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 18

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 18 “The Most Important Thing Is…Avoiding Pitfalls” Risk, Volatility

“…trying to avoid losses is more important than striving or great investment successes. The latter can be achieved some of the time, but the occasional failures may be crippling. The former can be done more often and more dependably…and with consequences when it fails that are more tolerable…A portfolio that contains too little risk can make you underperform in a bull market, but no one ever went bust from that; there are far worse fates.”

“You could require your portfolio to do well in a rerun of 2008, but then you’d hold only Treasurys, cash and gold. Is that a viable strategy? Probably not. So the general rule is that it’s important to avoid pitfalls, but there must be a limit. And the limit is different for each investor.”

Volatility, Psychology, Trackrecord, When To Buy, When To Sell, Clients

“…almost nothing performed well in the meltdown of 2008…While it was nigh onto impossible to avoid declines completely, relative outperformance in the form of smaller losses was enough to let you do better in the decline and take grater advantage of the rebound.”

“In periods that are relatively loss free, people tend to think of risk as volatility and become convinced they can live with it. If that were true, they would experience markdowns, invest more at the lows and go on to enjoy the recovery, coming out ahead in the long run. But if the ability to live with volatility and maintain one’s composure has been overestimated—and usually it has—that error tends to come to light when the market is a its nadir. Loss of confidence and resolve can cause investors to sell at the bottom, converting downward fluctuations into permanent losses and preventing them from participating fully in the subsequent recovery. This is the great error in investing—the most unfortunate aspect of pro-cyclical behavior—because of its permanence and because it tends to affect large portions of portfolios.”

“While it’s true that you can’t spend relative outperformance, human nature causes defensive investors and their less traumatized clients to derive comfort in down markets when they lose less than others. This has two very important effects. First, it enables them to maintain their equanimity and resist the psychological pressures that often make people sell at lows. Second, being in a better frame of mind and better financial condition, they are more able to profit from the carnage by buying at lows. Thus, they generally do better in recoveries.”

Volatility is not the true risk; the true risk lies in what investors do / how they behave during volatile periods.

Mistakes, Creativity, Psychology

“One type of analytical error…is what I call ‘failure of imagination’…being unable to conceive of the full range of possible outcomes or not fully understanding the consequences of the more extreme occurrences.”

“Another important pitfall…is the failure to recognize market cycles and manias and move in the opposite direction. Extremes in cycles and trends don’t occur often, and thus they’re not a frequent source of error, but they give rise to the largest errors.”

“…when the future stops being like the past, extrapolation fails and large amounts of money are either lost or not made…the success of your investment actions shouldn’t be highly dependent on normal outcomes prevailing; instead, you must allow for outliers…"

“…the third form of error doesn’t consist of doing the wrong thing, but rather of failing to do the right thing. Average investors are fortunate if they can avoid pitfalls, whereas superior investors look to take advantage of them…a different kind of mistake, an error of omission, but probably one most investors would be willing to live with.”

“The essential first step in avoiding pitfalls consists of being on the lookout for them…learning about pitfalls through painful experience is of only limited help. The key is to try to anticipate them…The markets are a classroom where lesson are taught every day. The keys to investment success lie in observing and learning.”

“The fascinating and challenging thing is that the error moves around. Sometimes prices are too high and sometimes they’re too low. Sometimes the divergence of prices from value affects individual securities or assets and sometimes whole markets – sometimes one market and sometimes another. Sometimes the error lies in doing something and sometimes in not doing it, sometimes in being bullish and sometimes in being bearish…avoiding pitfalls and identifying and acting on error aren’t susceptible to rules, algorithms, or roadmaps. What I would urge is awareness, flexibility, adaptability and a mind-set that is focused on taking cues from the environment.”

Correlation, Diversification, Risk

“There’s another important aspect of failure of imagination. Everyone knows assets have prospective returns and risks, and they’re possible to guess at. But few people understand asset correlation: how one asset will react to a change in another, or that two assets will react similarly to a change in a third. Understanding and anticipating the power of correlation – and thus the limitations of diversification – is a principal aspect of risk control and portfolio management, but it’s very hard to accomplish…Investors often fail to appreciate the common threads that run through portfolios.”

“Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem. It’s easier to assess the return and risk of an investment than to understand how it will move relative to others. Correlation is often underestimated, especially because of the degree to which it increases in crisis. A portfolio may appear to be diversified as to asset class, industry and geography, but in tough times, non-fundamental factors such as margin calls, frozen markets and a general risk in risk aversion can become dominant, affecting everything similarly.”

Hedging, Expected Return, Opportunity Cost, Fat Tail

“…a dilemma we have to navigate. How much time and capital should an investor devote to protecting against the improbable disaster? We can insure against every extreme outcome…But doing so will be costly, and the cost will detract form investment returns when that protection turns out not to have been needed…and that’ll be most of the time.”

Long Weekend Beer & Reflection

A few months ago, a friend sent me this gem of an article titled Some Thoughts On Becoming An Independent Fund Manager. Perfect light reading (and reflection) for Labor Day Weekend – grab an alcoholic beverage and enjoy!

The Illusion That Returns Are Enough

"I believed if we delivered high double-digit returns at relatively low volatility, the rest of the business would take care of itself. I have been cured of that illusion." --Andy Redleaf, Whitebox Anyone who believes that investment acumen alone is enough to build a successful investment management business should read the article below. Excerpts are derived from Andy Redleaf's April 2014 Commentary.

“Back in 1999 when I launched Whitebox, I was determined to build an investment organization full of intellectually passionate, creative money managers who by working together would perform better than as individuals—with the side benefit of an enormously fun and stimulating place to work. We would be organized around a shared investment philosophy, driven by unconventional investment ideas, and settle disagreements by reasoned argument and persuasion, not reversion to status and testosterone wars. If we had a cult it would be a cult of ideas, not of personality.

When I left Deephaven Capital Management I was in a position financially to do pretty much what I liked, including going back to what I had done for most of my career: make a nice living trading on my own account. I knew I didn’t want to do that. I liked coming up with investment ideas; figuring out what the market was thinking and how to respond, but I didn’t like doing those things alone. I wanted camaraderie. I wanted the stimulation of debate and discussion with other smart people who shared my interests but who knew things I didn’t or had skills I lacked.

