Klarman 1991 Interview with Barron's

This 1991 Barron's interview with Seth Klarman offers some intriguing insights into how Baupost got its start, and the nature of Klarman’s initial client base and business structure. Baupost currently manages ~$32 Billion AUM (per latest firm ADV), whereas ~24 years ago that figure stood at $400mm, and ~33 years ago only $27mm. Time + compounding + inflows can lead to staggering absolute sums. Clients

“My first real education in investing came when I took a summer job in my junior year at college with Max Heine and Mike Price at Mutual Shares. They invited me back to join them in January of '79. I worked there about 20 months until I left for business school. Just before graduation, I was offered the opportunity to join with several individuals who had decided to pool their assets and helped to form the Baupost Group to steward those assets. That was 9 1/2 years ago…These people are all still involved. They were never active day to day…They are wonderful partners…They are on the board of the company. They are partial owners of the company. And each of them has all of his liquid investable assets here, as do all the principals, all the people who run the money.”

“We set out at the beginning to be somewhat unconventional, with our clients acting as board members and as part owners. The incentive really was to do whatever it took to maximize the return on their money, not necessarily to grow a profitable business. Along the way, some decisions were made, including one to turn down most of the people who tried to become clients. We actually closed for new clients about five years ago. And we have grown from compounding ever since…over the years we have grown through word of mouth. In the earlier years, we grew beyond the initial three families, for a couple of reasons. One was that they had some friends who liked the idea of what we were trying to do and wanted to come in. They are the kind of people who say yes to friends. And also partly because we didn't want to be overly dependent on any one person for the success of our business going forward…There were the three families and I had a partner who was a part-time person who focused primarily on administrative matters… The compound return to investors after our profit-sharing arrangement has been 20%-25% in the limited partnerships…over the 8 3/4 years the partnerships have been in existence.”

“They correctly perceived that they could spend a lot of their time clipping coupons, collecting dividends, making sure that all the numbers were right. And it could become, if not a full-time job, at least one that consumed a substantial amount of their time. And these were the kind of people who didn't want to spend all their time just counting their money and paying attention to such details. So they pooled it to form Baupost.”

“We are blessed with a client base that is not short-term-oriented. I don't think any money manager knows how deep the reservoir of client goodwill is.”

Maximizing performance returns and building a profitable investment management business are not necessarily mutually inclusive objectives. The latter often requires quick AUM ramp. This is why seed investor arrangements can lead to potential conflicts.

Klarman and his capital partners first defined the goal and alignment of interest (usually the hardest part). The rest was structuring and execution. Baupost wasn’t conventional or unconventional, simply a solution to their circumstance and situation.

AUM

“Q: How much money do you manage? A: A little bit over $400 million. Q: And how much did you start with 10 years ago? A: $27 million.”

“Q: …Can we take it you stopped accepting new money because you think there is only a certain amount of money you can efficiently manage? A: That is a fair way to put it. There are dis-economies of scale in terms of the returns that can be earned on managed money. That probably kicks in a lot smaller than we are. It probably kicks in at $50 million or $100 million. But over the realm of all possible sizes, you just don't want to get beyond a certain level, particularly when you have an eclectic strategy like ours. There is only so much that you can buy that fits our kind of criteria. And we are comfortable at our current size. Q: So this is pretty much a matter of feel? A: That's right. I think we also want to stay small because it is frankly more fun. We enjoy the camaraderie of being a small firm with everybody doing work, and everybody understanding pretty much where we are going. The last thing I want to be is manager of a staff of a dozen analysts and portfolio managers. I wouldn't like that at all.”

Um, that obviously changed. A friend recently commented that all successful investors must eventually learn to manage larger amounts of capital. Why? Even without large inflows, compounding alone will force you into ever larger realms of AUM.

Mandate

“Q: Is this institutional money you're managing? A: All individual money. Q: It's really unusual to have that much individual money…”

“Q: Do you call yourself a hedge fund? A: No. We do not. We are compensated somewhat like hedge funds but do not hedge in the sense of always being long and short. We tend to be long investors. We are rarely on the short side.”

It’s okay to admit that you’re not a “hedge fund”…

“…perhaps most important, we are not just focusing on equities. We focus on any security of a company that is mispriced. We can even find some companies where one security, like the equity, is overvalued, but where another security, like the debt, might be undervalued. We have flexibility in our partnership agreement to do pretty much anything we like. Right now, and for the better part of the last two years, much of our investment has been in the senior securities of overleveraged companies.”

It puzzles me when people fixate on Baupost’s 13F (the latest discloses $5.9Bn worth of public equity assets). This is only ~18% of the firm’s total AUM. The remaining 82% is invested elsewhere included private real estate & bankruptcy workouts (such as a large position in Lehman).

“If you are asking, ‘Is there more competition in many of the areas that we are looking at?’ that is absolutely true. The good news is that first of all, we are flexible enough to not be committed in any single area. Take, for example, distressed securities. In 1985, as far as we can remember there was only one firm doing research in dis tress. That was R.D. Smith. In 1991, we check our faxes and our research reports, and we count 44 firms doing work in that area…So there is no question that there's now a crowd. The research coverage and Wall Street's attention to it have increased probably more than the considerable proliferation of opportunities in that area. So we have more competition. But we have flexibility, we also have patience. These people have special-purpose funds to do whatever it is they are doing, to do distressed securities, to do LBOs, whatever their funds are looking for. And when opportunities cease to exist, they will probably distribute the funds and go out of business. Already, we see many of the arbitrageurs from the 'Eighties disappear and go into new lines of business like distressed securities.”

