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.

Michael Price & Portfolio Management

Summaries below are extracted from a speech Michael Price gave at the 2013 (June) London Value Investor Conference. If you have read our previous article based on an interview Peter J. Tanous conducted with Michael Price many years ago, you’ll find that Price’s portfolio management philosophy has not changed much since then. Many thanks to my friend John Huber of BaseHitInvesting for sharing this me with me. The complete video can be found here (Market Folly). Cash, Volatility, Patience, Hurdle Rate

2/3 of his portfolio consists of “value” securities (those trading at a discount to intrinsic value), and remaining 1/3 are special situations (activism, liquidation, etc). When he can’t find opportunities for either category, he holds cash.

The expected downside volatility of this type of portfolio in a bear market (excluding extreme events like 2008) is benign because when the overall market declines, cash won’t move at all and securities trading at 60% of intrinsic value won’t move down very much.

The key to constructing a portfolio like this is patience, because you must be willing to wait for assets to trade to 1/2 or 1/3 discount to intrinsic value, or sit with cash and wait when you can’t find them right away.

Price says he does not have any preconceived notions of what amount of cash to hold within the portfolio (aside from a 3-5% minimum because he likes “having the ammunition”). Instead, the portfolio cash balance is a function of what he is buying or selling. Cash increases when markets go up because he is selling securities/assets, and cash decreases when markets go down because he is buying securities/assets. He also mentions that he doesn’t care what he’s earning on cash, which is interesting because does this imply that Price’s hurdle rate for investments is likely always higher than what he can earn on cash?

Sizing, Diversification

Price prefers to hold a more diversified portfolio of cheap names, spreading his risk across 30-70 positions, “not 13 holdings.” Over time, as he does more work, good ideas float to the top, and he sizes up the good ideas as he builds more conviction, whereas names that are merely “interesting” stay at 1% of NAV.

The resulting portfolio may have 40 securities, with the top 5 names @ 5% NAV each, the next 5-10 names @ 3% NAV each, and the next 20-30 names @ 1% NAV each.

Price likes constructing his portfolio this way because he is then able to compare and contrast across more companies/securities, to help drive conviction, making him smarter over time. It’s a style decision, and may not work for everyone, but it works for him.

When To Sell, Mistakes, Tax

Price calls it the “art of when to sell things” because it’s not always straightforward, and especially tricky when a security you purchased at a discount to intrinsic value appreciates to 90-100% of intrinsic value. For example, he bought into the Ruth's Chris rights offering at $2.50/share, and the stock is now trading at $11/share. He sold a quarter of his stake because “it’s getting there” and “you don’t know when to unwind the whole thing so you dribble it out.”

Other rules for selling: when you make a mistake, or lose conviction. Especially important before it becomes long-term gains because it will then offset other short-term gains dollar-for-dollar (anyone investing in special situations / event-driven equities will likely generate a good portion of short-term gains).

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  

Buffett Partnership Letters: 1968 & 1969

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

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

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

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

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

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

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

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

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

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

Process Over Outcome

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

AUM, Sizing

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

Returning Capital

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

An Interview with Bruce Berkowitz - Part 1

Bruce Berkowitz of Fairholme Funds manages $7Bn+ of assets (this figure is based on fund prospectus disclosures, may not be inclusive of separately managed accounts) and was once named Morningstar’s Manager of the Decade. As you are probably aware, since 2010, it’s been a trying couple of years for Berkowitz. His fund was down 32% in 2011, then rallied ~37% in 2012 -- such volatility is not for the faint of heart!

However, we believe that trying times often reveal wonderful insights into an investor’s investment philosophy (his thoughts on cash are especially interesting). Accordingly, below are portfolio management highlights extracted from an August 2010 WealthTrack interview with Consuelo Mack (which, by the way, is an absolute treasure trove of investment wisdom). For more on Berkowitz, there’s also a thorough Fortune Magazine article from December 2010.

