BlueCrest’s Michael Platt

Michael Platt and BlueCrest Capital have been in the headlines recently as the latest hedge fund billionaire to return external capital and morph into a private partnership / family office. Below are portfolio management tidbits from Platt's interview with Jack Schwager in Hedge Fund Market Wizards. Capital Preservation, Risk, Team Management

“I have no appetite for losses. Our discretionary strategy’s worst peak-to-trough drawdown in over 10 years was less than 5 percent, and this strategy lost approximately 5 percent in one month. One thing that brings my blood to a boiling point is when an absolute return guy starts talking about his return relative to anything. My response was, ‘You are not relative to anything, my friend. You can’t be in the relative game just when it suits you and in the absolute game just when it suits you. You are in the absolute return game, and the fact that you use the word relative means that I don’t want you anymore.’”

“The risk control is all bottom-up. I structured the business right from the get-go so that we would have lots of diversification. For example, on the fixed income side, I hire specialists. I have a specialist in Scandinavian rates, a specialist in the short end, a specialist in volatility surface arbitrage, a specialist in euro long-dated trading, an inflation specialist, and so on. They all get a capital allocation. Typically, I will hand out about $1.5 billion for every $1 billion we manage because people don’t use their entire risk allocation all the time. I assume, on average, they will use about two thirds. The deal is that if a trader loses 3 percent, he has to give me back half of his trading line. If he loses another 3 percent of the remaining half, that’s it. His book is auctioned. All the traders are shown his book and take what they want into their own books, and anything that is left is liquidated.”

“Q: What happens to the trader at that point? Is he out on the street? A: It depends on how he reached his limit. I’m not a hard-nosed person. I don’t say, you lost money, get out. It’s possible someone gets caught in a storm. A trader might have some very reasonable Japanese positions on, and then there is a nuclear accident, and he loses a lot of money. We might recapitalize him, but it depends. It is also a matter of gut feel. How do I feel about the guy?

Q: Is the 3 percent loss measured from the allocation starting level? A: Yes, it is definitely not a trailing stop. We want people to scale down if they are getting it wrong and scale up if they are getting it right. If a guy has a $100 million allocation and makes $20 million, he then has $23 million to his stop point.

Q: Do you move that stop up at any point? A: No, it rebases annually.

Q: So every January 1, traders start off with the same 3 percent stop point? A: Yes, unless they carry over some of their P&L. One year, one of my guys made about $500 million of profits. He was going to get a huge incentive check. I said to him, ‘Do you really want to be paid out on the entire $500 million? How about I pay you on $400 million, and you carry over $100 million, so you still have a big line.’ He said, ‘Yeah, that’s cool. I’ll do that.’ So he would have to lose that $100 million plus 3 percent of the new allocation before the first stop would kick in.”

“I don’t interfere with traders. A trader is either a stand-alone producer or gone. If I start micromanaging a trader’s position, it then becomes my position. Why then am I paying him such a large percentage of the incentive fee?”

“We have a seven-person risk management team…The key thing they are monitoring for is a breakdown in correlation…because most of our positions are spreads. So lower correlations would increase the risk of the position. The most dangerous risks are spread risks. If I assume that IBM and Dell have a 0.95 correlation, I can put on a large spread position with relatively small risk. But if the correlation drops to 0.50, I could be wiped out in 10 minutes. It is when the spread risks blow up that you find out that you have much more risk than you thought.

Controlling correlations is the key to managing risk. We look at risk in a whole range of different ways…They stress test the positions for all sorts of historical scenarios. They also scan portfolios to search for any vulnerabilities in positions that could impact performance. They literally ask the traders, ‘If you were going to drop $10 million, where would it come from?’ And the traders will know. A trader will often have some position in his book that is a bit spicy, and he will know what it is. So you just ask him to tell you. Most of what we get in the vulnerabilities in positions reports, we already know anyway. We would hope that our risk monitoring systems would have caught 95 percent of it. It is just a last check.”

Creativity, Psychology

“The type of guy I don’t want is an analyst who has never traded—the type of person who does a calculation on a computer, figures out where a market should be, puts on a big trade, gets caught up in it, and doesn’t stop out. And the market is always wrong; he’s not…

I look for the type of guy in London who gets up at seven o’clock on Sunday morning when his kids are still in bed, and logs onto a poker site so that he can pick off the U.S. drunks coming home on Saturday night. I hired a guy like that. He usually clears 5 or 10 grand every Sunday morning before breakfast taking out the drunks playing poker because they’re not very good at it, but their confidence has gone up a lot. That’s the type of guy you want —someone who understands an edge. Analysts, on the other hand, don’t think about anything else other than how smart they are.”

“I want guys who when they put on a good trade immediately start thinking about what they could put on against it. They just have the paranoia. Market makers get derailed in crises far less often than analysts. I hired an analyst one time who was a very smart guy. I probably made 50 times more money on his ideas than he did. I hired an economist once, which was the biggest mistake ever. He lasted only a few months. He was very dogmatic. He thought he was always right. The problem always comes down to ego. You find that analysts and economists have big egos, which just gets in the way of making money because they can never admit that they are wrong.”

“Both the ex-market makers who blew up became way too invested in their positions. Their ego got in the way. They just didn’t want to be wrong, and they stayed in their positions.”

Psychology, Opportunity Cost, Mistake

“I don’t have any tolerance for trading losses. I hate losing money more than anything. Losing money is what kills you. It is not the actual loss. It’s the fact that it messes up your psychology. You lose the bullets in your gun. What happens is you put on a stupid trade, lose $20 million in 10 minutes, and take the trade off. You feel like an idiot, and you’re not in the mood to put on anything else. Then the elephant walks past you while your gun’s not loaded. It’s amazing how annoyingly often that happens. In this game, you want to be there when the great trade comes along. It’s the 80/20 rule of life. In trading, 80 percent of your profits come from 20 percent of your ideas.”

“…I look at each trade in my book every day and ask myself the question, 'Would I enter this trade today at this price?' If the answer is 'no,' then the trade is gone.”

“When I am wrong, the only instinct I have is to get out. If I was thinking one way, and now I can see that it was a real mistake, then I am probably not the only person in shock, so I better be the first one to sell. I don’t care what the price is. In this game, you have an option to keep 20 percent of your P&L this year, but you also want to own the serial option of being able to do that every year. You can’t be blowing up.”

How many of us have been in a situation when we were busy putting out fire(s) on existing position(s) when we should have been focused on new/better ideas?

Exposure

“I like buying stuff cheap and selling it at fair value. How you implement a trade is critical. I develop a macro view about something, but then there are 20 different ways I can play it. The key question is: which way gives me the best risk/return ratio? My final trade is rarely going to be a straight long or short position.”

His core goal is not all that different from what fundamental investors are try to achieve: buy cheap, sell a fair or higher value. The main difference stems from how the bets are structured and the exposures created.

Creativity, Diversification, Correlation 

“I have always liked puzzles…I always regarded financial markets as the ultimate puzzle because everyone is trying to solve it, and infinite wealth lies at the end of solving it."

“Currently, because of the whole risk-on/risk-off culture that has developed, diversification is quite hard to get. When I first started trading about 20 years ago, U.S. and European bond markets weren’t really that correlated. Now, these markets move together tick by tick.”

“The strategy is always changing. It is a research war. Leda has built a phenomenal, talented team that is constantly seeking to improve our strategy.”

Markets are a zero sum game less transaction costs. Participants / competitors are constantly shifting and changing their approach to one-up each other because there is infinite wealth involved. What worked yesterday may not work today or tomorrow. Historical performance is not indicative of future result. This is also why so many quantitative frameworks for diversification and correlation that use historical statistics are so flawed. Investors must constantly improve and adapt to current and future conditions. Otherwise someone else will eat your lunch.

Howard Marks' Book: Chapter 19

This concludes our series on portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 19 “The Most Important Thing Is…Adding Value” Trackrecord, Compounding, Capital Preservation

“It means relatively little that a risk taker achieves a high return in a rising market, or that a conservative investors is able to minimize losses in a decline. The real question is how they do in the long run and in climates for which their style is ill suited…Without skill, aggressive investors move a lot in both directions, and defensive investors move little in either direction…

Aggressive investors with skill do well in bull markets but don’t’ give it all back in corresponding bear markets, while defensive investors with skill lose relatively little in bear markets but participate reasonably in bull markets. Everything in investing is a two-edged sword and operates symmetrically, with the exception of superior skill.”

“The performance of investors who add value is asymmetrical. The percentage of the market’s gain they capture is higher than the percentage of loss they suffer…Only skill can be counted on to add more in propitious environments than it costs in hostile ones. This is the investment asymmetry we seek.”

