Professional investors soon grow used to the way their fund’s performance is always being compared with something – whether that is a competitor or a stock market index. Arguably one of the things a value investor can find hardest to come to terms with, therefore, is the need to stop thinking about this ‘relative’ approach to investing and focus instead on the job of generating real or ‘absolute’ returns.
One reason this is easier said than done can be neatly illustrated using the example of HSBC, the largest company in the UK. Let’s say you loved HSBC as a company – that you thought it was the best-run business in the whole world – how much of your own wealth would you invest in it? Would you, for example, invest 10% – one-tenth of everything you own?
You would probably conclude that was an enormous risk to take on one company – and certainly that is our view with regard to the funds we run. So what about 5% of your wealth then? You might feel more comfortable with that. Again, we would view that as an enormous position to take in a single company but it is one we would consider in certain circumstances.
The interesting wrinkle in this set-up is that HSBC currently represents about 7% of the FTSE all-share index, so even a 5% holding leaves you two percentage points ‘underweight’ in the company. So, if you were the sort of investor who obsesses about your performance against the index and HSBC’s shares doubled tomorrow, you would actually significantly underperform the benchmark.
You might almost even wish the shares had not gone up – but of course that would be madness because you still have 5% of your portfolio in the business. If your house goes up in value, you are going to be nothing but delighted. You do not care – or even consider – your house may make up a bit less of your total wealth than, say, your neighbour. You own something that has risen in price. Happy days.
As we said though, competition and comparison are hotwired into professional investors and it can take a long time to accept the idea you might love a company and see it rise in value yet still underperform your benchmark – and, more importantly, that you will want and pray it goes up and you underperform because you have bought something for your investors that, in absolute terms, has risen in value.
There may be more extreme examples but we know of no stronger illustration of how ignoring a benchmark and focusing on real returns – on what you own being worth more tomorrow than it is today – is ironically the best way to outperform the benchmark over time. That mentality puts you in a good place to think about absolute risk and absolute return, which is exactly how most people think about their own money and so how we, as fund managers, should think about investing it for them.