Our primary objective is to maximize the terminal wealth of our investors that is consistent with their risk profile. Since portfolio allocation is paramount to this process, we have determined the mathematically optimal allocation that achieves the highest possible compound return. (See the discussion of pension fund performance below.)
It is a well established fact that asset allocation or the percentage of different asset classes allocated within a portfolio is the most dominant factor affecting performance. More important than individual security selection or market timing, the allocation decision has more in common with probability theory than investment analysis. This explains why risk management is so crucial and why we adopted the Kelly Capital Growth Criterion as our central governing approach.
Tramco Capital has devised a proprietary algorithm based on the Kelly betting system for harvesting the volatility in the stock, bond and precious metals markets. In short, the greater the volatility the greater the return. With the Kelly system, minimizing losses is the key to maximizing profits. This differs from the traditional risk/reward model of greater returns only being possible through greater risk.
Advantages of the Kelly risk management method:
- The greater the market fluctuations the more profitable the Kelly method becomes.
- Between 1974 and 2000 the USA experienced the greatest bull market in history, without major fluctuations.
- But between 2000 and 2010 there were two stock market corrections of 50% or more. Kelly achieved superior returns during this period.
- Kelly is also most profitable during a worst-case scenario of a 90% stock market correction, like what happened between 1929 and 1932.
- From a probability and psychological standpoint the Kelly method makes more sense than an all stock portfolio, or any other allocation approach.
- Probability wise, it is impossible to predict the size of market fluctuations.
- Psychologically, the Kelly method will keep you sane during bear markets. It also enables the investor to buy low and sell high.
- Since we know that large market corrections are likely, the logic of the Kelly risk model becomes clear.
- Kelly also gives you the confidence to have a concentrated equity portfolio of superior companies.
Since equities are most responsible for growth within a balanced portfolio, we invest in a select group of only the highest quality companies. We believe superior results are achieved through ownership of great companies, not high volume stock trading. Factors that contribute to high quality are:
- Strategic competitive advantage
- Low debt levels
- Stringent cost control
- High profit margins
- High returns on equity
Successful growth companies are profitably reinvesting earnings. This cannot be easily determined from financial statements. This requires an extra level of effort and skill, including interviewing the management and/or visiting the company in person.
Cost control is an extremely important and often overlooked component of successful growth companies. Organizations and leaders who practice rigorous cost control have a significant advantage over competitors who do not. The more savings they find in controlling costs, the more they can reinvest in their operations and utilize the power of compound interest.
We believe in the value investing approach, which include growth and asset plays. We also examine intangible factors such as quality of management and general reputation of the company. We strive to acquire these companies at attractive valuations. We believe this approach will achieve superior growth over time.
We seek to invest in securities trading at a discount to intrinsic value, so it is important to find opportunities with a significant margin of safety. Regarding bonds, this means the issuer must have tangible assets that more than cover the par value of the offering as well as a satisfactory earnings to interest coverage ratio. Regarding common stocks, issuers must meet the following criteria:
- Suitable and established dividend return
- Stable and adequate earnings record
- Satisfactory backing of tangible assets
We put less of an emphasis on trend of earnings, as this dupes investors into paying too much for growth and leaving them vulnerable to speculative bubbles. One reason why earnings trends are poor indicators of future performance is because of diminishing returns. New competitors are always entering the marketplace with improved products and business methods. Another reason is the inevitable ebb and flow of the business cycle, as companies often display their highest performance trends just before an economic collapse. It is wiser to buy in while the trend is flat, just before an uptick in earnings growth. Investors should also take care to ensure that massive growth is not overly financed by debt. If earnings growth goes hand in hand with an increase in debt levels, or if debt grows faster than earnings, investors should beware.
A key factor of our investment approach is that we do not use leverage. We have determined through probability and historical worst-case analysis that using naked leverage lowers compound return.
The more leverage you use the more dependent you become on market timing. If heavy leverage is employed and you cannot time the markets correctly you will suffer devastating losses.
Pension Fund Performance
A study was published in the Financial Analysts Journal comparing data from 91 large pension funds over a nine year period. The purpose of the study was to determine which of three aspects: 1) Market Timing, 2) Security Selection, or 3) Portfolio Allocation, contributed the most to total returns.
The study found that Portfolio Allocation contributed the most to investment performance by a significant margin.