“In good years in the market, it’s good enough to be average. Everyone makes money in the good years...There is a time, however, when we consider it essential to beat the market, and that’s in the bad years…it’s our goal to do as well as the market when it does well and better than the market when it does poorly. At first blush that may sound like a modest goal, but it’s really quite ambitious. In order to stay up with the market when it does well, a portfolio has to incorporate good measure of beta and correlation with the market. But if we’re aided by beta and correlation on the way up, shouldn’t they be expected to hurt us on the way down? If we’re consistently able to decline less when the market declines and also participate fully when the market rises, this can be attributable to only one thing: alpha, or skill…Asymmetry – better performance on the upside than on the downside relative to what our style alone would produce – should be every investor’s goal.”

For more on the topic of asymmetry, be sure to check out our article titled “Asymmetry Revisited”

Volatility

“A portfolio with a beta above 1 is expected to be more volatile than the reference market, and a beta below 1 means it’ll be less volatile. Multiply the market return by the beta and you’ll get the return that a given portfolio should be expected to achieve…If the market is up 15 percent, a portfolio with a beta of 1.2 should return 18 percent (plus or minus alpha).”

We often find common threads between different investors. For example, there is evidence that Buffett was thinking about expected beta as early as the 1950s and 1960s (back in the day when he did not have permanent capital) -- see our articles on Buffett Partnership Letters and Volatility.

Expected Return, Risk

“Although I dismiss the identity between risk and volatility, I insist on considering a portfolio’s return in the light of its overall riskiness…A manager who earned 18 percent with a risky portfolio isn’t necessarily superior to one who earned 15 percent with a lower-risk portfolio. Risk-adjusted return holds the key, even though – since risk other than volatility can’t be quantified – I feel it is best assessed judgmentally, not calculated scientifically.”

“‘beating the market’ and ‘superior investing’ can be far from synonymous…It’s not just your return that matters, but also what risk you took to get it…”

Opportunity Cost, Benchmark

“…all equity investors start not with a blank sheet of paper but rather with the possibility of simply emulating an index...investors can decide to deviates from the index in order to exploit their stock-picking ability…In doing so they will alter the exposure of their portfolio to…price movements that affect only certain stocks, not the index…their return will deviate as well."

We are all faced with this choice that, at a minimum, we can emulate an index. If we choose not to, it’s because we believe we can generate outperformance via higher returns and same risk, similar returns at lower risk, or higher returns at lower risk. If we cannot accomplish any of the above, then we have failed to do better than an index (and failed to add value as investors). But if we did not have an index or benchmark against which to measure progress, how would we know whether we have succeeded or failed?

Howard Marks’ Book: Chapter 17

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 17 “The Most Important Thing Is…Investing Defensively” -- a rather apt topic given today's market environment. Psychology, Capital Preservation, Expected Return, Risk, Opportunity Cost

“What’s more important to you: scoring points or keeping your opponent from doing so? In investing, will you go for winners or try to avoid losers? (Or, perhaps more appropriately, how will you balance the two?) Great danger lies in acting without having considered these questions.

And by the way, there’s no right choice between offense and defense. Lots of possible routes can bring you to success, and your decision should be a function of your personality and leanings, the extent of your belief in your ability, and the peculiarities of the markets you work in and the clients you work for.”

“Like everything in investing, this isn’t a matter of black and white. The amount of risk you’ll bear is a function of the extent to which you choose to pursue return. The amount of safety you build into your portfolio should be based on how much potential return you’re willing to forego. There’s no right answer, just trade-offs…Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing returns in the good times, investors must choose between the two.” 

Are capital preservation (defense, avoiding losers, etc.) & expected return (offense, going for winners, etc.) mutually exclusive concepts? Perhaps in the short-run, but in the long-run, they are two side of the same coin. Avoiding loss is essential to capital compounding over time. This is because the effects of compounding math are not symmetrical. A 50% loss in one period requires a 100% in a subsequent period just to break even! See our previous article titled: “Asymmetry Revisited” for more on the interplay between capital preservation and compounding.

Capital Preservation, Volatility, Diversification, Leverage

“But what’s defense? Rather than doing the right thing, the defensive investor’s main emphasis is on not doing the wrong thing.

Is there a difference between doing the right thing and avoiding doing the wrong thing? On the surface, they sound quite alike. But when you look deeper, there’s a big difference between the mind-set needed for one and the mind-set needed for the other, and a big difference in the tactics to which the two lead.

While defense may sound like little more than trying to avoid bad outcomes, it’s not as negative or non-aspirational as that. Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance.

There are two principal elements in investment defense. The first is the exclusion of losers from portfolios…and being less willing to bet on continued prosperity, and rosy forecasts and developments that may be uncertain. The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes…this aspect of investment defense requires thoughtful portfolio diversification, limits on the overall riskiness borne, and a general tilt toward safety.

Concentration (the opposite of diversification) and leverage are two examples of offense. They’ll add to returns when they work but prove harmful when they don’t: again the potential for higher highs and lower lows from aggressive tactics. Use enough of them, however, and they can jeopardize your investment survival if things go awry. Defense, on the other hand, can increase your likelihood of being able to get through the tough times and survive long enough to enjoy the eventual payoff from smart investments.”

Psychology, Luck, Process Over Outcome

“The choice between offense and defense investing should be based on how much the investor believes is within his or her control…But investing is full of bad bounces and unanticipated developments…The workings of economies and markets are highly imprecise and variable, and the thinking and behavior of the other players constantly alter the environment…investment results are only partly within the investors’ control…The bottom line is that even highly skilled investors can be guilty of mis-hits, and the overaggressive shot can easily lose them the match.”

“Playing for offense – trying for winners through risk bearing – is a high octane activity. It might bring the gains you seek…or pronounced disappointment. And there’s something else to think about: the more challenging and potentially lucrative the waters you fish in, the more likely they are to have attracted skilled fishermen. Unless your skills render you fully competitive, you’re more likely to be prey than victor. Playing offense, bearing risk and operating in technically challenging fields mustn’t be attempted without the requisite competence.”

Psychology plays an integral role in successful investing. One must learn to distinguish between the impact of process (avoiding the mis-hits) vs. the outcome (sometimes uncontrollable), and to not be deterred by the occasional but inevitable “bad bounce.” Additionally, there’s the self-awareness and honesty requirement so that one can exercise discipline and remove oneself from the game if/when necessary.

Psychology, Trackrecord

“Investing is a testosterone-laden world where too many people think about how good they are and how much they’ll make if the swing for the fences and connect. Ask some investors of the ‘I know’ school to tell you what makes them good, and you’ll hear a lot abut home runs they’ve hit in the past the home runs-in-the-making that reside in their current portfolio. How many talk about consistency, or the fact that their worst year wasn’t too bad.”

“One of the most striking things I’ve noted over the last thirty-five years is how brief most outstanding investment careers are. Not as short as the careers of professional athletes, but shorter than they should be in a physically nondestructive vocation.

Where’d they go? Many disappeared because organizational flaws render their game plans unsustainable. And the rest are gone because they swung for the fences but struck out instead.

That brings up something that I consider a great paradox: I don’t think many investment managers’ careers end because they fail to hit home runs. Rather, they end up out of the game because they strike out too often – not because they don’t have enough winners, but because they have too many losers. And yet, lots of managers keep swinging for the fences.”

“Personally, I like caution in money managers. I believe that in many cases, the avoidance of losses and terrible years is more easily achievable than repeated greatness, and thus risk control is more likely to create a solid foundation for a superior long-term trackrecord.”

Related to the above, please see our previous articles on the concepts of “Toward vs. Away-From Motivation” and “Outer vs. Inner Scorecard.”

Montier on Exposures & Bubbles

Below are some wonderful bits on bubbles and portfolio construction from James Montier. Excerpts were extracted from a Feb 2014 interview with Montier by Robert Huebscher of Advisor Perspectives – a worthwhile read. Cash, Expected Returns, Exposure

“The issue is…everything is expensive right now. How do you build a portfolio that recognizes the fact that cash is generating negative returns…you have to recognize that this is the purgatory of low returns. This is the environment within which we operate. As much as we wish it could be different, the reality is it isn’t, so you have to build a portfolio up that tries to make sense. That means owning some equities where you think you’re getting at least some degree of reasonable compensation for owning them, and then basically trying to create a perfect dry-powder asset.

The perfect dry-powder asset would have three characteristics: it would give you liquidity, protect you against inflation and it might generate a little bit of return.

Right now, of course, there is nothing that generates all three of those characteristics. So you have to try and build one in a synthetic fashion, which means holding some cash for its liquidity benefits. It means owning something like TIPS, which are priced considerably more attractively than cash, to generate inflation protection. Then, you must think about the areas to add a little bit of value to generate an above-cash return: selected forms of credit or possibly equity-spread trades, but nothing too risky.”

Dry powder is generally associated with cash. But as Montier describes here, it is possible that in certain scenarios cash is not the optimal dry-powder asset.

His description of creating a perfect dry-powder asset is akin to creating synthetic exposures, something usually reserved for large hedge funds / institutions and their counterparties.

