2019 in Review

2019 was a pleasing year for the Fund, delivering investors a 36% return, outpacing the MSCI World SMID Index by 9 percentage points. Although this is understandably an important data point for investors, evaluating performance on a single number can be a blunt tool that obscures the nature of the underlying decisions. In this piece we unpack the Fund’s returns by providing the metrics we find useful in analysing the quality of our decision making.  

Separating Luck from Skill

When evaluating performance, it is important to keep in mind ‘attribution bias’; the tendency to attribute any successes to skill whilst blaming randomness for any failures. This idea is highlighted by Nassim Taleb in ‘Fooled by Randomness’:

“There is one world in which I believe the habit of mistaking luck for skill is most prevalent - and most conspicuous - and that is the world of markets.”

In order to combat this bias, Inalytics, a firm dedicated to analysing active managers, developed two metrics that expose whether the decisions of an investment manager add value.

• Hit Rate: Defined as the number of correct decisions as a percentage of the total number of decisions. For our purposes, a correct decision is an investment that outperforms the MSCI World SMID Index.

• Win/Loss Ratio: Compares the amount of alpha generated by good decisions to the alpha lost from poor decisions. For example, a high hit rate is useless if a small number of large, negative outcomes wipe out all gains from the remainder of the portfolio.

Unpacking Fairlight’s Performance

In 2019 Fairlight owned 47 stocks, 12 of which were new positions purchased during the year, 13 of which were sold, leaving 25 which were held for the entire year. Of the 47 stocks owned, 32 outperformed the MSCI World SMID Index over the holding period, a Hit Rate of 68%.

Digging deeper into the 15 names that underperformed:

• Four were recent purchases. Given Fairlight’s long-term investing time horizon, it is not unusual for new positions to underperform in the short term.
•  A further 6 were sold during the year when the investment team identified investment thesis drift or that a mistake had been made.
• Of the remaining 5 stocks, all have been held since the inception of the strategy in 2017. We believe a period of short term underperformance is not a reason to relinquish a high quality business, provided the investment thesis remains intact. These 5 positions continue to be held by the Fund.  

From a Win/Loss perspective, the 32 ‘winners’ outperformed the index by 26% on average, compared to an average underperformance of 10% across the 15 ‘losers’, equating to a Win/Loss Ratio of 2.6x (Figure 1).

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Position Sizing

In addition to picking more winners than losers, another avenue for a manager to add value is via position sizing. Ideally, the largest positions in the portfolio would be the biggest winners, whilst any mistakes quarantined to a small weight. Figure 2 plots the absolute return of each stock in the Fairlight portfolio against the maximum weight it was held at during 2019, categorized by the three investment types.

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The two worst performing stocks, Prada (1913-HK, -14%) and Health Care Services Group (HCSG, -23%) were both held at small weights as the range of outcomes was deemed large:

• Prada (1913-HK): A low risk turnaround predicated on recovery of the brand and improved cost control. When reported results indicated neither were on track the thesis was invalidated and position sold.
• Health Care Services Group (HCSG): Originally classified as a Stable Compounder, the business surprised with a profit downgrade and historical accounting restatements. This indicated a misappraisal of the quality of the business resulting in a swift sale.

Conversely, the three largest positions in the portfolio; CDW, RBA and AUTO delivered returns of +78%, +34% and +38% respectively.

The Fairlight View

Looking to 2020, we believe the Fairlight portfolio is well positioned to deliver on our aim of an 8% - 12% return through the market cycle with lower volatility than the index. We continue to believe a portfolio of the highest quality businesses, purchased with valuation discipline will outperform over the long term whilst protecting and preserving client capital.

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