Matthew McLennan on Variegation, Positional Assets, and Resilient Wealth

Matthew McLennan

There is a certain thread of continuity that links all our stock investments: we like scarcity of market position, whether in the assets a company owns, its market share, or its capability in a particular arena. Scarcity in a real or intangible asset.

What matters when we put a portfolio together is this notion of variegation — intentional non-uniformity. We want different industry exposures, different country exposures. We tend to be quite diffuse, but not in a way that mimics the market. The market is over 70% US, and we will not take that much risk on a single country. The market is very concentrated in tech stocks, some of which we like, but we will not take that much risk on one sector. The market does not carry a defensive ballast element like gold; we intentionally do.

Diversification is part of the curation process, part of selectivity. It is intentionally bringing non-uniformity to the portfolio in a way that is distinct from naive diversification. We do not want our portfolio to be a unidimensional theme — not a Mag 7 portfolio, not just a long-Europe portfolio. Acknowledging uncertainty, we want many sources of scarcity value so they can come to fruition at different times and different seasons.

Matthew McLennan

I always like to come back to Seneca's line: "If a man knows not to which port he sails, no wind is favourable." It really pays to know the destination before you set out on the journey. Knowing that the goal is to participate in the march of humankind but survive crises along the way is a good guiding light. It tells you, rather like Seneca's sailor, that you need to travel the journey with some ballast.

That is why, even though we are primarily business buyers, we might typically hold 15 to 25% of the portfolio in a combination of cash — short-term deferred purchasing power — and gold as long-term purchasing power. It is analogous to a ship's ballast: you set out knowing you will encounter unexpected storms, and the ballast does not generate the voyage, but it allows you to survive it.

It also informs the kinds of businesses we want to own. We like there to be scarcity in the nature of the assets a company controls. If you control a real asset that is well-positioned and at an advantage, it will garner premium rents or premium margins relative to the industry. You may go through business cycles, but you are likely to survive. If it is not a real-asset business, then high market share gives you scale economies in whatever matters to the unit economics — R&D, advertising, sales force density, distribution — and therefore lower costs and better pricing power.

Businesses with scarcity also tend to be predators when times get tough. They survive, they likely still generate cash flow, and they can consolidate their market position counter-cyclically. That is an unusual position. Even if you are not augmenting your market position, you have the option value of buying back stock when it is depressed. Scarcity in the position of a company gives us that positive fundamental convexity.

The key element alongside all of that is a valuation margin of safety. If the future is uncertain, do not buy a company on the presumption that you can forecast decades of growth. Buy at a valuation where not much growth is priced in at all, so that if growth occurs, you get the benefit largely for free. This comes back to variegation: if you have not paid for growth and you have variegation in the portfolio, something will do well — perhaps unexpectedly — and you will capture that value.

Matthew McLennan

It is alluring, but very difficult to execute with discipline, and very difficult to take people with you given the volatility. Most out-of-the-money options expire either worthless or for less than the premium paid. One has to be careful, when looking at the track record of people who built great wealth through extreme concentration, that there is survivorship bias at work. You are looking at the handful who survived out of many thousands who tried and did not.

My deputy, Christian Heck, made an observation that has stayed with me: during World War II, if you owned a diversified portfolio of companies that people cannot do without, you did well over time. If you have companies people cannot do without and you hold quite a lot of them, you will be fine whatever happens. Variegation is the disciplined version of that insight.

Matthew McLennan

Real truths tend to be paradoxical. In business school you are taught that the risk-free asset is a Treasury bill: fixed principal, guaranteed coupon. On the other hand, a classic old master painting has no cash flow — in traditional finance theory, nothing to discount and therefore no value. Gold and a vacant block of land are similarly difficult to value by conventional means.