Interestingly, anyone can (try to) create synthetic exposures by isolating characteristics of certain assets / securities to build a desired combination that behaves a certain way in XYZ environment, or if ABC happens.

For more on isolating and creating exposures, see our previous article on this topic. 

Hedging, Fat Tail

“Bubble hunting can be overrated…I’m not sure it’s particularly helpful, in many regards…

Let’s take an equity‐market bubble, like the technology‐media‐telecom (TMT) bubble. Everyone now agrees I think, except maybe two academics, that TMT was actually a bubble. To some extent it didn’t really matter, because you had a valuation that was so extraordinarily high. You didn’t actually have to believe it was a bubble. You just knew you were going to get incredibly low returns from the fact that you were just massively overpaying for those assets.

Knowing it was a bubble as such helped reassure those of us who were arguing that it was a bubble, though we could see the more common signs of mania like massive issuance, IPOs and shifting valuation metrics that eventually were off the income statement altogether.

All of those things are good confirming evidence, but ultimately it didn’t matter because the valuation alone was enough to persuade you to think, ‘Hey, I’m just not going to get any returns in these assets even if it isn’t a bubble.’

Bubblehunting is much more useful when it is with respect to things like credit conditions and the kind of environments we saw in 2007, when it was far less obvious from valuation alone. Valuation was extended, but wasn’t anywhere near the kinds of levels that we saw in 2000. It was extended, but not cripplingly so by 2000 standards. But the ability to actually think about the credit bubble or the potential for a bubble in fundamentals or financial earnings is very useful.

The use of bubble methodology is certainly not to be underestimated, but people can get a little too hung up on it and start to see bubbles everywhere. You hear things about bond bubbles. Do I really care? All I need to know is bonds are going to give me a low return from here. Ultimately, for a buy-and-hold investor, the redemption yield minus expected inflation gives me my total return for bonds. There can’t be anything else in there.

You get the conclusion that, ‘Hey, I don’t really care if it’s a bubble or not.’ I suspect bubble hunting can be useful in some regards. But people use the term too loosely and it can lead to unhelpful assessments.”

Expected Return, Capital Preservation

“You can imagine two polar extreme outcomes: Central banks could end financial repression tomorrow. You would get real‐rate normalization and the only asset that survives unscathed is cash. Bonds suffer, equities suffer and pretty much everything else suffers. Or, the central banks keep their rates incredibly low for a very, very long period.

The portfolios you want to hold under those two different outcomes are extremely different. I have never yet met anyone with a crystal ball who can tell me which of these two outcomes is most likely – or even which one could actually happen. You’re left trying to build a portfolio that will survive both outcomes. It won’t do best under either one of the two outcomes or the most probable outcome, but it will survive. That really is the preeminent occupation of my mind at the moment.”

When To Buy, When To Sell, Psychology

“One of curses of value managers is we’re always too early both to buy and to sell. One of the ways that were trying to deal with that is to deliberately slow our behavior down, so we try to react at least to a moving average of the forecast rather than the spot forecasts.”

Howard Marks' Book: Chapter 16

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 16 “The Most Important Thing Is…Appreciating the Role of Luck.” Luck, Capital Preservation

“We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.”

Luck, Process Over Outcome

“The investment world is not an orderly and logical place where the future can be predicted and specific actions always produce specific results. The truth is, much in investing is ruled by luck. Some may prefer to call it chance or randomness, and those words do sound more sophisticated than luck. But it comes down to the same thing: a great deal of the success of everything we do as investors will be heavily influenced by the roll of the dice.”

“Randomness (or luck) plays a huge part in life’s results, and outcomes that hinge on random events should be viewed as different from those that do not. Thus, when considering whether an investment record is likely to be repeated, it is essential to think about the role of randomness in the manager’s results, and whether the performance resulted from skill or simply being lucky.”

“Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not skill…In the short run, a great deal of investment success can result from just being in the right place at the right time…the keys to profit are aggressiveness, timing and skill, and someone who has enough aggressiveness at the right time doesn’t need much skill.”

“…randomness contributes to (or wrecks) investment records to a degree that few people appreciate fully…We all know that when things go right, luck looks like skill. Coincidence looks like causality. A ‘lucky idiot’ looks like a skilled investor. Of course, knowing that randomness can have this effect doesn’t make it easy to distinguish between lucky investors and skillful investors.”

“Investors are right (and wrong) all the time for the ‘wrong reason’…The correctness of a decision can’t be judged from the outcome. Nevertheless, that’s how people assess it. A good decision is one that’s optimal at the time that it’s made, when the future is by definition unknown. Thus, correct decisions are often unsuccessful, and vice versa.”

“[Nassim] Taleb’s idea of ‘alternative histories’ – the other things that reasonably could have happened – is a fascinating concept, and one that is particularly relevant to investing.

Most people acknowledge the uncertainty that surrounds the future, but they feel that at least the past is known and fixed. After all, the past is history, absolute and unchanging. But Taleb points out that the things that happened are only a small subset of the things that could have happened. Thus, the fact that a stratagem or action worked – under the circumstances that unfolded – doesn’t necessarily prove the decision behind it was wise.

Maybe what ultimately made the decision a success was a completely unlikely event, something that was just at matter of luck. In that case that decision – as successful as it turned out to be – may have been unwise, and the many other histories that could have happened would have shown the error of the decision.”

“What is a good decision?…A good decision is one that a logical, intelligent and informed person would have made under the circumstance as they appeared at the time, before the outcome was known.”

“Even after the fact, it can be hard to be sure who made a good decision based on solid analysis but was penalized by a freak occurrence, and who benefited from taking a flier…past returns are easily assessed, making it easy to know who made the most profitable decision. It’s easy to confuse the two, but insightful investors must be highly conscious of the difference.

In the long run, there’s no reasonable alternative to believing that good decisions will lead to investor profits. In the short run, however, we must be stoic when they don’t.”

Luck, Historical Performance Analysis, Expected Return, Volatility

“Investment performance is what happens to a portfolio when events unfold. People pay great heed to the resulting performance, but the questions they should ask are: were the events that unfolded (and the other possibilities that didn’t unfold) truly within the ken of the portfolio manager? And what would the performance have been if other events had occurred instead? Those…are Taleb’s ‘alternative histories.’”

“…investors of the ‘I know’ school…feel it’s possible to know the future, they decide what it will look like, build portfolios designed to maximize returns under that one scenario, and largely disregard the other possibilities. The sub-optimizers of the ‘I don’t know’ school, on the other hand, put their emphasis on constructing portfolios that will do well in the scenarios they consider likely and not too poorly in the rest…

Because their approach is probabilistic, investors of the ‘I don’t know’ school understand that the outcome is largely up to the gods, and thus that the credit or blame accorded the investors – especially in the short run – should be appropriately limited.”

“Randomness alone can produce just about any outcome in the short run…market movements can easily swamp the skillfulness of the manager (or lack thereof).”

For further reading on luck and process over outcome: Howard Marks wrote an entire memo on the topic in Jan 2014 titled Getting Lucky. One of my favorite articles on this topic is from Michael Mauboussin & James Montier on Process Over Outcome. Michael Mauboussin recently wrote an entire book, The Success Equation, dedicated to untangling skill and luck. 

Asymmetry Revisited

Return asymmetry is a topic that emerges over and over again on PM Jar. It’s a topic that spans across investments strategies and philosophies (see the end of this article for links to previous PM Jar articles on return asymmetry). This is no coincidence – creating (positive) return asymmetry over time is the hallmark of great investors. So why is it so important to achieve positive return asymmetry (through decreasing the number of left tail / negative return occurrences)? Because positive return asymmetry saves investors from wasting valuable time and effort digging out of the negative return hole (compounding math is not symmetric: losing 50% in one period requires gaining 100% in the next period just to breakeven). This holds true for all investors, regardless of investment strategy and philosophy, hence why the theme of return asymmetry comes up so often.

Our last article on Howard Marks discussing the ability of a fund manager to outperform and add-value by reducing risk reminded me of article that a kind Reader sent me earlier this summer (Comgest Commentary 2013 July) in which the author describes with refreshing clarity the importance of creating positive return asymmetry and the interplay between compounding, capital preservation, and risk management. Compounding, Capital Preservation, Trackrecord

“The Asymmetry of Returns Dictates the Compounding of Returns:

Berkshire Hathaway CEO and legendary investor Warren Buffett is often quoted as saying, “Rule No.1: Never lose money. Rule No. 2: Never forget rule No. 1.” But why are these the most important two (well, one) rules of investing? The answer lies in the inherent asymmetry of returns, which is the basis for how returns compound over time.