Mandate flexibility provides a competitive advantage. Investing is a fiercely competitive. Why make your life harder by limiting where you may seek returns? Klarman may have lots of institutional capital today, but it didn’t start off that way. An institutional capital base may/will constrain the type of investments you can or can’t make.

AUM's Impact On Performance

People often remark that “AUM is the enemy of performance.” But is this truly always the case? Here’s another thought-provoking excerpt from Stephen Duneier of Bija Capital Management that explores the nuances of the AUM-Performance relationship. AUM, Expected Return, Sizing, Selectivity, Liquidity

“Since becoming a portfolio manager more than ten years ago, I have managed as little as $8 million and as much as $910 million. What did I do differently at each extreme? Nothing. On average, I had the same number of trades in the portfolio, structured the positions the same, analyzed the markets the same, generated trade write-ups the same, and in proportion to the overall portfolio, I sized the positions the same. Those are the relevant factors that investors should be asking about when it comes to AuM and here is why. With a minimal amount in AuM, you are clearly not confronted with capacity constraints, therefore you can be highly selective when choosing among opportunities, allowing for optimal portfolio composition. While operating below your capacity constraint, the portfolio composition runs within a fairly steady range. So how do you identify the limits of a PM's capacity? 

Well there are two determinants of capacity. One is internal (mental) and the other is external (market). For those trained as prop traders and PMs within large organizations, you are typically allocated risk rather than capital, which means you think of gains and losses in notional terms. That makes for a difficult adjustment to the world of proportional returns, and particularly shifts in AuM, thereby prematurely capping either AuM growth, or the risk and returns on it. The external constraint is market liquidity per trade or structure. So long as I can maintain the same proportional exposure to a given position, I remain under my capacity limit. Once I have to increase the number of trades in order to maintain the same overall proportional risk exposure, I have breached max capacity for my style. You see, before you reach capacity, you are selecting only the best ideas and expressing them via the optimal structures. You could do more, but you choose not to. When your overall risk budget gets to a point where you cannot maintain the same overall exposure with the same number of trades, you must begin adding less optimal structures and even ideas of lesser conviction. That is the true signal of having breached your maximum capacity.”

Consequences of Contrarian Actions

Below are excerpts from a speech Bob Rodriguez of First Pacific Advisors gave in May 2009. Quite a few interesting lessons derived from his previous trials and tribulations in dealing with clients and redemptions during periods of contrarian actions and underperformance. Psychology

“I believe I have found success because I have been deeply aware of the need to balance the human emotions of greed and fear. In a word, DISCIPLINE…is a key attribute to becoming a successful investor. I stress that, without a strong set of fundamental rules or a core philosophy, they will be sailing a course through the treacherous investment seas without a compass or a rudder.”

AUM, Clients, Redemptions, Patience

“It seems as though it was a lifetime ago in 1986, when I had few assets under management, and the consultant to my largest account insisted that, if I wanted to continue the relationship, I had to pay to play. I was shocked, dismayed and speechless. Though this would probably have never become public, if I had agreed, how would I have ever lived with myself? By not agreeing, it meant that I would lose nearly 40% of my business. When I was fired shortly thereafter, this termination compromised my efforts in the raising of new money for nearly six years because I could not say why. Despite pain and humiliation, there was no price high enough for me to compromise my integrity. With the subsequent disclosure of improprieties at this municipal pension plan, the cloud of suspicion over me ultimately lifted. I not only survived, I prospered.”

“While technology and growth stock investing hysteria were running wild, we did not participate in this madness. Instead, we sold most of our technology stocks. Our ‘reward’ for this discipline was to watch FPA Capital Fund’s assets decline from over $700 million to just above $300 million, through net redemptions, while not losing any money for this period. We were willing to pay this price of asset outflow because we knew that, no matter what, our investment discipline would eventually be recognized. With our reputation intact, we then had a solid foundation on which we could rebuild our business. This cannot be said for many growth managers, or firms, who violated their clients’ trust.”

“Having the courage to be different comes at a steep price, but I believe it can result in deep satisfaction and personal reward. As an example, FPA Capital Fund has experienced heavy net redemptions since the beginning of 2007, totaling more than $700 million on a base of $2.1 billion. My strong conviction that an elevated level of liquidity was necessary, at one point reaching 45%, placed me at odds with many of our shareholders. I estimate that approximately 60% left because of this strategy…We have been penalized for taking precautionary measures leading up to and during a period of extraordinary risk. Though frustrating, in our hearts, we know that our long-term investment focus serves our clients well. I believe the words of John Maynard Keynes…‘Investment based on genuine long-term expectations is so difficult today as to be scarcely practicable,’ and ‘It is the long-term investor, he who most promotes the public interest, who will in practice come in for the most criticism wherever investment funds are managed by committees or boards or banks. For it is the essence of his behavior that he should be eccentric, unconventional, and rash in the eyes of average opinion.’”

“I believe superior long-term performance is a function of a manager’s willingness to accept periods of short-term underperformance. This requires the fortitude and willingness to allow one’s business to shrink while deploying an unpopular strategy.”

As I write this, the world’s smallest violin is playing in the background, yet it must be said: what about clients violating a fund’s trust by redeeming capital at inopportune times to chase performance elsewhere? The trust concept flows both ways.

There will be times in every fund manager’s career when doing what you believe is right will trigger negative consequences. The key is anticipation, preparation, and patience.

Historical Performance Analysis, Luck, Process Over Outcome, Mistakes

“Let’s be frank about last year’s performance, it was a terrible one for the market averages as well as for mutual fund active portfolio managers. It did not matter the style, asset class or geographic region. In a word, we stunk. We managers did not deliver the goods and we must explain why. In upcoming shareholder letters, will this failure be chalked up to bad luck, an inability to identify a changing governmental environment or to some other excuse? We owe our shareholders more than simple platitudes, if we expect to regain their confidence.”