So I launched Whitebox as a collaborative, intellectually dynamic organization. It was always intended not as a fund but as a fund family. And it was never my intention to manage any Whitebox fund directly…I wanted to work with people who would be better fund managers than I. My job would be to articulate our investment philosophy, foster collaboration, and propose or critique investment ideas and strategies in a way that would not discourage the flow of ideas but promote it."

"That was always the Whitebox idea. Gather together outstanding managers like Rob, Jason, Paul and our about three dozen investment professionals and talk to each other for fun and business. Twenty of those professionals—myself, the three Global Strategy Heads, and 16 “Senior Portfolio Managers”—are authorized, at need, to trade on their own authority without asking anyone’s permission. Of course they rarely do except in routine matters, because discussion and collaboration is at the core of what we do...I have no data, but I’d guess the average age of senior investment people at Whitebox is on the high side for any hedge fund that has more than a handful. People stay here.

Of those 16 Senior Portfolio Managers, by the way, none of them has an independent P&L. There are firms, even successful firms, that handle talent by giving the talent a little capital, waiting a quarter to see if they lose money or make money and then firing them or giving them more capital accordingly. It’s supposed to be a ruthlessly rational way of evaluating talent, just as the market is supposed to be ruthlessly efficient. I think it is a great way to court disaster. The Hedge Fund as Band of Quasi-Independent Gun Slingers goes against everything we set out to accomplish at Whitebox. It encourages secrecy and all the bad things that come with that. It also wastes people’s brains.

Maybe Einstein orNewton needed to work in splendid solitude, but most pretty-smart people benefit from some intellectual back and forth and the mutual support of a team. Solitude especially makes no sense for an organization focused primarily on arbitraging relative value relationships often across markets or even geographies. Metcalfe’s Law says the value of the network is the square of the nodes. Whitebox is a network of professionals. Their outbound focus may be on a particular strategy or asset class—in that sense we get the benefits of specialization. But looking in or across the network, their job is to share information so that collectively the organization has a broad view of multiple market relationships.

In any case, the fact that 16 SPMs have independent trading authority gives some sense of their stature in the firm and to what extent we have succeeded in building the collaborative, non-hierarchical, principle-based and idea-driven organization we set out to build almost 15 years ago. Our approach to the Investment Committee is another example. Ninety percent of our work is done outside of our weekly meeting in daily ongoing discussion. Even in meetings we don’t vote and no one has a veto—we discuss until we reach consensus."

"When I launched Whitebox I believed if we delivered high double-digit returns at relatively low volatility, the rest of the business would take care of itself. I have been cured of that illusion.

Over the past year or so we’ve been engaged in a monumental effort—still ongoing—to strengthen everything else about the business. Doubling the size of the Marketing Group to improve the customer experience has been part of that. I think it is beginning to show. Certainly we know many of our investors better than we did a year ago, and have more frequent contact. More recently we have expanded the responsibilities of our Communication Group to work more closely with Marketing in refining the tools we use to communicate with investors and prospective investors so that they begin to know us better as well….

Since launching Whitebox nearly 15 years ago, I believe we have built a durable organization, rooted in a set of beliefs, even an ethic, that is the real source of our ongoing success. Whitebox is not just an investment company, it is an investment culture. Helping to build that is what I’d like to be known for."

Elementary Worldly Wisdom - Part 1

The following are portfolio management highlights extracted from a gem of a Munger speech given at USC 20 years ago in 1994. It’s long, but contains insights collected over many years by one of the world's greatest investment minds. Caustically humorous, purely Munger, it is absolutely worth 20 minutes of your day between browsing ESPN and TMZ. Creativity

“…the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form.”

“The…basic approach…that Ben Graham used—much admired by Warren and me…this concept of value to a private owner...if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you've got a lot of edge going for you...

You had a huge margin of safety—as he put it—by having this big excess value going for you. But he was, by and large, operating when the world was in shell shock from the 1930s—which was the worst contraction in the English-speaking world in about 600 years...People were so shell-shocked for a long time thereafter that Ben Graham could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on… 

…the trouble with what I call the classic Ben Graham concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and it wouldn't click.

But such is the nature of people who have a hammer—to whom, as I mentioned, every problem looks like a nail that the Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they'd always done. And it still worked pretty well. So the Ben Graham intellectual system was a very good one…

However, if we'd stayed with classic Graham the way Ben Graham did it, we would never have had the record we have. And that's because Graham wasn't trying to do what we did…having started out as Grahamites which, by the way, worked fine—we gradually got what I would call better insights. And we realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other.

And once we'd gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses…Much of the first $200 or $300 million came from scrambling around with our Geiger counter. But the great bulk of the money has come from the great businesses.”

“…Berkshire Hathaway's system is adapting to the nature of the investment problem as it really is.”

So much of life consists of identifying problems and finding creative solutions. This is also true for the investment business. Yet, our industry sometimes focuses so much on complying with the rules, chasing that institutional $ allocation, that we fail to consider the rationale and why the rules came into existence in the first place. Conventionality does not equate the best approach. 

The content and knowledge featured on PM Jar is far more useful to Readers when digested and synthesized into your own mental latticeworks. Liberal interpretations are encouraged. Great and unique ideas are usually the craziest (at first).

Clients

“…the reason why we got into such idiocy in investment management is best illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, ‘My God, they're purple and green. Do fish really take these lures?’ And he said, ‘Mister, I don't sell to fish.’

Investment managers are in the position of that fishing tackle salesman. They're like the guy who was selling salt to the guy who already had too much salt. And as long as the guy will buy salt, why they'll sell salt. But that isn't what ordinarily works for the buyer of investment advice.

If you invested Berkshire Hathaway-style, it would be hard to get paid as an investment manager as well as they're currently paid—because you'd be holding a block of Wal-Mart and a block of Coca-Cola and a block of something else. You'd just sit there. And the client would be getting rich. And, after a while, the client would think, ‘Why am I paying this guy half a percent a year on my wonderful passive holdings?’

So what makes sense for the investor is different from what makes sense for the manager. And, as usual in human affairs, what determines the behavior are incentives for the decision maker.”