If you start with $100 and subsequently gain 10% and then lose 10%, it may be surprising that you don’t end up back with the same $100 you had at the beginning. The reason is that your 10% loss hurt more, because it came off the larger asset base you had after your 10% gain. In sequence: $100 → gain 10% ($10) → $110 → lose 10% ($11) → $99. You can reverse the order of the gain and loss and the end result is still the same: $100 → $90 → $99, where your percentage loss is still based on a higher amount of capital than is your percentage gain. The end result is a net loss of 1%, hence the asymmetry – gains and losses of equal percentages have different impacts. As your returns swings get larger, this effect becomes more pronounced. For instance, starting with $100 and then gaining/losing 20% leaves you with a net loss of 4%, while gaining/losing 50% leaves you with a net loss of 25%. At the extreme, gaining/losing 100% leaves you with a net loss of 100% – all your capital, resulting on complete ruin. It doesn’t matter what any of the other payoffs are for someone who at any one point loses his or her entire bankroll.

Another way to look at this is to see what kind of return is necessary to get back to even after a loss. If you lose 10%, you need an 11% gain to get back to even. If you lose 20%, you need a 25% gain to close the gap. Losing 50% requires a doubling of your money, while losing 90% means you need a 900% return (!) to compensate. While 100% losses are rare in equity portfolios and thus true ruin is unlikely, this exercise shows how large losses cripple the long-term returns of a portfolio.”

“...the goal is to avoid an 'extinction' event, which I’ve put in quotes because extinction for an investment portfolio doesn’t only mean complete disappearance. It can also be seen as irreparable damage to a long-term track record.”

Risk

“Risk Management and Higher Math Are Not Natural Partners:

…The prevailing view of risk management in today’s investment world seems to be that it must be done with a lot of math and only a set of numbers, preferably from a complicated model, can describe an approach to risk. That’s just not how we see it. Instead, we think understanding the companies’ profitability characteristics is a far more effective way to understand the risk embedded in a portfolio. We side with James Montier, who wrote, “The obsession with the quantification of risk (beta, standard deviation, VaR) has replaced a more fundamental, intuitive, and important approach to the subject. Risk clearly isn’t a number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single figure.” Even the revered father of modern security analysis, Benjamin Graham, tips his cap to a more fundamental and less market-price-driven approach to risk: “Real investment risk is measured… by the danger of a loss of quality and earnings power through economic changes or deterioration in management.” It’s important to realize that our view of risk is at the fundamental security level, while standard industry risk models start from price volatility and covariance matrices, which are market-level inputs. In other words, we focus on what’s happening in the business, not what’s going on in the market, to understand risk. We think that our approach to risk management, that of decreasing the left tail of the distribution of potential outcomes by buying quality stocks is a more time-tested approach that runs a far lower risk of model specification error.”

In case you'd like some related reading, here is what Howard Marks, Stanley Druckenmiller, Warren Buffett, and others have said about return asymmetry.

Mind of an Achiever

In the competitive world of investing, each of us should constantly be seeking out competitive advantages. Personally, I believe that a certain degree of competitive advantage can be found in the cross-pollination of different schools of investment thought. Many in the value school often deride trading strategies, but they cannot deny the existence of those who practice the trading style of investing and have generated fantastical trackrecords over time, even if the disbelievers cannot understand the basis of how they have done so.

The following excerpts derived from Jack Schwager’s interview with Charles Faulkner in The New Market Wizards relate to trading strategies, but I think many of the psychological and process-focused aspects are also applicable to fundamental investors.

Psychology, Portfolio Management

“Natural Learning Processes [NPL]…the study of human excellence…studies great achievers to pinpoint their mental programs – that is, to learn how great achievers use their brains to product results…The key was to identify…the essence of their skills – so it could be taught to others. In NPL we call that essence a model.”

“If one person can do it, anyone else can learn to do it…Excellence and achievement have a structure that can be copied. By modeling successful people, we can learn from the experience of those who have already succeeded. If we can learn to use our brains in the same way as the exceptionally talented person, we can possess the essence of that talent.”

This is the goal of Portfolio Management Jar: to study the rationale behind portfolio management decisions of great investors, and perhaps one day generate returns the way they do. Notice, there’s a distinction between observing the actions and decisions vs. analyzing the rationale behind those actions & decisions. The true treasure trove is the latter – the way they use their brains.

Process Over Outcome, Psychology, Portfolio Management

On characteristics of successful traders:

“Another important element is that they have a perceptual filter that they know well and that they use. By perceptual filter I mean a methodology, an approach, or a system to understanding market behavior…In our research, we found that the type of perceptual filter doesn’t really make much of a difference…all these methods appear to work, provided the person knows the perceptual filter thoroughly and follows it.”

“People need to have a perceptual filter that matches the way they think. The appropriate perceptual filter for a trader has more to do with how well it fits a trader’s mental strategy, his mode of thinking and decision making, than how well it accounts for market activity. When a person gets to know any perceptual filter deeply, it helps develop his or her intuition. There’s no substitution for experience.”

Interestingly, this is very applicable to portfolio management. Because the portfolio management process has so many inputs and differs depending on the person and situation, in order to master the art of portfolio management, investors need to figure out what works for them depending on “mental strategy, his mode of thinking and decision making.” It helps to observe and analyze the thought processes of the greats who came before you, but there’s “no substitute for experience.”

Process Over Outcome, Luck, Psychology

“…if a trader does very well in one period and only average in the next, he might feel like he failed. On the other hand, if the trader does very poorly in one period, but average in the next, he’ll probably feel like he’s doing dramatically better. In either case, the trader is very likely to attribute the change of results to his system…rather than to a natural statistical tendency. The failure to appreciate this concept will lead the trader to create an inaccurate mental map of his trading ability. For example, if the trader switches from one system to another when he’s doing particularly poorly, the odds are that he’ll do better at that point in time even if the new system is only of equal merit, or possibly even if it is inferior. Yet the trader will attribute his improvement to his new system…Incidentally, the same phenomenon also explains why so many people say they do better after they have gone to a motivational seminar. When are they going to go to a motivational seminar? When they’re feeling particularly low…statistically, on average, these people will do better in the period afterwards anyway – whether or not they attended the seminar. But since they did, they’ll attribute the change to the seminar.”

“Medical science researchers take the view that the placebo effect is something bad…However, Bandler and Grinder [founders of NPL] looked at it differently. They saw the placebo effect as a natural human ability – the ability of the brain to heal the rest of the body.”

Mistakes, Process Over Outcome, Psychology

Traders seem to place a lot of value on “emotional objectivity,” a term I found interesting since it’s definitely something that’s applicable to fundamental investors especially in situations involving mistakes.

“We’ve all been in trading situations where the market moved dramatically against our position. The question is: How unsettling or disconcerting was it? What happens when you’re in a similar situation a couple of weeks or even a couple months later? If you begin to experience some of the same unsettling feelings just thinking about it, you’ve conditioned yourself just like Pavlov’s dogs.”

“Manage of one’s emotional state is critical. The truly exceptional traders can stand up to anything. Instead of getting emotional when things don’t go their way, they remain clam and act in accordance with their approach. This state of mind may come naturally. Or some people may have ways of controlling or dissipating their emotions. In either case, they know they want to be emotionally detached from feelings regarding their positions.”

Is important question is how to un-condition oneself, to remain emotionally objective when mistakes have been made. Of course, since each of us is mentally programmed differently, the answer to this question likely differs from person to person.

Psychology, Capital Preservation, Risk

“There are two different types of motivation…either toward what we want or away from what we don’t want. For example, consider how people respond to waking up in the morning…The person who wouldn’t get up until he saw images like his boss yelling at him has an ‘Away From’ motivational direction. His motivation is to get away from pain, discomfort, and negative consequences…He moves away from what he doesn’t want. The person who can’t wait to get out of bed has a ‘Toward’ motivational direction. He moves toward pleasure, rewards, goals…he moves toward what he wants. People can have both types of motivation…but most people specialize in one or the other. They are very different ways to getting motivated, and both are useful in different situations.”

“People who move toward goals are greatly valued in our society…However, the Away From direction of motivation has gotten a bad rap…The Toward motivation may be enshrined in success magazines, but the less appreciated Away From motivation individuals can also be very successful…Many outstanding traders reveal an Away From motivation when they talk about ‘protecting themselves’ or ‘playing a great defense.’ They’re only willing to take so much pain in the market before they get out. As Paul Tudor Jones said in your interview, ‘I have a short-term horizon for pain.’”

“Very often they come in with a developed Toward motivation – toward success, toward money – that’s why they got into the markets in the first place. However, those that are primarily Toward motivated must spend the time and energy to develop the Away From motivation required for proper money management. In my studies of traders I’ve found that it’s nearly impossible to be a really successful trader without the motivation to get away from excessive risk.”

Some people are more genetically inclined to focus on capital preservation. Some people are less genetically inclined to control “risk.”

The Inner vs. Outer Scorecard

We all have egos in the psychological sense – defined as “a person’s sense of self-esteem or self-importance.” It’s the degree that denotes the positive or negative association that’s often attached to the term “ego.” There are two passages below, one from Howard Marks and the other from Warren Buffett, that share a common denominator: the role of ego upon an individual’s investment philosophy & decisions.