Cash, Liquidity, Redemptions, Expected Return

“MACK: Another Wall Street kind of conventional wisdom is that…you shouldn't hold a lot of cash in equity funds. Well, the Fairholme Fund has a history of holding a lot of cash. And I remember you telling me that cash is your financial valium.

BERKOWITZ: Yes. Well, the worst situation is if you're backed into a corner and you can't get out of it, whether for illiquidity reasons, shareholders may need money, or you have an investment that, as usual, you're a little too early, and you don't have the money to buy more, or you don't have the flexibility. That's a nightmare scenario. And this is nothing new. I mean, the great investors never run out of cash. It's just as simple as that…We haven't re-created the wheel here, but we always want to have a lot of cash, because cash can become awfully valuable when no one else has it.”

I have written in the past about the parallels between operating businesses and the investment management business (i.e., capital reinvestment and compounding).

Cash management is yet another relevant parallel – both should monitor future liquidity obligations, whether it’s client redemptions, debt maturity, potential future asset purchases or expansion opportunities.

Operating businesses have the advantage of term financing that’s permanent for a specified period of time. Most public market investors don’t have this luxury (private equity and real estate investors are more fortunate in this respect), which should compel them to keep even more rainy day cash.

However, as Mack describes, conventional Wall Street wisdom dictates the exact opposite -- that investors should not hold excess cash on the sidelines!

Also, Berkowitz’s last sentence about cash becoming “awfully valuable when no one else has it” implies that the value of cash changes in different market environments. This is in essence a calculation of the future expected return of cash – crazy I know, but similar to an idea echoed by another very smart investor named Jim Leitner, who said:

“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.”

For those of you who have not read the pieces on Jim Leitner, a former member of Yale Endowment's Investment Committee, I highly recommend doing so.

When To Buy, Intrinsic Value, Cash, Expected Return, Hurdle Rate, Opportunity Cost

“We don't predict. We price. So if timing the market means we buy stressed securities when their prices are way down, then yes. Guilty as charged. But, again, we're trying to compare what we're paying for something, versus what we think, over time, we're going to get for the cash we're paying. And, we try not to have too many predetermined notions about what it's going to be.”

The first part is self-explanatory.

In the second portion, when Berkowitz refers to comparing “what we’re paying for something, versus what we think, over time, we’re going to get for the cash we’re paying,” he’s inherently talking about a hurdle rate and opportunity cost calculation that’s going to determine whether it’s worthwhile to purchase a particular asset.

The purchase decision is not solely driven by price vs. intrinsic value. There’s an additional factor that’s slightly more intangible, because its calculation involves predicting both the future expected return of cash (see above), as well as the future expected return of XYZ under evaluation.

Buffett Partnership Letters: 1965 Part 4

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

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

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

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

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

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

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

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

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

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

Sourcing, Sizing

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

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

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

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

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

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

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

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

When To Buy

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

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

Buffett Partnership Letters: 1965 Part 1

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. The 1965 letter is a treasure trove of insightful portfolio management commentary from Warren Buffett. This is the Buffett for purists – the bright, candid young investor, encountering intellectual dilemmas, thinking aloud about creative solutions, and putting to paper the mental debates pulling him one direction and then another. Fascinating stuff!

Portfolio Management, Sizing, Diversification, Expected Return, Risk, Hurdle Rate, Correlation, Selectivity, Psychology

“We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change underlying value of the investment.

We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations. Frankly there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects that range of all possible relative performances, including negative ones, adjusted for the probability of each…) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorrelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage.

It doesn’t work that way.

We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations vary substantially. The question always is, ‘How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?’ This depends to a great degree on the wideness of the spread between the mathematical expectations of number one versus number eight. It also depends upon the probability that number one could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have 0.05 chance of performing fifteen percentage points or more worse than the Dow, and the second might have only 0.01 chance of such performance. The wide range of expectation in the first case reduces the desirability of heavy concentration in it.

