Whitebox on Risk & Risk Management

There must be something in the Whitebox water supply: it's producing an army of investment math nerds with acute self-awareness and sensibilities, led by their fearless leader Andy Redleaf. Those of you who have not yet seen Whitebox's "10 Enduring Principles To Interpret Constant Market Change" are missing out -- it is absolutely worth three minutes of your day. The text below is extracted from a Jan 2015 Andy Redleaf article titled "Getting Past the Romance of Risk":

“The courage to ‘take a chance.’ The fearlessness of being a ‘risk taker.’ Risk as the force of entrepreneurship. These ideas are so ingrained in the American psyche that in the investment industry they have become dogma: to increase returns the investor must be willing to accept more risk. That is the core result of Modern Portfolio Theory, even if it is hedged with theories about how to accept risk systematically on the “efficient frontier.”

Given this persistent quasi-romance with risk, we have to ask: What great investor or entrepreneur ever succeeded by deliberately taking on more risk?

...the entrepreneur’s goal should always be to create asymmetries of risk and reward in which there is far more to be gained than lost. We strongly believe all investment managers should be doing the same, which is why the first of Whitebox’s 10 Investment Principles is: The source of investment return is the efficient reduction of risk.

If risk is not the basis of return, should an investor strive to take no risk at all? No. There is no such thing as a risk-free portfolio. We believe that the right goal is to reduce risk efficiently: reduce the risks of a position more than one reduces its potential return. One can do this in various ways, but it comes down to the investor striving to own only and exactly what he wants to own…

How do we believe an investor can own only and exactly what he wants to own? In practical terms, what does this look like?

In reality, most securities, taken individually, are bundles of both good and bad qualities. Even a stock that presents generally favorable prospects for potentially good returns is likely to contain at least some unfavorable qualities; the same is generally true for bonds. As such, we believe the key – and the whole point of alternative investing – is to be able to identify and isolate the good from the bad, so that you own only and exactly what you want.

How is this achieved? Sometimes this is done at the security level, by buying securities with desirable qualities and canceling out the undesirable qualities through carefully constructed positions in our short book. Sometimes it is done at the portfolio level, by combining investment “themes” in ways that retain the attractive qualities of an investment idea while, hopefully, canceling out the risks.

Sometimes, it can be achieved by striving to identify and implement hedges that are in themselves what we perceive as sound, attractive investments, the goal being to reduce risk through tactics and decisions that are themselves potentially return-generating investments…

Viewing risk-reduction in itself as a source of potential returns is in stark contrast to a more traditional approach, which we believe accepts some measure of loss in exchange for potential payoff.

Exercising sound judgment in investing, we believe, involves choosing the particular over the abstract. This can mean the difference between buying up “lots” of securities in bundles (often to satisfy a predetermined allocation percentage, for example) versus sorting through individual names, looking for nuances lurking beyond-the-obvious that enhance value, and identifying idiosyncratic dislocations – even among securities that are bought and sold in “lots.” It means looking at risk specifically, not from a high level of abstraction, striving to reduce that risk efficiently through a hedge that in itself is an investment with potential payoff.

Put another way, we believe efficient reduction of risk begins with and cannot be separated from the investment process. To us, every investment decision, therefore, should be a decision about risk. We reject the concept of risk management as an “overlay.”

Most of all, we believe this investment principle entails viewing risk and risk mitigation as a matter of judgment. We feel confident in our belief that investors who exercise good judgment are more likely to prosper than investors who do not…

Seen from this perspective, the concept of risk is somewhat reframed. We simply reject the idea that says “the greater the risk, the greater potential for return.” To us, a truly alternative approach to investing involves what we believe to be a fairly straightforward endeavor: efficiently reduce risk so as to own only and exactly what you want to own.”

On efficient markets: “We believe this…approach to investing isn’t safe, mostly because we see it as lazy. On every point listed above, we’re convinced that money managers who go along with these dogmas are saving themselves work, but risking investors’ money.”

Cross-Pollination: Volatility & Options

In our continual search for differentiation in this fiercely competitive investment biosphere, we remain intrigued by the idea of cross-pollination between investment strategies. After all, regardless of strategy, all investors share a common goal: capital compounding through the creation of return asymmetry over time. Fundamental investors often shy away from options and volatility, labeling them as too complicated and esoteric. Are they truly that complicated, or merely made to seem so by industry participants enamored with jargon and befuddlement?

In this brief video (8:30-8:35am time slot), Richard “Jerry” Haworth of 36South shares a few thoughts & observations on options and volatility that all investors can incorporate into their portfolios.

Summary Highlights:

Options (a type of “volatility assets”) are a potentially rich source of alpha since pricing in options market are mainly based on models, not fundamental analysis. Occasionally massive mispricings occur, especially in long-dated options.

Most wealth is generated by luck or asymmetry of risk & return. Most options have asymmetry. Long options positions (especially long-dated) behave like “perfect traders” – they always obey stop loss (downside is limited by premium outlay) and positions are allowed to run when working in your favor (especially as delta improves for out-of-the-money options).

Options also have natural embedded leverage (especially out-of-the-money), providing cheap convexity. Better than debt, because it’s non-recourse – max loss is limited to premium outlay.

Volatility (a $65 trillion notional market) is counter intuitive – people tend to sell vol when low, and buy when high – great for contraians who like to buy low and sell high. Natural human behavioral bias makes it so this phenomenon will never go away.

Portfolio managers are in the “business of future-proofing people’s portfolios” – seeking to maximize return while minimizing risk and correlation. The “further you get away from $0 the more you are future-proofing a portfolio…” But this is extremely difficult to implement well, especially in low interest rate environment where future expected returns are difficult to find.

Short-term downside volatility is noise. But long-term volatility on the downside is permanent loss of capital – counter to goal of “future-proofing” portfolios. When people think about risk, they tend to use volatility as proxy for risk, but this is a very limiting definition. Volatility has been minimized by low rates, which has lead people to mistakenly think that we’ve minimized risk since we’ve minimized volatility. Classic mistake: people are now taking on “risk and correlation that they don’t see…for returns that they do see.”

Correlation – only important in crisis, no one cares about correlation when asset prices going up. Perceived vs. Actual Correlation: dangerous when you think you have a “diversified” portfolio (with low correlation between assets) when in reality correlation of assets in portfolio actually very high. People focus on minimizing correlation, but often fail when truly need minimized correlation (example: during a systemic crisis).

Writing / shorting volatility (such as selling options) in a portfolio increases yield & adds to expected return, but makes correlation and risk more concave, with a tendency to snowballs to downside. Whereas long volatility assets are convex, it takes slightly from return (cuz premium outlay) but offers uncapped expected return on the upside.

