Investing Outside the Box (of fees, correlation, market volatility, and certain death)

I've always struggled to explain how and why I do what I do when managing money.  I am a contrarian by nature—I don't believe you can make money by doing what everyone else does. But beyond that, I've made some non-traditional decisions in terms of assets and allocation.  

I've evolved into my current strategy over a long period, but my general approach has been based on a couple core principles.

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I want to build a portfolio that is truly diversified, where the risk of each individual investment is something I understand and can personally impact. World stock and bond markets are strongly correlated at this point (they go up and down together).  Moreover, the risk is one huge black box.  I have no ability to understand, impact, or predict what is going to happen in any particular market.  That requires macroeconomic knowledge I don't have.  The few times I've invested in the market, it’s been via index funds, but even that is too risky and correlated (all your investments can go down together) for me.  

It's either crazy or brilliant, but I quite honestly couldn’t care less what happens in the stock market. Generally, I don't even know or keep track.  The investments I make succeed or fail over long periods of time based on intrinsic measures of success.  There is no daily obsession with what someone else (or the world) thinks the value is.  And there is no daily volatility in value as a result—just hard work to create long-term returns.

Second, I want to isolate the segment of the portfolio where the loss of principal is very low and separate it from the portion of the portfolio where I am willing to take bigger risks to generate outsized absolute returns.  In portfolio theory terms, this approach is called a "bar bell," because risk is high or low with nothing in between.  

Finally, liquidity is over-rated.  I make long-term investments and make sure I have a cash buffer and plenty of income.  But liquidity comes at a cost, and in general, I'd rather have higher returns than infinite flexibility.

I have three legs to my investment stool: hard assets, yield, and risk.

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No, what I'm talking about is buying stuff that retains its value in a wide variety of economic scenarios (so that if you fuck everything else up, you still have a portion of your portfolio that is never going away). How much to put in hard assets depends a bit on the size of your overall portfolio (the more you have, the more you can comfortably lose by allocating to riskier asset classes), but I tend to think a quarter to a third in hard assets is a good amount for most people.

Over the last 15 years, that has meant real estate for me, because my wife is uniquely good at finding well-situated properties in bad condition and fixing them up.  This has been a great trade during this period.  I get nervous that real estate values are going to get stupid again, but I try to tell myself that I'm not a market timer and that our real estate holdings will retain value no matter the external environment, which is true.  

I know guys who have bought farms and farm land, and I would put that into this hard asset category (along with most natural resource plays).  If you are buying gold or silver because of its intrinsic value rather than some Mad Max scenario, I'm okay with that too. It's just always felt too esoteric to me.  Besides, we get to live in and share our real estate holdings with friends and family.  Not a bad side benefit.  You can't do that with gold—unless your brother gets off by holding your bars of gold and revolver collection at the same time pretending he's Butch Cassidy. 

Okay, enough.  Take a chunk of what you have and buy shit of value that isn't going away.  And then forget about it.  Don't watch the market.  Don't actively trade it.  Buy with the intention of holding forever. Save your brain cells for the stuff that matters.

I happen to like income.  Who doesn't?  I tell people I haven't had a real job since 1997.  That's kind of true and kind of not (I did run a venture firm in there for a little while).  But suffice it to say that I like when my investments send me cash every month.  Feels good and pays the bills. This is the portion of the portfolio I call "yield."

I think about yield very differently than some portfolio manager at Fidelity buying and selling government and corporate bonds.  I'm looking for big-ass yield.  For most of the recent past, you have not gotten paid to take duration risk.  Pretty much everything available in the bond market pays 5% or less.  That is a complete waste of my time.  When I say "yield," I am talking about 15% annually (or more) with what I deem to be very low-risk investments. The yield portion of the portfolio, along with the hard assets, forms the totally safe never-going-to-lose principal bedrock portion of the portfolio.  And to date, I have never lost principal on any of my yield investments while generating yield in the high teens and low 20s.

The three ways I have been able to sidestep historically low interest rates in my debt investments are based on company size, industry, and location. 

My biggest theme has been around size. While the US government and Fortune 500 companies have been able to pay close to zero on their debt for small and medium-sized companies, even profitable and very credit-worthy ones have had a very hard time borrowing at any price.  I first noticed this discrepancy most profoundly after the credit crisis seven years ago.  

To take advantage of this, I helped start two investment firms that focused on investing in the debt of small and medium-sized businesses in pretty much any industry.  One of those firms is in Rhode Island, and the other is in Los Angeles.  Both have provided strong returns.  

I helped start a third fund in NYC that focuses on the same kind of debt at all-in yields in the high teens. But this firm has an industry focus: software as a service ("SaaS") companies.  SaaS enterprises generally have very sticky customers that sign long-term contracts.  These companies reinvest that revenue in sales and marketing efforts to attract new customers.  As a result, they don't show a profit even though their core operations are highly profitable and stable based on those long-term contracts.  

While all three of these funds have been big winners for me, the majority of the capital I have deployed in the "yield" category has been through direct investments in companies I know well and have an ongoing relationship with.  The largest of these is a specialty finance company in Mexico that I have been involved in for five years now.  The company is extremely profitable and growing quickly.  They issue dollar-denominated debt that pays 20% annually.   

If that company were in the US, the yield would likely be far less than half that. When I got involved in the company five years ago, it was a contrarian bet on Mexico as a country.  All you ever read about then was the drug war.  And yet, I could see that the economy in Mexico was growing, there was a growing middle class, and debt as a percentage of the GDP was a lot lower than in the US.  That has all turned out well, as has the company itself.  I never ever worry about the credit quality of my 20% yield.  It's money good.