The above may make the whole operation sound very precise. It isn’t. Nevertheless, our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations. Imprecise and emotionally influenced as our attempts may be, that is what the business is all about. The results of many years of decision-making in securities will demonstrate how well you are doing on making such calculations – whether you consciously realize you are making the calculations or not. I believe the investor operates at a distinct advantage when he is aware of what path his thought process is following.”

"There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can’t reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation."

Lots of fantastic insights here. The most important take away is that, even for Buffett, portfolio management involves more art than science – it’s imprecise, requiring constant reflection, adaptation, and awareness of ones decisions and actions.

Expected Return, Trackrecord, Diversification, Volatility

“The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable. The greater the number of selections, the less will be the average year-to-year variation in actual versus expected results. Also, the lower will be the expected results, assuming different choices have different expectations of performance.

I am willing to give up quite a bit in terms of leveling of year-to-year results (remember when I talk of ‘results,’ I am talking of performance relative to the Dow) in order to achieve better overall long-term performance. Simply stated, this means I am willing to concentrate quite heavily in what I believe to be the best investment opportunity recognizing very well that this may cause an occasional very sour year – one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater…Looking back, and continuing to think this problem through, I fell that if anything, I should have concentrated slightly more than I have in the past…”

Here, Buffett outlines the impact of diversification on the expected return and expected volatility of a portfolio, as well as the resulting trackrecord.

Consciously constructing a more concentrated portfolio, Buffett was willing to accept a bumpier trackrecord (more volatile returns vs. the Dow) in return for overall higher long-term returns.

To fans of this approach, I offer two points of caution:

• Increased concentration does not automatically equate to higher returns in the long-term – this is also governed by accurate security selection, or as Buffett puts it, “the various expectations of choices available”
• Notice, at this juncture in 1965-1966, Buffett has a 10-year wildly superior trackrecord. This is perhaps why short-term volatility no longer concerned him (or his clients) as much. If your fund (and client base) is still relatively new, think carefully before emulating.

Howard Marks' Book: Chapter 6 - Part 2

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 6 “The Most Important Thing Is…Recognizing Risk” Marks does a fantastic job illustrating the impact of the (low) risk free rate on portfolio expected risk & return, position selectivity, hurdle rate & opportunity cost.

Expected Return, Hurdle Rate, Opportunity Cost, Risk Free Rate, Selectivity

“The investment thought process is a chain in which each investment sets the requirement for the next…The interest rate on the thirty-day T-bill might have been 4 percent. So investors, says, ‘If I’m going to go out five years, I want 5 percent. And to buy the ten-year note I have to get 6 percent.’ Investors demand a higher rate to extend maturity because they’re concerned about the risk to purchasing power, a risk that is assumed to increase with time to maturity. That’s why the yield curve, which in reality is a portion of the capital markets line, normally slopes upward with the increase in asset life.

Now let’s factor in credit risk. ‘If the ten-year Treasury pays 6 percent, I’m not going to buy a ten-year single-A corporate unless I’m promised 7 percent.’ This introduces the concept of credit spread. Our hypothetical investor wants 100 basis points to go from a ‘guvvie’ to a ‘corporate’…

What if we depart from investment-grade bonds? ‘I’m not going to touch a high yield bond unless I get 600 over a Treasury note of comparable maturity.’ So high yield bonds are required to yield 12 percent, for a spread of 6 percent over the [ten-year] Treasury note, if they’re going to attract buyers.

Now let’s leave fixed income altogether. Things get tougher, because you can’t look anywhere to find the prospective return on investments like stocks (that’s because, simply put, their returns are conjectural, not ‘fixed’). But investors have a sense for these things. ‘Historically S&P stocks have returned 10 percent, and I’ll buy them only if I think they’re going to keep doing so…And riskier stocks should return more; I won’t buy on the NASDAQ unless I think I’m going to get 13 percent.’

From there it’s onward and upward. ‘If I can get 10 percent from stocks, I need 15 percent to accept the illiquidity and uncertainty associated with real estate. And 25 percent if I’m going to invest in buyouts…and 30 percent to induce me to go for venture capital, with its low success ratio.’