Howard Marks' Book: Chapter 19

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

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

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

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

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

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

Volatility

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

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

Expected Return, Risk

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

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

Opportunity Cost, Benchmark

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

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

Howard Marks' Book: Chapter 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.”

Howard Marks’ Book: Chapter 17

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

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

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

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

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

Capital Preservation, Volatility, Diversification, Leverage

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

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

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

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

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

Psychology, Luck, Process Over Outcome

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

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

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

Psychology, Trackrecord

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

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

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

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

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

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

Montier on Exposures & Bubbles

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

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

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

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

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

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

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

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

Hedging, Fat Tail

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

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

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

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

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

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

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

Expected Return, Capital Preservation

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

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

When To Buy, When To Sell, Psychology

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

Baupost Letters: 2000-2001

This concludes our series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts, only our interpretive summaries. For those of you wishing to read the actual letters, they are available on the internet. We are not posting them here because we don’t want to tango with the Baupost legal machine.

Volatility, Psychology

Even giants are not immune to volatility. Klarman relays the story of how Julian Robertson’s Tiger Fund closed its doors largely as a result of losses attributed to its tech positions. As consolation, Klarman offers some advice on dealing with market volatility: investors should act on the assumption that any stock or bond can trade, for a time, at any price, and never enable Mr. Market’s mood swings to lead to forced selling. Since it is impossible to predict the timing, direction and degree of price swings, investors would do well to always brace themselves for mark to market losses.

Does mentally preparing for bad outcomes help investors “do the right thing” when bad outcomes occur? 

When To Buy, When To Sell, Selectivity

Klarman outlines a few criteria that must be met in order for undervalued stocks to be of interest to him:

• Undervaluation is substantial
• There’s a catalyst to assist in the realization of that value
• Business value is stable and growing, not eroding
• Management is able and properly incentivized

Have you reviewed your selectivity standards lately? How do they compare with three years ago? For more on this topic, see our previous article on selectivity. 

Psychology, When To Buy, When To Sell

Because investing is a highly competitive activity, Klarman writes that it is not enough to simply buy securities that one considers undervalued – one must seek the reason for why something is undervalued, and why the seller is willing to part with a security/asset at a “bargain” price.

Here’s the rub: since we are human and prone to psychological biases (such as confirmation bias), we can conjure up any number of explanations for why we believe something is undervalued and convince ourselves that we have located the reason for undervaluation. It takes a great degree of cognitive discipline & self awareness to recognize and concede when you are (or could be) the patsy, and to walk away from those situations.

Risk, Expected Return, Cash

Klarman’s risk management process was not after-the-fact, it was woven into the security selection and portfolio construction process.

He sought to reduce risk on a situation by situation basis via

• in-depth fundamental analysis
• strict assessment of risk versus return
• demand for margin of safety in each holding
• event-driven focus
• ongoing monitoring of positions to enable him to react to changing market conditions or fundamental developments
• appropriate diversification by asset class, geography and security type, market hedges & out of the money put options
• willingness to hold cash when there are no compelling opportunities.

Klarman also provides a nice explanation of why undervaluation is so crucial to successful investing, as it relates to risk & expected return: “…undervaluation creates a compelling imbalance between risk and return.”

Benchmark

The investment objective of this particular Baupost Fund was capital appreciation with income was a secondary goal. It sought to achieve its objective by profiting from market inefficiencies and focusing on generating good risk-adjusted investment results over time – not by keeping up with any particular market index or benchmark. Klarman writes, “The point of investing…is not to have a great story to tell; the point of investing is to make money with limited risk.”

Investors should consider their goal or objective for a variety of reasons. Warren Buffett in the early Partnership days dedicated a good portion of one letter to the “yardstick” discussion. Howard Marks has referenced the importance of having a goal because it provides “an idea of what’s enough.”

Cash, Turnover

Klarman presents his portfolio breakdown via “buckets” not individual securities. See our article on Klarman's 1999 letter for more on the importance of this nuance. 

The portfolio allocations changed drastically between April 1999 and April 2001. High turnover is not something that we generally associate with value-oriented or fundamental investors. In fact, turnover has quite a negative connotation. But is turnover truly such a bad thing?

Munger once said that “a majority of life’s errors are caused by forgetting what one is really trying to do.”

Yes, turnover can lead to higher transaction fees and realized tax consequences. On taxes, we defer to Buffett’s wonderfully crafted treatise on his investment tax philosophy from 1964, while the onset of electronic trading has significantly decreased transaction fees (specifically for equities) in recent days.

Which leads us back to our original question: is portfolio turnover truly such a bad thing? We don’t believe so. Turnover is merely the consequence of portfolio movements triggered by any number of reasons, good (such as correcting an investment mistake, or noticing a better opportunity elsewhere) and bad (purposeful churn of the portfolio without reason). We should judge the reason for turnover, not the act of turnover itself.

Hedging, Expected Return

The Fund’s returns in one period were reduced by hedging costs of approximately 2.4%. A portfolio’s expected return is equal to the % sizing weighted average expected return of the sum of its parts (holdings or allocations). Something to keep in mind as you incur the often negative carry cost of hedging, especially in today’s low rate environment.

Cliff Asness on Volatility, Risk & Loss

The debate on the relationship between volatility, risk, and permanent impairment of capital rages on. Below are some thoughts on the subject from Cliff Asness of AQR Capital Management, extracted from an article titled "My Top 10 Peeves" published earlier this year in the Financial Analysts Journal. “Volatility” Is for Misguided Geeks; Risk Is Really the Chance of a “Permanent Loss of Capital”

There are many who say that such “quant” measures as volatility are flawed and that the real definition of risk is the chance of losing money that you won’t get back (a permanent loss of capital). This comment bugs me.

Now, although it causes me grief, the people who say it are often quite smart and successful, and I respect many of them. Furthermore, they are not directly wrong. One fair way to think of risk is indeed the chance of a permanent loss of capital. But there are other fair methods too, and the volatility measures being impugned are often misunderstood, with those attacking them setting up an easy-to-knock-down “straw geek.”

The critics are usually envisioning an overvalued security (which, of course, they assume they know is overvalued with certainty) that possesses a low volatility. They think quants are naive for calling a security like this “low risk” because it’s likely to fall over time. And how can something that is expected to fall over time—and not bounce back—be low risk?

