Active Value Investing

The Motley Fool will soon unveil Motley Fool Alpha, a new investment service that seeks to bridge the gap between traditional stock newsletters and the real world of hedge fund investing. John Del Vecchio and I will be heading up this venture, drawing upon our years of market-beating experience in the hedge fund world. Motley Fool Alpha will opportunistically invest both long and short, with the goal of compounding our capital at 15%-plus over time while defending against significant drawdowns.

Today is the second of our four-part series on the investing principles guiding Motley Fool Alpha. Last time, we articulated Motley Fool Alpha's overarching goals and philosophy. This time, I want to focus on our investment strategy, which I describe as "active value." This speaks to our willingness to tweak our portfolio as often as necessary to keep it skewed for greater profit than loss. Maybe that sounds obvious, but I think it takes an intentional mind-set grounded in two key principles.

Make asymmetric bets
The essence of a great investment idea is one whose characteristics favor the probabilities of significantly greater potential for profit than loss -- i.e., an asymmetric bet. At Motley Fool Alpha, we will require a minimum of two times more potential reward than risk, and our high-conviction ideas will regularly feature a 3-to-1 ratio of reward versus risk. Also, we'll only take a position if we think it can deliver 20% annualized returns -- deliberately aiming above our long-term portfolio goal of 15% annualized returns to allow for the inevitable missteps.

We'll subject every new idea, long or short, to an assessment of downside risk versus upside reward. The downside/upside calculus primarily revolves around fundamental factors such as valuation, untapped opportunities, overlooked vulnerabilities, and any strategic value to an acquirer. To a lesser extent, we may also look to established levels of technical support (demand), resistance (supply), and trend lines. We'll be as analytical as possible in gauging risk versus reward, but clearly it's a subjective endeavor. There's no ironclad law that will set a definitive floor or ceiling on a stock. We must remember we're always dealing in probabilities, and our goal is merely to handicap the odds with some semblance of accuracy.

In addition to our downside/upside analysis at the outset of any new position, we'll also apply this same line of thinking to all our existing positions as part of the ongoing portfolio management process. For example, let's say we have a $10 stock that we think is worth $16 and with estimated downside risk to $8. That corresponds to a 3:1 ratio of reward versus risk, with ample upside, so we may take a 10% position. But if that stock catches a quick 30% increase to $13, and our intrinsic value estimate is still $16, we're then looking at reward/risk scenario that's now far less compelling -- $3 up and $5 down.

We may choose to write a covered call to protect some of our gains, or trim our position back to 3%, or possibly even sell the stock altogether. If we do continue to hold our large position, it will be with a clear-minded realization that the stock has in fact become a more risky proposition. Whatever we choose to do, it'll be based on a constant assessment of how much can we make versus how much can we lose.

Our overall goal from a portfolio perspective is to constantly rotate our chips from less favorable to more favorable opportunities. This is a more active, higher- turnover approach to investment management, but we believe the payoff will be seen in a portfolio that maintains an asymmetric upside bias.

Think like an owner
We just stated our willingness to eliminate a stock from our portfolio if we catch a sudden profitable move in our favor. But let me be clear: That doesn't mean we approach investing with a short-term mind-set. The way we think about stocks is long-term, even if our actions turn out to be short-term.

This may seem like a philosophical tangent, but allow me to briefly articulate our perspective on stocks. A stock is a fractional piece of ownership in a business, and that business has a current value based on the company's long-term prospects. Thus, the analytically correct way to approach stocks is from the standpoint of long-term value creation. That means thinking about big-picture issues, such as: how well a business will endure the test of time, its vulnerability to new competition, the company's growth opportunities, its margin structure, and whether management is deploying the company's profits in a wise manner. It's these long-term factors that drive a company's value. Even if we don't end up owning for the long term, we still need to think like an owner if we're to properly understand what a company is worth -- i.e., its intrinsic value. This matters because eventually the stock market will tend to reflect a company's true value, and we'll be rewarded.

Of course, many of our fellow market participants tend to be renters, rather than owners, of stocks. And many of these folks both think and act like renters, putting their attention on short-term factors like stock price momentum, the quarterly earnings game, following an analyst's recommendation, or responding in knee-jerk fashion to a news story. Because many investment professionals are compensated based on short-term investment performance, there's a huge amount of capital that rushes through the market with a renter's mentality. This is one of the primary factors that causes stock prices to diverge from their intrinsic value, thereby creating opportunity for those of us with an owner mentality.

Here's the crux: We think like owners in how we assess value, but we don't hold ourselves to an owner's commitment of long-term involvement in any particular stock. We'll remain involved in a stock for as long as the risk/reward is in our favor. Occasionally that period may be measured in years, but more often it'll be measured in months, and sometimes in only a matter of weeks.

Before we leave this topic, let me address the issue of portfolio turnover. Some investors have come to think of high turnover as "bad" because of the perceived inefficiencies of short-term taxes and trading expenses. The view we hold in Motley Fool Alpha is that portfolio turnover is neither good nor bad, but rather it can be either productive or unproductive. For instance, if we buy a stock and it quickly appreciates to our estimate of intrinsic value, we're going to sell -- and that's productive turnover. We're freeing up our capital from a fully valued asset to make it available for the next asymmetric opportunity. To us, the key issue is not turnover, but keeping our portfolio positioned for much greater potential profit than loss -- and to the extent that requires higher turnover, we'll endure the frictional costs. Higher taxes and commissions are worth the cost if we can succeed in compounding our capital at the 15%-plus goal that we've set for ourselves.

What's next
Next time, we'll continue unpacking our Motley Fool Alpha investing principles with a look at what I consider to be the two most important factors of security analysis.

If you would like to learn more about Motley Fool Alpha as soon as details are available, click here.

Matthew Richey is excited to be back at The Motley Fool, teaming up with John Del Vecchio on Motley Fool Alpha. True to its name, The Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool has a disclosure policy.


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