Howard Marks (The Most Important Thing, Chapter 10):

“…thoughtful investors can toil in obscurity, achieving solid gains in the good years and losing less than others in the bad. They avoid sharing in the riskiest behavior because they’re so aware of how much they don’t know and because they have their egos in check. This, in my opinion, is the greatest formula for long-term wealth creation – but it doesn’t provide much ego gratification in the short-term. It’s just not that glamorous to follow a path that emphasizes humility, prudence, and risk control. Of course, investing shouldn’t be about glamour, but often it is.”

Warren Buffett (The Snowball, Chapter 3):

“The big question about how people behave is whether they’ve got an Inner Scorecard or an Outer Scorecard. It helps if you can be satisfied with an Inner Scorecard. I always posed it this way. I say: ‘Lookit. Would you rather be the world’s greatest lover, but have everyone think you’re the world’s worst lover? Or would you rather be the world’s worst lover but have everyone think you’re the world’s greatest lover?’ Now that’s an interesting question.

Here’s another one. If the world couldn’t see your results, would you rather be thought of as the world’s greatest investor but in reality have the world’s worst record? Or be thought of as the world’s worst investor when you were actually the best?

In teaching your kids, I think the lesson they’re learning at a very, very early age is what their parents put the emphasis on. If all the emphasis is on what the world’s going to think about you, forgetting about how you really behave, you’ll end up with an Outer Scorecard. Now, my dad: He was a hundred percent Inner Scorecard guy.

He was really a maverick. But he wasn’t a maverick for the sake of being a maverick. He just didn’t care what other people thought. My dad taught me how life should be lived…”

Also, notice Marks’ statement that the best method of wealth creation is capturing portfolio return (volatility) asymmetry: “solid gains in the good years [compounding] and losing less than others [capital preservation] in the bad.” I think Buffett would agree with this approach - see Buffett 1966 Part 1 article. 

Howard Marks' Book: Chapter 9

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 9 “The Most Important Thing Is…Awareness of the Pendulum” Psychology, Risk, When To Buy, When To Sell

As the title of this chapter gives away, much of Marks’ comments emphasize the importance of awareness of market participants’ psychology, specifically their attitudes toward risk, which creates optimal conditions for buying or selling (depending on the “location” of the pendulum). For more on this, be sure to read a previous discussion on Howard Marks’ concept of the “perversity of risk” and resulting risk manifestation.

“Investment markets follow a pendulum-like swing:

• Between euphoria and depression;
• Between celebrating positive developments and obsessing over negatives…
• Between overpriced and underpriced.”

“…the pendulum also swings with regard to greed versus fear; willingness to view things through an optimistic or a pessimistic lens; faith in developments that are on-the-come; credulousness versus skepticism; and risk tolerance versus risk aversion.

The swing in the last of these – attitudes toward risk – is a common thread that runs through many of the market’s fluctuations. Risk aversion is THE essential ingredient in a rational market…and the position of the pendulum with regard to it is particularly important. Improper amounts of risk aversion are key contributors to the market excesses of bubble and crash.”

When To Buy

“Major bottoms occur when everyone forgets that the tide also comes in. Those are the times we live for.”

“The swing back from the extreme is usually more rapid – and thus takes much less time – than the swing to the extreme.”

The comment regarding the speed of swing back from the extremes is interesting.

Mariko Gordon of Daruma Capital (who writes wonderfully insightful and entertaining letters) once pointed out that opportunities “tend to make themselves available between the two extremes of ‘fire hose’ and ‘dripping faucet’ and that what ultimately matters is “having a sound strategy for uncovering the best when ideas are as plentiful as mushrooms after a rain, and locating the gems when the pendulum inevitably swings back the other way.”

I think both Marks and Gordon would agree that it’s not only the ability to identify when the pendulum reaches the extremes that counts, but also the ability to act quickly and take advantage of those rare and fleeting moments.

Catalyst

“The market has a mind of its own, and its changes in valuation parameters, caused primarily by changes in investor psychology (not changes in fundamentals), that account for most short-term changes in security prices. This psychology, too, moves like a pendulum.”

Stanley Druckenmiller once commented that: “I never use valuation to time the market…Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction…The catalyst is liquidity…”

Is investor psychology (one of) the initial catalyst(s) that impacts liquidity, which then drives valuation?

Risk, Expected Return, Capital Preservation, Opportunity Cost

“In my opinion, the greed/fear cycle is caused by changing attitudes toward risk. When greed is prevalent, it means investors feel a high level of comfort with risk and the idea of bearing it in the interest of profit. Conversely, widespread fear indicates a high level of aversion to risk. The academics consider investors’ attitudes toward risk a constant, but certainly it fluctuates greatly. Finance theory is heavily dependent on the assumption that investors are risk-averse. That is, they ‘disprefer’ risk and must be induced – bribed – to bear it, with high expected returns.”

“…I’ve recently boiled down the main risks in investing to…: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both. In an ideal world, investors would balance these two concerns…In 2005, 2006, and early 2007, with things going so swimmingly and the capital markets wide open, few people imagined that losses could lie ahead. Many believed risk had been banished. Their only worry was that they might miss an opportunity; if Wall Street came out with a new financial miracle and other investors bought and they didn’t…since they weren’t concerned about losing money, they didn’t insist on low purchase prices, adequate risk premiums or investor protection. In short, they behaved too aggressively.”

2005-2007 provides a great example of how misjudgments in risk and expected return can also cloud estimations of opportunity cost (which is a function of expected risk and return predictions). This caused investors to think the opportunity cost of not investing high – when in fact the exact opposite was true – leading to detrimental results.

Baupost Letters: 1997

Continuation in our series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts, only our interpretive summaries, for this series.

Mandate, Trackrecord, Expected Return

For the past several years, Klarman had invested heavily into Baupost’s international efforts/infrastructure because he believed that opportunities in the U.S. marketplace were less attractive than those found abroad, due to increased competition and higher market valuations.

Did Baupost’s flexible investment mandate give it an advantage in trackrecord creation and return generation?

For example, a healthcare fund cannot start investing in utilities because the latter provides better risk-reward, whereas Baupost can invest wherever risk-reward is most attractive.

The trackrecord creation and return generation possibilities for those with more restrictive mandates are bound by the opportunities available within the mandate scope. Baupost, on the other hand, has the freedom to roam to wherever pastures are greenest.

Cash, Expected Return, Risk Free Rate

In the category of largest gains, there was a $2.2MM gain for “Yield on Cash and Cash Equivalents” which at the end of Fiscal Year 1997 (October 31, 1997) consisted of $39MM or 25.5% of NAV.

In 1997, cash earned 5-6% ($2.2MM divided by $39MM) annually, in drastic contrast to virtually nothing today. I point this out as a reminder that historically, and perhaps one day in the future, cash does not always yield zero. In fact, cash interest rates are often highest during bull markets when it’s most prudent to keep a higher cash balance as asset values increase.

For those who fear the performance drag from portfolio cash balances, or those who feel the pressure to “chase” yield in order to boost portfolio returns, this serves as a reminder that cash returns are not static throughout the course of a market cycle.

Hedging, Cash

At 10/31/97, value of “Market Hedges” was $2.0MM, or 1.4% of NAV. Hedges were also the source of his second largest loss that year, declining $2.1MM in value.

That’s a whole lot of premium bleed worth $2.0MM or ~1.5% of NAV! Interestingly, this is almost the exact gain from portfolio cash yields (see above). Coincidence?

If you believe that the phenomenon of the last 20 years will continue to hold – that interest rates will increase as the underlying economy recovers and equity markets move higher, then one can roughly use interest rates (and consequently portfolio cash yields) as a proxy to determine how much hedging premium to spend.

Theoretically, this should be a self-rebalancing process: higher cash yields in bull equity markets = more hedging premium to spend (when you need it most) vs. lower cash yields in bear equity markets = less hedging premium to spend (when you need it least).

Cash, Opportunity Cost

Klarman comments that cash provides protection in turbulent times and ammunition to take advantage of newly created opportunities, but the act of holding cash involves considerable opportunity cost in the form of foregoing attractive investments in the interim – but investors must keep in mind they cannot earn investment returns without actually investing.

After a temporary hiccup in the markets, Klarman discusses portfolio repositioning: adding to some positions while reducing or deleting others, to take advantage of the shifts in the market landscape.

It’s a delicate balance determining when to deploy capital, and when to hold it in the form of cash. You can’t run an investment management business holding cash forever – that would make you a checking account with extremely high fees.

The second point serves as an excellent reminder that the “opportunity cost” calculation involves not only the comparison between cash and a potential investment, but also between a potential investment and current portfolio holdings.

Derivatives, Leverage

Klarman held a wide variety of options and swaps in his portfolio, such as SK Telecom equity & swaps, Kookmin Bank equity and swaps, etc.