“If they do not reflect upon what they have done wrong in this cycle and attempt to correct their errors, why should their investors expect a different outcome the next time?”

Examine your historical performance not only to provide an explanation to your clients, but also to yourself. For example, was there anything that you could have done to avoid the “stink”?

Rodriquez mentions “bad luck.” During this reflective process (which ideally should occur during times of good and bad performance) it’s important to understand whether the returns resulted due to luck or to skill. See Michael Mauboussin & James Montier’s commentary on Process Over Outcome & Luck.

Psychology, When To Sell, When To Buy

“Investors have long memories, especially when they lose money. As an example, prior to FPA’s acquisition of FPA Capital Fund in July 1984, the predecessor fund was a poster child for bad performance from the 1960s era. Each time the fund hit a $10 NAV, it would get a raft of redemptions since this was its original issue price and investors thought they were now finally even and just wanted out.”

Anchoring is a powerful psychological bias that can compel investors to buy and sell for the wrong reasons, as well as to allow those who recognize the phenomenon to take advantage of the bad decisions of others.

Is the opposite true: investors have short memories when they’re make money?

Buffett Partnership Letters: 1968 & 1969

During 1969, the Partnership transitioned into Berkshire Hathaway. Therefore this concludes our series on portfolio management and the Buffett Partnership Letters. Please see our previous articles in this series. Control, Hurdle Rate, Compounding, When To Sell

“…controlled companies (which represent slightly over one-third of net assets at the beginning of the year)…we cannot make the same sort of money out of permanent ownership of controlled businesses that can be made from buying and re-selling such businesses, or from skilled investment in marketable securities. Nevertheless, they offer a pleasant long term form of activity (when conducted in conjunction with high grade, able people) at satisfactory rates of return.”

“Particularly outstanding performances were turned in by Associated Cotton Shops, a subsidiary of DRC run by Ben Rosner, and National Indemnity Company, a subsidiary of B-H run by jack Ringwalt. Both of these companies earned about 20% on capital employed in their businesses.”

We’ve previously written that portfolio capital compounding can be achieved in multiple ways:

• “Compounding can be achieved by the portfolio manager / investor when making investments, which then (hopefully) appreciates in value, and the repetition of this cycle through the reinvestment of principal and gains. However, this process is limited by time, resources, availability of new ideas to reinvest capital, etc.”

• Compounding can be achieved by operating entities owned in the portfolio by “reinvesting past earnings back into the same business (or perhaps new business lines). In this respect, the operating business has an advantage over the financial investor, who must constantly search for new opportunities.”

In the quotes above, Buffett was referring to the latter method.

Toward the end of the Partnership, Buffett struggled with the continuous churn & reinvestment process as prices in the marketplace rose and rendered good capital reinvestment opportunities difficult to find. Enter the attractiveness of leaving capital with operating entities (in which he had a controlling stake) that can generate profits (compound) & reinvestment capital, at “satisfactory rates of return,” without Buffett having to watch too closely (provided he found “high grade, able people” to oversee these control investments).

Buffett seemed agnostic between the two as long as the control situations produced “satisfactory rates of return.” As always, the devil lies in the details: what is a “satisfactory rate of return”? Was this figure Buffett’s mental hurdle rate?

Nevertheless, this serves as an useful reminder to investors today that the process of buying and selling assets is not the only way to compound and generate portfolio returns. In fact, sometimes it’s better to hold on to an asset, especially when good reinvestment opportunities are rare.

Process Over Outcome

“It is possible for an old, over-weight ball player, whose legs and batting eye are gone, to tag a fast ball on the nose for a pinch-hit home run, but you don’t change your line-up because of it.”

AUM, Sizing

“…our $100 million of assets further eliminates a large portion of this seemingly barren investment world, since commitments of less than about $3 million cannot have a real impact on our overall performance, and this virtually rules out companies with less than about $100 million of common stock at market value…”

Returning Capital

For those searching for language related to returning capital, the letter dated May 29^th, 1969 is a must read.

An Interview with Bruce Berkowitz - Part 2

Part 2 of portfolio management highlights extracted from an August 2010 WealthTrack interview with Consuelo Mack (in my opinion, WealthTrack really is an underrated treasure trove of investment wisdom). Be sure to check out Part 1.

AUM, Compounding, Subscription, Redemptions

“MACK: There’s a saying on Wall Street...that size is the enemy of performance…

BERKOWITZ: …we think about this every day. And, the important point is that, as the economy still is at the beginning of a recovery, and there's still much to do…we can put the money to work. The danger's going to be when times get better, and there's nothing to do, and the money keeps flocking in. That obviously is going to be a point we're going to have to close down the fund...But of course, it's more than that. Because if we continue to perform, which I hope we do, 16 billion's going to become 32, and 32's going to become 64.”

Berkowitz makes a great point. It’s not just subscriptions and redemptions that impact assets under management. Natural portfolio (upward or downward) compounding will impact AUM as well.

We’ve discussed before: there’s no such thing as a “right” AUM, statically speaking. The “right” number is completely dependent upon opportunities available and market environment.

AUM, Sourcing

"CONSUELO MACK: …as you approached 20 billion under management, has the size affected the way you can do business yet?

