By Justin Carbonneau (@jjcarbonneau) —
Imagine if all your investing decisions could be boiled down to a few simple matrixes. It would make investing, which can be complicated and complex, a lot simpler and easier, and certainly more systematic for many – which I am proponent of. It would still involve predictions and forecasts, which are very often wrong, but matrixes can help us understand who we are as investors, how to look at parts of the market and bring structure to the different paths we take.
We did an episode of our Excess Returns podcast with Darius Dale of 42 Macro that got me thinking about this. In the episode, Darius referenced his two-by-two macro decision making matrix that utilizes inflation and growth expectations and looks at how asset classes perform in various quadrants of the grid. After the talk with Darius, I started thinking about other visuals and matrixes I had seen over the years and I thought it would be interesting to look at some of the more interesting ones.
What Type of Investor Are You?
The first matrix comes courtesy of Howard Marks, co-founder of Oaktree Capital Management. In Marks’ 2006 memo, “Dare To Be Great”, he talks about unconventional behavior and contrarian investing.
Most investors tend to follow conventional behavior and follow the crowd, but if you are seeking above-average returns, you need to have unconventional thinking and a contrarian mindset, but also get the outcome correct.
In the memo, Marks’ pulls in a quote from David Swenson’s “Pioneering Portfolio Management”:
“Contrarian, long-term investing poses extraordinary challenges under the best of circumstances … Unfortunately, overcoming the tendency to follow the crown, while necessary, proves insufficient to guarantee investment success … While courage to take a different path enhances the chances for success, investors face likely failure unless a thoughtful set of investment principles undergrids the courage.”
This is the two-by-two matrix that captures this concept. Investors should try to assess whether they are conventional or unconventional in their thinking and also the probabilities of favorable or unfavorable outcomes to help determine if you can really distinguish yourself from others in the market over time.
source: https://www.oaktreecapital.com/docs/default-source/memos/2006-09-07-dare-to-be-great.pdf?sfvrsn=2
What Type of Market Are We In?
The next two-by-two moves from the individual to the type of market environment we are in, and which asset classes investors should have exposure to depending on that answer. These diagrams tie back to the growth and inflation grid system I discussed earlier.
Originally published by Bridgewater Associates, this was the core idea behind the firm’s all-weather portfolio. An investment strategy that had 25% in each quadrant would be positioned for all different types of market regimes. But this matrix helps us see which environments favor which asset classes.
For instance, equities tend to do well when we have rising growth expectations (upper left box) or falling inflation (lower right) or commodities do well when we have rising inflation expectations (upper right) and nominal bonds when we have falling growth (lower left).
There are market expectations factored into all of these asset classes, and knowing what type of market regime we are in and positioning your portfolio to take advantage of it can be important for investors who invest based on the macro cycle.
source: https://www.bridgewater.com/research-and-insights/the-all-weather-story
How to Grade Your Growth Companies
The Growth Share Matrix was developed at Boston Consulting Group (BCG) as a way for business managers to determine what businesses they should focus on and where investments or divestures in the business should be made.
On the BCG web site they describe the four quanderants as follows:
- Low Growth, High Share. Companies should milk these “cash cows” for cash to reinvest.
- High Growth, High Share. Companies should significantly invest in these “stars” as they have high future potential.
- High Growth, Low Share. Companies should invest in or discard these “question marks,” depending on their chances of becoming stars.
- Low Share, Low Growth. Companies should liquidate, divest, or reposition these “pets.”
source: https://www.bcg.com/about/overview/our-history/growth-share-matrix
While not intended as an investing framework, I think investors (specifically growth investors) can learn from this by thinking about where stocks in their portfolio would sit inside the matrix and if the qualities they are showing both in terms of their financials and in the narrative around them support continued success or improvement in the business, which should be a positive for the equity owned by investors.
A Creating Wealth Matrix
A value framework to help investors identify those companies that are adding shareholder value is through the Wealth Creation Matrix developed by Applied Finance. The firm’s research shows companies that are producing high levels of economic profitability (i.e., profitability above a firm’s cost of capital) and investing those profits back into the business produce the best returns for shareholders over time (upper right box), whereas those firms that are low on profitability and high on reinvestment (upper left) are wealth destroying.
We talked about this concept with Applied Finance founder Rafael Resendes on episode 78 of our Excess Returns podcast.
source: https://www.appliedfinance.com/quantitative-vs-fundamental-analysis-finances-60-year-schism/1
For investors, finding those stocks that sit and can remain in the compounding wealth bucket can be powerful. At the same time, companies that can sustain a shift in their profitability upward and increase reinvestment may also be very good opportunities as many of those stocks wouldn’t be valued at the same level as stocks in the compounding wealth bucket.
Visualizing the Types of Shareholder In Today’s Market
Lawrence Cunningham, Research Professor of Law at George Washington University and known Warren Buffett scholar, talked to us about quality shareholders on episode 38 of our Excess Returns podcast.
Using this matrix, which charts investment conviction (low to high) and investment horizon (short to long), we can see the different types of investors in the market. Those investors that have little conviction and trade actively would be consider “transients”, while those investors or firms with little investment conviction but a long-time horizon would be considered “indexers”. An “activist” investor may have high conviction but really isn’t a long-term shareholder, and an investor that is high on conviction and has a long-term time horizon is considered a “quality” shareholder. Many factors influence where investors and investment firms fall in this matrix, but this is a good way to visualize the major sets of shareholders in the market.
source: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3697259
The Eisenhower Matrix
This last matrix may not be an investing related matrix per se, but may be the one most people want to start with.
This matrix below is called the Eisenhower Matrix, which is a time management framework developed by President Eisenhower. This framework allows tasks to be categorized as Not Important or Important and Urgent or No Urgent. If something is Important and Urgent, you complete the task, where if something is Not Urgent and Not Important, you eliminate the task from your list. If something is Important but Not Urgent, you plan for it, and if something is Urgent but Not Important you delegate it out.
Some things related to personal finance might be things like a will – you know a will is important but it’s not urgent so you plan time over the next few months to contact an attorney and start the process. Or saving for retirement. If you are mid-career and haven’t started saving and investing yet, you know that is important and it probably falls somewhere in-between urgent and not urgent in that you don’t need to start tomorrow but you know the longer you have in the markets the more your money can compound.
Simple matrixes like the ones in this article can be powerful tools in helping investors chart what type of investor they are, or want to be, and also how to how to hone in on specific asset classes or specific companies with superior investment qualities. Through the use of these concepts, many investors can learn, grow and add to their toolset as they look to become better, more successful long-term investors.
Justin J. Carbonneau is VP at Validea & Partner at Validea Capital Management.
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