What we have here is a failure to communicate.A quant calling something “low risk” is very different from a quant saying, “You can’t lose much money owning this thing.” Even the simplest quant framework allows for not just volatility but also expected return. And volatility isn’t how much the security is likely to move; it’s how much it’s likely to move versus the forecast of expected return. In other words, after making a forecast, it’s a reflection of the amount you can be wrong on the upside or downside around that forecast. Assuming the quant and non-quant agree that the security is overvalued (if they don’t agree, then that is an issue separate from the definition of risk), the quant has likely assigned it a negative expected return. In other words, both the quant and the non-quant dislike this security. The quant just expresses his dislike with the words “negative expected return” and not the words “very risky.”

A clean example is how both types of analysts would respond to a rise in price unaccompanied by any change in fundamentals now or in the future. On the one hand, those who view risk as “the chance of permanent loss” think this stock just got riskier. Viewed in their framework, they are right. On the other hand, quants tend to say this stock’s long-term expected return just got lower (same future cash flows, higher price today) rather than its risk/volatility went up, and they too are right!

It is also edifying to go the other way: Think about a super-cheap security, with a low risk of permanent loss of capital to a long-term holder, that gets a lot cheaper after being purchased. I—and everyone else who has invested for a living for long enough—have experienced this fun event. If the fundamentals have not changed and you believe risk is just the chance of a permanent loss of capital, all that happened was your super-cheap security got superduper cheap, and if you just hold it long enough, you will be fine. Perhaps this is true. However, I do not think you are allowed to report “unchanged” to your clients in this situation. For one thing, even if you are right, someone else now has the opportunity to buy it at an even lower price than you did. In a very real sense, you lost money; you just expect to make it back, as can anyone who buys the same stock now without suffering your losses to date.

If you can hold the position, you may be correct (a chance that can approach a certainty in some instances if not ruined by those pesky “limits of arbitrage”). For example, when my firm lost money in 1999 by shorting tech stocks about a year too early (don’t worry; it turned out OK), we didn’t get to report to our clients,“We have not lost any of your money. It’s in a bank we call ‘short NASDAQ.’” Rather, we said something like, “Here are the losses, and here’s why it’s a great bet going forward.” This admission and reasoning is more in the spirit of “risk as volatility” than “risk as the chance of a permanent loss of capital,” and I argue it is more accurate. Putting it yet one more way, risk is the chance you are wrong. Saying that your risk control is to buy cheap stocks and hold them, as many who make the original criticism do, is another way of saying that your risk control is not being wrong. That’s nice work if you can get it. Trying not to be wrong is great and something we all strive for, but it’s not risk control. Risk control is limiting how bad it could be if you are wrong. In other words, it’s about how widely reality may differ from your forecast. That sounds a lot like the quants’ “volatility” to me.

Although I clearly favor the quant approach of considering expected return and risk separately, I still think this argument is mostly a case of smart people talking in different languages and not disagreeing as much as it sometimes seems.

Elementary Worldly Wisdom – Part 2

The following is Part 2 of 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. Expected Return, Selectivity, Sizing, When To Buy

“…the one thing that all those winning betters in the whole history of people who've beaten the pari-mutuel system have is quite simple: they bet very seldom… the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple.

…yet, in investment management, practically nobody operates that way…a huge majority of people have some other crazy construct in their heads. And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they'll come to know everything about everything all the time.”

“How many insights do you need? Well, I'd argue: that you don't need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that's with a very brilliant man—Warren's a lot more able than I am and very disciplined—devoting his lifetime to it. I don't mean to say that he's only had ten insights. I'm just saying, that most of the money came from ten insights.

So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds-against game full of craziness with an occasional mispriced something or other. And you're probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It's just that simple…

Again, this is a concept that seems perfectly obvious to me. And to Warren it seems perfectly obvious. But this is one of the very few business classes in the U.S. where anybody will be saying so. It just isn't the conventional wisdom.

To me, it's obvious that the winner has to bet very selectively. It's been obvious to me since very early in life. I don't know why it's not obvious to very many other people.”

“…investment management…is a funny business because on a net basis, the whole investment management business together gives no value added to all buyers combined. That's the way it has to work…I think a select few—a small percentage of the investment managers—can deliver value added. But I don't think brilliance alone is enough to do it. I think that you have to have a little of this discipline of calling your shots and loading up—you want to maximize your chances of becoming one who provides above average real returns for clients over the long pull.”

“…huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: You're paying less to brokers. You're listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded.”

Tax, Compounding, When To Sell

“Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you're going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum.

In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15%—or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.

Even with a 10% per annum investment, paying a 35% tax at the end gives you 8.3% after taxes as an annual compounded result after 30 years. In contrast, if you pay the 35% each year instead of at the end, your annual result goes down to 6.5%. So you add nearly 2% of after-tax return per annum if you only achieve an average return by historical standards from common stock investments in companies with tiny dividend payout ratios.

…business mistakes that I've seen over a long lifetime, I would say that trying to minimize taxes too much is one of the great standard causes of really dumb mistakes. I see terrible mistakes from people being overly motivated by tax considerations.”

Diversification, Hedging

“…one of the greatest economists of the world is a substantial shareholder in Berkshire Hathaway and has been for a long time. His textbook always taught that the stock market was perfectly efficient and that nobody could beat it. But his own money went into Berkshire and made him wealthy…he hedged his bet.”

If you can hedge without negative consequences, do it. It's likely that the economist's investment in Berkshire was not public knowledge.

Mauboussin: Frequency vs. Magnitude

Our last article on the uncontrollable nature of luck was just downright depressing. To lift spirits & morale, this article showcases more comforting content on factors that are within an investor’s control. The following excerpts are extracted from a piece by Michael Mauboussin written in 2002 titled The Babe Ruth Effect - Frequency versus Magnitude. Expected Return, Sizing

Quoting Buffett from the 1989 Berkshire Hathaway Annual Meeting: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.”

“…coming up with likely outcomes and appropriate probabilities is not an easy task…the discipline of the process compels an investor to think through how various changes in expectations for value triggers—sales, costs, and investments—affect shareholder value, as well as the likelihood of various outcomes.”

“Building a portfolio that can deliver superior performance requires that you evaluate each investment using expected value analysis. What is striking is that the leading thinkers across varied fields—including horse betting, casino gambling, and investing—all emphasize the same point.”

“…a lesson inherent in any probabilistic exercise: the frequency of correctness does not matter; it is the magnitude of correctness that matters.”

“Constantly thinking in expected value terms requires discipline and is somewhat unnatural. But the leading thinkers and practitioners from somewhat varied fields have converged on the same formula: focus not on the frequency of correctness, but on the magnitude of correctness.”

Bill Lipschutz, a currency trader featured in Jack Schwager’s book New Market Wizards advised readers that, “You have to figure out how to make money being right only 20 to 30 percent of the time.” 