“Most investment managers are in a game where the clients expect them to know a lot about a lot of things. We didn't have any clients who could fire us at Berkshire Hathaway. So we didn't have to be governed by any such construct.”

Clients, Volatility, Trackrecord, Benchmark

“…if you're investing for 40 years in some pension fund, what difference does it make if the path from start to finish is a little more bumpy or a little different than everybody else's so long as it's all going to work out well in the end? So what if there's a little extra volatility.

In investment management today, everybody wants not only to win, but to have a yearly outcome path that never diverges very much from a standard path except on the upside. Well, that is a very artificial, crazy construct…It's the equivalent of what Nietzsche meant when he criticized the man who had a lame leg and was proud of it. That is really hobbling yourself. Now, investment managers would say, ‘We have to be that way. That's how we're measured.’ And they may be right in terms of the way the business is now constructed. But from the viewpoint of a rational consumer, the whole system's ‘bonkers’ and draws a lot of talented people into socially useless activity.”

An Anecdotal Gem

The following anecdote comes from WkndNotes by Eric Peters (a treasure trove of humor and investment insight) and touches upon Tesla. Our readers know that PM Jar does not discuss ideas, and we have no intention of jumping into the Tesla debate or to declare ourselves Musk-lovers. The reason why we are showcasing this excerpt is because reading it, especially the last sentence, struck a chord. Enjoy. " 'Driverless electric Tesla’s, powered by Google, dispatched by Uber will shuttle people around continuously – the technology already exists, this future is inevitable,' explained the brilliant macro CIO, basking in California’s bright sunlight, whisking me 20yrs forward. Of course, regulations need to catch up. They will. 'And annual car sales will collapse from today’s 100mm pace to just 20mm.' You see automobiles are driven only 3% of the time, meaning the world needs far fewer once we harness technology to utilize them more efficiently, continuously. 'In that future, with Tesla as the world’s #2 auto company, it’ll be worth $100bln versus today’s $20bln market cap.' He’s owned Tesla for years, but is now nearly flat, waiting for a pull back. 'Most buyers today think it will be another BMW and with that rather modest ambition, it’s now aggressively priced.' Anyhow, the world is changing rapidly. Accelerating. So equity investors clamor to buy disruptive companies that’ll shape it, drive it. 'Maynard Keynes said in 100yrs, people will need to work 4hrs per week to meet their needs, and here we are.' Naturally, the growth in our 'needs' has far outpaced productivity gains. So we’re working harder than ever. But a radically new phase has begun, where robotics dominate production, services too. Thus the owners of capital and machines will accumulate vastly disproportionate wealth, while the middle class sinks. The poor drown. And governments race to redistribute or face riots, revolution. 'Viewed in this context, Obama-care was inevitable.' So I asked what theme most interests him. You see, he’s developed a series of simple rules to identify errors people make in their investment theses. 'I’m looking for opportunities in areas distorted by people who are afraid of change, yearning for things that are simply never coming back.' "

Embracing Chaos & Randomness

Investing is hard on the psyche. Events don’t always make sense, yet external pressures often demand that you make sense of everything seemingly random. This can lead to frustration stemming from cognitive dissonance -- the discomfort experienced when simultaneously holding two or more conflicting ideas, beliefs, values or emotional reactions. Perhaps this is why I enjoyed reading this speech that a man named Dean Williams gave almost exactly 32 years ago, advocating the value of simplicity and keeping an open mind to new possibilities, even if they don’t always make sense at first. Many thanks to my friend Dhawal Nagpal for sending this across. Psychology, Creativity

“The foundation of Newtonian physics was that physical events are governed by physical laws. Laws that we could understand rationally. And if we learned enough about those laws, we could extend our knowledge and influence over our environment. That was also the foundation of most of the security analysis, technical analysis…methods you and I learned about when we first began in this business…if we just tried hard enough…If we learned every detail about a company…If we discovered just the right variables…Earnings and prices and interest rates would all behave in rational and predictable ways. If we just tried hard enough.

In the last fifty years a new physics came along. Quantum, or sub-atomic physics. The clues it left along its trail frustrated the best scientific minds in the world. Evidence began to mount that our knowledge of what governed events on the subatomic level wasn’t nearly what we thought it would be. Those events just didn’t seem subject to rational behavior or prediction…the investment world I think I know anything about is a lot more like quantum physics than it is like Newtonian physics.”

“…we should be more content with probabilities and admit that we really know very little.”

Williams highlights three tenets of successful investing:

1. Respect the virtues of a simple investment plans

“Albert Einstein said that ‘…more of the fundamental ideas of science are essentially simply and may, as a rule, be expressed in a language comprehensible to everyone.’” 

“The reason for dwelling on the virtue of simple investment approaches is that complicated ones, which can’t be explained simply, may be disguising a more basic defect. They may not make any sense. Mastery often expresses itself in simplicity.”

2. Consistent approaches – good discipline and the sense to carry them out consistently

3. Exercise the “Beginner’s Mind” – opens your mind to more possibilities, avoids cognitive dissonance, and the possibility of confirmation bias

“A very special tolerance for the concept of ‘nonsense’…Expertise is great, but has a bad side effect. It tends to create an inability to accept new ideas.”

“In general, physicists don’t deal in nonsense. Most of them spend their professional lives thinking along well-established lines of thought. The ones who establish the established lines of thought, however, are the ones who aren’t afraid to venture into what any fool could have told them is pure nonsense…‘In the beginner’s mind there are many possibilities, but in the expert’s mind there are few.’”

PM Jar Exclusive Interview With Howard Marks – Part 5 of 5

Below is Part 5 of PM Jar’s interview with Howard Marks, the co-founder and chairman of Oaktree Capital Management, on portfolio management. Part 5: Creating Your Own Art

“You can glean insights from many places and then assemble them into your own formula. You can’t copy somebody else. Well you can – but that’s not very creative.”

PM Jar: Who are your investment intellectual influences?

Marks: Snippets here and there: John Kenneth Galbraith, Charlie Ellis, Nassim Taleb, Mike Milken, Ben Graham, and Warren Buffett more recently. You glean insights from many places and then assemble them into your own formula. You can’t copy somebody else. Well you can – but that’s not very creative. I’ve gleaned snippets from all of those and assembled them into my own philosophy.