In Klarman’s writings, you’ll generally find warnings against using leverage, and equity swaps definitely constitute leverage. I wonder if the derivative swaps were a product of his interest in emerging markets. For example, perhaps Baupost was not able to trade directly in certain markets, and therefore utilized swaps to gain exposure through a counterparty authorized to trade in those countries.

When To Buy

In a market downturn, momentum investors cannot find momentum, growth investors worry about a slowdown, and technical analysts don’t like their charts.

In extreme market downside events, patterns & trends in liquidity, trading volume, sales growth, etc. – that may have existed for years – disintegrate. Therefore, investors who rely on those patterns and trends become disoriented, which then fuels and reinforces more market chaos. This is what we witnessed in 2008-2009, and the time for fundamental investors, and those with intuition and foresight, to shine.

Capital Preservation, Compounding,

Over time, by again and again avoiding loss, you have taken the first step toward achieving healthy gains.

Volatility

Toward the end of the December 1997 letter, Klarman praises his team of analysts and traders who, like himself, hate to lose money, even temporarily, for any reason at any time.

So let it be written! Klarman acknowledges that he doesn’t like to lose money, even temporarily in the form of volatility. 

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.

The Math of Compounding

Here is an interesting piece from Ted Lucas of Lattice Strategies (2010 Q4 The Oracle of...Risk Management) on the complementary relationship between compounding and capital preservation, plus a few other insightful topics of discussion. Compounding, Capital Preservation

“Losses are linear, but the appreciation required to recover from losses scales exponentially as they deepen.

Thought experiment: Imagine a portfolio that was down 20% during the 2008 implosion, versus a portfolio that was down 40%. In the 2009 rebound, assume the first portfolio recovered by 25%, while the second rebounded by 40%. At the end of the two periods, the first portfolio would be back to its starting point, while the second – after knocking the lights out in 2009 – would still be down 16%, requiring another 19% gain to get back to even (i.e., a 40% gain on 60 cents on the dollar yields 84 cents; to get 84 cents back to a full dollar requires a 19% gain).

The key takeaway? Avoiding big drawdowns – and thereby limiting the destructive force of negative compounding and unleashing the power of positive compounding – is the critical driver of long-term returns.”

Simple concept, yet often ignored by investors. This is something that those with trading backgrounds do better than traditional value investors. For additional mindblowingly good commentary on this topic, be sure to read Stanley Druckenmiller’s (protégé of George Soros) thoughts on capital preservation and compounding.

Volatility

Using Warren Buffett andBerkshire’s historical price performance, Lucas also discusses volatility, and the concepts of upside and downside capture. (I should highlight that the concept of volatility or beta only makes sense when there is an underlying benchmark or index for comparison.)

As you well know, the world has been taught to avoid “volatility.” What terrible advice! One should only avoid downside volatility, and wholeheartedly embrace upside volatility. After all, the holy grail of all portfolios would provide super efficient upside capture and little or no downside capture.

Benchmark

Additionally, Lucas warns about the dangers of certain industry benchmarking practices which are not conducive to maximum return compounding because fan portfolio managers’ need to keep inline with the benchmark (or a particular index), and therefore exacerbate the likelihood of loss.

“It is the ‘shape’ of returns through a market cycle that is of infinitely greater importance than relative benchmark outperformance over a short time window. How does this factor into building resilient, long-term investment strategies? When constructing portfolios, investors would be well served by a willingness to trade off some upside during positive markets in order to disproportionately mitigate the downside experienced during negative periods. While this may not sound like a blinding insight, it is hard to reconcile this idea with an industry where strategies are promoted – and often chosen – based on relative benchmark outperformance over short time windows, typically when conditions are conducive to a particular strategy.”

Howard Marks' Book: Chapter 7

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 7 “The Most Important Thing Is…Recognizing Risk” Risk, Capital Preservation, Compounding

“…Warren Buffett, Peter Lynch, Bill Miller and Julian Robertson. In general their records are remarkable because of their decades of consistency and absence of disasters, not just their high returns.”

“How do you enjoy the full gain in up markets while simultaneously being positioned to achieve superior performance in down markets? By capturing the up-market gain while bearing below-market risk…no mean feat.”

“The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.”

The resilient yet participatory portfolio (this term was stolen from a very smart man named Ted Lucas at Lattice Strategies in San Francisco) – a rare creature not easily found. We know it exists because a legendary few, such as those listed above, have found it before. How to find it for ourselves remains the ever perplexing question.

Our regular Readers know that we’re obsessed with the complementary relationship between capital preservation and compounding. For more on this, be sure to check out commentary from Stanley Druckenmiller and Warren Buffett – yes, two very different investors.

Conservatism, Hedging

“Since usually there are more good years in the markets than bad years, and since it takes bad years for the value of risk control to become evident in reduced losses, the cost of risk control – in the form of return foregone – can seem excessive. In good years in the market, risk-conscious investors must content themselves with the knowledge that they benefited from its presence in the portfolio, even though it wasn’t needed…the fruits…come only in the form of losses that don’t happen.”

People talk a lot about mitigating risk in the form of hedging. But what about remaining conservatively positioned (such as having more cash) and incurring the cost of lower portfolio returns? Isn’t the “return foregone” in this case akin to hedging premium?

Conservatism, Fat Tail

“It’s easy to say that they should have made more conservative assumptions. But how conservative? You can’t run a business on the basis of worst-case assumptions. You won’t be able to do anything. And anyway, a ‘worst-case assumption’ is really a misnomer; there’s no such thing, short of a total loss…once you grant that such a decline can happen – for the first time – what extent should you prepare for? Two percent? Ten? Fifty?”

“Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so. Once in a while, a ‘black swan’ will materialize. But if in the future we always said, ‘We can’t do such-and-such, because the outcome could be worse than we’ve ever seen before,” we’d be frozen in inaction.

So in most things, you can’t prepare for the worst case. It should suffice to be prepared for once-in-a-generation events. But a generation isn’t forever, and there will be times when that standard is exceeded. What do you do about that? I’ve mused in the past about how much one should devote to preparing for the unlikely disaster. Among other things, the events of 2007-2008 prove there’s no easy answer.”

Risk, Making Mistakes, Process Over Outcome

“High absolute return is much more recognizable and titillating than superior risk-adjusted performance. That’s why it’s high-returning investors who get their pictures in the papers. Since it’s hard to gauge risk and risk-adjusted performance (even after the fact), and since the importance of managing risk is widely underappreciated, investors rarely gain recognition for having done a great job in this regard. That’s especially true in good times.”

“Risk – the possibility of loss – is not observable. What is observable is loss, and generally happens only when risk collides with negative events…loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment.”

“…the absence of loss does not necessarily mean the portfolio was safely constructed…A good builder is able to avoid construction flaws, while a poor builder incorporates construction flaws. When there are no earthquakes, you can’t tell the difference…That’s what’s behind Warren Buffett’s observation that other than when the tide goes out, we can’t tell which swimmers are clothed and which are naked.”

Good risk management = implementing prevention measures.

Once planted, the seeds of risk can remain dormant for years. Whether or not they sprout into loss depends on the environment and its conditions.

In other words, mistakes that result in losses are often made long before losses occur. Although loss was not the ultimate outcome does not mean mistakes were not made.

Stanley Druckenmiller Wisdom - Part 1

Druckenmiller is a legendary investor, and protégé of George Soros, who compounded capital ~30% annualized since 1986 before announcing in 2010 that his Duquesne fund would return all outside investor capital, and morph into a family office. Many of our Readers reside in the House of Value, but I believe that value investors can learn from those with more trading-oriented or macro philosophies – especially in terms of volatility considerations, trade structuring, and capital preservation.

The following portfolio management highlights were extracted from an interview with Stanley Druckenmmiller in Jack D. Schwager’s book The New Market Wizards. Be sure to check out Part 2 & Part 3.

Trackrecord, Capital Preservation, Compounding, Exposure

“Q: Your long-term performance has far surpassed the industry average. To what do you attribute your superior track record?

A: George Soros has a philosophy that I have also adopted: he way to build long-term returns is through preservation of capital and home runs. You can be far more aggressive when you’re making good profits. Many managers, once they’re up 30 or 40 percents, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the convictions, go for a 100 percent year. If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns.”

“Many managers will book their profits when they’re up a lot early in the year. It’s my philosophy, which has been reinforced by Mr. Soros, that when you earn the right to be aggressive, you should be aggressive. The years that you start off with a large gain are the times that you should go for it. Since I was well ahead for the year, I felt that I could afford to fight the market for a while. I knew the bull market had to end, I just didn’t know when. Also, because of the market’s severe overvaluation, I thought that when the bull market did end, it was going to be dramatic.”

We’ve discussed the importance of capital preservation, and its complementary relationship to long-term compounding. Here is Drunkenmiller’s well-articulated version of the same concept…plus a fascinating twist.