BRUCE BERKOWITZ: Yes. It's made a real contribution. How else could we have committed almost $3 billion to GGP, or to have done an American Credit securitization on our own, or help on a transformation transaction with Hertz, or offer other companies to be of help in their capital structure, or invest in CIT, or be able to go in with reasonable size? It's helped, and we think it will continue to help…”

In some instance, contrary to conventional Wall Street wisdom, larger AUM – and the ability to write an extremely large equity check – actually helps source proprietary deals and potentially boost returns.

Diversification, Correlation, Risk

“MACK: Just under 60% of his stock holdings are in companies such as AIG, Citigroup, Bank of America, Goldman Sachs, CIT Group and bond insurer, MBIA…your top 10 holdings…represent two-thirds of your fund, currently?

BERKOWITZ: Yes…we always have focused. And we're very aware of correlations…When times get tough, everything's correlated. So, we're wary. But we've always had the focus. Our top four, five positions have always been the major part of our equity holdings, and that will continue.”

“…the biggest risk would be the correlation risk, that they all don't do well.”

Weirdly, or perhaps appropriately, for someone with such a concentrated portfolio, Berkowitz is acutely aware of correlation risk. Better this than some investors who think they have “diversified” portfolios of many names only to discover that the names are actually quite correlated even in benign market environments.

As Jim Leitner would say, “diversification only works when you have assets which are valued differently…”

Making Mistakes, Sizing

“What worries me is knowing that it's usually a person's last investment idea that kills them…as you get bigger, you put more into your investments. And, that last idea, which may be bad, will end up losing more than what you've made over decades.”

For more on this, be sure to see a WealthTrack interview with Michael Mauboussin in which he discusses overconfidence, and how it can contribute to portfolio management errors such as bad sizing decisions.

Creativity, Team Management, Time Management

“…once we come up with a thesis about an idea, we then try and find as many knowledgeable professionals in that industry, and pay them to destroy our idea…We're not interested in talking to anyone who’ll tell us why we're right. We want to talk to people to tell us why we're wrong, and we're always interested to hear why we're wrong…We want our ideas to be disproven.”

According to a 2010 Fortune Magazine article, there are “20 or so full-time employees to handle compliance, investor relations, and trading. But there are no teams of research analysts.” Instead, “Berkowitz hires experts to challenge his ideas. When researching defense stocks a few years ago, he hired a retired two-star general and a retired admiral to advise him. More recently he's used a Washington lobbyist to help him track changes in financial-reform legislation.”       

This arrangement probably simplifies Berkowitz’s daily firm/people management responsibilities. Afterall, the skills necessary for successful investment management may not be the same as those required for successful team management.

When To Sell, Expected Return, Intrinsic Value, Exposure

“MACK: So, Bruce, what would convince you to sell?

BERKOWITZ: It's going to be a price decision…eventually…at what point our investments start to equate to T-bill type returns.”

As the prices of securities within your portfolio change, so too do the future expected returns of those securities. As Berkowitz points out, if the prices of his holdings climbed high enough, they could “start to equate to T-bill type returns.”

So with each movement in price, the risk vs. reward shifts accordingly. But the main question is what actions you take, if any, between the moment of purchase to when the future expected return of the asset becomes miniscule.

For more on his, check out Steve Romick's thoughts on this same topic. 

UPDATE:

Here’s a 2012 Fortune Magazine interview with Bruce Berkowitz, as he looks back and reflects upon the events that took place in the past 3 years:

Cash, Redemptions, Liquidity, When To Sell

“I always knew we'd have our day of negative performance. I'd be foolish not to think that day would arrive. So we had billions in cash, and the fund was chastised somewhat for keeping so much cash. But that cash was used to pay the outflows, and then when the cash started to get to a certain level, I began to liquidate other positions.”

“The down year was definitely not outside of what I thought possible. I was not as surprised by the reaction and the money going out as I was by the money coming in. When you tally it all up, we attracted $5.4 billion in 2009 and 2010 into the fund and $7 billion went out in 2011. It moves fast.”

Although Berkowitz was cognizant of the potential devastating impact of redemptions and having to liquidate positions to raise cash (as demonstrated by the 2010 interview, see Part 1), he still failed to anticipate the actual magnitude of the waves of redemptions that ultimately hit Fairholme.

I think this should serve as food for thought to all investors who manage funds with liquid redemption terms.

Buffett Partnership Letters: 1966 Part 1

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Conservatism, Volatility

“Proponents of institutional investing frequently cite its conservative nature. If ‘conservatism’ is interpreted to mean ‘productive of results varying only slightly from average experience,’ I believe the characterization is proper…However, I believe that conservatism is more properly interpreted to mean ‘subject to substantially less temporary or permanent shrinkage in value than total experience.’” 

“The first might be better labeled ‘conventionalism’ what it really says is that ‘when others are making money in the general run of securities, so will we and to about the same degree; when they are losing money, we’ll do it at about the same rate.’ This is not to be equated with ‘when others are making it, we’ll make as much and when they are losing it, we will lose less.’ Very few investment programs accomplish the latter – we certainly don’t promise it but we do intend to keep trying.”

Notice Buffett’s definition of conservatism in investing involves both “temporary or permanent shrinkage in value” – this is in contrast to a later Buffett who advises shrugging off temporary shrinkages in value. Why this change occurred is subject to speculation.

The second quote is far more interesting. Buffett links the concept of conservatism with the idea of portfolio volatility upside and downside capture vs. an index (or whatever industry benchmark of your choosing).

Ted Lucas of Lattice Strategies wrote an article in 2010 attributing Warren Buffett’s investment success to Buffett’s ability, over a long period of time, to consistently capturing more upside than downside volatility vs. the S&P 500. Based on the quote above, Buffett was very much cognizant of the idea of portfolio volatility upside vs. downside capture, so Ted Lucas’ assertion may very well be correct.