Strange as this advice may seem, it is congruent with Mauboussin’s words above that “the frequency of correctness does not matter; it is the magnitude of correctness that matters.” Depending on how you translate expected return estimations into portfolio sizing decisions, it is possible to make $ profits by being “right” less than 50% of the time (by upsizing your winners), just as it is possible to lose $ capital by being “right” more than 50% of the time (by upsizing your losers).

Psychology, Expected Return, Sizing

“The reason that the lesson about expected value is universal is that all probabilistic exercises have similar features. Internalizing this lesson, on the other hand, is difficult because it runs against human nature in a very fundamental way.”

“…economic behaviors that are inconsistent with rational decision-making… people exhibit significant aversion to losses when making choices between risky outcomes, no matter how small the stakes…a loss has about two and a half times the impact of a gain of the same size. In other words, people feel a lot worse about losses of a given size than they feel good about a gain of a similar magnitude.”

“This behavioral fact means that people are a lot happier when they are right frequently. What’s interesting is that being right frequently is not necessarily consistent with an investment portfolio that outperforms its benchmark…The percentage of stocks that go up in a portfolio does not determine its performance, it is the dollar change in the portfolio. A few stocks going up or down dramatically will often have a much greater impact on portfolio performance than the batting average.”

“…we are risk adverse and avoid losses compounds the challenge for stock investors, because we shun situations where the probability of upside may be low but the expected value is attractive.”

Selectivity, When To Buy, Patience

“In the casino, you must bet every time to play. Ideally, you can bet a small amount when the odds are poor and a large sum when the odds are favorable, but you must ante to play the game. In investing, on the other hand, you need not participate when you perceive the expected value as unattractive, and you can bet aggressively when a situation appears attractive (within the constraints of an investment policy, naturally). In this way, investing is much more favorable than other games of probability.”

“Players of probabilistic games must examine lots of situations, because the “market” price is usually pretty accurate. Investors, too, must evaluate lots of situations and gather lots of information. For example, the very successful president and CEO of Geico’s capital operations, Lou Simpson, tries to read 5-8 hours a day, and trades very infrequently.”

In a June 2013 speech, Michael Price shared with an audience his approach to portfolio construction and sizing. His portfolio consists of as many as 30-70 positions (his latest 13F shows 89 positions).  Price then compares and contrasts across positions, giving him a more refined palette to discern the wheat from the chaff, and eventually sizes up the ones in which he has greater conviction. 

When To Sell, Psychology, Expected Return

“Investors must constantly look past frequencies and consider expected value. As it turns out, this is how the best performers think in all probabilistic fields. Yet in many ways it is unnatural: investors want their stocks to go up, not down. Indeed, the main practical result of prospect theory is that investors tend to sell their winners too early (satisfying the desire to be right) and hold their losers too long (in the hope that they don’t have to take a loss).”

Howard Marks' Book: Chapter 16

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

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

Luck, Process Over Outcome

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

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

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

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

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

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

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

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

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

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

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

Luck, Historical Performance Analysis, Expected Return, Volatility

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

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

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

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

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

A Chapter from Swensen's Book

Given his reputation and the title of the book, we would be remiss not to feature excerpts from David Swensen’s Pioneering Portfolio Management. Below are portfolio construction & management highlights from Chapter 6: Portfolio Management. The manager anecdotes in this chapter are fairly interesting too, providing readers a window into how an institution (Yale/Swensen) evaluates its external managers. Portfolio Management, Risk, Expected Return

“In a world where risk correlates with return, investors hold risky assets in pursuit of returns exceeding the risk-free rate. By determining which risky assets are held and in what proportions, the asset allocation decision resides at the center of portfolio management discussions.”

“…the complexities of real-world investing drives a wedge between the easily articulated ideal and the messy reality of implementing an investment program.”

Putting aside whether you agree that risk is correlated with return, it is safe to postulate that markets are (usually) efficient enough to require investors bear some degree of risk, in the pursuit of any rate of return above the risk-free-rate. The portfolio management process involves determining which returns are worthwhile pursuing given the associated risks, and relative to the risk-free rate. However, sh*t happens (“a wedge between the easily articulated ideal and the messy reality”). So how does one navigate through the “complexities” and “messy reality” of implementation? Read on…

“Some investors pursue active management programs by cobbling together a variety of specialist managers, without understanding the sector, size, or style bets created by the more or less random portfolio construction process…Recognizing biases created in the portfolio management process allows managers to accept only those risks with expected rewards.”

“Disciplined implementation of asset allocation policies avoids altering the risk and return profile of an investment portfolio, allowing investors to accept only those active management risks expected to add value.”

“Concern about risk represents an integral part of the portfolio management process, requiring careful monitoring at the overall portfolio, asset class, and manager levels. Understanding investment and implementation risks increases the chances that an investment program will achieve its goals.”

“Unintended portfolio bets often come to light only after being directly implicated as a cause for substandard asset class performance.”

Awareness of what you own (the risks, expected return, how the holdings interact with one another, etc.) is an absolutely necessity. This concept has surfaced many times before on PM Jar, likely indicating that it is an important commonality across different investment styles and strategies.

Leverage, Expected Return, Risk, Volatility

“By magnifying investment outcomes, both good and bad, leverage fundamentally alters the risk and return characteristics of investment portfolios…leverage may expose funds to unanticipated outcomes. Inherent in certain derivatives positions, leverage lurks hidden in many portfolio, coming to the light only when investment disaster strikes.”

“Leverage appears in portfolios explicitly and implicitly. Explicit leverage involves use of borrowed funds for pursuit of investment opportunities, magnifying portfolio results, good and bad. When investment returns exceed borrowing costs, portfolios benefit from leverage. If investment returns match borrowing costs, no impact results. In cases where investment returns fail to meet borrowing costs, portfolios suffer.”

“…portfolio returns should exceed leverage costs represented by cash, the lowest expected return asset class.”

“Sensible investors employ leverage with great care, guarding against introducing materials excess risk into portfolio characteristics.”

Traditional academic leverage discussions focuses on the theoretical spread between cost of borrowed capital and what is earned through reinvestment of borrowed capital. While this spread is important to keep in mind, the actual utilization and implementation of leverage in a portfolio context is far messier that this elegant algebraic formula. There are many other articles on PM Jar discussing leverage in a portfolio context.

Leverage, Risk, Volatility, Derivatives

“Simply holding riskier-than-market equity securities leverages the portfolio…the portfolio either becomes leveraged from holding riskier assets or deleveraged from holding less risky assets. For example, the common practice of holding cash in portfolios of common stocks causes the domestic equity portfolio to be less risky than the market, effectively deleveraging returns.”

