Karen Firestone is chairman, CEO and co-founder of Aureus Asset Management. She is also the author of “Even the Odds: Sensible Risk-Taking in the Business, Investing, and Life” (Bibliomotion, 2016). Previously, Firestone spent 22 years at Fidelity Investments, where she worked with Peter Lynch before becoming a fund manager. We spoke at the CFA Institute’s Annual Conference in May about risk and investing.
—Charles Rotblut, CFA

Charles Rotblut (CR): Could you define what risk is?

Karen Firestone (KF): The definition of risk is an exposure to danger or uncertainty. That’s the backdrop about which we discuss risk, whether it’s an investing risk, fiscal risk or emotional risk. It’s all about an exposure to a potential downfall, an uncertainty that we need to consider before we take that extra step.

CR: In your book, you discuss four tenets of sensible risk-taking. It might be good if we just discuss each one separately.

KF: Sure.

CR: The first one is about right-sizing risk. You write about limiting client portfolios to about 35 to 40 stocks. What’s your logic? And for an individual investor, where do they set the limit at?

KF: I’ll give you a couple of ways to think about it. The first is how people invest today. One of the most common ways is through index funds. The S&P 500 index funds have 500 holdings. I’m not suggesting that that’s too many; it happens to be the constituency of the index. If my goal, as an investor, is to match the S&P 500 or to at least keep up with it, I don’t have a problem with owning an S&P 500 index fund or exchange-traded fund (ETF). If that’s where you want to be, that index fund is going to give you that constituency; it’s going to replicate the index.

We are professional investors who have a lot of experience. We can’t follow 500 names. I tell clients the reason that they want to pay us a fee is because we’re going to beat the S&P 500 over time. No one gets more than 100 pennies in exchange for a dollar, and that’s the same as what you get with an S&P index fund.

In order to do better than the index, we have to come up with some weighting of the various components or reduce the number of names we own so that parts of those components will outperform by enough that we beat the average. Originally, when we started Aureus Asset Management 11 years ago, we decided that 30 names would be the right number. The reason was because we did a lot of statistical analysis about how you would create a portfolio that would capture enough diversification, both at a sector level and a name level, to reduce the overall risk of concentration. We also wanted to be able to have enough concentration so that if we were to overweight a name that had outperformance, it would carry the whole portfolio to an outperforming level.

There were various matrices we examined, and we decided that 30 to 33 stocks was the right number. We later thought we should have a few more names. That was, in part, because the weight of index funds and ETFs in the entire market had grown so much that we felt that we needed to have a few more names to achieve the level of diversification we were able realize at 30 previously. So we increased the number to 35 to 38; we very rarely have 40.

We also feel that since we’re a small firm in terms of the number of people, we should keep our portfolio at a size of 35 to 40 names so that we can really know each company well.

CR: If you have a stock that does well relative to the rest of the portfolio, is there a point at which you look at paring the position down just because it’s getting too large?

KF: Yes. Above 4½% weight, we say, “We really should trim the position.” We’re lucky when stocks do well and they get to that point. We very, very rarely have holdings over a 5% weight.

CR: In terms of right-timing risk, you said it’s basically evaluating how risk will change when you take action. One example you brought up during your presentation at the CFA Institute’s 2016 Annual Conference was opening an ice cream shop in November instead of May. We could extend the discussion to 2008. You used the phrase “gut wrenching” to describe the financial crisis and how it changed confidence. Could you discuss timing risk?

KF: Timing is fascinating. Think about that ice cream shop example—we’ll apply it to the stock market in a minute: If you open your ice cream shop in December, and you have very few customers until May, you will still have six months of rent to pay, employee salaries, the cost of the raw material, etc.

By April you may have lost so much money that you can’t stay open through the summer. Now, hopefully that’s not the outcome, but the risk of default because you mistimed the opening is tremendous.

If we translate the analogy to the stock market, the difference of buying stocks in July of 2008 compared to April of 2009 was, let’s say, 40%. There were many stocks that were down more than 50% during that period. You could kill a hedge fund in that period of time if you opened your business the summer before September 2008, when everything collapsed.

If you were buying stocks only, as opposed to shorting them, you would have lost so much money for your clients, you could have very easily been out of business. If you weren’t out of business, you most likely had a terrible track record to start with. And overcoming a loss of 20% for the first six months is almost insurmountable in terms of attracting business.

If you started your hedge fund in April of 2009 and just went long only [no shorting], you probably have a very, very good track record for 2009 regardless of what you bought. That’s right-timing.