That’s the way it’s supposed to work…a big problem for investment returns today stems from the starting point for this process: The riskless rate isn’t 4 percent; it’s close to 1 percent…Typical investors still want more return if they’re going to accept time risk, but with the starting point at 1+ percent, now 4 percent is the right rate for the ten-year (not 6 percent)…and so on. Thus, we now have a capital market line…which is (a) at a much lower level and (b) much flatter.”

“…each investment has to compete with others for capital, but this year, due to low interest rates, the bar for each successively riskier investment has been set lower than at any time in my career.” Most investors have, at some point, gone through a similar thought process:

• Should I make this investment?
• What is the minimum return that will compel me to invest? (For discussion purposes, we’ll call this the Hurdle Rate.)
• How do I determine my hurdle rate?

Based on the quotes above, the hurdle rate is determined based upon a mixture of considerations including: (1) the risk-free rate (2) the expected return of other available investments or asset classes, and (3) perhaps a measure of opportunity cost (for which the calculation opens a whole new can of worms).

In essence, this is a selectivity exercise, comparing the expected returns between possible investment candidates along the “risk” spectrum. After all, “each investment has to compete with others for capital” because we can’t invest in everything.

Howard Marks highlights a problematic phenomenon of recent days: the declining risk-free-rate pushing down the starting point for this exercise, and consequently the entire minimum return requirement (hurdle rate) curve for investors.

So the following questions emerge:

• Is your minimum return requirement (hurdle rate) curve relative or absolute vs. the crowd?
• If relative, do you join the crowd and lower your minimum return hurdle rate?
• Just a little, you say? Is there a point at which you draw the proverbial line in the sand and say “no further” because everyone has lost their minds?
• Do you then go to cash? Is there any another alternative? Are you prepared to miss out on potential returns (as other investors continue to decrease their hurdle rates and chase assets/investments driving prices even higher)?

Wait, this sounds very familiar. Remember our Part 1 discussion on “risk manifestation” due to irrational market participant behavior and high asset prices?

Risk, Expected Return

“…the herd is wrong about risk at least as often as it is about return.”

We have often discussed the concept of expected return (a forward looking prediction on future return outcome), but we have been remiss in discussing the concept of expected risk (a forward looking prediction on future risk outcome).

Misguided predictions of either expected return or expected risk have the potential to torpedo investment theses.

Lisa Rapuano Interview Highlights - Part 3

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

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

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

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

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

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

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

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

When To Buy, Sizing

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

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

When To Sell

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

Creativity

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

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

Wisdom from Steve Romick: Part 3

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

Creativity, Team Management

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

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

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

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

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

Benchmark, Hurdle Rate

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

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

Volatility

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

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

Foreign Exchange

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

Inflation

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

Buffett Partnership Letters: 1963 Part 2

Continuation in a series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Topics covered include: Benchmark, Hurdle Rate, Expected Return, Volatility, & Team Management.  

Benchmark, Hurdle Rate

“At plus 14% versus plus 10% for the Dow, this six months has been a less satisfactory period than the first half of 1962 when we were minus 7.5% versus minus 21.7% for the Dow.”

“If we had been down 20% and the Dow had been down 30%, this letter would still have begun “1963 was a good year.”

“Our partnership’s fundamental reason for existence is to compound funds at a better-than-average rate with less exposure to long-term loss of capital than the above investment [benchmarks]. We certainly cannot represent that we will achieve this goal. We can and do say that if we don’t achieve this goal over any reasonable period, excluding an extensive speculative boom, we will cease operation.”

“A ten percentage point advantage would be a very satisfactory accomplishment and even a much more modest edge would produce impressive gains…This view (as it has to be guesswork – informed or otherwise) carries with it the corollary that we much expect prolonged periods of much narrower margins over the Dow as well as at least occasional years when our record will be inferior…to the Dow.”

Buffett’s performance goal was relative (10% annual above the Dow), not absolute return. He once again makes a statement about ceasing operation if he doesn’t achieve this goal – the man was determined to add value, not content leaching fees.