PM Jar: Your approach to achieving return asymmetry has been to lose less in down markets, but you’re not going to outperform in up markets. Is that approach Oaktree-specific?      

Marks: It’s inherent in our strategy. It’s inherent in our personalities. It’s inherent in our origins as debt investors. In Security Analysis, Graham & Dodd defined bond investing as a “negative art.” You add to your portfolio results not by what you include, but by what you exclude.

For example, let’s say all high yield bonds pay 6%. If they all pay 6%, then it doesn’t matter which of the ones that pay you buy, since all the ones that pay will give you the same return. Let’s assume 90% will pay, 10% will not pay. On the ones that don’t pay, you’ll lose money. Since all the bonds that pay will have the same return, the critical thing is to exclude the ones that don’t pay.

Obviously, what I’m describing is an extreme formulation. But in general, if you’re a bond investor, there aren’t different degrees of success, only different degrees of failure. The main way to increment your portfolio performance returns (versus your competition and the benchmark) is by avoiding the losers. That’s us. Our great contribution comes through not doing badly in bad times.

But that would not be an effective business model for a venture capitalist. A venture capitalist will be successful if out of every ten investments, seven turn out to be worthless, two break even, and one is Google. So they couldn’t possibly use our approach. We couldn’t possibly be venture capitalists, and they couldn’t possibly be bond investors.

My favorite fortune cookie says, “The cautious seldom err or write great poetry.” We know we’re not going to write that great poetry. We’re not going to have the 20x winner. We are most effective by avoiding mistakes.

Our model, our securities, and our strategies all go together. You have to do the thing that fits you. Different strokes for different folks. There are many ways to skin the cat. Investing is an art form. Take the hundred greatest painters, their paintings look nothing alike. The definition of great is not uniform.

There’s Something About Humility

Readers know that I’m a fan of Ted Lucas of Lattice Strategies. He recently wrote a piece (Applied Risk Strategy 1-21-13 - Humble Confidence and Creativity) discussing the impact of overconfidence on performance, as well as why a good risk management process should involve anticipating how assets behave in certain environments (in other words, predicting future volatility) – a task that requires both creativity and humility (awareness of what you don’t know). Psychology

“Indicators of overconfidence (said differently, lack of humility):

• Self-serving attribution bias – people attributing success to their own dispositions and skills, while attributing failure to external forces or bad luck
• Self-centric bias – individuals overestimating their contribution when taking part in an endeavor involving other participants
• Prediction overconfidence – the overestimation of the accuracy of one’s predictions
• Illusion of control – belief that one has more influence than is the case over the outcome of a random or partially random event.”

Interestingly, in the study referenced, the results showed that neither overconfidence nor over-trepidation were conducive to superior performance in the future. Perhaps we are at our decision making best when striking a fair balance between "gumption" (as Charlie Munger calls it) and healthy skepticism.

Risk, Volatility, Creativity, Psychology

“We need to look no further than the financial crisis five years ago to conclude that statistical artifacts like an asset’s historical beta or volatility – which are, respectively, the orthodox risk measures employed in Modern Portfolio Theory and its handmaiden tool, mean-variance optimization – fail to capture many far more critical elements of risk… A comprehensive philosophy of risk also seeks to understand the conditional dynamics of risk as the backdrop evolves – how do assets respond during varying risk regimes (particularly the most turbulent periods), and across changing macroeconomic contexts?”

“Effective risk allocation – the primary driver of long-term portfolio returns – is at heart a design problem…The most productive efforts here are likely to be those benefiting from the constraint of personal and predictive humility and the cultivation of humility’s companion, expanded creativity.”

For risk management, Lucas advocates that investors pay attention to how “assets respond during varying risk regimes” – something I interpret as anticipating future volatility. Not an easy task and one best approached with healthy doses of both creativity, and humility (awareness of what you don’t know).

Buffett Partnership Letters: 1967 Part 1

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

“…although I consider myself to be primarily in the quantitative school…the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a ‘high-probability insight.’ This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and of course, no insight is required on the quantitative side…So the really big money tends to be made by investors who are right on the qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.

Such statistical bargains have tended to disappear over the years…Whatever the cause, the result has been the virtual disappearance of the bargain issue as determined quantitatively – and thereby of our bread and butter.”

Rome wasn’t built in one day. Neither was Warren Buffett’s investment philosophy. Here, he is debating the merits of quantitative vs. qualitative analysis. In the 1966 & 1967 letters, we see Buffett gradually shifting his investment philosophy, drawing closer to the qualitative analysis for which he’s now famous, under the influence of Charlie Munger.

The necessity of this debate grew as AUM increased and markets got more expensive (disappearance of the quantitative "bread and butter"), and as Buffett considered next steps in career progression. By the end of 1967, he had proven that he can compound capital in a treadmill, fund-style vehicle, but what next, especially as the market environment became difficult and opportunities rare? (More on this in Part 2)

Today, it’s difficult to imagine the Oracle’s investment philosophy ever requiring improvement or change, but here we see evidence that suggests it has indeed evolved over the years. The ability to adapt & improve is what separates the one-trick ponies from the great investors of today and tomorrow.

This brings us to a corollary that’s very much applicable to the asset allocation and investment management world. During the fund manager evaluation process, most clients and allocators focus intensely on historical performance trackrecords because they believe it’s an indicator of potential future performance.

But by focusing on historical figures, it’s possible to lose sight of a very important variable: change.

Our personalities and investment philosophies are products of circumstance, in life and in investing – sensitive to external influences, personal or otherwise. Examples include: emergence of new competition, availability of opportunity sets, increased personal wealth, marriage & family, purchase of baseball teams, drug habits, etc. Even great investors like Warren Buffett have evolved over the years to accommodate those influences.

It would be wise to pay attention to external influences and agents of change (the qualitative) during the fund manager evaluation process, and not rely solely on the historical trackrecord (the quantitative). 

Cash, Liquidity, Volatility

As of November 1^st 1967, “we have about $20 million invested in controlled companies, but we also have over $16 million in short-term governments. This makes a present total of over $36 million which clearly will not participate in any upward movement the stock market may have.”