Sizing, AUM

“In the last three years we have come up with only two or three new ideas a year that have had such an expectancy of superior performance. Fortunately, in some cases, we have made the most of them…It is difficult to be objective about the causes for such diminution of one’s own productivity. Three factors that seem apparent are: (1) a somewhat changed market environment; (2) our increased size; and (3) substantially more competition.

It is obvious that a business based upon only a trickle of fine ideas has poorer prospects than one based upon a steady flow of such ideas. To date the trickle has provided as much financial nourishment as the flow…a limited number of ideas causes one to utilize those available more intensely.”

Sizing is important because when good ideas are rare, you have to make the most of them. This is yet another example of how, when applied correctly, thoughtful portfolio construction & management could enhance portfolio returns.

As AUM increases or declines, and as availability of ideas ebb and flow – both of these factors impact a wide variety of portfolio management decisions.

When To Buy, Intrinsic Value, Expected Return , Opportunity Cost

“The quantitative and qualitative aspects of the business are evaluated and weighted against price, both on an absolute basis and relative to other investment opportunities.”

“…new ideas are continually measured against present ideas and we will not make shifts if the effect is to downgrade expectable performance. This policy has resulted in limited activity in recent years…”

Buffett’s buying decision were based not only on the relationship between purchase price and intrinsic value, but also contribution to total “expectable performance,” and an investment’s merits when compared against “other investment opportunities,” the last of which is essentially an opportunity cost calculation.

Sizing, Diversification

“We have something over $50 million invested, primarily in marketable securities, of which only about 10% is represented by our net investment in HK [Hochschild, Kohn, & Co]. We have an investment of over three times this much in a marketable security…”

Hochschild, Kohn = 10% NAV

Another investment = “three times” size of Hochschild, or ~30% NAV

So we know in 1966, 40% of Buffett’s portfolio NAV is attributable to 2 positions.

Buffett Partnership Letters: 1965 Part 4

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. AUM, Trackrecord, Sizing

“…I believe that we have done somewhat better during the past few years with the capital we have had in the Partnership than we would have done if we had been working with a substantially smaller amount. This was due to the partly fortuitous development of several investments that were just the right size for us – big enough to be significant and small enough to handle.

I now feel that we are much closer to the point where increase sized may prove disadvantageous…What may be the optimum size under some market and business circumstances can be substantially more or less than optimum under other circumstances…as circumstances presently appear, I feel substantially greater size is more likely to harm future results than to help them.”

Asset under management (“AUM”) should not be a stagnant or passive consideration. The AUM is essentially the denominator in the return on equity calculation. The adjustment of AUM relative to portfolio gain and loss will directly impact the trackrecord. The optimal AUM will fluctuate depending on market conditions and/or opportunities available.

However, how to “adjust” AUM is a whole other can of worms.

Historical Performance Analysis, Special Situations, AUM, Expected Return, Hurdle Rate, Sizing, Time Management

“The ‘Workout’ business has become very spasmodic. We were able to employ an average of only $6 million during the year…and this involved only a very limited number of situations. Although we earned about $1,410,000, or about 23 ½% on average capital employed (this is calculated on an all equity basis...), over half of this was earned from one situation. I think it unlikely that a really interesting rate of return can be earned consistently on large sums of money in this business under present conditions.”

Over the previous 10 years, a portion of Buffett’s portfolio was consistently invested in special situations. But we see from that quote above that with AUM increasing, Buffett began to reconsider the allocation to this basket after examining its historical return contribution.

• Does the expected return available meet my minimum return standards (hurdle rate)?
• If so, can I deploy enough capital into the basket such that it contributes meaningfully to portfolio performance and absolute profts? (For example, a 1% allocation that returns 100%, while a return high percentage-wise, adds only a little boost to overall portfolio performance)
• How much of my (or my team’s) time am I will to allocate given the expected return and profits?

Perhaps another interesting lesson is that as AUM shifts, strategies that made sense at one point, may not always be as effective.

Sourcing, Sizing

“I do not have a great flood of good ideas as I go into 1966, although again I believe I have at least several potentially good ideas of substantial size. Much depends on whether market conditions are favorable for obtaining a larger position.”

Good ideas, even just a few, when sized correctly will lead to profits.

Conversely, ideas – no matter how good – if sized too small or impossible to obtain in adequate size for the portfolio, won’t make much of a difference.

Selectivity, Sizing, Expected Return, Opportunity Cost, Hurdle Rate, Correlation, Capital Preservation

“We are obviously only going to go to 40% in very rare situations – this rarity, of course, is what makes it necessary that we concentrate so heavily when we see such an opportunity. W probably have had only five or six situations in the nine-year history of the Partnership where we have exceeded 25%. Any such situations are going to have to promise very significantly superior performance relative to the Dow compared to other opportunities available at the time.

They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal (anything can happen on a short-term quotational basis which partially explains the greater risk of widened year-to-year variations in results). In selecting the limit to which I will go in any one investment, I attempt to reduce to a tiny figure the probability that the single investment (or group, if there is intercorrelation) can produce a result for our total portfolio that would be more than ten percentage points poorer than the Dow.”

Buffett’s sizing decisions were selective, and dependent upon a number of conditions, such as:

• The expected return of the potential investment
• The expected return of the potential investment compared with the expected return of the Dow, and other potential investments (this is the opportunity cost and hurdle rate consideration)
• Whether the potential investment is correlated with other current and potential investments
• The possibility of expected loss of the potential investment (capital preservation consideration)

When To Buy

“Our purchase of Berkshire started at a price of $7.60 per share in 1962…the average cost, however, was $14.86 per share, reflecting very heavy purchases in early 1965…”

Buffett was comfortable buying as prices went up. This is in contrast to many value investors who are most comfortable buying on the way down.

