Our March 2016 blog post “Turnover as a due diligence metric” argued that turnover can be used to measure the courage of change and the consistency of how managers respond in different market environments and pressure from investors to conform to certain styles. That’s true, but just knowing the turnover number by itself doesn’t necessarily tell you anything. You have to ask more questions to get the truth of what a portfolio manager is doing.
An example: the XYZ deep discount value product likes to hold onto stocks that are distinctly out-of-favor by the market – companies going through restructuring, bankruptcy, or bad publicity (aka headline risk). XYZ has had a terrible run of performance in the past 6 months, deeply underperforming the benchmark as fears of a market downturn punish the more risky fare extra-hard. That’s too bad for XYZ deep discount, but you are also a contrarian investor. So, you take a look at the XYZ product, and notice it’s had a terrible run of bad luck and think – “that’s the company for me”. You believe that the market is due for a turn-around and you also believe that the stocks which are under the greatest pressure are most likely to be the most oversold positions. If a rally occurs, these are the companies which should bounce back highest. I’m sure they have a bunch of great companies on discount.
Now, let’s take a look at turnover. You notice, with dismay, that XYZ management has replaced ALL of their positions within the past month! (A full 100% turnover every month would translate to an annual turnover of 1200% - an absurdly high number which we are using only to make an example.) Every single holding they had, and lost money on, they’ve realized the losses and used the cash proceeds to buy new stocks in the past few weeks.
So, here’s the big question: you thought you were buying a bunch of contrarian deep-value stocks at a discount, but what are you really getting from XYZ? The answer: it depends.
One scenario is that XYZ has acknowledged that their previous investment selection process was faulty, suffered a crisis of faith, replaced their management team, ditched their investment philosophy, and replaced their stock lineup with staid, relative value stocks which have also happened to outperform in the past few months.
Another scenario is that XYZ is as committed as ever to their contrarian viewpoint and that the new companies in the lineup have been punished EVEN MORE in the past six months than their previous holdings. Maybe the stock analysts at XYZ have calculated that the new companies in the lineup are simply trading at an even deeper discount than their previous holdings.
The turnover number, by itself, isn’t enough to tell you which scenario is true. Turnover, like other quantitative metrics, is just another tool to prompt you to ask more questions and to get better information about your investments.