But the interesting thing is that reality in the fullness of time can differ sharply from the near-term picture. A Treasury has a fixed principal, but it does not have a fixed supply. The government's asset is its ability to tax its citizens, and there is probably a real level of taxation that is optimal — beyond which it hurts productivity, below which it impairs social stability. The government has a certain real taxing capacity. If it runs sustained large deficits, it is printing more fixed claims on that real asset. John Cochrane, in The Fiscal Theory of the Price Level, argues this is almost like a share split: keep issuing debt against the same real asset, and the real value of each unit of debt must fall. Fixed principal and fixed coupon assets may be risk-free in the short term, but they can be quite risky in the long term because they are not fixed in supply.

A positional asset is the inverse: its fixity of supply is what can make it a better store of real long-term value, even though its short-term price fluctuates and it may offer little current cash flow. A vacant block of land on a great beach will be cyclical, but it will reflect the purchasing power of people who want to build on it. It participates in real income growth over time, perhaps more securely than a Treasury where you cannot know the future supply of government bonds.

The same can be said of gold. Max Gonwar on our board fund has calculated that the total above-ground stock of gold — a couple of hundred thousand tonnes — could fit inside a cube built on the centre court of the US Open. New mining adds only about 1.5% to that cube each year. Central banks, private investors, and people who desire jewellery are all competing for that fixed positional asset. Its value has accreted with the wealth of those competing for it.

Businesses are somewhere in between. A great business can generate cash flow today and, if its market position is preserved, participate in the income growth of its customers over time. The best businesses combine free cash flow and preservation of purchasing power. But all businesses carry long-run fade risk — new entrants eat into the profit pool. A business is a productive asset but a melting ice cube. You want to find ones with a slow melt rate: those approach positional assets.

Matthew McLennan

First, credit to my predecessor, Jean-Marie Eveillard, who had always invested some portion of the fund in gold and had recognised that in extremis, gold has value as a potential hedge. Jean-Marie used to say: "Gold is not a commodity. Gold is money."

The common criticism of gold is that it is inert and useless. But I think the paradox is that the utility of gold as a hedge is precisely its uselessness as a commodity. Because it is chemically inert, it naturally lasts forever. Because it is not used primarily as a commodity, it has lower sensitivity to the business cycle. A commodity that rusts or rots is produced for use — oil, copper, iron ore will track the business cycle. The inertness of gold gives it a naturally lower sensitivity to cycles and a naturally longer duration.

Gold is also innate — and not much is innate in life. Great businesses need management to avoid fade risk. Bitcoin needs an active community of miners. Sovereigns need fiscal and monetary discipline for their paper to hold value. Commercial real estate needs management. Gold simply is. When we looked for an alternative that was innate, scarce, dense, and easy to store, we could not find much else. On the periodic table, most similarly dense materials are useful in superalloys or catalytic converters, or get radioactive as they get heavier, and many are brittle and not malleable.

Gold is essentially defensive land — the most defensive land — in scarce supply. Unlike traditional land that is landlocked to a given community, gold is mobile and competed for globally. I came to a simple conclusion: the equilibrium value of gold over time will pace with nominal wealth. Not a brilliant insight — a common-sense observation, and one for which I owe a great debt to Jean-Marie and many members of the team.

And because we appreciate gold, that does not mean we are gold bugs. The same logic applies to gold as to stocks: scarcity plus a valuation margin of safety. If you buy gold after it has done very well for a long period, it will remain scarce, but without a margin of safety it can go a decade or two in the wilderness. As gold has recovered from being depressed relative to equities and government debt, the risk-reward is more symmetrical than it was.

We still hold gold at a mid-teens percentage of the portfolio across bullion and miners. On pockets of strength, we will sell some so it does not become outsized — much as a bank might hold 15% Tier 1 capital and deploy the rest productively. There is a state of the world where gold has done very well, equities have collapsed, and gold is expensive relative to history: we might then recycle gold into equities on advantageous terms, and our gold position could fall from the mid-teens to the mid-single digits. We might feel we need less ballast if risk assets are compellingly valued.