More Baupost Wisdom

Before my November vacation, I will leave you with a juicy Baupost piece compiled through various sources that shall remain confidential. Instead of the usual excerpts or quotes, below are summaries of ideas and concepts. Creativity, Making Mistakes

• False precision is dangerous. Klarman doesn’t believe that a computer can be programmed to invest the way Baupost does. (Does this mean their research, portfolio monitoring, and risk management process does not involve computers? Come to think of it, that would be pretty cool. Although it would make some administrative tasks more difficult, are computers truly necessary for the value-oriented fundamental investor?)
• Investing is a highly creative process, that’s constantly changing and requiring adaptations
• One must maintain flexibility and intellectual honesty in order to realize when a mistake has been made, and calibrate accordingly
• Mistakes are also when you’re not aware of possible investment opportunities because this means the sourcing/prioritization process is not optimal

When To Buy, Conservatism, Barbell

• Crisis reflection – they invested too conservatively, mainly safer lower return assets (that would have been money good in extremely draconian scenarios). Instead, should have taken a barbell approach and invested at least a small portion of the portfolio into assets with extremely asymmetric payoffs (zero vs. many multiples)

When To Buy, Portfolio Review

• They are re-buying the portfolio each day – an expression that you’ve undoubtedly heard from others as well. It’s a helpful concept that is sometimes forgotten. Forces you to objectively re-evaluate the existing portfolio with a fresh perspective, and detachment from any existing biases, etc.

Risk

• They try to figure out how “risk is priced”
• Risk is always viewed on an absolute basis, never relative basis
• Best risk control is finding good investments

Hedging

• Hedges can be expensive. From previous firm letters, we know that Baupost has historically sought cheap, asymmetric hedges when available. The takeaway from this is that Baupost is price sensitive when it comes to hedging and will only hedge selectively, not perpetually
• Prefer to own investments that don’t require hedges, there is no such thing as a perfect hedge
• Bad hedges could make you lose more than notional of original investment

Hedging, Sizing

• In certain environments, there are no cheap hedges, other solution is just to limit position sizing

Cash, AUM

• Ability to hold cash is a competitive advantage. Baupost is willing to hold up to 50% cash when attractive opportunities are not available
• The cash balance is calculated net of future commitments, liabilities, and other claims. This is the most conservative way.
• Reference to “right-sizing” the business in terms of AUM. They think actively about the relationship between Cash, AUM, and potentially returning capital to investors.

Returning Capital, Sizing

• Returning capital sounds simplistic enough, but in reality it’s quite a delicate dance. For example, if return cash worth 25% of portfolio, then capital base just shrank and all existing positions inadvertently become larger % of NAV.

Leverage

• Will take on leverage for real estate, especially if it is cheap and non-recourse

Selectivity

• Only 1-2% of deals/ideas looked at ultimately purchased for portfolio (note: not sure if this figure is real estate specific)

Time Management, Sizing

• Intelligent allocation of time and resources is important. It doesn’t make sense to spend a majority of your (or team’s) time on positions that end up only occupying 30-50bps of the portfolio
• Negative PR battles impact not only reputation, they also take up a lot of time – better to avoid those types of deals
• Klarman makes a distinction between marketing operations (on which he spends very little time) and investment operations (on which he spend more time).

Team Management

• There is a weekly meeting between the public and private group to share intelligence and resources – an asset is an asset, can be accessed via or public or private markets – doesn’t make sense to put up wall between public vs. private.
• Every investment professional is a generalist and assigned to best opportunity – no specialization or group barriers.
• Culture! Culture! Culture! Focus on mutual respect, upward promotion available to those who are talented, and alignment of interest
• Baupost has employees who were there for years before finally making a large investment – key is they don’t mind cost of keeping talented people with long-term payoff focus
• Succession planning is very important (especially in light of recent Herb Wagner departure announcement)
• The most conservative avenue is adopted when there is a decision disagreement
• They have a team of people focused on transaction structuring

Trackrecord

• Baupost invests focusing on superior long-term returns, not the goal of ending each year with a positive return. We have talked about this before, in relation to Bill Miller’s trackrecord – despite having little logical rationale, an investor’s performance aptitude is often measured by calendar year end return periods. Here, Klarman has drawn a line in the sand, effective saying he refuses to play the calendar year game

Sourcing

• Differentiated sourcing creates opportunities via better pricing, less competition, etc. Learned from Michael Price (or perhaps Max Heine’s playbook) – focused on differentiated sourcing, something that public investors generally don’t think about.

Superinvestors of Graham-and-Doddsville

The following portfolio management related excerpts are extracted from Superinvestors of Graham-and-Doddsville, an article based on a speech Warren Buffett gave at Columbia Business School on May 17, 1984  

Risk, Expected Return. Volatility

“Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, ‘I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million.’ I would decline – perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice – now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.

One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now so the person who would have paid $400 million would not have been crazy.

Now if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million and $80 million.”

Risk and reward is not always positively correlated, as traditional financial theory seems to suggest. (For further elaboration on this relationship, be sure to read Chapter 5 of Howard Marks’ book.)

On volatility, although Buffett doesn’t use historical volatility (historical beta) as a measure of risk when determining which securities to purchase, he never explicitly says that investors should ignore future volatility.

Perhaps this is the distinction – observed historical volatility vs. anticipation of future volatility – that reconciles value investing and volatility (price movement) considerations.