As dictated by the Rules of the Game, the scorecard in the investment management world is your trackrecord in the form of calendar year returns. The concept of earning the “right to be aggressive” in certain calendar years echoes in my mind like a siren song, so dangerous yet utterly irresistible.

Most traditional value investors would not dare dream of enacting such a brazen act. But, if you keep an open mind to ponder and digest, it makes a lot of sense.

UPDATE: One Reader (and friend who is very very bright) suggested that the genius behind the "right to be aggressive" derives from its utter contradiction of traditional value doctrine.  Buffett and Munger would say wait for an opportunity and then be aggressive.  Druckenmiller's effectively saying that he doesn't think you can ever truly know when it's a great time....so you wait until you know something for a fact: that you are having a good year.

Expected Return, Opportunity Cost

“…an attractive yield should be the last reason for buying bonds. In 1981 the public sold bonds heavily giving up a 15 percent return for thirty years because they couldn’t resist 21 percent short-term yields. They weren’t thinking about the long term. Now, because money market rates are only 4.5 percent, the same poor public is back buying bonds, effectively lending money at 7.5 percent for thirty years…”

Sadly the situation has deteriorated further. Today, money markets yield ~0% and thirty year bonds pay ~3%.

It’s important to remember that portfolio expected return should not be determined solely based upon returns available today, but also opportunities around the corner, not yet visible. This is what makes opportunity cost so difficult to determine – it's often a gut judgment call that involves predicting the availability of future expected returns.

Team Management

On working with George Soros:

“The first six months of the relationship were fairly rocky. While we had similar trading philosophies, our strategies never meshed. When I started out, he was going to be the coach – and he was an aggressive coach. In my opinion, Gorge Soros is the greatest investor that ever lived. But even being coached by the worlds greatest investor is a hindrance rather than help if he’s engaging you actively enough to break your trading rhythm. You just can’t have two cooks in the kitchen; it doesn’t work. Part of it was my fault because he would make recommendations and I would be intimidated. After all, how do you disagree with a man with a track record like his?

Events came to a head in August 1989 when Soros old out a bond position that I had put on. He had never done that before. To make matters worse, I really had a strong conviction on the trade. Needless to say, I was fairly upset. At that point, we had our first let-it-all-out discussion…Basically, Soros decided that he was going to stay out of m hair for six months.”

Buffett Partnership Letters: 1963 Part 4

Continuation in a series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Compounding, Capital Preservation

“Since the whole subject of compounding has such as crass ring to it, I will attempt to introduce a little class into this discussion by turning to the art world. Francis I of France paid 4,000 ecus in 1540 for Leonardo da Vinci’s Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the ecu, 4,000 converted out to abut $20,000.

If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000.00. That’s $1 quadrillion…all from 6%.

…there are other morals to be drawn here. One is the wisdom of living a long time. The other impressive factor is the swing produced by relatively small changes in the rate of compound.”

“If, over a meaningful period of time, Buffett Partnership can achieve an edge of even a modest number of percentage points over the major investment media, its function will be fulfilled.”

Starting around the early 1960s, Buffett discusses the concept of compounding more frequently – perhaps because he’s become increasingly interested in its power. After all, an author’s words often reflect the subject most prevalent in his/her mind.

We likewise believe that compounding is an important, yet under-discussed, area of investment management. The entire investment management industry stems from the belief in (oneself or others) the ability to compound capital at a higher rate than “average” (however you define “average”).

Our industry often profiles the “flavors of the week,” putting those with spectacular short-term returns on display. Unfortunately, investor prone to spectacular upside returns, are sometimes also prone to disastrous drawdowns.

Which brings to my mind the trackrecord of a well-known oil and gas investor. His long-term trackrecord was spectacular (something in the range of 20-30%+ annually for 20+ years) until he became enamored with natural gas (in all fairness, he may yet be proven correct in the “long-run”). In either 2009 or 2010 (when the price of natural gas plummeted) he produced a -97% year. Yep, minus ninety-seven percent.

Unfortunately, the law of compounding hath no pity. If you invested $1,000 with him at the very beginning, compounded at 25% for 20 years, but stayed around to experience the -97% return, the investment that was worth $86,736 in year 20 was now only worth $2,602 in year 21 (which doesn’t include the fees you paid over the years, so chances are, you’ve actually experienced loss of principal).

Remember, it was the tortoise, not the hare, who won the race. A 1-2% outperformance relative to “average” may seem negligible in the short-term, but over the course of many years, the absolute dollar contribution of that excess margin of return becomes substantial. It never hurts to remind your investors, every once in awhile, as Buffett did.

More from Ted Lucas

In this piece, Ted Lucas of Lattice Strategies discusses the relationship between correlation and diversification, as well as the intricate task of building investment portfolios that remain resilient during market drawdowns, yet retain upside participation during bull markets. To explore some of his other writings, they are all archived on Lattice Strategies’ website.Risk, Capital Preservation, Compounding

“But ‘risk management’ on its own is an abstraction, as is ‘beating the market’ over a short time period, if the end goal is to generate a real capital growth over a longer time window…For an asset manager seeking to generate long-term real growth of capital, the design problem is creating a portfolio structure that can both withstand periods of market turbulence and capture returns when they are available.”

Lucas highlights a very real dilemma for all investors: the tricky task of reconciling the goals of capital growth (compounding) with capital preservation. The frequently mentioned “abstraction” of “risk management” is merely a tool available to each investor to be incorporated, if and when necessary, to assist with this task.

Correlation, Diversification

Prior to the financial crisis in 2008, people believed that correlations between asset classes had “decoupled” given new breakthroughs on how risk was redistributed in the financial and economic markets, etc. Investors paid dearly for this assumption when many asset classes (equity, high yield, real estate, commodities, etc.) originally believed to be uncorrelated, all plummeted in value at the same time.

With investors still licking 2008 wounds, the opposite is now occurring. As Lucas writes, “There is much recent discussion about asset correlations rising to such elevated levels that diversification has been rendered useless.”

Correlation of assets/securities has a meaningful impact on the effects of diversification. Afterall, as Jim Leitner astutely points out, “diversification only works when you have assets which are valued differently…” Therefore, if all the assets/securities in your portfolio are highly correlated, diversification would be rendered useless regardless of how many positions you hold.

Lucas believes that investor fear of high asset correlations are overdone. I don’t have enough evidence to either agree or disagree with this view. However, the investing masses have a tendency to project the near-term past into the long-term future, and today’s assumptions about elevated levels of asset correlation could very well be overdone.

Regardless of whether you believe today’s asset correlations are high or low, the takeaway is that your view on future asset/security correlations will (or at least it should) influence your portfolio allocation decisions, because it directly impacts diversification and the volatility profile of your return stream.

Definition of Investing

“Here is a basic idea: the purpose of investing is to grow whatever capital is invested in real terms.”

Wisdom from Steve Romick: Part 2

Continuation of content extracted from an interview with Steve Romick of First Pacific Advisors (Newsletter Fall 2010) published by Columbia Business School. Please see Part 1 for more details on this series.  

Capital Preservation, Conservatism

“Most of our financial exposure is on the debt side. We were able to buy loans with very strong collateral, which we thought we understood reasonably well, and we stress tested the portfolios to determine what our asset coverage would be in a worst case scenario. We ended up buying things like Ford Credit of Europe, CIT, American General Finance, and International Lease Finance. We discounted the underlying assets tremendously, and in every case we didn‘t think we could lose money so we just kept buying.”

“The biggest lesson I ever learned from Bob is to prepare for the worst and hope for the best.”

Underwriting to an extremely conservative, worst case scenario helps minimize loss while increasingly likelihood of upside. This is similar to advice given by Seth Klarman in a previous interview with Jason Zweig.

Exposure, Intrinsic Value

“A lot of that has been culled back. The yield on our debt book was 23% last year and now it‘s less than 8%.”

The relationship between exposure and intrinsic value has been something we’ve previous discussed, nevertheless it remains an intriguingly difficult topic. Even Buffett ruminated over this in 1958 without providing a clear answer to what he would do.

For example:

Day 1 Asset 1 purchase for $100 Asset 1 is sized at 10% of total portfolio NAV Expected Upside is $200 (+100% from Day 1 price) Expected Downside is $80 (-20% from Day 1 price) Everything else in the portfolio is held as Cash which returns 0%

Day 2 Asset 1’s price increases to $175 Asset 1 is now worth 16.2% of total portfolio NAV (remember, everything else is held as Cash) Expected Upside is now +14.2% ($175 vs. $200) Expected Downside is now -54.2% ($175 vs. $80)

What would you do?

Not only has the risk/reward on Asset 1 changed (+14.2% to -54.2% on Day 2 vs. +100% to -20% on Day 1), it is now also worth a larger percentage of portfolio NAV (16.2% on Day 2 vs. 10.0% on Day 1)

Do you trim the exposure despite the price of Asset 1 not having reached its full expected intrinsic value of $200?

