Alpha Theory Best Practices (Part Four)

This is a continuation from our previous post (Alpha Theory Best Practices (Part Three))

Best Practice #4: MANAGE YOUR MENTAL CAPITAL
‍

“Time is Money”
– Benjamin Franklin

Funds have limited financial capital that they can deploy based on their asset under management. Portfolio managers work within those constraints to maximize return. Just like financial capital, the human brain has limited capital that can be allocated, but many portfolio managers don’t approach the Mental Capital constraints with the same rigor they employ to financial capital restrictions. This causes funds to expect too much from analysts with a resultant degradation in research quality.

We can approach Mental Capital from the bottom-up. Let’s say a firm has a portfolio manager and four analysts. All five of these investment professionals (IP) have limitations on the amount of time they can dedicate to research, their Mental Capital. If we assume that each IP can perform research for 40 hours a week (excludes non-productive time like staring at the P&L) and they work 50 weeks a year for a total of 2,000 hours per IP per year that results in 10,000 hours for a five IP fund. Now let’s assume that each analyst needs to perform 100 hours per year of research per name (about 8 hours per month per stock). That means a total of 100 stocks can be effectively covered or 20 stocks per IP.

20 stocks per IP or 100 positions for the fund seems like a reasonable figure, but remember this includes ideas, as well as active names in the portfolio. If we assume that half of analysts’ time is spent working on new ideas that would cut the number of active names per analyst in half to 10. This means a fund with a team of five can reasonably cover 50 active positions. But a majority of funds end up with 100+ positions meaning that something is being sacrificed for the sake of diversification. More than likely, the portfolio ends up with a mix of insignificant positions that take just as much time as the “core” positions, but have very little impact on the portfolio’s returns. Very rarely will the 50bps position have a large impact on portfolio returns but it can be a big expense of precious Mental Capital.

To cut down on pointless wastes of Mental Capital, it is important to have a checklist of requirements before spending time on research. Does this stock meet our liquidity requirements? Is this stock is in a sector we know, or will we have to spend time on exhaustive background work? Do we have an edge? Perform a quick valuation analysis and if it doesn’t look sufficiently cheap (or sufficiently expensive) then move on. Purge names from the existing portfolio that also are no longer sufficiently cheap or expensive. Mental Capital is a finite resource that is to be spent with caution. Treat it with the same care as financial capital and you’ll end up with a better portfolio.