Around this time, BPL had ~$70MM AUM. This means cash accounted for 23% of NAV, and control positions for 29% of NAV.

The control positions likely had very limited liquidity if Buffett needed to sell. This leads me to wonder if the high cash balance was kept for reasons other than dry powder for future opportunities, such as protection against possible investor redemptions. (Remember, at this juncture, Buffett did not yet have permanent capital).

Also, notice that Buffett’s is very much aware of the expected volatility of his portfolio vs. his benchmark – that over 50% ($36MM) of the portfolio will likely not participate in any upward market movement.

Expected Return, Volatility

“We normally enter each year with a few eggs relatively close to hatching; the nest is virtually empty at the moment. This situation could change very fast, or might persist for some time.”

Quoting Ben Graham: “‘Speculation is neither illegal, immoral nor fattening (financially).’ During the past year, it was possible to become fiscally flabby through a steady diet of speculative bon-bons. We continue to eat oatmeal but if indigestion should set in generally, it is unrealistic to expect that we won’t have some discomfort.”

Expected Return ≠ Expected Volatility

Making Mistakes

“Experience is what you find when you’re looking for something else.”

Probable Munger-ism.

Munger Wisdom: 2013 Daily Journal Meeting

Below are my personal notes (portfolio management highlights) from Charlie Munger’s Q&A Session during the 2013 Daily Journal Shareholders Meeting this Wednesday in Los Angeles. Opportunity Cost

After the meeting, I approached Munger to ask him about his thoughts on opportunity cost (a topic that he mentioned numerous times while answering questions, and in previous lectures and speeches).

His response: “Everyone should be thinking about opportunity cost all the time.”

During the Q&A session, Munger gave two investment examples in which he cites opportunity cost.

Bellridge Oil: During the the Wheeler-Munger partnership days, a broker called to offer him 300 shares of Bellridge Oil (trading at 20% of asset liquidation value). He purchased the shares. Soon after, the broker called again to offer him 1500 more shares. Munger didn’t readily have cash available to make the purchase and would have had to (1) sell another position to raise cash, or (2) use leverage. He didn’t want to do either and declined the shares. A year and a half later, Bellridge Oil sold for 35x the price at which the broker offered him the shares. This missed profit could have been rolled into Berkshire Hathaway.

Boston-based shoe supplier to JCPenney: One of the worst investments Berkshire made, for which they gave away 2% of Berkshire stock and received a worthless asset in return.

For both examples, opportunity cost was considered in the context of what "could have been" when combined with the capital compounding that transpired at Berkshire.

Making Mistakes, Liquidity

DRC (Diversified Retailing Company) was purchased by Munger & Buffett in the 1960s with a small bank loan and $6 million of equity. Munger owned 10% so contributed $600,000. But as soon as the ink dried on the contract, they realized that it wasn’t all that great a business due to “ghastly competition.” Their solution? Scrambled to get out as FAST as possible.

Related to this, be sure to read Stanley Druckenmiller’s thoughts on making mistakes and its relationship to trading liquidity (two separate articles).

Generally, humans are bad at admitting our mistakes, which then leads to delay and inaction, which is not ideal. Notice Druckenmiller and Munger come from completely different schools of investment philosophies, yet they deal with mistakes the exact same way – quickly – to allow them to fight another day. Liquidity just happens to make this process easier.

Another Munger quote related to mistakes: “People want hope.” Don’t ever let hope become your primary investment thesis.

“Treat success and failures just the same.” Be sure to “review stupidity,” but remember that it’s “perfectly normal to fail.”

Leverage

Munger told story about press expansion – newspapers paying huge sums for other newspapers – relying largely on leverage given the thesis of regional market-share monopolies. Unfortunately, with technology, the monopolies thesis disintegrated, and the leverage a deathblow.

Perhaps the lesson here is that leverage is most dangerous when coupled with a belief in the continuation of historical status quo.

Luck, Creativity

The masterplan doesn’t always work. Some of life’s success stories derive from situations of people reacting intelligently to opportunities, fixing problems as they emerge, or better yet:

“Playing the big bass tuba in an open field when it happened to rain gold.”

Turnover

Munger’s personal account had zero transactions in 2012.

Psychology

On the decline of the General Motors: “prosperity made them weak.”

This is a lesson in hubris, and associated behavioral biases, that's definitely applicable to investment management. Investing, perhaps even more so than most businesses, is fiercely competitive. In this zero sum game, the moment we rest on the laurels of past performance success, and become overconfident etc., is the moment future performance decline begins.

Always be aware, and resist behavior slithering in that dangerous direction.

Mandate

Berkshire had “two reasonable options” to deploy capital, into both public and private markets. Munger doesn’t understand why Berkshire’s model hasn’t been copied more often. It makes sense to have a flexible hybrid mandate (or structure) which allows for deployment of capital into wherever assets are most attractive or cheapest.

Clients, Time Management

Most people are too competitive – they want ALL business available, and sometimes end up doing things that are "morally beneath them," and/or abandon personal standards. Plus, general happiness should be a consideration as well.

The smartest people figure out what business they don’t want and avoid all together – which leads to foregoing some degree of business and profit – that’s absolutely okay. This is what he and Buffett have figured out and tried to do over time.

On doing what’s right: He and Buffett fulfill their fiduciary duty in that they “wanted people who we barely know who happen to buy the stock to do well.” Munger doesn’t think there are that many people in the corporate world who subscribe to this approach today.

An Interview with Bruce Berkowitz - Part 2

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

AUM, Compounding, Subscription, Redemptions

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

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

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

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

AUM, Sourcing

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

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

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

Diversification, Correlation, Risk

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

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

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

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

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

Making Mistakes, Sizing

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

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

Creativity, Team Management, Time Management

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

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

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

When To Sell, Expected Return, Intrinsic Value, Exposure

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

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

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

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

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

UPDATE:

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

Cash, Redemptions, Liquidity, When To Sell

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

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

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

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

Lisa Rapuano Interview Highlights - Part 3

Part 3 of highlights from an insightful interview with Lisa Rapuano, who worked with Bill Miller for many years, and currently runs Lane Five Capital Management. Selectivity, Hurdle Rate, Opportunity Cost, Sizing

“We do not own many stocks, and anything we buy has to improve the overall portfolio and/or be better than something else we already own…I’ll go into portfolio construction in a bit, but the short answer here is that it has to be better than something we already own, or improve the overall risk profile of the portfolio to make it in.”