“Derivatives provide a common source of implicit leverage. Suppose an S&P 500 futures contract requires a margin deposit of 10 percent of the value of the position. If an investor holds a futures position in the domestic equity portfolio, complementing every one dollar of futures with nine dollars of cash creates a position equivalent to holding the underlying equities securities directly. If, however, the investor holds five dollars of futures and five dollars of cash, leverage causes the position to be five times as sensitive to market fluctuations.

Derivatives do not create risk per se, as they can be used to reduce risk, replicate positions, or increase risk. To continue with the S&P 500 futures example, selling futures against a portfolio of equity securities reduces risks associated with equity market exposure. Alternatively, using appropriate combinations of cash and futures creates a risk-neutral replication of the underlying securities. Finally, holding futures without adequate balancing cash positions increases market exposure and risk.”

One must tread carefully when utilizing derivatives not because they are derivatives, but because of the implicit leverage that comes with derivatives.

Liquidity

“Less liquid asset types introduce the likelihood that inability to vary exposure causes actual allocations to deviate from target levels…Since by their very nature private holdings take substantial amounts of time to buy or sell efficiently, actual portfolios usually exhibit some functional misallocation. Dealing with the over- or under-allocation resulting from illiquid positions creates a tough challenge for the thoughtful investor.”

“…rebalancing requires sale of assets experiencing relative price strength and purchase of assets experiencing relative price weakness, the immediacy of continuous rebalancing causes managers to provide liquidity to the market.”

Expected Return, Risk

“Returns from security lending activity exhibit patterns characteristic of negatively skewed distributions, along with their undesirable investment attributes. Like other types of lending activity, upside represents a fixed rate of return and repayment of principal, while downside represents a substantial or total loss. Unless offset by handsome expected rates of return, sensible investors avoid return distributions with a negative skew…negatively skewed return pattern exhibits limited upside (make a little) with substantial downside (lose a lot), representing an unattractive distribution of outcomes for investors.”

Wisdom From James Montier

I have a confession to make: I have a huge crush on James Montier. I think the feeling might be mutual (see picture below, from a signed copy of his book Value Investing: Tools and Techniques for Intelligent Investment.) Jokes aside, below are some fantastic bits from his recent essay titled “No Silver Bullets.”

Risk, Correlation

“…private equity looks very much like public equity plus leverage minus a shed load of costs…hedge funds as an ‘asset class’ look like they are doing little more than put selling! In fact, I’d even go as far as to say if you can’t work that out, you probably shouldn’t be investing; you are a danger to yourself and to others!

The trick to understanding risk factors is to realize they are nothing more than a transformation of assets. For instance, what is the ‘equity risk?’ It is defined as long equities/short cash. The ‘value’ risk factor is defined as long cheap stocks/short expensive stocks. Similarly, the ‘momentum’ risk factor is defined as long stocks that have gone up, and short stocks that have done badly. ‘Carry’ is simply long high interest rate currencies/short low rate currencies. Hopefully you have spotted the pattern here: they are all long/short combinations.”

Proper investing requires an understanding of the exact bet(s) that you are making, and correct anticipation of the inherent risks and correlated interactivity of your holdings. This means going beyond the usual asset class categorizations, and historical correlations. For example, is a public REIT investment real estate, equity, or interest rate exposure?

For further reading on this, check out this article by Andy Redleaf of Whitebox in which he discusses the importance of isolating bets so that one does not end up owning stupid things on accident. (Ironic fact: Redleaf and Montier have butted heads in the recent past on the future direction of corporate margins.)

Leverage

“…when dealing with risk factors you are implicitly letting leverage into your investment process (i.e., the long/short nature of the risk factor). This is one of the dangers of modern portfolio theory – in the classic unconstrained mean variance optimisation, leverage is seen as costless (both in implementation and in its impact upon investors)…

…leverage is far from costless from an investor’s point of view. Leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one by transforming the temporary impairment of capital (price volatility) into the permanent impairment of capital by forcing you to sell at just the wrong time. Effectively, the most dangerous feature of leverage is that it introduces path dependency into your portfolio.

Ben Graham used to talk about two different approaches to investing: the way of pricing and the way of timing. ‘By pricing we mean the endeavour to buy stocks when they are quoted below their fair value and to sell them when they rise above such value… By timing we mean the endeavour to anticipate the action of the stock market…to sell…when the course is downward.’

Of course, when following a long-only approach with a long time horizon you have to worry only about the way of pricing. That is to say, if you buy a cheap asset and it gets cheaper, assuming you have spare capital you can always buy more, and if you don’t have more capital you can simply hold the asset. However, when you start using leverage you have to worry about the way of pricing and the way of timing. You are forced to say something about the path returns will take over time, i.e., can you survive a long/short portfolio that goes against you?”

Volatility, Leverage

“As usual, Keynes was right when he noted ‘An investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money.’”

Expected Return, Intrinsic Value

“...the golden rule of investing holds: ‘no asset (or strategy) is so good that it can it be purchased irrespective of the price paid.’”

“Proponents of risk parity often say one of the benefits of their approach is to be indifferent to expected returns, as if this was something to be proud of…From our perspective, nothing could be more irresponsible for an investor to say he knows nothing about expected returns. This is akin to meeting a neurosurgeon who confesses he knows nothing about the way the brain works. Actually, I’m wrong. There is something more irresponsible than not paying attention to expected returns, and that is not paying attention to expected returns and using leverage!”

Hedging, Expected Return

“…whenever you consider insurance I’ve argued you need to ask yourself the five questions below:

1. What risk are you trying to hedge?
2. Why are you hedging?
3. How will you hedge?
• Which instruments will work?
• How much will it cost?
4. From whom will you hedge?
5. How much will you hedge?”

“This is a point I have made before with respect to insurance – it is as much a value proposition as anything else you do in investment. You want insurance when it is cheap, and you don’t want it when it is expensive.”

Trackrecord, Compounding

“…one of the myths perpetuated by our industry is that there are lots of ways to generate good long-run real returns, but we believe there is really only one: buying cheap assets.”

Klarman’s Margin of Safety: Ch.13 – Part 3

This is a continuation in our series of portfolio construction & management highlights extracted from Seth Klarman’s Margin of Safety. In Chapter 13 (Portfolio Management and Trading) - Part 3 below, Klarman shares his thoughts on a number of portfolio construction and management topics such as risk management, hedging, and correlation.