Historical volatility should not play a central role in investment decisions (because historical volatility is a bad predictor of future outcome). However, investors (even those from Graham-&-Doddsville) should pay attention to and anticipate future volatility because it impacts the portfolio return stream, as well as other cash, opportunity cost, and firm management considerations.

Expected Return, AUM

“When I wound up Buffett Partnership I asked Bill [Ruane] if he would set up a fund to handle all of our partners so he set up the Sequoia Fund…Bill was the only person I recommended to my partners, and I said at the time that if he achieved a four point per annum advantage over the Standard & Poor’s, that would be solid performance. Bill has achieved well over that, working with progressively larger sums of money. That makes things much more difficult. Size is the anchor of performance. There is no question about it.”

During the Partnership days (starting around 1957), Buffett’s goal was to beat the Dow by 10% annually over a long period of time. By 1970, based on the quote above, Buffett thought a 4% annual outperformance over the S&P would be “solid.”

The decline in expected return is either an indication that (1) Buffett believed he could achieve higher returns than Bill Ruane, or (2) Buffett’s portfolio expected return changes with the market environment – with the latter as the more probable explanation.

This idea of shifting expected return is directly applicable to the “equities = annual 8% return” mentality that’s still prevalent among investors today, and fueling all sorts of problems. Ahem, pensions. Future investment returns are a function of market environments and available purchase price, not previously determined or historical return rates – this is true for all investors, including Warren the Great.

Interestingly, Buffett’s expected return figure seems to have declined even further in recent days. At the 2012 Berkshire meeting, to roughly paraphrase Buffett (based on notes taken by Ben Claremon, the Innoculated Investor):

“Todd [Combs] and Ted [Weschler] get a few million dollars in salary and then get 10% of how much they beat the S&P by. This is measured on a rolling, 3 year basis.”

The margin of outperformance above the S&P or Dow has now altogether disappeared. Today, the goal is simply to beat the index.

On AUM, Buffett knew/believed from the very beginning (we see evidence of this circa 1963 in the Partnership letters) that increasing assets under management can lead to declining performance. We see this again above in this statement that “size is the anchor of performance.”

So, why then did Berkshire get so big? Or was this AUM-Performance rule only true “on average,” and talented investors were exempt?

Buffett Partnership Letters: 1963 Part 3

Continuation in a series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Topics covered include: When To Buy, When To Sell, Activism, Catalyst, AUM When To Buy, Activism, Catalyst, Control

“…controls develop from the general category. They results from situations where a cheap security does nothing price-wise for such an extended period of time that we are able to buy a significant percentage of the company’s stock…Whether we become active or remain relatively passive at this point depends upon our assessment of the company’s future and the management’s capabilities.”

“We do not want to get active merely for the sake of being active. Everything else being equal I would much rather let others do the work. However, when an active role is necessary to optimize the employment of capital, you can be sure we will not be standing in the wings.”

“Active or passive, in a control situation there should be a built-in profit…Our willingness and financial ability to assume a controlling position gives us two-way stretch on many purchases in our group of generals. If the market changes its opinion for the better, the security will advance in price. If it doesn’t, we will continue to acquire stock until we can look to the business itself rather than the market for vindication of our judgment.” 

Warren Buffett is renowned for his strong stomach, and willingness to continuously purchase and ingest increasing stakes as falling prices deter others. I believe the quote above holds the rationale behind this courageous behavior.

I think it's important to point out, that for each purchasing quest as the price falls, there exists a tipping point – the point at which Buffett obtains a controlling position – such that if the market continues to undervalue the asset, he will “look to the business itself rather than the market for vindication,” thus unlocking value by enacting his own catalyst as a control/majority investor.

Many investors attempt to emulate Buffett’s strong-stomach approach. However, I would advise caution to those investors with limited cash resources or asset under management, without which investors could end up with too much of his/her portfolio in a minority stake of an asset that remains perpetually undervalued.

AUM

“Our rapid increase in assets always raises the question of whether this will result in a dilution of future performance. To date, there is more of a positive than inverse correlation between size of the Partnership and its margin over the Dow…Larger sums may be an advantage at times and a disadvantage at others. My opinion is that our present portfolio could not be improved if our assets were $1 million or $5 million. Our idea inventory has always seemed to be 10% ahead of our bank account. If that should change, you can count on hearing from me.”

I have heard it remarked that capital is the enemy of return. This is true under many circumstances, however in some instances, as Buffett outlines above, a large capital base has its benefits. For example, see our discussion above on When To Buy, Activism, Catalyst, and Control.

When To Sell

“Our business is making excellent purchases – not making extraordinary sales.”

Buffett Partnership Letters: 1961 Part 1

This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. During 1961, Buffett started to write semi-annual letters because his clients told him the annual letter was “a long time between drinks.” The summary below is derived from the first of two letters written about the results of 1961.

Separate Accounts, Fee Structure

The business underwent conversion from multiple separately managed accounts to a pooled partnership vehicle. Buffett grappled with housekeeping issues such as proper allocation of “future tax liability due to unrealized gains” during the transition process since all the different partnerships would contribute different tax liabilities to the new pooled vehicle.

More interesting is the fee structure of the Buffett Partnerships. The new pool vehicle would charge 0% management fees, 25% incentive fee above a 6% hurdle, and “any deficiencies in earnings below the 6% would be carried forward against future earnings, but would not be carried back.”

Previously, the multiple partnerships had a number of different fee structures including:

1. 6% Hurdle, 33.33% incentive fee
2. 4% Hurdle, 25.00% incentive fee
3. 0% Hurdle, 16.67% incentive fee

Additionally, Buffett provides his clients with a unique liquidity mechanism to supplement the annual redemption window:

“The right to borrow during the year, up to 20% of the value of your partnership interest, at 6%, such loans to be liquidated at yearend or earlier. This will add a degree of liquidity to an investment which can now only be disposed of at yearend…I expect this to be a relatively unused provision, which is available when something unexpected turns up and a wait until yearend to liquidate part or all of a partner’s interest would cause hardship.”