“The actual position sizing we choose will be based on…the return profile of the name relative to other things in the portfolio as well as on an absolute basis…”

There are a few concepts here – selectivity, opportunity cost, and hurdle rate – all interrelated in the delicate web that is portfolio management.

Selectivity – not all investments reviewed makes it into the portfolio. They are judged against existing positions and other potential candidates.

Opportunity Cost – should I put capital into this idea? How much capital? If I do this, what is the cost of foregoing future opportunities? Calculating this “cost” is a whole other can of worms. See what other investors have to say about opportunity cost. Jim Leitner has some especially interesting thoughts.

Hurdle Rate – based on the quotes above, the hurdle rate could be a return figure or a risk-related figure since whether or not an idea makes it into the portfolio is dependent upon its merits compared to the expected returns and risk of existing portfolio positions.

Curiously, does this mean that an investor’s hurdle rate can be extracted from the expected return profile of his/her current portfolio? In the spirit of bursting gaskets, how then does this “hurdle rate” figure reconcile with the “discount rate” concept that’s frequently used by investors to value companies?

When To Buy, Sizing

“Value investors like I am are usually a bit too early, both on the buy and the sell side. It’s just part of our process…we’ll be buying long before any catalyst is evident (and thus discounted)…we try to mitigate the impact of being early on the buy side, just by recognizing who may be selling…and controlling our position sizing so that as the stock continues to fall we can confidently buy more.”

Important concept: the relationship between sizing decisions and ability/willingness to buy more if the price of a security continues to decline.

When To Sell

“On the sell side, we learned long ago that holding on to terrific businesses a bit longer than our original value might have indicated is usually a good idea. That being said, there are not that many truly terrific businesses, so most should be sold as they approach value.”

Creativity

“Our philosophy remains static but we pride ourselves on being adaptive in process and tactics.”

“…one of our Core Values at Lane Five is to Adapt and Evolve Actively. The tools change and people get smarter and information flows more quickly. To maintain a competitive advantage we have to evolve ahead of the market.”

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.

Ruane Cunniff Goldfarb Investor Day

The following excerpts (of Q&A) were extracted from the Ruane Cunniff Goldfarb Investor Day Transcript. For those with a little free time, I highly recommend the reading of the entire transcript. These guys are masters at dissecting businesses and identifying the heart of any topic. Psychology, Creativity

Question:

About 36 years ago, shortly before Benjamin Graham passed away, he did an interview for the Financial Analysts Journal…This is before the explosion of information, ETFs, mutual funds. Asked if he advised “careful study of and selectivity among” individual stocks in constructing a portfolio, he answered, “In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a good deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in light of the enormous amount of research now being carried on,” — 1976 we are talking about — “I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent, I'm on the side of the ‘efficient market’ school of thought now generally accepted by the professors.” I'm just wondering if you would comment on that and how the investment industry has changed over that period of time.

Greg Alexander:

...I would add — that it is a funny thing — I have kids 14 and 11, and I think that the next generation will go about their decision making maybe differently than us. They have every expectation that they can go and spend an hour on the Internet and become semi-expert on anything that they are interested in, whether it is figuring out how to do a Rubik’s cube, which I remember looking at and not having the least idea. But with all the information, the timeless human struggle remains judgment, the ability to think long term when there are problems that are short term, and whether we see something solid where everyone perceives uncertainty — many factors of that nature. Looking in new areas where people have not thought so much, there are many factors like that, that are timeless. I always tell people there will be men and women on the moon but we still will not understand the guy next door.

Activism

Question:

Would you be kind enough to share with us the philosophy of some of your adventures in corporate governance?

David Poppe:

I think as we said in the letter that we wrote to clients a few weeks ago, the goal is really to own best-of-breed world-class companies and to be positive and passive shareholders. Ideally for us we are going to spend a lot of time on research on the front end. We are going to identify a business that we love and a management team that we think is really strong. Then we are going to make an investment. Afterwards, I would not say we are going to go away, but we are going to be quiet. We are going to own it and if we get everything right, we are going to own it for a really long time. Where you have to get involved, you really need sharp elbows and you need a different kind of personality than we have. It's a different — I don't want to say effort level — but different relationship…So hopefully we are not going to have a lot of adventures in corporate governance if we are doing our jobs really well.

Team Management

David Poppe:

We do allow the analysts to trade in their own accounts; they do have personal accounts. They can buy things that we do not own in Sequoia, but I do not think they do so often. The only time that really comes up is when Bob and I reject something for Sequoia and the analyst strongly believes that it was a great idea, and he did a lot of work on it and feels good about it. We think that is an appropriate outlet for frustration.

Reflections by Anonymous

A friend sent me a fund letter a few months ago, and I ruminated over whether to post the following excerpt. Ultimately, I felt compelled to share it with our Readers given its beautifully written and reflective thoughts. It indirectly illustrates the competitive nature of this business. The author of this article (and many more just like him, or perhaps more intelligent) is your daily competition in this zero sum game. For anyone who believes that he/she has an edge, it would serve him/her well to reconsider that belief – again surfaces our daily struggle for self-awareness, and the delicate balance between arrogance and humility.

Creativity, Psychology

“I meet a lot of inquisitive and extremely intelligent people in this business and I have come to think that maybe this is something of a problem. Perhaps they are just too smart. Perhaps they just try too hard. Rightly or wrongly, the highest return on intellectual capital of any endeavour in the world today comes from the management of other people’s money. So it is entirely rational (especially if you have never met a hedge fund manager) to assume the industry attracts the brightest, smartest minds. The beautiful mind, if you will. But I am not aiming to outsmart George, Stan, Julian, Bruce or the others. I do not think it is logical to try and outsmart the smartest people. Instead, my weapons are irony and paradox. The joy of life is partly in the strange and unexpected. It is in the constant exclamation ‘Who would have thought it?’