Matthew McLennan

One area that has been quite out of favour is healthcare, and Becton Dickinson is a good illustration. The company has really honed its focus over the last few years: it spun out its diabetes business into Embecta, and recently completed a reverse Morris Trust exchanging its biosciences and diagnostics business for a stake in Waters. What remains is a world-leading franchise for syringes and catheters — every hospital encounter likely involves a Becton Dickinson product. They have more than half the world market.

That market share gives them scale economies in manufacturing and R&D, and they are embedded in the hospital system. Being closest to patients in the most locations creates a regenerative feedback loop: they know what technology to add to the syringe or catheter to make it more efficacious. The company is highly cash-flow generative, and because healthcare has been out of favour, it trades at 12 to 13 times earnings — an 8% earnings yield. The market prices in essentially no growth.

Yet if we think about positional assets: as more medications shift from pills to biologicals, syringes and catheters become more important. They are adding software and systems technology to deliver medications more efficiently. One could imagine AI allowing remote monitoring of dosing rather than a nurse checking every hour. That is a business with a scarce intangible market position, broad free cash flow, healthy dividends, and buybacks at depressed valuations — a royalty on a small slice of the world economy.

Matthew McLennan

In investing, mundane can be beautiful. Almost everyone wants an opinion on AI because it is the focal point of markets right now. By definition, trying to predict which company will be the greatest AI beneficiary is a highly competitive enterprise. Identifying a company with a very strong position in a small slice of the world economy is far less competitive.

Hoshizaki is a good example. It is the world leader in commercial ice machines: restaurants, hotels, stadiums. A niche technology where they have developed a reputation for the best quality, and at their scale they can produce quality at reasonable cost. Around that core, they have expanded into other areas of the commercial kitchen. The company is listed in Japan — not a household name — and trades at 8 to 9 times EBITDA, well below where most private-equity buyouts have been done. Their German competitor, Rational, trades at 20 times EBITDA.

Management have been great stewards long-term. Increasingly they are allocating capital more actively: paying good dividends, buying back stock, making small bolt-on acquisitions in complementary products. That shift is quite different from the norm in Japan a decade or two ago, when companies hoarded capital. It is a de facto royalty — not a royalty in the contractual sense, but given the strength of their market share, it functions as one. And it is certainly eclectic.

The mental model is the toll collector. If you think of a sequence of numbers from 1 to 3,000, only a certain percentage are prime — not derivatives of other numbers. Great businesses are like prime numbers. In the investable universe of several thousand companies worldwide, perhaps 10% are primes that really hold a scarce market position. At any given moment, most are fully valued. But if you are willing to own prime real estate in any of 400 major metropolitan areas, something will always be happening somewhere to bring prices to a level you want to buy at. Our waiting game is global and patient: it might take a decade to get a business we like at the right price, and then we plan to own it through the next decade.

Matthew McLennan

It is difficult psychologically because we are wired for annual cycle time. You go through school one grade to another, through university one year to another, and then you get your annual performance review. We are inherently impatient. And yet some of the most reliable sources of outperformance take a long time to play out.

Going back to the garden: stuff that grows quickly is not necessarily the best. Molière said something to the effect that the best fruit comes from the trees that are slowest to grow. The benefits of scarce market position — the cash flow generation, pricing power, free cash flow accumulation — do not make a huge difference in any given quarter or even over a year, but they accumulate over a decade. Sensible capital allocation decisions do not always look like the hot choice in any given moment, but over a decade they make a large difference: not deploying cash flow into something speculative, distributing it or buying back stock when the business is out of favour.

Likewise the degree to which a business has incumbency advantage. If it has a slower melt rate than the typical business, that does not much affect short-term sentiment, but over a decade of being more of a positional asset, it will make a difference. And demanding a valuation margin of safety — the 2 or 3% incremental earnings or free cash flow yield — does not dominate returns in the short term. In the short term, what dominates is sentiment shifts: risk on, risk off, beat the quarter or not, a war starting or ending. Over the long term, the power of arithmetic is ineluctable.