Note that taken as a whole, my yield portfolio is highly illiquid.  It generates lots of income, but getting my principal back quickly is impossible.  I've made long-term commitments.  The portfolio is highly non-correlated by industry, geography, and any other measure.  It's impossible to imagine one macro event negatively impacting all these investments at the same time—very unlike any portfolio of publicly traded debt instruments, which by their very nature are highly correlated to each other and rise and fall together.

Each of my yield investments rises or falls on its own merits.  In each of the three funds, I have a strong influence on portfolio management, and for each direct investment, I spend significant time on the ground with management to ensure continuity and personally increase the odds of success. In terms of allocation, I like to think of a third to a half of my assets as being in this yield category. Frankly, as the value of successful risk investments increases, that percentage may go down some, but I rebalance using excess income from the yield portfolio to bring the percentages back into line.

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I try to be agnostic regarding sector, but as I gain success in one investment, it tends to breed similar investments; I ultimately generate concentric investment circles where I develop spheres of expertise.  But I don't draw it up that way because of my desire to be diversified.  Current sectors in which I have risk investments include gaming, SaaS, and consumer finance, for instance.  

I am willing to take write-offs in my risk portfolio in the name of finding core holdings that can generate big returns for long periods of time.  I have owned my two biggest risk investments (by which I really mean that I own a meaningful amount of equity in the companies) for five years each.  Both companies are doing extremely well.  And there is no real goal or sign of liquidity anytime in the near future. 

When I say “risk,” let me be clear. I expect 9 out of 10 of my investments in this category to perform. I stage my investments so that any strike-out is likely to happen at the preliminary stage, when I have much less capital invested. To put big chunks of money to work, I need to see that I’m investing in a profitable business with asset value that is not going away. The bet is on how fast my CEO can grow the company (and thereby generate outsized returns), not whether or not the company is going to survive.

Let me take a step back. I spent a decade of my life running a VC firm where we invested purely in start-ups. Of over 30 companies that we started from scratch, the bulk of the return came from three companies that we grew all the way to scale and sold for hundreds of millions of dollars over the course of that decade. We worked incredibly hard on all the companies we invested in. But the vast majority failed. We sold some at a modest profit. And the good ones required constant attention from day one through multiple leadership changes, dodged bullets, and organizational growing pains. It was exhausting work with huge risks every step of the way.

Maybe we sucked as investors (though I don’t think so). And maybe the world has changed such that unicorns grow on trees and magically appear months after investing (I also don’t think so). But it is very rare that as an investor, you get paid for seed-staged VC investing, contrary to the romantic tech start-up dream that seems to be playing itself out across the nation these days.

I’d be lying if I said I never invest in start-ups. I occasionally still do, usually because I really like the people or their idea. But the total amount I have allocated to pure start-ups in my portfolio is less than 1% of the total value. In other words, it doesn’t matter. 

What I prefer to invest in are search funds. This is where a group of investors collectively invest in an entrepreneur who sets out to buy an existing company in a particular sector. The dollars for the search phase are modest—it’s simply to pay the searcher a salary and offset his expenses. 75% of the time, the searcher finds a company to buy. Money invested in the search gets rolled into the deal at a 50% step up in value. And search investors have the right to invest pro rata in the acquisition.

There are several reasons I favor this kind of equity investing. Searchers tend to be recent graduates from top business schools and/or smart young executives with a background in banking, consulting, or private equity. They are looking to buy a company and then run it. I really enjoy the interaction with searchers and am confident that I am bringing real value to the table—value that increases their odds of success.

The companies that searchers buy tend to be recurring revenue businesses with strong profit margins, usually in some well-protected niche where the founder has gotten tired and wants to cash out but industry trends support future growth. We are playing in the area just below the reach of private equity; these are businesses of tangible asset value, which can increase handsomely when professional management is deployed to grow them into the scale that PE firms like to buy.

That being said, the best companies are the ones you never, ever sell. The co-founders of my most successful search fund have been at it for five years. They are now 37, and they very much look at their company as their life’s work. They have no intention of selling. As a shareholder, the power of compounding makes me want to hold my equity in their company forever. Why would I want to try to redeploy what is now a big chunk of my portfolio (after paying taxes, mind you) when these guys have proven their ability to generate growth quarter after quarter and year after year far in excess of the market and even my 35% goal? 

I have no expectation that all my search funds will end up being that successful. But I put a little money down for a search. 25% of the time, I lose it. 75% of the time, it gets rolled into a successful acquisition, and depending on my view of the deal and the CEO, I invest a more meaningful chunk. I don’t expect to ever lose money once we have bought a company. But returns will vary, with the average being 35% (Stanford University did a study of all search funds and came up with that number, so I am not just making it up). 

I do make other investments in the category of “risk,” but I’m going to spare you the gory details here. They generally involve my buying assets directly or making investments that have the ability to hit my 35% goal. But far and away, my largest and most important type of risk investing is search funds.

My overall allocation between hard assets, yield, and risk has varied a bit over time, beginning with a strong leaning toward yield (I just love when people send me money every month—it’s the ultimate form of financial reporting in my mind). I probably started out 50% yield and 25% each to hard assets and risk. I’m probably closer now to one-third each.

The best part of this strategy is that I can sleep at night. I never worry about what any stock or bond market is doing. I try to think deeply about the particular businesses I am investing in and how I can personally help. But there is no black box investing. I know the management teams. I see the financials. I am under the hood working to make a good thing better, which in my way of thinking, is a lot more fun (and productive) than chasing a highly volatile and correlated market in publicly traded securities.

All images by the awesome Stephen Sheffield