Trading ends up lowering returns. Investors have an overwhelming urge to sell winners and hold on to losers. Other papers of his went on to substantiate these findings.
Kirby goes on to talk about the fundamental flaws in the investment industry and how profit centric it has become, what he calls the “Orbital Velocity of the investment industry”. Once that orbital velocity is reached (Obtaining an impressive track record), it doesn’t matter what happens thereon (An investment organization will be quite well off by the time clients get worn out by all the losses).
Nevertheless, coming back to the coffee can portfolio, Kirby identifies 2 potential problems with it –
- Who would buy a product which can only be evaluated after 10 years? Who has the time to do so? If it wasn’t viable in 1984, is it today in a competitive cut-throat world where crises are always just around the corner?
- Regardless of the potential returns, who can pay a sizeable amount upfront to hire a group of professionals to have the ability to identify a superior 10-year portfolio? Even if you do, a lot is dependent on their collaborative efforts which has historically been laborious for any group of humans.
So, although a fascinating idea that might deliver us potential returns, none of the major organisations tend to propagate it.
However, on researching, I came across this boutique investment bank Ambit capital that has widely asserted their use of the CCP to invest. And it does seem to work well, for them atleast. So, what they do is, they use 2 main filters on all listed companies over the past 10 years at each point.
- Return on Capital Employed of at least 15 %
- Revenue growth of at least 10%
Based on the results they proceed to construct CCPs of such stocks which are then allowed remain unevaluated over the next 10 years instead of trying to rebalance frequently based on short term financial data. By 2015, they’d had almost 7 CCPs which had completed a full 10-year cycle. The found them to have significantly outperformed the sensex, usually by 5-15 percentage points. Even in risk-adjusted terms (i.e., accounting for maximum drawdown), 14 out of the 15 iterations of the CCP have outperformed the Sensex. This however has to be taken with a grain of salt as there isn’t complete transparency and we have to bank on the words of the upper management.
Kirby ends the paper with the belief that acute scrutiny of short-term returns has vastly diminished the ability of money managers to make better investment decisions. He also believes transaction costs are a major detriment to total investment returns. An investment decision with a 5-year time horizon is more likely to have an element of certainty than if it had a six-month time horizon, while also saving the investor substantial transaction costs. He re-asserts that the industry must facilitate investing instead of just being a sophisticated trader, in its actual meaning for the benefit of the manager and the client, which he thinks the CCP can served. However, Fair note of warning. At the time of writing this paper Kirby had never endeavoured to create such a CCP nor did he have any plans to do so, considering its inherent limitations.