But a question continues to tickle my brain:

Why 10% above the Dow? Why not 5% or 15.7%? What is significant about this 10% figure (other than an incredibly ambitious goal)? Buffett plays coy claiming “guesswork – informed or otherwise,” but we know that Buffett was not the random-number-generating-type.

Expected Return, Volatility

“We consider all three of our categories to be good businesses on a long-term basis, although their short-term price behavior characteristics differ substantially in various types of markets.”

“Our three investment categories are not differentiated by their expected profitability over an extended period of time. We are hopeful that they will each, over a ten or fifteen year period, produce something like the ten percentage point margin over the Dow that is our goal. However, in a given year they will have violently differentiated behavior characteristics, depending primarily on the type of year it turns out t be for the stock market generally.”

As we have discussed in the past, Buffett was extremely conscious of the expected return and expected volatility (in a number of different scenarios) of his portfolio positions. For more commentary on this, please see our previous articles on expected return and volatility.

Buffett is “hopeful” that the investments he selects “will each, over a ten or fifteen year period, produce something like the percentage point margin over the Dow that is our goal.”

But how does he determine which investment fits this criteria during the initial diligence process prior to purchase – especially since the Dow itself is perpetually fluctuating?

Team Management

“…the Dempster story in the annual letter, perhaps climaxed by some lyrical burst such as ‘Ode to Harry Bottle.’ While we always had a build-in profit in Dempster because of our bargain purchase price, Harry accounted for several extra serves of dessert by his extraordinary job.”

“Beth and Donna have kept an increasing work load flowing in an excellent manner. During December and January, I am sure they wish they had found employment elsewhere, but they always manage to keep a mountain of work ship-shape…Peat, Marwick, Mitchell has done their usual excellent job of meeting a tough timetable.”

Praise – lay it on thick. The tool of appreciation can perhaps reach the uncharted corners of loyalty in your employees’ hearts where compensation had previously failed.

Buffett Partnership Letters: 1963 Part 1

Continuation in a series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Clients, Leverage, Subscriptions, Redemptions

“We accept advance payments from partners and prospective partners at 6% interest from date of receipt until the end of the year…Similarly, we allow partners to withdraw up to 20% of their partnership account prior to yearend and charge them 6% from date of withdrawal until yearend…Again, it is not intended that partners use us like a bank, but that they use the withdrawal right for unanticipated need for funds.                                     

“Why then the willingness to pay 6% for an advance payment money when we can borrow from commercial banks at substantially lower rates? For example, in the first half we obtained a substantial six-month bank loan at 4%. The answer is that we except on a long-term basis to earn better than 6%...although it is largely a matter of chance whether we achieve the 6% figure in any short period. Moreover, I can adopt a different attitude in the investment of money that can be expected to soon be part of our equity capital than I can on short-term borrowed money.” 

“The advance payments have the added advantage to us of spreading the investment of new money over the year, rather than having it hit us all at once in January.”

Buffett allowed his investors annual windows for subscription and redemption (to add or withdraw capital). However, clients could withdraw capital early at 6% penalty. Clients could also add capital early and receive 6% return.

Paying investors 6% for their advance payments technically constitutes a form of leverage. However, as Buffett points out, not all forms of leverage are created equal. Margin lines are usually short-term with the amount of capital available constantly shifting, tied to value of underlying portfolio holdings which are usually marketable securities. Bank loans have limited duration until the debt must be repaid or terms renegotiated. In contrast to the two previous common forms of leverage, paying investors 6% (or whatever percentage depending on the environment) is most similar to long-term leverage with permanent terms (until the annual subscription window), since the capital will stay, converting from “debt” to an equity investment.

A friend recently relayed a story on Buffett giving advice to an employee departing to start his own fund. Apparently, it was a single piece of information: allow subscriptions and redemptions only one day per year.

