Buffett Partnership Letters: 1966 Part 1

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

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

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

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

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

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

Sizing, AUM

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

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

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

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

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

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

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

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

Sizing, Diversification

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

Hochschild, Kohn = 10% NAV

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

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

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.

Buffett Partnership Letters: 1964 Part 3

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Historical Performance Analysis, Process Over Outcome, Psychology

“…the workouts (along with controls) saved the day in 1962, and if we had been light in this category that year, our final results would have been much poorer, although still quite respectable considering market conditions during the year…In 1963 we had one sensational workout which greatly influenced results, and generals gave a good account of themselves, resulting in a banner year. If workouts had been normal, (say, more like 1962) we would have looked much poorer compared to the Dow…Finally, in 1964 workouts were a big drag on performance.”

There is a chart in the January 18, 1965 partnership letter, in which Buffett breaks down the performance of Generals vs. Workouts for 1962-1964, and discusses the return attribution of each category in different market environments.

Most investors conduct some form of historical performance review, on a quarterly or annual basis. It’s an important exercise for a variety of reasons:

• To better understand your sources of historical return – performance analysis forces you to examine the relationship between your process vs. the outcome. Was the outcome as expected? If not, do changes need to be made to the process?
• To help you and your team become more self-aware – what you do well, badly, and perhaps reveal patterns of behavioral strength and weakness (here's an article about an interesting firm that offers this analysis)
• Team Compensation
• Highlight necessary adjustment to the portfolio and business
• Etc.

The investment management world spends a lot of time scrutinizing the operations of other businesses. Shouldn’t we apply the same magnifying glass to our own?

Sizing, Catalyst, Hedging, Activism, Control

“What we really like to see in situations like the three mentioned above is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it…Such activity should usually result in either appreciation of market prices from external factors or the acquisition by us of a controlling position in a business at a bargain price. Either alternative suits me.”

“Many times…we have the desirable ‘two strings to our box’ situation where we should either achieve appreciation of market prices from external factors or from the acquisition of control positions in a business at a bargain price. While the former happens in the overwhelming majority of cases, the latter represents an insurance policy most investment operations don’t have.”

Buffett discusses the phenomenon known as the “two strings” on his bow which allowed for heavy concentration in a few positions. The potential to (eventually) acquire a controlling stake in the underlying company served has an “insurance policy” via the creation of a catalyst after asserting control. (Some may argue that activism is applicable here as well. However, we tread cautiously on this train of thought because activism by no means entails a 100% success rate.)

It’s important to understand that control is not an option available to all investors. Therefore, when sizing positions, one should reconsider the exact emulation of Buffett’s enthusiastic buying as price continues to decline, and concentrated approach.

Interestingly, if a controlling stake in a company serves as an insurance policy (as Buffett describes it), is ‘control’ a type of portfolio hedge?

Activism, Control

“We have continued to enlarge the positions in the three companies described in our 1964 midyear report where we are the largest stockholders…It is unlikely that we will ever take a really active part in policy-making in any of these three companies…”

Control ≠ Activism

Conservatism

“To too many people conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional or an unconventional approach, per se, is conservative.”

“Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. In some corner of the world they are probably still holding regular meetings of the Flat Earth Society.”

“We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t. A public opinion poll is no substitute for thought. When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case – whether conventional or unconventional – whether others agree or disagree – we feel we are progressing in a conservative manner.”

More Baupost Wisdom

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

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

When To Buy, Conservatism, Barbell

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

When To Buy, Portfolio Review

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

Risk

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

Hedging

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

Hedging, Sizing

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

Cash, AUM

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

Returning Capital, Sizing

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

Leverage

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

Selectivity

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

Time Management, Sizing

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

Team Management

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

Trackrecord

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

Sourcing

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

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).

Baupost Letters: 1995

Here is the first installment of a 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 for this series.

When To Buy, Risk

In a previous article on The Pensioner in Steve Drobny’s book Invisible Hands, we discussed how most people analyze risk as an afterthought once a portfolio has been constructed (whether by identifying factors, or by analyzing the resulting return stream), and not usually as an input at the beginning of the portfolio construction process.

Klarman’s discusses how risk can slip into the portfolio through the buying process, for example, when investors purchase securities too soon and that security continues to decline in price.

This would support the idea of controlling risk at the start, not just the end. To take this notion further, if risk can sneak in through the buying process, can it also do so during the diligence process, the fundraising process (certain types of client, firm liquidity risk), etc.?

Benchmark, Conservatism, Clients

Baupost is focused on absolute, not relative performance against the S&P 500.

Similar to what Buffett says about conservatism, Klarman believes that the true test for investors occurs during severe down markets. Unfortunately, the cost of this conservatism necessary to avoid losses during these difficult times is underperformance during market rallies.

Klarman also deftly sets the ground rules and client expectations, such that if they did not agree with his philosophy of conservatism and underperformance during bull markets, they were more than welcomed to take their money and put it with index funds.

Selectivity, Cash

We’ve discussed in the past the concept of selectivity– a mental process that occurs within the mind of each investor, and that our selectivity criteria could creep in either direction (more strict or lax) with market movements.

Klarman is known for his comfort with holding cash when he cannot find good enough ideas. This would imply that his level of selectivity does not shift much with market movements.

