How We Think About Performance
Our distinctive investment approach informs how we think and talk about performance. Here’s how we help our clients—and our colleagues—remember what’s most important.
By Keith Lee, Chief Executive Officer, Chief Investment Officer, President and Senior Portfolio Manager
Dizzy Gillespie, trumpeter extraordinaire and leading icon in the development of bebop and improvisational jazz, once said, “It’s taken me all my life to learn what not to play.” I like that quote, not only because I am a lifelong jazz fan, but also because I can relate to it professionally. I have been part of the Brown Capital Small Company portfolio management team for more than 30 years, and I have attended countless meetings with clients. I enjoy these conversations; I am always reinvigorated after talking with the institutional investors, consultants, advisors and private clients we serve. These savvy investors are trying to make a real impact on people and organizations, and it is a personal honor to play a part in helping them achieve their missions.
Sometimes, though, clients ask us about topics that do not align with how we think about investing or what we do as investors. This most often happens when markets are particularly turbulent, or when our short-term performance is lagging, as we will explore below. Even clients who have invested with us for decades may start asking us about things that have nothing to do with how we think or invest: sector attribution, factor analysis, style rotation, our macroeconomic outlook, etc. These may be germane topics for our clients as asset allocators and evaluators, but they are less relevant to Brown Capital as Exceptional Growth Company (EGC) portfolio managers. (Click the link for our definition of EGCs.) It took us a while, but eventually we learned that conversations about these topics are the music notes for us “not to play,” as they can leave the wrong impression about how we invest.
To help bridge that gap, I am sharing our thoughts on performance. At Brown Capital, our stated objective is To deliver investment returns in excess of relevant benchmarks for time periods of five years or more. Fortunately, we have largely achieved that goal across strategies going back to our founding in 1983. This note should capture our philosophy on performance, and remind clients how our process brings that philosophy to life. We will cover two main themes: indexes and time horizon.
Benchmark-Agnostic but Benchmark-Measured
Although many portfolio managers describe themselves as benchmark-agnostic, we truly are agnostic, and in ways it is important to understand. We make no portfolio decision based on anything to do with an index—its composition, its weightings, its sectors or its performance. We do not sector rotate or set position sizes with an eye on a benchmark. Instead, we are 100% bottom up, spending our time researching EGCs, not analyzing indexes. Our clients comprise some of the most sophisticated investors, consultants and advisors in the industry. In truth, they often know much more about indexes than we do, and some of them analyze our performance on their own by looking at sectors, company size, styles and other esoteric factors. If that is helpful to them, we are fine with that. We just know that our spending time analyzing indexes would distract us from researching companies and constructing portfolios.
We sometimes get asked, “If your process is benchmark-agnostic, why do you define performance success in terms of excess returns vs. an index?” It is an appropriate enough question. Ideally, we would prefer to be marked against whether clients succeed in meeting their goals, liabilities and obligations, but we know this is not realistic. So we believe benchmarks that measure the performance of companies that could be in our universes and that provide an indication of competitors’ returns are a reasonable alternative.
Being benchmark-agnostic in process (which we can control) but benchmark-measured in performance (which is an outcome) has a direct impact on the way we report and communicate. I tell new clients all the time that we are one of the least metric-driven asset managers you will ever find. That is why we generally do not supply common metrics such as sector overweights/underweights and quarterly performance attribution in our reporting. In the past, when we have provided such data, we wound up spending an inordinate amount of time discussing portfolio statistics and characteristics that we do not remotely use in our investment process. That took away from the time we had to discuss the pertinent aspects of how we actually invested. Today, we supply clients a Contribution to Return report, which shows which companies helped and hurt our returns during a specific time period. To be helpful to quantitative evaluators, on our website we also provide Portfolio Statistics for each of our strategies, but we make it clear that we do not have targets for any of these performance-based data points.
Five Years and Beyond
The second notable part of our performance objective is our time horizon of five years or more, or roughly the average duration of a business cycle, at least historically. This choice ties directly back to the evaluation horizon of three to five years we use when researching EGCs. As a reminder, EGCs are what we believe to be the rare companies with discernible paths to sustained long-term revenue growth. By identifying these companies early, and then having the patience and tolerance to hold them for years or decades, we believe we can sometimes generate returns that are multiples—as opposed to percentages—of invested capital. Because it is inherently more difficult to look so far out into a company’s future (as opposed to next quarter or next year), we want to make sure that the EGCs that do make it into our portfolios have significant long-term upsides. After all, we know a lot can happen to a company in three to five years, and we are going to get some companies wrong.
Given the long-term nature of our decisions on individual EGCs, we think it is fitting for our overall portfolio performance objective to be equally long-term. After all, it would not make much sense to make our portfolio decisions looking three to five years out, and then measure our performance, say, monthly, quarterly or even annually. That is why we generally do not analyze or discuss short-term performance. Analogous to the discussion of benchmarks above, we think analyzing short-term performance results would be a distraction from our long-term decision-making, akin to staring in the rear-view mirror while you drive on the highway.
Our unwavering view on the long term sometimes puts us out of step with clients, who frequently ask for bullets summarizing the macro or market drivers of quarterly returns. As any reader of our quarterly Commentaries knows, we do not talk much about that. Instead, we focus our commentaries on what is happening with the companies in our portfolios through the lens of our research, only discussing the economic or market environment when it plays a pivotal role. For example, in the first half of 2020, at the onset of the COVID-19 pandemic lockdowns, our Small Company strategy outperformed the Russell 2000® Growth index by more than 2000 basis points. Then, as economies started to reopen, high-quality growth stocks fell out of favor and junkier companies rallied. Clients less familiar with us asked why we did not undo our “COVID trade” as the year wore on. Of course, we had never put one on to begin with. Instead, we had remained disciplined in our EGC approach, and it was market sentiment that had dramatically flipped, as we stated. The point is, we have learned over the decades that the more we engage with clients on topics outside the portfolio, the more difficult we make it to understand what we do. As with jazz, the notes you do not play are as important as the notes you do.
I hope this note provides some insight into how we think and talk about performance. We are committed to unpacking other parts of our philosophy and process in upcoming posts. Please let me know what you think, or if you have suggestions for future topics.