The paperwork, etc. aside, I believe the true rationale behind this advice lies in the last quote shown above. Similar to how advance payments allowed Buffett the advantage of “spreading the investment of new money over the year,” having one subscription/redemption date would allow a portfolio manager to offset capital inflows against capital outflows, thereby decreasing the necessity of having to selling positions to raise liquidity for redemptions and scraping around for new ideas to deploy recent subscriptions. In other words, it minimizes the impact of subscriptions and redemptions on the existing portfolio.

Risk Free Rate, Fee Structure, Hurdle Rate

“…6% is more than can be obtained in short-term dollar secure investments by our partners, so I consider it mutually profitable.”

Not only was 6% the rate applicable to early redemptions or subscriptions, 6% was also the incentive fee hurdle rate, such that if the Partnership returned less than 6%, Buffett would not receive his incentive fee.

Based on the quote above, it would seem in 1963, 6% was approximately the risk free rate. Today (Aug 2012), the rate that can be “obtained in short-term dollar secure investments” is 1% at best.

Some funds still have minimum hurdle rate requirements built into incentive structure (I see this most commonly with private equity / long-term-commitment style vehicles). But most liquid vehicles (e.g., hedge funds) don’t have minimum hurdle rates determining whether they collect incentive fees in any given year.

This makes me wonder: why don’t most liquid funds vehicle fee structures have hurdle rates? It doesn’t seem unreasonable to me that, at a minimum, these funds should have an incentive fee hurdle rate equivalent to the risk-free-rate in any given year.

Tax

“A tremendous number of fuzzy, confused investment decisions are rationalized through so-called ‘tax considerations.’ My net worth is the market value of holdings less the tax payable upon sale. The liability is just as real as the asset unless the value of the asset declines (ouch), the asset is given away (no comment), or I die with it. The latter course of action would appear to at least border on a Pyrrhic victory. Investment decisions should be made on the basis of the most probably compounding of after-tax net worth with minimum risk.”

Taxes made simple by Warren Buffett.

Sadly, many investment funds today fail to consider tax consequences because the clients who matter (the large pensions and foundations) don’t pay taxes. So their smaller taxable clients suffer the consequences of this disregard.

Buffett Partnership Letters: 1961 Part 2

This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. During 1961, Buffett started to write semi-annual letters because his clients told him the annual letter was “a long time between drinks.” The second of the two 1961 letters written is a treasure trove of portfolio management information, so robust in material that the summary (organized by topic) will require multiple installments.

For those interested in Warren Buffett’s portfolio management style, I highly recommend the reading of this second letter in its entirety.

Hurdle Rate, Expected Return, Volatility

“There are bound to be years when we are surpassed by the Dow, but if over a long period we can average ten percentage points per year better than it, I will feel the results have been satisfactory…Specifically, if the market should be down 35% or 40% in a year…we should be down only 15% or 20%. If it is more or less unchanged during the year, we would hope to be up about ten percentage points. If it is up 20% or more, we would struggle to be up as much.”

Buffett had a goal of beating the Dow by 10% annually, on average, over a long period of time. In order to achieve this, he had to seek investments that met a return hurdle of 10% higher than the Dow – no easy feat since the Dow itself is a moving target. Additionally, the portfolio had to have an asymmetric volatility profile that captured the Dow’s upside volatility, but only a fraction of the Dow’s downside volatility. As the history books have shown, he was certainly successful in achieving his goal, but the means of how he did so remains a mystery. I believe that Buffett’s partnership letters, in particular the second 1961 letter, holds some clues.

Part of the answer lies in Buffett’s strategy of segmenting his portfolio and analyzing the return potential and volatility contribution of each portion.

“Our avenues of investment break down into three categories. These categories have different behavior characteristics, and the way our money is divided among them will have an important effect on our results, relative to the Dow in any given year.”

“The generals tend to behave market-wise very much in sympathy with the Dow. Just because something is cheap does not mean it is not going to go down. During abrupt downward movements in the market, this segment may very well go down percentage-wise just as much as the Dow. Over a period of years, I believe the generals will outperform the Dow, and during sharply advancing years like 1961, this is the section of our portfolio that turns in the best results. It is, of course, also the most vulnerable in a declining market.”