Portfolio Management, Risk

“The challenge of successfully managing an investment portfolio goes beyond making a series of good individual investment decisions. Portfolio management requires paying attention to the portfolio as a whole, taking into account diversification, possible hedging strategies, and the management of portfolio cash flow. In effect, while individual investment decisions should take risk into account, portfolio management is a further means of risk reduction for investors.”

“….good portfolio management and trading are of no use when pursuing an inappropriate investment philosophy; they are of maximum value when employed in conjunction with a value-investment approach.”

Portfolio management is a “further means” of risk management.

Cash, Liquidity, Risk, Expected Return, Opportunity Cost

“When your portfolio is completely in cash, there is no risk of loss. There is also, however, no possibility of earning a high return. The tension between earning a high return, on the one hand, and avoiding risk, on the other, can run high. The appropriate balance between illiquidity and liquidity, between seeking return and limiting risk, is never easy to determine.”

Everything in investing is a double-edged sword. See Howard Marks’ words on this same topic. 

Risk, Diversification

“Even relatively safe investments entail some probability, however small, of downside risk. The deleterious effects of such improbably events can best be mitigated through prudent diversification. The number of securities that should be owned to reduce portfolio risk to an acceptable lever is not great; as few as ten to fifteen different holdings usually suffice.”

“Diversification is potentially a Trojan horse. Junk-bond-market experts have argued vociferously that a diversified portfolio of junk bonds carries little risk. Investors who believed them substituted diversity for analysis and, what’s worse, for judgment…Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail.”

Awhile back, we posed an interesting question to our Readers, would you ever have a 100% NAV position (assuming you cannot lever to buy/sell anything else)? And if not, what is the cutoff amount for “excessive” concentration? 

Risk, Hedging, Expected Return

“An investor’s choice among many possible hedging strategies depends on the nature of his or her underlying holdings.”

“It is not always smart to hedge. When the available return is sufficient, for example, investors should be willing to incur risk and remain unhedged. Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment. When the cost is reasonable, however, a hedging strategy may allow investors to take advantage of an opportunity that otherwise would be excessively risky. In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits.”

Correlation, Volatility

“Investors in marketable securities will not have predictable annual results, however, even if they possess shares representing fractional ownership of the same company. Moreover, attractive returns earned by Heinz may not correlate with the returns achieved by investors in Heinz; the price paid for the stock, and not just business results, determines their return.”

Different types of correlation:

• portfolio returns to indices/benchmarks
• portfolio assets/securities with each other
• price performance of assets/securities with the actual underlying operating performance

Klarman’s Margin of Safety: Ch.13 – Part 2

This is a continuation in our series of portfolio construction & management highlights extracted from Seth Klarman's Margin of Safety. In Chapter 13 (Portfolio Management and Trading) - Part 2 below, Klarman shares his thoughts on the illusory nature of liquidity, and the tricky task of knowing when to sell. Liquidity, Catalyst, When To Buy, When To Sell

Liquidity can be illusory. As Louis Lowenstein has stated, ‘In the stock market, there is liquidity for the individual but not for the whole community. The distributable profits of a company are the only rewards for the community.’ In other words, while any one investor can achieve liquidity by selling to another investor, all investors taken together can only be made liquid by generally unpredictable external events such as takeover bids and corporate-share repurchases. Except for such extraordinary transactions, there must be a buyer for every seller of a security."

Liquidity is possible not only through sale of securities, but also through other events & catalysts that result in cash flowing into the portfolio. 

“In times of general market stability the liquidity of a security or class of securities can appear high. In truth liquidity is closely correlated with investment fashion. During a market panic the liquidity that seemed miles wide in the course of an upswing may turn out only to have been inches deep. Some securities that traded in high volume when they were in favor may hardly trade at all when they go out of vogue.”

“For many securities the depth of the market as well as the quoted price is an important consideration. You cannot sell, after all, in the absence of a willing buyer; the likely presence of a buyer must therefore be a factor in the decision to sell. As the president of a small firm specializing in trading illiquid over-the-counter (pink-sheet) stocks once told me: ‘You have to feed the birdies when they are hungry.’”

Historical liquidity does not equal future liquidity. Miscalculation on this front has contributed to a phenomenon eloquently described as “up the stairs, out the window” syndrome.

When To Sell, Expected Return, Risk, Opportunity Cost

“Many investors are able to spot a bargain but have a harder time knowing when to sell. One reason is the difficulty of knowing precisely what an investment is worth. An investor buys with a range of value in mind at a price that provides a considerable margin of safety. As the market price appreciates, however, that safety margin decreases; the potential return diminishes and the downside risk increases. Not knowing the exact value of the investment, it is understandable that an investor cannot be confident in the sell decision as he or she was in the purchase decision.

To deal with the difficulty of knowing when to sell, some investors create results for selling…none of these rules make good sense. Indeed, there is only one valid rule for selling: all investments are for sale at the right price…Decisions to sell, like to buy, must be based upon underlying business value. Exactly when to sell – or buy – depends on the alternative opportunities that are available…It would be foolish to hold out for an extra fraction of a point of gain in a stock selling just below underlying value when the market offers many bargains.”

Awhile ago, we featured an interview with Steve Romick of FPA discussing the sizing & dilemma of whether to sell as price moves closer, though not quite yet, to intrinsic value. Here, Klarman's comment advises investors to also take into consideration "alternative opportunities that are available" during this decision making process.

When To Buy

“In my view, investors should usually refrain from purchasing a ‘full position’ (the maximum dollar commitment they intend to make) in a given security all at once…Buying a partial position leaves reserves that permit investors to ‘average down’ lowering their average cost per share, if prices decline.

Evaluating your own willingness to average down can help you distinguish prospective investments from speculations. If the security you are considering is truly a good investment, not a speculation, you would certainly want to own more at lower prices.”

Klarman's Margin of Safety: Ch.13 - Part 1

Many years ago, Seth Klarman wrote a book titled “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.” It is now out of print, and copies sell for thousands on eBay, etc. This marks our first installment of portfolio construction & management highlights extracted from this book. We begin this series not with Chapter 1, but more appropriately with Chapter 13 which discusses “Portfolio Management and Trading.” In Part 1 below, Klarman offers some differentiated insights on portfolio liquidity and cash flow.

Portfolio Management, Liquidity, Cash, Catalyst, Duration, Mistakes, Expected Return, Opportunity Cost

“All investors must come to terms with the relentless continuity of the investment process. Although specific investments have a beginning and an end, portfolio management goes on forever.”

“Portfolio management encompasses trading activity as well as the regular review of one’s holdings. In addition, an investor’s portfolio management responsibilities include maintaining appropriate diversification, making hedging decisions, and managing portfolio cash flow and liquidity.”