The average tenure in a mutual fund or hedge fund implies less than a one-year holding period. That is renting a business, not owning it. Some people do that very well. I will be the first to acknowledge we do not have a monopoly on the right approach. But that is not something we do well. We are patient investors because that is where we see the more reliable ability to add value. The challenge is keeping clients with you on that journey through stretches where patience is not rewarded.

Matthew McLennan

Firstly, you have to acknowledge it is not easy. Anyone who says it is easy is probably just insensitive to the cues of the environment. There were times when the whole team was doing what we thought was prudent stewardship, and people outside felt let down because we were not participating in what was working. That can be painful.

You step back and ask: what gave us conviction? Ultimately the knowledge that arithmetic does play out, as long as the businesses you bought were not fading faster than typical and you bought them at decent prices and they had something special that would accumulate and manifest, perhaps unpredictably. An analogy I have used: it is like making popcorn. You put the kernels in and heat them up, and it is very difficult to predict which one will pop and when. But if the process has integrity, most of it works out.

One thing that helped was focusing on the process itself, on the task at hand. There is a book that affected me in this regard: The Snow Leopard by Peter Matthiessen. It is about an individual who suffered an enormous personal loss and goes off in search of the snow leopard, not knowing whether he will find it. At the end, it is not about whether the mission was accomplished. It was about understanding that it is the task itself that matters, and the reward is in doing something well.

We spend a lot of time as a team asking: are we doing our research well? Are we really thinking about competitive advantage locally? Are we thinking rigorously about how to value intangible assets? Are we staying true to a time-tested approach? Focusing on the quality of the process is the real source of stamina. And there is something genuinely satisfying about doing something intrinsically worthwhile and having it rewarded episodically.

Matthew McLennan

Sometimes the act of seeking something makes it recede into the horizon. The snow leopard is a good metaphor for that — it senses your presence. Like a good Zen koan, the only resolution is to become at peace with the fact that you may never see it. Because that is its inherent specialness, its ability to remain elusive. That passage captures his arrival at wisdom.

There is a book by a University of Chicago economics professor, Galenson, called Young Geniuses and Old Masters. His hypothesis was that artists paint their best work in their late thirties or early forties, with enough experience but still enough energy. He looked at the historical record and found something bimodal instead: typically young artists had a stunning new insight and their best works were their first, or there were old masters who were chasing an asymptote and their last work was their best. For those of us who have not been fortunate enough to have a stunning early insight, there is at least the hope that you can chase some asymptote into your later years.

Matthew McLennan

It is a brilliant book, stunning in its breadth. McGilchrist is a polymath — neuroscience, philosophy, literature. If I could do it the injustice of condensing it to a key insight: we have grown up in a time following the Scottish Enlightenment where linear reductionist thinking is the perceived path forward, and AI is the ultimate manifestation of that. But what we think of as the scientific revolution and critical thinking is a very left-brain activity.

The right side of the brain behaves very differently: non-linear pattern recognition. Many psychological disorders involve patients with overactive left brains who are missing basic pattern recognition, empathy, and other right-brain capacities. The right brain recognises flow and emergence in systems, and the role that humans play in actualising potentiality and perceiving beauty.

The insight that stayed with me is that thinking about investing as a business gardener makes sense precisely because the market is not a machine. It cannot be digitised and reduced to specific models. It is an emergent system, inherently complex. You have to work with the elements — like Seneca's sailor — rather than imagine you sit outside the system and can predict the wind with precision.

Steve Wolfram showed in A New Kind of Science that unless a system is obviously simple, it is inherently computationally irreducible and almost equivalent to randomness. Markets have crossed a sufficient complexity threshold that even deterministic elements are very hard to rely on. The underlying economy is complex; markets are another layer of complexity incorporating expectations about that economy. It is complexity squared.

Matthew McLennan

Immanuel Kant provides an analogy here. Linear relationships are only really legible when you slice time at a small moment. If you look at an ant colony from above, it seems self-organised in a complex way; but at the level of individual ants, they are simply following pheromone trails to food. Drill down to the cellular dynamics, and it is complex again. Where you slice the system changes your sense of correlations.