“[The work-outs] will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout a year with a large portion of our portfolio in work-outs, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year.” 

“The final category is “control” situations…Such operations should definitely be measured on the basis of several years…the stock may be stagnant market-wise for a long period while we are acquiring. These situations, too, have relatively little in common with the behavior of the Dow.”

“…I am more conscious of the dangers presented at current market levels than the opportunities. Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from these dangers.”

We have written in the past that Buffett thought consciously about the expected return of his portfolio in our post on the 1957 Letter - Part 2, specifically, that he “left nothing to hope or chance, and thought very strategically about position sizing, the annualized expected return of these positions, and the estimated hurdle rate required to outperform his benchmarks by a margin of 10% annually.”

The excerpts from the 1961 letter shown above, clearly demonstrate that he segregated his portfolio into three segments and assigned expected return figures to each. The percentage weighting of these segments then impacted the overall expected return of his portfolio.

Going one step farther, Buffett also monitored the expected volatility– yes, the forward looking volatility – of each of these segments by anticipating how each segment would behaved in different market scenarios relative to his benchmark (the Dow). For example, the “generals” moved in tandem with the Dow, whereas Buffett believed that the “work-outs” had a relatively uncorrelated volatility profile “to a large extent irrespective of the course of the Dow.”

I have written in a previous post on the 1958 Letter - Part 1 that Buffett “never ignored volatility because he recognized the impact of this phenomenon on his performance return stream.” His words above lend confirmation.

Today, Buffett preaches that permanent impairment of capital is what he’s most worried about. Perhaps that’s true for the billionaire Buffett with a permanent capital base and established trackrecord. However, back in the day, he was much more focused on avoiding impairment of capital of any kind – even that temporary type incurred via price movement (i.e., volatility). After all (roughly paraphrasing Buffett’s words, not mine, see quotes above), just because something is cheap, doesn’t mean it can’t go down more.

Buffett Partnership Letters: 1958 Part 2

This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. Selectivity, Hurdle Rate, Risk

“The higher level of the market, the fewer the undervalued securities and I am finding some difficulty in securing an adequate number of attractive investments. I would prefer to increase the percentage of our assets in work-outs, but these are very difficult to find on the right terms.”

All investors practice some degree of selectivity, since not all ideas/securities/assets we examine makes it into our portfolios. Selectivity implies that, for each of us, there exists some form of selection criteria (e.g., hurdle rate, risk measurement, good management, social responsibility, etc.).

In 1958, Buffett talks about finding it difficult to locate “attractive investments” on the “right terms” as the market got more expensive. Perhaps it’s a comfort to know that Buffett grappled with problems just like the rest of us mere mortals!

Jokes aside, as markets rise, what happens to our standards of selectivity? Do we change our usual parameters (whether consciously or subconsciously) – such as changing the hurdle rate or risk standards?

It’s a dynamic and difficult reality faced by all investors at some point in our careers, made more relevant today as markets continue to rally. I believe how each of us copes and adapts in the face of rising asset prices (and whether we change our selectivity criteria) separates the women from the girls.

Intrinsic Value, Exposure, Opportunity Cost

“Unfortunately we did run into some competition on buying, which railed the price to about $65 where we were neither buyer nor seller.”

“Late in the year we were successful in finding a special situation where we could become the largest holder at an attractive price, so we sold our block of Commonwealth obtaining $80 per share…It is obvious that we could still be sitting with $50 stock patiently buying in dribs and drags, and I would be quite happy with such a program…I might mention that the buyer of the stock at $80 can expect to do quite well over the years. However, the relative undervaluation at $80 with an intrinsic value of $135 is quite different from a price $50 with an intrinsic value of $125, and it seemed to me that our capital could better be employed in the situation which replaced it.”