“Investing is in some ways an endless process of managing liquidity. Typically an investor begins with liquidity, that is, with cash that he or she is looking to put to work. This initial liquidity is converted into less liquid investments in order to earn an incremental return. As investments come to fruition, liquidity is restored. Then the process begins anew.

This portfolio liquidity cycle serves two important purposes. First…portfolio cash flow – the cash flowing into a portfolio – can reduce an investor’s opportunity cost. Second, the periodic liquidation of parts of a portfolio has a cathartic effect. For many investors who prefer to remain fully invested at all times, it is easy to become complacent, sinking or swimming with current holdings. ‘Dead wood’ can accumulate and be neglected while losses build. By contrast, when the securities in a portfolio frequently turn into cash, the investor is constantly challenged to put that cash to work, seeking out the best values available.”

Cash flow and liquidity management is not what usually comes to mind when one thinks about the components of portfolio management. “Investing is in some ways an endless process of managing liquidity.” It’s actually quite an elegant interpretation.

Diversification (when implemented effectively) assures that certain assets in the portfolio do not decline (relative to other assets) and are therefore able to be sold at attractive prices (if/when desired) with proceeds available for reinvestment. Hedges provide liquidity at the “right” time to redeploy when assets are attractively priced. Catalysts ensure duration (and cash flow) for an otherwise theoretically infinite duration equity portfolio. Duration also forces an investor to remain vigilant and alert, constantly comparing and contrasting between potential opportunities, existing holdings, and hoarding cash.

The spectrum of liquidity of different holdings within a portfolio is determined by the ability to transition between investments with minimal friction (transaction costs, wide bid-ask spread, time, etc).

“Since no investor is infallible and no investment is perfect, there is considerable merit in being able to change one’s mind…An investor who buys a nontransferable limited partnership interest or stock in a nonpublic company, by contrast, is unable to change his mind at any price; he is effectively locked in. When investors do no demand compensation for bearing illiquidity, they almost always come to regret it.

Most of the time liquidity is not of great importance in managing a long-term-oriented investment portfolio. Few investors require a completely liquid portfolio that could be turned rapidly into cash. However, unexpected liquidity needs do occur. Because the opportunity cost of illiquidity is high, no investment portfolio should be completely illiquid either. Most portfolios should maintain a balance, opting for great illiquidity when the market compensates investors well for bearing it.

A mitigating factor in the tradeoff between return and liquidity is duration. While you must always be well paid to sacrifice liquidity, the required compensation depends on how long you will be illiquid. Ten or twenty years of illiquidity is far riskier than one or two months; in effect, the short duration of an investment itself serves as source of liquidity.”

People often discuss the risk-adjusted return. However you define “risk,” it may make sense to consider a liquidity-adjusted return.

Liquidity affords you the luxury to change your mind. This not only applies to instances when you realize that you have made a mistake (preventing potential capital loss), but also helps minimize opportunity cost from not being able to invest in something “better” that materializes at a later date.

Howard Marks' Book: Chapter 15

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 15 “The Most Important Thing Is…Having a Sense for Where We Stand.” Cash, Risk, Opportunity Cost

“The period from 2004 through the middle of 2007 presented investors with one of the greatest opportunities to outperform by reducing their risk, if only they were perceptive enough to recognize what was going on and confident enough to act…Contrarian investors who had cut their risk and otherwise prepared during the lead-up to the crisis lost less in the 2008 meltdown and were best positioned to take advantage of the vast bargains it created.”

The quote above highlights a concept not given enough attention within the investment management industry – a fund manager’s ability to generate outperformance (versus a benchmark or on an absolute basis) derives not only from his/her ability to capture upside return, but also by avoiding downside loss!

Marks’ comment that some investors were “best positioned to take advantage” of newly available bargains reminds us of an interesting theoretical discussion on the value of cash, which it is based on not only what you can earn or purchase with it today, but also on what you can potentially purchase with it in the future. Jim Leitner, a former Yale Endowment Committee Member summarizes this concept best: “…we tend to ignore the inherent opportunity costs associated with a lack of cash…cash affords you flexibility…allocate that cash when attractive opportunities arise…When other assets have negative return forecast…there is no reason to not hold a low return cash portfolio…The correct way to measure the return on cash is more dynamic: cash is bound on the lower side by its actual return, whereas, the upper side possesses an additional element of positive return received from having the ability to take advantage of unique opportunities…Holding cash when markets are cheap is expensive, and holding cash when markets are expensive is cheap.”

Expected Return

“The seven scariest words in the world for the thoughtful investor – too much money chasing too few deals…You can tell when too much money is competing to be deployed…

…It helps to think of money as a commodity…Everyone’s money is pretty much the same. Yet institutions seeking to add to loan volume, and private equity funds and hedge funds seeking to increase their fees, all want to move more of it. So if you want to place more money – that is, get people to go to you instead of your competitors for their financing – you have to make your money cheaper.

One way to lower the price for your money is by reducing the interest rate you charge on loans. A slightly more subtle way is to agree to a higher price for the thing you’re buying, such as by paying a higher price/earnings ratio for a common stock or a higher total transaction price when you’re buying a company. Any way you slice it, you’re settling for a lower prospective return.”

The future expected return of any asset is a direct function of the price that you pay combined with the economic return potential of that asset.

Psychology, Risk, When To Buy, When To Sell

“…even if we can’t predict the timing and extent of cyclical fluctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act accordingly.”

“If we are alert and perceptive, we can gauge the behavior of those around us and from that judge what we should do. The essential ingredient here is inference, one of my favorite words. Everyone sees what happens each day, as reported in the media, But how many people make an effort to understand what those everyday events say about the psyches of market participants, the investment climate, and thus what we should do in response? Simply put, we must strive to understand the implications of what’s going on around us. When others are recklessly confident and buying aggressively, we should be highly cautious; when others are frightened into inaction or panic selling, we should become aggressive.”

“There are few fields in which decisions as to strategies and tactics aren’t influenced by what we see in the environment. Our pressure on the gas pedal varies depending on whether the road is empty or crowded. The golfer’s choice of club depends on the wind. Our decisions regarding outerwear certainly varies with the weather. Shouldn’t our investment actions be equally affected by the investing climate?”

