We talk a lot about Warren Buffett around these parts (for good reason), but today, I’m going to share with you something a bit different:
Wisdom from a now-deceased investor from California you’ve likely never heard of … that was written three decades ago … and that originally appeared in a stunningly boring-sounding publication called The Journal of Portfolio Management.
Stay with me, though. It’s worth it!
Back to the future
At the time Robert G. Kirby published “The Coffee Can Portfolio,” he had already been in the money management industry for 30 years, most prominently in senior roles with the Capital Group, a Los Angeles-based institutional investor of many, many billions of dollars.
Even in 1984, well before computer-driven algorithms and high-frequency trading were the flavours of the day, Kirby, the wily veteran of the markets that he was, had found a flaw with how most money was being managed by institutional investors — aka “the pros.”
In a nutshell: transactions.
More specifically, Kirby found flaw in the number of transactionsmade by institutional money managers. All their transactions had a detrimental impact on their portfolio performance because of — you guessed it — the costs of every transaction.
These costs were (and still are) a significant performance drag, in Kirby’s estimation. He figured there had to be a better way.
One alternative Kirby identified was simply indexing a portfolio. His rationale here was that since it was
widely known that in aggregate most money managers couldn’t beat a broadly based, unmanaged portfolio, why bother?
Kirby pointed to two flaws in this approach: 1. Indexes too are, in reality, actively managed. 2. Does a widely followed index like the S&P/TSX Composite or the S&P 500 truly represent the market?
Though the number of changes an index makes over the course of a year is relatively small in comparison to a typical professionally managed portfolio, over time, they can add up. And as a result, so too can transaction costs and the accompanying drag they bring to your portfolio.
Also, the changes that occur in an index are not necessarily the result of a formula that produces a consistent, predictable kind of alteration. Human judgement is involved, which can open gaps to possible error between what the index represents and what the market actually is.
Though we acknowledge Kirby’s reservations with indexing, for many it truly does offer a perfectly viable investment strategy.
For those of us that believe the “market” is beatable, Kirby’s other alternative is deeply insightful, well thought out, and best of all, timeless. (In my opinion, at least!)
Kirby had for years been intrigued by the idea of the “Coffee Can Portfolio,” a strategy that harkens back to the Old West, when people put their valued possessions in a coffee can under their mattress. The can represented a no-cost way to hold valuables.
Kirby’s core idea: that investors treat their brokerage account like a coffee can. Inside the can would live a collection of the best companies around. Once a company’s stock was purchased, it was not to be touched for 10 years.
Each stock would be left to its own devices to grow and compound over that period of time. Some would, some wouldn’t — but in the end, Kirby theorized, those that succeeded would trounce the ones that flailed and the investor would be very nicely ahead.
Kirby never did employ this methodology — the practicalities of the institutional money management industry were too daunting. And besides, the article provided no irrefutable proof that the Coffee Can Portfolio actually works.
But he did tell a story that demonstrated these coffee-can-like principles in action.
The firm at which Kirby once worked utilized a method of portfolio management that involved regular rebalancing. Winning stocks that were deemed “expensive” and had grown into large portfolio positions were sold, the proceeds recycled into less successful investments that had grown “cheaper.”
One day, a client called to indicate her husband had passed away; she was to transfer her deceased husband’s assets over to Kirby’s firm (where her money was already being managed).
When the list of assets was received, Kirby found that the husband had been piggybacking his wife’s account — following the same recommendations that she’d been receiving as a client of Kirby’s firm. But there was one major difference.
The value of his estate was vastly bigger than the value of her account.
Though the husband had been selecting the same stocks, he paid no attention to the advice to sell down the winners and put the money into the less successful companies in the mix.
He simply put $5,000 into every purchase recommendation, and he forgot about it.
A number of his holdings were valued below $2,000 — down significantly. Several were valued in excess of $100,000 … and there was one massive winner that was worth more than $800,000!
This single stock exceeded the value of his wife’s account — where it had likely been shaved continuously over the years and/or had been completely sold out of for much less than what the husband had gained.
Iain Butler, CFA
Chief Investment Adviser | Motley Fool Canada