I have a good friend who was a colleague at Fidelity and opened a hedge fund in 2007. He rented very expensive space in the West End in London. He had extremely expensive data systems. He had too many employees. He invested all the money he raised and then the market crashed. He had to let almost everyone go. He downsized his space. He lost clients. Even when the market was going very well in 2007, I thought to myself, “The timing is wrong here, because we’ve been on this incredible run of the market since the beginning of 2002. I just think the market’s a little overheated.”

He’s doing fine now. It is many years later. He’s rebuilt his hedge fund, but he had to get over very bad performance and the bad will that was created at the beginning.

CR: What about someone who is taking retirement withdrawals or who is about to retire, do you tell them keep a certain amount in cash? There is obviously a big timing risk when transitioning to retirement.

KF: The sad thing for people at the retirement level—and I have clients who are in this situation—is that they would really like to have more income. The rate on debt is so low, it makes that choice painful.

The opportunity cost of shifting from low-paying fixed income to equities is so low that this trade has been very common over the last few years. This is why consumer staples, dividend-paying stocks, have been so strong and trade at such high multiples. At a certain level, interest rates will rise enough to encourage people to shift back to fixed income, but that hasn’t happened yet. Investors and retirees still have very few safe alternatives on the debt side.

So, we would still advocate that people keep 5% to 10% of their assets in very liquid low-interest-bearing assets, then another 10% to 15% in something with medium-term—three- to five-year—maturities and moderate yields.

CR: Let’s move on to your next tenet of sensible risk-taking: relying on knowledge, skills and experience. During your presentation, and in your book, you emphasize letting the data, as opposed to emotions, guide decisions.

KF: We have knowledge from our own experiences. People constantly disregard what they know. If someone tells them it’s a good idea, they say, “Oh, yeah, I guess that must be,” while forgetting that they might know something about it themselves.

So, for example, you know that the interest you’re paid on your checking account is a quarter of a percent. Somebody at your banking institution or your brokerage firm says, “Oh, we’ve got this new vehicle that’s got a 7% yield and it’s extremely low risk.” How could the 7% possibly be extremely low risk? You know it isn’t; that’s common sense. People convince themselves otherwise, because they think the person who is speaking to them knows more.

Think about a couple who is moving from a house that they’ve lived in for 30 years. They might be thinking about moving to a retirement community. There’s so much they can learn before making that decision: the stability of the enterprise, how well it’s financed and how well the property is maintained. How happy are the people who live there? They can go and speak to them. The couple doesn’t have to make decisions until they get references. That’s how you use knowledge to make choices which might otherwise carry great risk.

I’m a big one for checking out multiple sources of information before I make decisions, particularly if there’s risk involved. You don’t have to do it under pressure usually.

CR: On the flip side is knowing your limits. You said, for instance, that your firm uses outside managers for certain types of investments.

KF: We have experience as stock-pickers. We also do a lot of investing for people that’s through external managers in other asset classes that we don’t know as much about, whether it’s commodities, foreign debt or even private companies. These areas are not our own particular expertise, so we find other experts with whom we invest.

CR: Then, finally, there’s the tenet to remain skeptical. You said to question the experts and be wary when they are too positive.

KF: Everyone likes to be positive. It’s much more fun to be positive than negative, although we are all fascinated by the catastrophes of others.

If you’re an analyst on Wall Street and it’s your job to follow, say, the retail industry, you’re going find lots of reasons to like Lululemon (LULU), Starbucks (SBUX), or another retailer. You’re very rarely going to be negative about those companies, because you know the management and you know how they built their business. You also have invested lot of your own time and energy in creating that very, very elaborate model of the company. You want your firm to invest in your ideas. It makes you feel more important, rather than saying, “Oh, I’ve done all of this work, but now don’t buy it.”

It’s the job of the portfolio manager or the individual investor to say, “Well, I don’t know, maybe it isn’t such a great idea. Perhaps they’re overly optimistic.”

We think it’s very important to be skeptical of the enthusiasm from corporate executives who have a vested interest in being positive. We all hear about great ideas constantly on the news, from colleagues and from friends. I think it’s critical to be skeptical all the time.

CR: During the Q&A following your presentation, you warned about being skeptical of high valuations. Could you elaborate?

KF: Well, that’s where it’s toughest, because it’s counterintuitive. The more expensive stocks become, the more enthusiasm the market has for them. You would think that people understand the buy low/sell high concept, but they don’t. They understand momentum, they realize that many people have profited when something has gone up and they wish they had been on that bandwagon.

So, there’s this energy that moves toward buying into what’s already inflated. The additional wrinkle here is that trends last longer than you would think. Let’s take real estate in Manhattan. It goes up for three years—2010, 2011, and 2012—and you might think, “Well, it’s bound to settle down and not go up anymore.”

Guess what? It goes up even more. Momentum carries all kind of assets higher than you expect. But at a certain point, there’s going to be some type of bubble and there will be, I would say, a resetting of price. It doesn’t have to be a crash, but it definitely will be a resetting.