Once a security has been purchased, the risk-reward shifts with each price movement. Any degree of appreciation naturally makes it a larger % of NAV, alters portfolio exposures, and changes the theoretical amount of opportunity cost (to Buffett’s point of his “capital could better be employed” in another situation).

So what actions does a portfolio manager take, if any, when a security appreciates but has not reached the target price, to a place where it’s neither too cheap nor too expensive, where we are “neither buyer nor seller”?

Unfortunately, Buffett offers no solutions in the 1958 letter. Any thoughts and suggestions from our Readers?

Buffett Partnership Letters: 1957 Part 2

This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. Cash, Special Situations

“…if the market should go considerably higher our policy will be to reduce our general issues as profits present themselves and increase the work-out portfolio.”

His describes the “general issues” basket – mostly undervalued securities with no catalyst – in greater detail in later letters.

Interestingly, the quote implies that Buffett used his “work-out” basket as a quasi-cash equivalent. Theoretically, when a security has little/no downside capture, assuming there’s enough trading volume and liquidity, it can be utilized in a portfolio context as a quasi-cash equivalent with upside potential. This allows the portfolio manager to decrease exposure as underlying markets get expensive, while squeezing out some return potential greater than pure cash yields. Should the underlying market decline, accumulated performance is preserved as the “work-out” basket does not decline, and could be sold to serve as a source of liquidity to purchase other (now cheap) securities that have declined with the market.

A useful tactic for investors who wish to decrease exposure when markets get frothy, but don't want to blatantly lag if the rally continues. Of course, this is all predicated upon one's ability to identify "work-out" securities with 1957 attributes. Please see our 1957: Part 1 discussion for more details.

Sizing, Expected Return, Hurdle Rate

“One of these positions accounts for between 10% and 20% of the portfolio of the various partnerships and the other accounts for about 5%...will probably take in the neighborhood of three to five years of work but they presently appear to have potential for a high average annual rate of return…”

“Earlier I mentioned our largest position which comprised 10% to 20% of the assets of the various partnerships. In time I plan to have this represent 20% of the assets of all partnerships but this cannot be hurried.”

“Over the years, I will be quite satisfied with a performance that is 10% per year better than the Averages…Our performance, relatively, is likely to be better in a bear market than in a bull market…In a year when the general market had a substantial advance I would be well satisfied to match the advance of the Averages.”

Buffett left nothing to hope or chance, and thought very strategically about position sizing, the annualized expected return of these positions, and the estimated hurdle rate required to outperform his benchmarks by a margin of 10% annually.

Too often, investors are anchored to certain return figures (e.g., 8-15%+ for equities, etc.) regardless of current market conditions and entry price. Unpleasant negative surprises would occur less often if investors followed Buffett’s approach in examining portfolio holdings, percentage exposures, and assigning realistic expected returns based on present market conditions.

I do not wish to imply that the expected return of a portfolio can be extracted via a scientific formula involving the calculation of a weighted average return figure – false precision is equally as dangerous as false expectations. However, I do believe that knowing the general direction of potential future portfolio returns can be helpful in setting realistic expectations for portfolio managers, external fund investors, and assist with other portfolio related decisions such as fundraising, headcount expansion, etc.

Separate Accounts

“All three of the 1956 partnerships showed a gain during the year amounting to about 6.2%, 7.8%, and 25% on yearend 1956 net worth. Naturally a question is created as to the vastly superior performance of the last partnership, particularly in the mind of the partners of the first two. This performance emphasizes the importance of luck in the short run, particularly in regard to when funds are received. The third partnership was started in the latest in 1956 when the market was at a lower level and when several securities were particularly attractive. Because of the availability of funds, large positions were taken in these issues. Whereas the two partnerships formed earlier were already substantially invested so that they could only take relatively small positions in these issues.”

For those who manage separate accounts and have received inquiries from clients regarding performance discrepancies related to fund flow / timing differences, feel free to tell them that this would happen even if Buffett managed their account. Perhaps not in those exact words, but I thought to include this quote in case a Reader finds it useful.