The question then follows: how does one ensure that selectivity stays constant? This is easily said in theory, but actual implementation is far more difficult, especially when one is working with a large team.

Catalyst, Volatility, Special Situations

Following in the tradition of Max Heine and Michael Price, Klarman invested in special situations / catalyst driven positions, such as bankruptcies, liquidations, restructurings, tender offers, spinoffs, etc.

He recognized the impact of these securities on portfolio volatility, both the good (cushioning portfolio returns during market declines by decoupling portfolio returns from overall market direction) and the bad (relative underperformance in bull markets).

Hedging

Many people made money hedging in 2008. In the true spirit of performance chasing, hedging remains ever popular today, 4 years removed from the heart of financial crisis.

Hopefully, our Readers have read our previous article on hedging, and the warnings from other well-known investors (such as AQR and GMO) to approach with caution. I believe that hedging holds an important place in the portfolio management process, but investors should hold no illusion that hedging is ever profitable.

For example, even the great Seth Klarman has lost money on portfolio hedges. However, he continues to hedges with out-of-the-money put options to protect himself from market declines.

The moral of the story: be sure to carefully consider the purpose of hedges and the eventual implementation process, especially in the context of the entire portfolio as a whole.

Buffett Partnership Letters: 1961 Part 4

This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. For those interested in Warren Buffett’s portfolio management style, I highly recommend the reading of the second 1961 letter in its entirety, and to check out our previous posts on 1961.

Conservatism

“Many people some years back thought they were behaving in the most conservative manner by purchasing medium or long-term municipal or government bonds. This policy has produced substantial market depreciation in many cases, and most certainly has failed to maintain or increase real purchasing power.”

“You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you…You will be right, over the course of many transactions, if your hypothesis is correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”

“I might add that in no way does the fact that our portfolio is not conventional provide that we are more conservative or less conservative than standard methods of investing. This can only be determined by examining the methods or examining the results. I feel the most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets.”

Conservatism ≠ Buying “Conservative” Securities

Food for thought: currently (today’s date is 6/23/12), millions of retirees and older individuals in America hold bonds and other fixed income securities believing that they are investing “conservatively.” In light of current bond market conditions, where the 10-Year Treasury and 30-Year Treasury yields 1.67% and 2.76% respectively, is it time for people to reconsider the traditional definition of conservatism and conservative allocation? The bond example recounted by Buffett sounds hauntingly familiar. According to history, it ended badly for bond holders the last time around.

Buffett also highlights the importance of focus on conservatism inherent in the investment process, that of objective fact gathering and interpretation “through knowledge and reason.”

Interestingly, the last quote above implies that Buffett believed “evaluation of performance in down markets” an adequate measure of conservatism. Another name for this measurement is called drawdown analysis, and drawdown analysis is very much a measure of volatility (i.e., temporary impairment of capital). How then, does this view reconcile with his later comments about temporary vs. permanent impairments of capital?

Clients, Benchmark

“The outstanding item of importance in my selection of partners, as well as in my subsequent relations with them, has been the determination that we use the same yardstick. If my performance is poor, I expect partners to withdraw…The rub, then, is in being sure that we all have the same ideas of what is good and what is poor. I believe in establishing yardsticks prior to the act; retrospectively, almost anything can be made to look good in relation to something or other.”

“While the Dow is not perfect (nor is anything else) as a measure of performance, it has the advantage of being widely known, has a long period of continuity, and reflects with reasonable accuracy the experience of investors generally with the market…most partners, as an alternative to their investment in the partnership would probably have their funds invested in a media producing results comparable to the Dow, therefore, I feel it is a fair test of performance.”

For any business, tapping the right client base and keeping those clients happy is crucial. Buffett advises the establishment of a mutually agreed upon objective (i.e., benchmark), so that the client and portfolio manager can mutually agree whether performance during any given period is “good” or “poor.” Coincidentally, this is similar to what Seth Klarman advises during an interview with Jason Zweig.

This is why the benchmark is so important – it is the mechanism through which clients can decide if a portfolio manager is doing a good or bad job. Picking the right benchmark is the tricky part…

Clients

“With over 90 partners…”

For those of you wondering how many clients Buffett had in his partnerships at the end of 1961, there you go!

Trackrecord, Mark To Market, Liquidity

“Presently, we own 70% of the stock of Dempster with another 10% held by a few associates. With only 150 or so other stockholders, a market on the stock is virtually non-existent…Therefore, it is necessary for me to estimate the value at yearend of our controlled interest. This is of particular importance since, in effect, new partners are buying in based upon this price, and old partners are selling a portion of their interest based upon the same price…and at yearend we valued our interest at $35 per share. While I claim no oracular vision in a matter such as this, I believe this is a fair valuation to both new and old partners.”

With such a large, illiquid controlling stake, Buffett had difficulty determining the “fair” mark to market for Dempster. Dilemmas such as this are still commonplace today, especially at funds that invest in illiquid or private companies.

As Buffett points out, the mark directly impacts new and old investors who wish to invest or redeem capital from the fund. Anyone who invests in a fund of this type should carefully diligence the mark to market methodology before investing (and redeeming) capital.

There’s another more murky dimension, the investment management industry’s dirty little secret: difficulty in determining an accurate mark makes it possible for funds to “jimmy” the mark and therefore influence the performance trackrecord / return stream reported to investors.

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?