The same applies to markets. And I would say both Munger and Dalio — despite their disciplined left-brain models — also had significant pattern recognition capacity. Munger talked about lollapalooza effects, incentives, human behaviour, empathy. Dalio saw big patterns in the evolution of systems — the history of fiat money, the relationship between China and the US. They were both looking at patterns as well as correlations.

My own take: some things have a directional skew that persists through the noise. Fiat money has agency costs — it is always easier to stimulate in a crisis, run deficits, hold rates at zero, than to do the opposite in good times. No one wants to take away the punch bowl. So while currencies and interest rates go through cycles, over time most forms of man-made money have been diluted or have died. You have to hold onto angles that persist through the noise, behavioural in nature. And you have to resist the temptation to predict everything all the time.

That brings us back to where we started: developing a portfolio that can endure through uncertainty. Recognising uncertainty is almost like recognising you may not see the snow leopard. It will certainly see you. Uncertainty will certainly impact you. But if you can structure your affairs to endure it, that is perhaps the most valuable lesson from all of this reading.

Matthew McLennan

You have hit the key points. I would add: it is not just about identifying businesses with scarcity, but being sensitive to your entry point from a valuation standpoint. You are most likely to benefit from those businesses if you have not paid much for growth. Scarcity plus value together position you well.

And just recognise that there is no silver bullet. If you sit entirely in cash, know that over time the growth rate of government debt will likely exceed the yield on that cash. You will have no short-term risk, but long-term you risk impairing your purchasing power. The only logically consistent reason to hold cash is what you think you can realistically deploy in a market drawdown. The return on that cash is not just the yield — it is the option value of buying a great business at a great price in a crisis. You need to be able to deploy it within a cycle to capture that option value.

We talked about gold, but even that is sensitive to valuation over the long term. And the final thing is the willingness to stick to an approach rather than chasing what is hot today. What is hot today is rather ephemeral, and it often results in very disappointing returns when market focus shifts or too much capital flows into a sector and drives returns down.

Matthew McLennan

If all you do is sit in front of a computer reading financial statements, it can become a rather left-brained activity — exactly the kind we were discussing with McGilchrist. If the goal is to promote pattern recognition and to see the world differently from other people, having interests outside linear inquiry is really important.

Backgammon is a good example. Many patterns that emerge in the game have given me analogies for portfolio construction. I love studying the great wines of the world — the selectivity, the curation, the patience of great winemakers has informed how I think about being a business gardener. Seeing it in a different field helped me better appreciate what it takes in my own.

Travel works the same way. If you go to Tokyo or Seoul or Paris, you see the world through a different lens from sitting in New York all the time. Trying new sports — sculling, the occasional golf lesson — takes your neural wiring to a level where you are uncomfortable, and I think that broadens your range. Being monolithically focused on the task, as wonderful as that is, tends to produce more left-brain thinking. Broad engagement with the world in the limited spare time you have is good for the right-brain activity, and it helps the art side of our business.

McGilchrist wrote: "I suspect that the appreciation of beauty is one of the things life is for." Going to a museum, following an artist who was painting 300 years ago, appreciating that beauty across time — that is its own reward. McGilchrist cites philosophers who have come to the notion that humans exist as a form of complex evolution so that the universe can perceive itself. Whether you are looking for beauty in a business, in a valuation entry point, in an old master painting, in the way you play a sport, or in the relationships you have — that is a uniquely human endeavour.

And I will close with a quote William shared with me from Abraham Heschel: "Mankind will not perish for want of information, but only for want of appreciation. The beginning of our happiness lies in the understanding that a life without wonder is not worth living." When I come to the office and I see a team of people, each in search of their own wonder in their different industries and personal lives — that is quite powerful. Cumulative team experience is a critical element of building an investment operation. That shared experience helps you understand how another person might be looking at a problem, and understand your own biases better than you can alone.

Matthew McLennan

Thank you, William. And for the listeners — the books that so moved me were actually recommendations of William's. It is important to surround yourself with people who help expand the way you think.