Why did ten year treasuries yield 14% under the vice like grip of iron-man Volker but yield just 1.8% under the bookish and most definitely Weimar-like Bernanke? Why does France in 2012 flirt with the notion of electing a socialist president intent on reducing the retirement age, imposing a top rate of tax of 75% and increasing the size of the public sector? Why do we hang on the every word of elected politicians when Luxembourg’s prime minister Jean Claude Junker openly admits, ‘When it becomes serious, you have to lie’?

You cannot make stuff like this up. It is simply too absurd.

That is perhaps a long way of saying that existentialism is alive and well in the 21st century. For, if the last ten years have taught me anything, it must be that the French philosopher Albert Camus, in his search for an understanding of the principals of ethics that can shape and form our behaviour, may have surreptitiously provided us with three basic principles for macro investing. I am perhaps doing him a gross injustice, but I would summarise as follows: God is dead, life is absurd and there are no rules. In other words, you are on your own and you must take ownership of your own destiny.

For me this has always meant being detached from the sell-side community. It is not a question of respect, it is just that I prefer not to engage in their perpetual dialogue of determining where the 'flow' is. I cannot be reached by telephone. I suspect that I am one of the few CIOs who does not maintain daily correspondence with investment bankers and their specialist hedge fund sales teams. Not one buddy, not one phone call, not one instant message. I am not seeking that kind of 'edge.' [Redacted fund name] occupies an area outside the accepted belief system.

          ‘I have striven not to laugh at human actions,           not to weep at them,           not to hate them, but to understand them’           --Baruch Spinoza, Tractatus Politicus, 1676

I attempt to cultivate my own insights and to recognise the precarious uncertainty of global macro trends. I attempt to observe such things first hand through my extensive travel…and seek to understand their significance by investigating how previous societies coped under similar circumstances. But first and foremost, I am always preoccupied with the notion that I just do not have the answer. I am not blessed with the notion of certainty. Someone once said we should think of the world as a sentence with no grammar. If we do I see my job as putting in the punctuation. But above all, my job is to make money.”

Wisdom from Steve Romick: Part 3

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.  

Creativity, Team Management

“G&D: We also noticed that you recently hired Elizabeth Douglass, a former business journalist with the LA Times, which we found interesting – can you talk about that decision?

SR: We are trying to do due diligence in a deeper way and get information that may not be easily accessible. For example, with Aon, Elizabeth will help us track down people who used to work for Aon and get their phone numbers…So, she is an investigative journalist for us, a data synthesizer, research librarian and just a great resource to have.”

During my tenure at the multi-billion family office, my colleagues and I used to joke about Manager Bingo. Instead of numbers, on a bingo card, we’d write certain buzz words – “private equity approach to public market investing,” “long-term focus,” “margin of safety,” “bottom-up stock selection with top-down macro overlay” etc. – you get the idea. In meetings, each time a manager mentioned one of these buzz words/concepts, we’d check off a box. Blackouts were rare, though not impossible, depending on the manager.

But I digress. In the marketing materials of most funds, there’s usually a paragraph or sentence dedicated to “proprietary diligence methodology” or something to that effect. Most never really have anything close to “proprietary” – just the usual team of analysts running models, following earnings, and setting up expert network calls with the same experts as the competition.

Here, Steve Romick describes an interesting approach: a “research librarian” and detective to organize and track down new resources that others on Wall Street have not previously tapped, thus potentially uncovering fresh information and perspective. This is not the first time I’ve heard of investment management firms hiring journalists, but the practice is definitely not commonplace. Kudos on creativity and establishing competitive advantage!

Benchmark, Hurdle Rate

“Beating the market is not our goal. Our goal is to provide, over the long term, equity-like returns with less risk than the stock market. We have beaten the market, but that‘s incidental. We don‘t have this monkey on our back to outperform every month, quarter, and year. If we think the market is going to return 9% and we can buy a high-yield bond that’s yielding 11.5% and we’re confident that the principal will be repaid in the next three years, we‘ll take that…We are absolute value investors. We take our role as guardians of our clients’ capital quite seriously. If we felt the need to be fully invested at all times, then we would have to accept more risk than I think we need to.”

Romick’s performance benchmark is absolute value driven, not to outperform the “market”. I wonder, what is a adequate figure for “long term, equity-like returns?” Is this figure, then, the hurdle rate that determines whether or not an investment is made?

Volatility

“Fortunately, people are emotional and they make visceral decisions. Such decisions end up manifesting themselves in volatility, where things are oversold and overbought.”

Emotions and investor psychology causes volatility (Howard Marks would agree with this), which is a blessing to the patient, rational investor who can take advantage when “things are oversold or overbought.”

Foreign Exchange

“The government is doing its best to destroy the value of the US dollar. We have made efforts to de-dollarize our portfolio, taking advantage of other parts of the world that have better growth opportunities than the US with more exposure to currencies other than our own.”

Inflation

“We are seeking those companies that are more protected should inflation be more than expected in the future…We are looking for companies where we feel the pricing power would offset the potential rise in input costs. That leads us to a whole universe of companies, while keeping us away from others.”

Wisdom from Steve Romick: Part 1

The content below is extracted from an interview with Steve Romick of First Pacific Advisors (Newsletter Fall 2010) published by Columbia Business School. Be sure to browse the other quarterly newsletters containing interviews with well-known investors. Many thanks to my friend Janice Davies of Karlin Asset Management for tipping PM Jar on this useful link. For more information on Steve Romick and FPA's investment philosophy, explore the FPA website – there’s a wealth of information from old letters, speech transcripts, etc.

Creativity

“I felt that most mutual funds were style box constrained, and didn't take advantage of a deep toolbox…I didn't think there were a lot of public funds out there that invested in such diverse asset classes, but felt that such a vehicle made sense for people. For years, I had to fight the idea that I was a style box manager.”

We’ve previously discussed how the investment management business is no different from a business that makes widgets. It is important to consider one’s competitive advantage vs. the competition, which in Romick’s case is differentiation through creativity of investment mandate.

Romick’s Crescent Fund has the ability implement a variety of investment strategies – such as buying residential whole loans, investing with a community bank private fund, shorting securities, etc. – in a go anywhere opportunistic approach. His mutual fund peers, with their mandate restrictions, are usually not allowed to take advantage of this “deep toolbox.”