Baupost Letters: 1999

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

Sizing, Catalyst, Expected Return, Hurdle Rate, Cash, Hedging, Correlation, Diversification

In the 1999 letter, Klarman breaks down the portfolio, which consists of the following components:

1. Cash (~42% of NAV) – dry powder, available to take advantage of bargains if/when available
2. Public & Private Investments (~25% of NAV) – investments with strong catalysts for partial or complete realization of underlying value (bankruptcies, restructurings, liquidations, breakups, asset sales, etc.), purchased with expected return of 15-20%+, likelihood of success dependent upon outcome of each situation and less on the general stock market movement. This category is generally uncorrelated with markets.
3. Deeply Undervalued Securities – investments with no strong catalyst for value realization, purchased at discounts of 30-50% or more below estimated asset value. “No strong catalyst” doesn’t mean “no catalyst.” Many of the investments in this category had ongoing share repurchase programs and/or insider buying, but these only offered modest protection from market volatility. Therefore this category is generally correlated with markets.
4. Hedges (~1% NAV)

Often, investments are moved between category 2 and 3, as catalyst(s) emerge or disappear.

This portfolio construction approach is similar to Buffett’s approach during the Partnership days (see our 1961 Part 3 article for portfolio construction parallels). Perhaps Klarman drew inspiration from the classic Buffett letters. Or perhaps Klarman arrived at this approach independently because the “bucket” method to portfolio construction is quite logical, allowing the portfolio manager to breakdown the attributes (volatility, correlation, catalysts, underlying risks, etc.) and return contribution of each bucket to the overall portfolio.

Klarman also writes that few positions in the portfolio exceed 5% of NAV in the “recent” years around 1999. This may imply that the portfolio is relatively diversified, but does lower sizing as % of NAV truly equate to diversification? (Regular readers know from previous articles that correlation significantly impacts the level of portfolio diversification vs. concentration of a portfolio.) One could make the case that the portfolio buckets outlined above are another form of sizing – a slight twist on the usual sizing of individual ideas and securities – because the investments in each bucket may contain correlated underlying characteristics. 

Duration, Catalyst

Klarman reminds his investors that stocks are perpetuities, and have no maturity dates. However, by investing in stocks with catalysts, he creates some degree of duration in a portfolio that would otherwise have infinite duration. In other words, catalysts change the duration of equity portfolios.

Momentum

Vicious Cycle = protracted underperformance causes disappointed holder to sell, which in turn produces illiquidity and price declines, prompting greater underperformance triggering a  new wave of selling. This was true for small-cap fund managers and their holdings during 1999 as small-cap underperformed, experienced outflows, which triggered more selling and consequent underperformance. The virtuous cycle is the exact opposite of this phenomenon, where capital flows into strongly performing names & sectors.

Klarman’s commentary indirectly hints at the hypothesis that momentum is a by-product of investors’ psychological tendency to chase performance.

Risk, Psychology

Klarman writes that financial markets have been so good for so long that fear of market risk has completely evaporated, and the risk tolerance of average investors has greatly increased. People who used to invest in CDs now hold a portfolio of growth stocks. The explanation of this phenomenon lies in human nature’s inability to comprehend that we may not know everything, and an unwillingness to believe that everything can change on a dime.

This dovetails nicely with Howard Mark’s notion of the ‘perversity of risk’:

“The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it. Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the ‘perversity of risk.’”

When To Buy, Psychology

Klarman writes that one should never be “blindly contrarian” and simply buy whatever is out of favor believing it will be restored because often investments are disfavored for good reason. It is also important to gauge the psychology of other investors – e.g., how far along is the current trend, what are the forces driving it, how much further does it have to go? Being early is synonymous to being wrong. Contrarian investors should develop an understanding of the psychology of sellers. Sourcing

When sourcing ideas, Baupost employs no rigid formulas because Klarman believes that flexibility improves one’s prospectus for returns with limited risk.

AUM's Impact On Performance

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

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

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

PM Jar Exclusive Interview With Howard Marks - Part 1 of 5

“Investing is an art form. Take the hundred greatest painters, their paintings look nothing alike. The definition of great is not uniform.” When asked about the art on the walls, he answers he is not a collector, merely an admirer. There’s no corner office with custom or museum-quality furniture. There’s no glaring display of power or wealth. Yet the scent of importance and influence is most definitely present, only subtly so. Accepted and balanced, not flaunted.

Here is a thoughtful and reflective man who is acutely aware of himself and his environment. Here is a man who has been called ‘Guru to the Stars’ by Barron’s, whose admirers include Chris Davis, Warren Buffett, and Jeremy Grantham, and whose firm oversees nearly $80 billion in assets.

Ever gracious and generous with his time, Howard Marks, the co-founder and chairman of Oaktree Capital Management, sat down with PM Jar to discuss his approach to the art of investing: transforming symmetrical inputs into asymmetric returns. What follows are excerpts from that conversation.

Part 1: An Idea of What Is Enough

“I think that having an idea of a goal is something to work for, but it's also important to have an idea of what is enough.”

Marks: The goal of investing is to have your capital be productive. It's to make money on your money. Certain investment organizations – pension funds, insurance companies, endowments – have specific goals and requirements to make a certain amount of money that will permit them to accomplish their objectives. Everybody has a goal, and some are different from others. Some people don’t have a specific goal – they just want to make money.

In 2007, people said: “I need 8%. It would be nice to make 10%. It would terrific to make 12%. It would be wonderful to make 15%. It would be absolutely fabulous to make 18%. 20% would be fantastic.” Whereas they should have said: “I need 8%. If I get 10%, that would be great. 12% would be wonderful. I’m not going to try for 15% because to try for 15%, I’d have to take risks that I don’t want to take.” I think that having an idea of a goal is something to work for, but it’s also important to have an idea of what is enough.

PM Jar: In your book, The Most Important Thing, you wrote that it’s difficult to find returns if they’re not available, and chasing returns is one of the dumbest things that an investor can do. Does an investor’s return goal change with the market cycle or where the pendulum is located?

Marks: You should be cognizant of where you are buying because where you buy says a lot about the return which is implied in your investment. Every time we organize a fund, we talk about the return we can make, which is informed by where we expect to buy things. Consequently, sometimes we think we will get very high returns because we have the opportunity to buy stuff cheap. Sometimes we think we’ll get lower returns because we can’t buy that much stuff cheap. So clearly, different points in time and different positions of the pendulum imply different kinds of returns – not with any certainty, but you should have a concept of whether you are getting great bargains, so-so bargains, or paying excessive prices (in which case, you should be a seller not a buyer).

But we’re dangerously close to confusing two topics. A return goal is what you want, what you need to be successful, or what you aspire to. An expected return is what you think you can make on the things you can buy today – sometimes you should be able to make 5% and sometimes you should be able to make 15% – which may have nothing to do with your desired return or required return. 

Continue Reading -- Part 2 of 5: Real World Considerations