AUM

“Estimated total assets of the partnership will be in the neighborhood of $4 million, which enables us to consider investments such as the one mentioned earlier in this letter, which we would have had to pass several years ago.”

Buffett was cognizant of the relationship between AUM and his fund’s investment strategy. I suspect the investment “mentioned earlier in this letter” was an activist situation which required him owning an influential or controlling stake in the company – therefore requiring a minimum amount of capital commitment, now made possible by the higher total partnership assets of $4 million.

Portfolio managers are not the own ones who should monitor the AUM figure. The relevance of the relationship between AUM and a fund’s investment strategy has wider implications. For example, investors who allocate capital to funds should also be monitoring AUM and asking whether the changes in AUM impact a fund’s ability to generate returns due to sizing, strategy shift / drift, changing opportunity sets, etc.

Expected Return, Catalyst, Risk

“We have also begun open market acquisitions of a potentially major commitment which I, of course, hope does nothing marketwise for at least a year. Such a commitment may be a deterrent to short range performance but it gives strong promise of superior results over a several year period combined with substantial defensive characteristics.

The above quote highlights two important portfolio management topics.

First: the concept of “yield to catalyst.” Similar in concept to yield to call or maturity for bonds, it’s the annualized return between today to until the catalyst or price target occurrence – a sort of expected annualized return figure. In this situation, the price target was high enough that even if the security “does nothing for at least a year,” the “superior results over a several year period” was enough to make the investment worthwhile. For his basket of “work-outs” (see our 1957 Part 1 post for more details on this), the price target was usually lower, but the catalyst was usually not far away, therefore the yield to catalyst was still adequately high to justify an investment.

Second: the concept of risk-adjusted return. This one is slightly more difficult to estimate since “risk” is a squishy term and difficult to quantify. In the quote above, Buffett references the “substantial defensive characteristics” of the investment. This indicates that he is measuring the return against the risk profile. Unfortunately, he does not give any details as to how he defines risk, or does that math.

Klarman-Zweig Banter: Part 1

Seth Klarman of Baupost is a great investor. Jason Zweig is a great writer. When combined, we get a great Klarman-Zweig Interview published Fall 2010 in the Financial Analyst Journal (Volume 66 Number 5) by the CFA Institute. Here is Part 1 of tidbits from that conversation. Part 2 is available here.

Volatility

Graham and Dodd’s works help Klarman “think about volatility in marks as being in your favor rather than as a problem.” Volatility is a good thing because it creates opportunities and bargains.

Intrinsic Value, Exposure

“A tremendous disservice is perpetrated by the idea that stocks are for the long run” because most people don’t have enough staying power or a long time horizon to actually implement this belief. “The prevailing view has been that the market will earn a high rate of return if the holding period is long enough, but entry point is what really matters.”

“If we buy a bond at 50 and think it’s worth par in three years but it goes to 90 the year we bought it, we will sell it because the upside/downside has totally changed. The remaining return is not attractive compared with the risk of continuing to hold.”

Shorting

Baupost does not sell short because the “market is biased upward over time…the street is biased toward the bullish side.” But this also means that there are more “low-hanging fruit on the short side.”

Leverage

“We do not borrow money. We don’t use margin.” However, it should be pointed out that Baupost has substantial private real estate investments, many of which would employ leverage or financing. Perhaps it’s the non-recourse nature of real estate financing that distinguishes whether Klarman is willing to employ leverage. In addition, Baupost does engage in derivative transactions (such as interest rate options) that are quasi forms of leverage (e.g., premiums in return for large notional exposure).

Cash

The “inability to hold cash and the pressure to be fully invested at all times meant that when the plug was pulled out of the tub, all boats dropped as the water rushed down the drain.”

“We are never fully invested if there is nothing great to do…we always have cash available to take advantage of bargains – we now have about 30 percent cash across our partnerships – and so if clients ever feel uncomfortable with our approach, they can just take their cash back.”

AUM

“…probably number one in my mind most of the time – how to think about firm size and assets under management. Throughout my entire career, I have always thought size was a negative. Large size means small ideas can’t move the needle as much…As we entered the chaotic period of 2008…for the first time in eight years, we went to our wait list...We got a lot of interesting phone calls from people who needed to move merchandise in a hurry – some of it highly illiquid…So, to have a greater amount of capital available proved to be a good move.”

Returning Capital

“…I think returning cash is probably one of the keys to our future success in that it lets us calibrate our firm size so that we are managing the right amount of money, which isn’t necessarily the current amount of money.”

Redemptions

“Not only are actual redemptions a problem, but also the fear of redemptions, because the money manager’s behavior is the same in both situations.” In preparation for, or the mere threat of possible redemptions, may prompt a manager to start selling positions at exactly the wrong time in an effort to make the portfolio more liquid.

Clients

“Having great clients is the real key to investment success. It is probably more important than any other factor…We have emphasized establishing a client base of highly knowledgeable families and sophisticated institutions…”

Ideal clients have two characteristics:

1. “…when we think we’ve had a good year, they will agree.”
2. “…when we call to say there is an unprecedented opportunity set, we would like to know that they will at least consider adding capital rather than redeeming.”

“Having clients with that attitude allowed us to actively buy securities through the fall of 2008, when other money managers had redemptions and, in a sense, were forced not only to not buy but also to sell their favorite ideas when they knew they should be adding to them.”