Although this freedom to roam mandate may seem like common sense (and more frequently observed with hedge funds), it is still a rarity in today’s institutional mutual fund world, let alone back in the early 1990s.

Time Management

“I realized that you can’t wear all the hats well, and I was wearing too many hats. I wanted to just focus on investing. I wanted someone to insulate me from the marketing and back office. It just took too much time away from the portfolio.”

On why he joined FPA after running his own money management firm for a few years. Romick was wise in recognizing his strength as an investor and potential weakness (or perhaps just low interest level) in dealing with marketing and back office operations.

I have often told people that the investment management business is a 3-legged-stool with each leg representing:

1. Investing
2. Operations
3. Marketing / Client Management

In my previous position at a large single family office with substantial external manager allocations, I had the benefit of meeting many bright investors who left existing employers to launch their own funds. The common denominator for success was surprisingly not investment acumen (of course that helps), it was thoughtful consideration of all three legs of the stool.

With a finite 24 hours in a day, any extra time spent on operations or marketing, equates to less time spent on investing. Few people manage to successfully juggle all three roles. For those who cannot, or prefer not to juggle, the key is to not underestimate the importance of operations and marketing when building an investment management business, and seek help / external expertise when necessary, as Romick did.

Psychology

“Honestly, people shouldn't have given me money then [when he started his own money management firm in 1990]. With what I know now, and what I thought I knew then, it’s such a vast difference. People took a chance on me…I’m better now than I was then. I think that in the money management business, knowledge is cumulative, or rather should be cumulative rather than repetitive, and one should improve the longer one is in the business. I’m much more comfortable wearing the skin of an investor than I was back then. I guess I was too ignorant to realize that when I was younger.”

“G&D: In your first letter in 1993, you wrote that you often found niche companies with excellent track records that Wall Street has yet to discover. Is it worth your time looking for these opportunities now that you have $4 billion under management?                

SR: I think that I was naïve. What is really undiscovered? I think it's morphed from undiscovered to unloved or misunderstood. There aren’t that many undiscovered names out there.”

Other well-known investors have discussed the importance of awareness in the past. Unfortunately, self-awareness is difficult to learn. An effort can be made, but perhaps it merely leads us to think that we are self-aware. Often times, only the benefit of time and experience can reveal to us the mistakes/naiveté of our past/youth.

Far from the Madding Crowd

Investing is full of paradoxes. For example, in this zero-sum game, everyday we walk a fine line between arrogance (conviction that we are right) and humility (possibility that we may be wrong). We’ve written in the past about the importance of self-awareness. Self-aware of our mental weakness(es). Self-aware of our (perceived) strengths. Self-aware of how we stack up relative to the competition. But is there a point when we are too self-aware, such that it becomes our enemy?

In a 2011 Fortune article about Bob Rodriguez of First Pacific Advisors (many thanks to my good friend and former colleague Robert Terrell of Karlin Asset Management for sharing this with PM Jar), there’s a part that talks about how Bob was teased as a child and didn't care.

"When Rodriguez was 12, he had a major operation on his teeth that, for two years, left him with a heavy speech impediment. Classmates teased him -- so he gave a speech on the topic of elocution to show that he could make fun of himself. ‘Most people, when they're different, they become self-conscious,’ says Dick [his brother]. ‘Bob hasn't been one to sacrifice his ethics or his intellect to fit in.’"  

Ignoring negativity would definitely be easier if one lacked the self-awareness to realize that others were hurling it in your direction. Whether this is through naiveté or deliberate choice, in terms of investing, is it easier to stick to a contrarian strategy and sustain creativity when you are far away from the madding crowd, either mentally or physically?

Wisdom from David E. Shaw: Part 1

Previously, we summarized an interview with Michael F. Price from Peter J. Tanous’ book Investment Gurus. We now move to the near opposite end of the investment style spectrum, to an interview in the same book with David E. Shaw, the ingenious and unorthodox founder of D.E. Shaw, a well-known and renowned quant fund. Although Shaw runs a quant strategy, he provides a number of unique perspectives within the chapter that I believe valuable to traditional fundamental investors. After all, cross pollination and being open to new ideas is a good thing.

Creativity

Tanous: David, there’s something else that comes up when you talk to a lot of the successful managers. Many of them, especially the ones who are clearly superior to their peers, may well have a sixth sense of some sort, in additional to their other qualities. Now they’re all very smart, they’re all very disciplined, they’re all focused, but you wonder if there isn’t an undefinable something extra at work. I suppose instinct and intuition…

Shaw: I think you’re talking about what I think of as a sort of “right brain” thought process…What we do is similar to what a classical natural scientist does. You go out there and study some set of phenomena. Then, using that sort of experienced-based pattern recognition and creative thought that’s so hard to describe, you formulate a well-defined hypothesis about what may be going on…One thing I think is often misunderstood, not just about our type of business but about the nature of science in general, is that the hardest part, the part that really distinguishes a world-class scientist from a knowledgeable laboratory technician, is that right-brain, creative part. 

Food for thought: does analyst = laboratory technician vs. portfolio manager = world-class scientist?

Here, creativity again rears its head – from an investor that runs a completely different strategy from some of the others that we’ve covered, such as Howard Marks, in reference to what makes investors successful.

As someone who has spent countless hours speaking with different fund/portfolio managers, I suspect the reason why creativity keeps creeping up is in part due to the competitive nature of our business. The defensive moat described by Buffett is just as important for the investment management business as it is for a business that makes widgets. Creativity allows an investor to stay one step ahead, to discover unique mispricings before the crowd, and thus efficiency, closes in.

Unfortunately, there is no formula for creativity in the investment or portfolio management process. In fact, once verbalized, the concept of a formula for creativity sounds quite absurd! Alas, perhaps there’s hope in that the intangible creative process could be taught or learned over time?

Team Management

“What we care about most is finding, literally, the very best people in the world for whatever the position is…We spend an unbelievable amount of money on recruitment, relative to our total operational budget. In particular, we spend a lot identifying the very best people in the world in whatever category that interest us. In fact, we’ll often start way before the point where we really need someone.”