Embracing an Active Approach to Public Equity Investing

We have spent previous blog posts talking about how we invest in the Public Equity markets at Swingbridge. We have also mentioned our stated mandate to outperform the S&P 500 over the long-term. To accomplish this, we have chosen to take an active approach to the management of our fund.

It is a popular debate in the world of investing as to whether or not an active investment strategy can truly outperform a passive, index-based investing strategy over the long-term. The legendary investor, Warren Buffett, famously challenged the hedge fund industry in 2008 with a million-dollar bet that the S&P 500 Index would outperform a basket of hedge funds over a 10-year period. And at the end of the 10-year period, he was proven to be correct. (As an aside, Buffett himself is an active Investor, and the real purpose to his bet was to point out how the typical hedge fund 2% / 20% fee structure puts a major drag on Investor returns; the Swingbridge Public Equity LP has a significantly lower fee structure).

But it wasn’t that simple throughout the bet. Due to the broader markets stumbling shortly after the bet began in 2008, it wasn’t until nearly 4 years into the challenge at which point the passive index cumulative return surpassed that of the hedge funds. And even as they approached the final years of the bet, the cumulative returns of each strategy were neck-and-neck. And so, the real takeaway, perhaps, is that timing matters.

It is our belief that the broader S&P 500 index is now trading at valuation levels that are historically consistent with mediocre long-term returns as measured by our upside/downside skew metrics. In the simplest sense, despite a modestly growing economy and expected earnings growth in the coming years, the index trades at a valuation multiple that doesn’t offer enough “excess” return potential to justify the possible downside risk exposure, when compared to other investment opportunities including individual stocks. This doesn’t suggest avoiding broader U.S. stock market exposure altogether. However, by utilizing these metrics, we are able to gain a sense of the underlying attractiveness of the broader market and overall investment climate, as well as to benchmark against our own investment opportunity set. 

One of our expected challenges to investing in a passively managed, large capitalization index like the S&P 500 for the next several years is likely to be the current aggregate concentration among just a handful of mega capitalization stocks. This includes Apple, Microsoft, Amazon, Google, Nvidia, Tesla, and Meta, which together account for nearly $11 trillion of market cap and, more importantly, nearly a 30% combined weighting within the S&P 500 index. To be fair, these companies have earned their current valuations through dominant category leadership, superior products, and aggressive capital allocations strategies. But the concern here is that these businesses are not immune from the Law of Large Numbers. As an example, growing from a $3 trillion valuation to $5 trillion (in the case of Apple) is highly difficult absent consistent growth expansion at excessively high levels, all while facing competitors who also want a piece of the pie. And if just seven companies represent 30% of an index, the return profile of that index becomes highly contingent upon the performance of those seven companies.

Compared to recent years in which the passive index investing environment was more favorable, the biggest risk to this approach today - which represents a long-standing tenet of investing - is that there are periods of time where great companies do not equal great stocks to own. Could these large businesses see a stalling in their historically high growth rates, which impacts their valuations going forward, and ultimately leads to a major headwind for the underlying S&P 500 index? We believe it is certainly possible, particularly with a number of these big technology companies facing renewed competitors and regulatory scrutiny due to their sheer scale and influence. And how long will passive investors, who have been magnetized to the reliability and predictable performance of these mega cap names, continue to enjoy the realization of above average market returns from this basket of stocks? Time will tell, but nothing is permanent in the world of investing.

Of course, no one can say with any degree of certainty where the broader stock market will be 1 month, 1 year, or 10 years from now. But given the above, it seems reasonable to us that more risk tolerant investors staring down the growing likelihood of below average long-term equity returns via a passively managed / indexing strategy approach may seek alternative ways to enhance their long-term equity return profile.

There are two main approaches to effectively accomplishing this. First, “leveraged beta” strategies – the process of using implicit/explicit leverage or other means of optionality to in effect increase the underlying portfolio basis so any return generation is either magnified on the original investment dollars or done at reduced risk/cost. Second, “active management” strategies – the process of using individual stock selection to identify opportunities in companies that will deliver better investment returns than that of the overall market or comparative index.

While both mentioned strategies have their pros and cons, our approach within the Swingbridge Public Equity LP is to employ an active management strategy, which is comprised of investing in companies that generally have more individual “beta” than the overall S&P 500 index as a result of their aggressive capital allocation plans, industry exposure, and/or growth profiles. And while businesses with higher beta, by definition, have more underlying potential volatility (risk and reward), we seek to manage and mitigate this via robust metrics and disciplined processes that help us better capture realized upside return relative to that potential volatility.

At a consolidated portfolio level, we aim to maintain an estimated portfolio skew greater than 5x (i.e. 5x return potential relative to each unit of downside risk), which currently compares to a long-term S&P 500 index skew less than 1x by our measures. While that in and of itself doesn’t guarantee strong outperformance vs the S&P 500 in the coming periods, it does shift the probabilities of success in our favor given our more attractive risk/reward weighting, particularly if we are diligent in underwriting and disciplined with risk management.

On the other hand, investors employing leveraged beta strategies need to consider or manage to a variety of “macro-level” inputs, including valuation, economic factors, seasonality, market internals, and other sentiment-related indicators - all of which impact the value of their optionality. There are a number of practitioners who employ these strategies and some are hugely successful. However, it is our view (and in better alignment with our skillsets) that we are better off with our active management approach:

Step 1: Identify and monitor a pool of individual companies with highly attractive characteristics

Step 2: Invest in a concentrated subset of the best companies in that pool

Step 3: Manage that portfolio through disciplined processes

We also believe that it is simply easier to buy and sell quality businesses at attractive prices than to consistently predict the behavior of the broader capital markets.

As we outlined in our A Glance at the Swingbridge Investment Playbook blog post, it is our strategy to invest in a concentrated portfolio of ~15 companies, at attractive entry points, and with clear sightlines to value creation. In turn, this gives us ample opportunities to use the market to develop a strong thesis of where value for each company may be at any given moment, and what related action may be considered. And it is this approach that forms our active management investing strategy. When we reach what we view to be an “attractive” price, we buy. When we reach what we view to be our target “realized” price, we sell. And of course, when our original thesis has been “eliminated” due to management action (or inaction), we also sell.

When taking this active approach, combined with our consistently managing to a total portfolio skew greater than 5x, we believe it will help us preserve better performance against the S&P 500 index over time. And we believe the timing now is right for this approach.