Steve Romick’s words seem to imply that he trimmed his exposure as the positions increased in value.

Risk, Hedging

“You can protect against certain types of risk, not just by hedging your portfolio, but by choosing to buy certain types of companies versus others.”

Practice risk “prevention” by choosing not to buy certain exposures, versus neutralizing risks that have already leaked into the portfolio via hedges (which require additional attention, not to mention option premium).

Klarman-Zweig Banter: Part 2

Here is Part 2 of tidbits from a conversation between Seth Klarman and Jason Zweig. Part 1 and the actual text of the interview is available here. Time Management

“…sourcing of opportunity…a major part of what we do – identifying where we are likely to find bargains. Time is scarce. We can’t look at everything.”

“...we also do not waste a lot of time keeping up with the latest quarterly earnings of companies that we are very unlikely to ever invest in. Instead, we spent a lot of time focusing on where the misguided selling is, where the redemptions are happening, where the overleverage is being liquidated – and so we are able to see a flow of instruments and securities that are more likely to be mispriced, and that lets us be nimble.

Team Management

“…we are not conventionally organized. We don’t have a pharmaceutical analyst, an oil and gas analyst, a financials analyst. Instead, we are organized by opportunity.” Examples include spinoffs, distressed debt, post-bankruptcy equities.

During the recruiting and screening process, Baupost looks for “intellectual honesty…we work hard to see whether people can admit mistakes…We ask a lot of ethics-related questions to gauge their response to morally ambiguous situations. We also look for ideational fluency, which essentially means that someone is an idea person…do they immediately have 10 or 15 different ideas about how they would want to analyze it – threads they would want to pull a la Michael Price…we are looking for people who have it all: ethics, smarts, work ethic, intellectual honesty, and high integrity.”

Michael Price, Creativity

Mike taught him the importance of an endless drive to get information and seek value, as well as creativity in seeking opportunities.

“I remember a specific instance when he found a mining stock that was inexpensive. He literally drew a detailed map – like an organization chart – of interlocking ownership and affiliates, many of which were also publicly traded. So, identifying one stock led him to a dozen other potential investments. To tirelessly pull treads is the lesson that I learned from Mike Price.”

Risk, Creativity

The process of risk management is not always straightforward and requires creative thought. “An investor needed to put the pieces together, to recognize that a deteriorating subprime market could lead to problems in the rest of the housing markets and, in turn, could blow up many financial institutions. If an investor was unable to anticipate that chain of events, then bank stocks looked cheap and got cheaper.”

Capital Preservation, Conservatism

“Avoiding round trips and short-term devastation enables you to be around for the long term.”

“We have picked our poison. We would rather underperform in a huge bull market than get clobbered in a really bad bear market.”

During 2008, Baupost employed a strategy of identifying opportunities by underwriting to a depression scenario. “We began by asking, ‘Is there anything we can buy and still be fine in the midst of a depression?’ Our answer was yes…Ford bonds had an amazing upside under almost any scenario – if default rates only quadrupled (rather than octupled, as we assumed) to 20%, the bonds were worth par – and thus appeared to have a depression-proof downside.”

“Our goal is not necessarily to make money so much as to do everything we can to protect client purchasing power and to offset, as much as possible, a large decline in market value in the event of another severe global financial crisis…we also want to avoid the psychological problem of being down 30 or 40 percent and then being paralyzed.”

Foreign Exchange, Benchmark, Inflation

“We judge ourselves in dollars. Our clients are all effectively in the United States…we hedge everything back to dollars.” Michael Price used to do the same. Please see an earlier post on an interview given by Michael Price.

“When Graham was talking about safety of principal, he was not referring to currency. He wasn’t really considering that the currency might be destroyed, but we know that can happen, and has happened many times in the 20^th century.”

Klarman is worried “about all paper money,” and has also mentioned Baupost’s goal to “protect client purchasing power.” Does he mean purchasing power on a global basis? Which brings forth an interesting dilemma: as the world becomes increasingly connected, and clients become increasingly global, will return benchmarks still be judged in US dollars and US-based inflation metrics?

Lessons from Jim Leitner - Part 3 of 3

Here is Part 3 on the wonderfully insightful interview in Steve Drobny's book The Invisible Hands with Jim Leitner, who runs Falcon Investment Management, and was previously a member of Yale Endowment's Investment Committee. Leitner is an investor who has spent considerable time contemplating the science and art of investing, making money opportunistically across all asset classes, unconstrained, focused on finding the right price and structure, not losing money...and remaining humble (an increasingly rare quality in our industry).

His very clearly articulated thoughts about hedging, risk management, cash, and a number of other topics are profound. Below is Part 3 of a summary of those thoughts (please also see Part 1 and Part 2). I would highly recommend the reading of the actual chapter in its entirety.

Definition of Investing

“Investing is the art and science of extracting risk premia from financial markets over time.”

Risk, Preservation of Capital, Volatility

The risk management process starts with what you buy and how you structure those “themes and trades.” Jim manages his portfolio with a particular focus on the downside, where he “never wants to lose more than 20 percent and structures his portfolio to make sure that under no possible scenario can he ever exceed this loss threshold.”

People have a tendency to spend “more time thinking about returns than about how to manage downside risk. The investment process seems to be driven by a need to generate certain returns rather than a need to avoid absolute levels of loss on deployed capital.”

Jim gives a number of reasons why it’s important to preserve capital and limit downside volatility.

1. Psychological – the emotional damage and potential impact on decision making, associated with large losses even if they’re unrealized or not permanent. He talks about not being willing to lose more than 10% in any given month, no more than 20% in any given year – these figures were determined based on personal “psychological recognition.”
2. Career Risk – investors and bosses may not care that your losses are unrealized or not permanent
3. Negative Compounding – After a drawdown, the law of mathematics makes it an uphill battle to get back to even. For example, when an investor is down 40%, it means he/she would need to make 67% to breakeven. This doesn’t account for any cash outflows/redemptions, which makes it even more difficult to get back to breakeven $ wise.

“While I am not sure what my focus on truncating downside risk has cost me over time in terms of lost opportunity, I am certain that I have not maximized return. But at least I can be sure that I will be around for future opportunities.”

Diversification

As a part of his process, he tries to identify crowded trades, securities, assets, “even portfolio approaches” because “…diversification only works when you have assets which are valued differently…If everything is expensive, everything will go down, so it doesn’t really matter if you own different things for diversification’s sake.”

Lesson from 2007-2008: “At the beginning of this period, all risk assets were no longer cheap. There was no real diversification in owning a portfolio of overvalued assets. This is the true lesson. Overvaluation becomes a risk factor that must be addressed directly in portfolio construction.”

And it begins...with Michael F. Price

Michael F. Price is going to kick off our inagural post. Well, sort of. I'd like to share the summary (mainly the categorized juicy portfolio management bits) of an interview with MFP in Peter J. Tanous' book Investment Gurus.

Sourcing, Creativity: Price discusses how competitive the traditional bankruptcy and restructuring game has become (this was 1997 folks, think of how much more competitive it must be today). As a creative way to deploy capital into distressed situations, he would do “standby purchaser” deals, in which companies would do a rights offering to raise additional capital and reserve a certain % of the deal for Mutual Series, as well as whatever % existing shareholders didn’t want. These “standby purchaser” deals required him to keep an eye out for companies near liquidity crunches, and meet with them beforehand to offer his assistance, thereby requiring more work and proprietary sourcing, but involved far less competition than traditional bankruptcy/restructuring situations. Reminds of the recent Buffett deals (convertible preferred + warrants) with GE, Goldman Sachs, Bank of America.

Risk: “Risk is not the same as volatility. It’s very hard to measure risk. It’s very simple to measure return. You can’t model it.” He also discusses how earnings and asset value both help mitigate risk.

Cash / Special Situations / Volatility: Cash is ~5-25% of his portfolio “always.” Special situations (bankruptcy, arbitrage, tender offer, merger, buyback, liquidation, etc.) positions don’t move with general market but more with progress of individual situation. Cash + Special Situation is ~40% portfolio. The remaining ~60% consists of POCS (Plain Old Common Stock, value ideas trading below “intrinsic value”) which should theoretically go down less than the market. Therefore his portfolio beta is ~0.6.

Catalyst, Activism: “We perform well because some of our stocks have these catalysts. You asked why do we spend our time going around to shake some cages? It’s because a lot of times you can buy good values. But until there’s a catalyst, the value is not going to get realized.”

Turnover: Portfolio turnover is in mid-70s, skewed upwards by Special Situations basket.

Capital Preservation: “My mission isn’t to make money in bull markets. My mission is to preserve capital.”

Foreign Exchange: “Foreign positions are hedged perfectly every day so currency movements don’t affect our fund price.”

So there you have it: a little sample to whet your appetite! I'll be posting more summaries from other great investors in the weeks and months ahead, be sure to check back for updates.