CR: Switching to a different topic, I know you worked directly under Peter Lynch. Is there anything about his investment philosophy, his process, that people don’t understand?

KF: Peter would say all the time that you should buy what you know. Not buy everything you know, just—as with my tenet about relying on knowledge and experience—what you feel you know very well, and certainly don’t buy what you don’t know. If you feel you know something that is very positive and you don’t see it reflected in the market’s pricing of that company, that’s a very good sign. Peter would always look for what was embedded within a corporation that hadn’t yet been recognized.

An example I remember clearly is Consolidated Freightways—we owned this trucking company’s stock. They came in to visit us and they talked about how they were using small trucks, within cities, as a new delivery service for packages. It was competition for UPS.

Nobody understood that there was a value to this little entity within Consolidated Freightways. It was growing very fast and it was competitive. There was an increasing demand for the shipment of packages that people were beginning to order. This was before the internet and people were just starting to order things from direct mail companies, rather than buying everything where they lived.

This division grew much faster than the trucking division and Consolidated Freightways ended up selling it eventually to DHL for a huge profit. The division became worth as much as the entire trucking business and helped the stock double.

Peter recognized that value before other investors did. The way I could see his mind working—and he would do this often with company executives—was that he would ask them about something that didn’t seem to be on anyone’s radar. If he liked what he heard, he’d keep asking about that part of the business, because he began to develop, in his mind, a model of how that small division that nobody had yet recognized as being important would become worth a lot of money. Once it was well understood by the market, the stock would have already gone up considerably.

CR: So, he was basically looking for growth trends without a high valuation?

KF: Yes, that’s right. The market hasn’t valued that part of the growth story.

CR: Interesting. Since you worked as a fund manager for Fidelity before running your own firm, I’d like to ask you how investors should look at fund performance? As the insider looking out, what would you tell investors?

KF: Well, it’s interesting. We look at our performance all the time and we also compare ourselves to lots of public mutual funds. I’m always looking at how we compare to Fidelity, to my colleagues. You have to look at the long-term record. I always look at one, three, five, seven, however many years I can look at the performance under that manager.

We carefully consider concentration, because sometimes very concentrated funds can have extremely strong performance for one or two years, but it’s just because the top three holdings might constitute 20% of the whole fund. That can be dangerous. They might sell those over a few years and replace them with three other large positions that badly underperform.

It’s also worth looking at sector concentration. If you have big sector concentrations, it can be great or it can be horrible. Sector weights, by the way, are the major determinant of performance. Whatever people tell you about how, “Oh, it’s really about individual stock-picking,” if you look at mutual funds, their big sector overweights and underweights often determine the performance of that fund. Then consider whether the turnover is very high, because there will be tax implications. A mutual fund that has 150% turnover rate will generate a lot more capital gains—and generally short-term capital gains—than a portfolio that averages 30% turnover per year.

Our average turnover is 35%, so we turn over about a third of our stocks per year. We also watch our capital gains very carefully. We try to reduce everyone’s short-term capital gains.

I know, as a mutual fund manager, that very few mutual fund managers think much about the tax implication. They care about the return number, which is pretax. You can’t fault them for that, but it’s important for investors to look at aftertax returns.

CR: How do you screen for stocks? Are there any particular traits you look for?

KF: In our company, we have five people who manage the stock portfolios together. We’re a team. All of us have different screens that we look at regularly.

For example, I like to look at screens that show a combination of improving sequential fundamentals: quarter-over-quarter revenue growth and earnings growth that are accelerating. You have a company that’s growing sales and earnings consistently at 4% or 5%. Then, all of a sudden, you get a few quarters where the sales number grows at 6%, 8% or 9%, and there is a similar change in earnings growth. That’s usually a very good sign for the stock.

I like to see that in combination with examining how the technical factors have looked in terms of the amount of volume in the stock that’s trading daily. Also, I look at how the stock has responded to earnings, because if it’s showing improving sequential earnings growth, the stock should respond positively. That would be a good buying opportunity.

So, I try to combine some fundamental and technical positive factors. There are guys at Aureus who look very carefully at the balance sheet. They look very hard at improvements in cash generation, EBITDA (earnings before interest, taxes, depreciation and amortization) and the likelihood that a firm can generate enough cash to pay a higher dividend over time, repurchase stocks and make capital investments.

We all have our biases toward screens, but we probably run, within our company, a couple hundred screens. We screen over 20,000 names, U.S. and foreign, to get to 35 stocks. We narrow that very wide pool tremendously to get to the names that we end up owning.

Then we talk to and visit these companies. We stay close with our companies. We model them ourselves. We really don’t rely on Wall Street at all for our work.

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