Value Investing: Lessons from Major Art Collections
I am the co-founder (in 1994) of Firebird, the first portfolio fund dedicated to the Russian stock market. For the last 30 years I have been managing money throughout Eastern Europe, both in public and private equity funds, as well as investing my own assets. Prior to Firebird, I was an M&A lawyer and once upon a time published a novel about a lawyer who becomes an inside trader, Rick Green, Esquire (Simon & Schuster 1995). I’ve also been an avid art collector for two decades and serve on various committees at the Met.
I will post occasionally, with a focus on investing and art. My first post combines the two; it was originally published, in a different form, in Marc Faber’s Gloom, Boom & Doom newsletter. The piece discusses a key dilemma in “value investing” and lessons we can draw from major art collections. It then proposes a framework for managing active stock portfolios, and concludes with a few cheers for index investing.
What is Value Investing?
The objective of value investing in public markets is to buy stocks that are underpriced based on fundamental analysis. You would want to understand why that is, have a view about how the condition will be rectified, and then, if you are proven right … what? Sell? But what if you are selling the gem of the portfolio, the stock that will still be on the medal winners’ stand five, ten, even twenty years hence? Won’t you be sorry to have sold, like someone who bought Facebook at $18 when it seemed obviously too cheap, then did the disciplined thing and took a profit when it reached $50? (The anonymous protagonist in this sad tale is the author.)
It is possible to “trade around” a position, i.e., sell when it is popular and fairly priced, and buy back when it is fundamentally cheap again. This requires the investor to master their emotions, because unless they have godlike market timing skills, they will be forced to buy or sell well after the turn has happened. There are also trading costs and tax consequences. And while this strategy may work in sideways markets, a bull market may never give them a chance to buy back in, as has happened to the many professional investors who have largely missed the great U.S. bull market since 2009 while waiting for a buying opportunity.
Lessons from Famous Art Collections
Shedding some light on this problem are major art collections, which provide examples of portfolios that are held intact and for long periods of time. Unlike a stock, it is difficult to sell off part of a Cézanne painting when it rerates higher, or “trim the Matisse position”. Cezanne and Matisse are both in the famed collection of John Maynard Keynes, which was bequeathed to King’s College, Cambridge and has been kept intact ever since. The Cézanne “Still-life with Apples” that Keynes bought in 1918 still contains the same seven apples: they have not merged or gone private, as happens with stocks. As a result, one can assess the long-term return of a truly static portfolio. It has been excellent, 10.4% annualized as of 2019, not far below U.K. equities with dividends reinvested. Keynes’ total expenditures of approximately £13,000 built a collection worth approximately £76 million in 2019. As further detailed by Horizon Research Group in a 2010 study, several art dealers of the era, like Heinz Berggruen, built comparably massive art fortunes.
I am less interested in the fact that art-based wealth was built than in how. The dealers accumulated many works in their personal collections, most of which never appreciated greatly, but over a long period tremendous value grew and became concentrated in a small number. (They exhibit “positive skewness”, in investment language.) The five most valuable works in Keynes’ collection make up 75% of the current value, and one alone is 25%. This is not unusual. Now imagine if Keynes or King’s College had periodically sold interests in the Cézanne painting because it was “overweight”, or worse, had sold it entirely because it seemed overvalued at some point or other. The return on the whole collection would have been far lower, unless the proceeds had been reinvested into, say, a Jackson Pollock in 1952, thus winning the lottery twice.
The math was done in the Horizon study, whose authors used the art dealers’ collections to examine the potential benefit of holding an investment portfolio static, as opposed to turning it over annually. The authors divided a $1 million theoretical portfolio into five quintiles, which then appreciate per year at 25%, 15%, 10%, 0, and -10%, respectively. Horizon applies their model to indexation, which makes sense in a developed market like U.S. stocks, but less so to niche asset classes like art, where the initial portfolio should be constructed by someone with at least moderate expertise. Keynes had little taste in art himself but good advice from his Bloomsbury friends, without which there would probably have been no compounding at all.
Looking at Horizon’s theoretical portfolio over 25 years, it turns out that if it is “rebalanced” every year, as active stock portfolios tend to be, the annualized return is 8% (excluding taxes and transaction costs), worth $6 million, whereas if it is kept static, the return is 18%, worth $62 million. The critical equation Horizon provides is one showing that over 25+ years, the return of a static portfolio converges with the return of the top quintile of holdings.
This is not inconsistent with my investing experience, and I have a controlled case to demonstrate that it works. In the mid-00’s, I established a managed account for my children at a brokerage. When I took personal control of the account in 2010, I sold several of the positions and with the proceeds bought Microsoft, making it approximately 20% of the portfolio. Since then, I have barely touched the account, and now Microsoft represents 75% of the value, having mightily outperformed the rest of the stocks. The overall return on the portfolio has been increasingly converging with the total return on Microsoft since 2011 and, if the latter keeps performing, this will be even more so.
Admittedly, not every stock is a Microsoft, and if I had let, say, Disney grow into a 75% position, I would have been upset, and my long-term return compromised when it halved a couple of years ago. I have given this dilemma a lot of thought and have concluded that the two approaches (sell positions at fair value vs. hold everything static forever) are irreconcilable. You can, however, draw lessons from each one to try to generate attractive returns without taking reckless single-stock risk. One way to do this is to separate your portfolio into three main categories.
Long-Term Champions are companies you believe to be long-term compounders. A stock like that should be held, trimmed sparingly, and only significantly reduced when it becomes highly overvalued, or changes in some fundamental way. Fundamental change is not something that cannot happen to a Cézanne but can and does to a company, e.g., because of macro events, technological disruption, or management changes.
Medium-Term Performers are companies you like but cannot visualize as a potential Cézanne. Here it becomes more important to manage its weighting in your portfolio. Cyclicals such as resource companies go in this bucket, since they are vulnerable to large commodity price fluctuations over time. These kinds of stocks can graduate to the top category if they have excellent managements and/or operate in the right sectors. Of course, medium-term performers can also be downgraded to the uninvestable category.
Arbitrages are stocks that you think are currently undervalued and where you see a catalyst for value-recognition – but have no conviction beyond that point. In these cases, you need to remember to sell when the stock reaches the range of fair value, and if it is not very liquid, to leave something on the table for the market. In the past I have made the mistake of holding onto less liquid stocks for the top tick and finding it hard to sell on the way back down.
A framework like the above cannot be applied mechanically because the markets are always presenting investors with new circumstances. Still, even if it does nothing other than make an investor hesitate before deciding to reduce a Cézanne or Matisse stock just because it “went up a lot”, then it is valuable.
Index Investing
Finally, as Horizon demonstrated in 2010, index investing addresses the value dilemma in the easiest way for most investors, who have neither the time nor the expertise to manage their own portfolios. In an index fund, the best-performing companies gain larger weightings, while the underperformers grow ever smaller and may ultimately be replaced in the index. The index investor has been forced, for example, to build a bigger portfolio in tech stocks since 2010 as Apple and Microsoft skyrocketed, when they might not have done so on their own. While the greatest stock-pickers can outperform an index fund, 90% of professional active managers have not done so over the last 15 years.