BlueCrest’s Michael Platt

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

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

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

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

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

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

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

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

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

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

Creativity, Psychology

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

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

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

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

Psychology, Opportunity Cost, Mistake

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

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

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

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

Exposure

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

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

Creativity, Diversification, Correlation 

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

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

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

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

Howard Marks' Book: Chapter 19

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

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

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

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

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

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

Volatility

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

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

Expected Return, Risk

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

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

Opportunity Cost, Benchmark

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

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

Howard Marks' Book: Chapter 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.”

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?”

Howard Marks' Book: Chapter 14

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 14 “The Most Important Thing Is…Knowing What You Don't Know” Mistakes, Sizing, Diversification, Leverage, Opportunity Cost

“…the biggest problems tend to arise when investors forget about the difference between probability and outcome – that is, when they forget about the limits on foreknowledge:

• when they believe the shape of the probability distribution is knowable with certainty (and that they know it),
• when they assume the most likely outcome is the one that will happen,
• when they assume the expected result accurately represents the actual result, or
• perhaps most important, when they ignore the possibility of improbable outcomes.”

“Investors who feel they know what the future holds will act assertively: making directional bets, concentrating positions, levering holdings, and counting on future growth – in other words, doing things that in the absence of foreknowledge would increase risk. On the other hand, those who feel they don’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possible outcomes.”

“If you know the future, it’s silly to play defense. You should behave aggressively and target the greatest winners; there can be no loss to fear. Diversification is unnecessary, and maximum leverage can be employed. In fact, being unduly modest about what you know can result in opportunity costs (foregone profits). On the other hand…Mark Twain put it best: ‘It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.’”

A few months ago, we wrote about Michael Mauboussin’s discussion on utilizing the Kelly Formula for portfolio sizing decisions. The Kelly Formula is based upon an investor’s estimation of the probability and amount of payoff. However, if the estimation of probability and payoff amount is incorrect, the mistake will impact portfolio performance through position sizing. It’s a symmetrical relationship: if you are right, the larger position size will help performance; if you are wrong, the larger position size will hurt performance.

Marks’ words echo a similar message. They remind us that an investor’s perception of future risk/reward drives sizing, leverage, and a variety of other portfolio construction and management decisions. If that perception of future risk/reward is correct/incorrect, it will lead to a positive/negative impact on performance, because “tactical decisions like concentration, diversification, and leverage are symmetrical two-way swords.” In order to add value, or generate alpha, an investor must create asymmetry which comes from “superior personal skill.” One interpretation of superior personal skill is correct perception of future risk/reward (and structuring the portfolio accordingly).

Psychology

“Awareness of the limited extent of our foreknowledge is an essential component of my approach to investing.”

“Acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage.”

“No one likes having to invest for the future under the assumption that the future is largely unknowable. On the other hand, if it is, we’d better face up to it and find other ways to cope…Whatever limitations are imposed on us in the investment world, it’s a heck of a lot better to acknowledge them and accommodate them than to deny them and forge ahead.”

Investors must embrace uncertainty and the possibility of unpredictable events. Acknowledgement of “the boundaries of what you can know” won’t make you immune from the possible dangers lurking in the unknown future, but at least you won’t be shocked psychologically if/when they occur.

Macro, Luck, Process Over Outcome

“…the future is unknowable. You can’t prove a negative, and that certainly includes this one. However, I have yet to meet anyone who consistently knows what lies ahead macro-wise. Of all the economists and strategists you follow, are any correct most of the time?”

“…if the forecasters were sometimes right – and right so dramatically – then why do I remain so negative on forecasts? Because the important thing in forecasting isn’t getting it right once. The important thing is getting it right consistently.”

“One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fixed view long enough, you may be right sooner or later. And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did. But that doesn’t mean your forecasts are regularly of any value…It’s possible to be right about the macro-future once in a while, but not on a regular basis. It doesn’t do any good to possess a survey of sixty-four forecasts that includes a few that are accurate; you have to know which ones they are. And if the accurate forecasts each six months are made by different economists, it’s hard to believe there’s much value in the collective forecasts.”

“Those who got 2007-2008 right probably did so at least in part because of a tendency toward negative views. As such, they probably stayed negative for 2009.”

PM Jar Exclusive Interview With Howard Marks - Part 4 of 5

Below is Part 4 of PM Jar’s interview with Howard Marks, the co-founder and chairman of Oaktree Capital Management, on portfolio management. Part 4: The Art of Transforming Symmetry into Asymmetry

“If tactical decisions like concentration, diversification, and leverage are symmetrical two-way swords, then where does asymmetry come from? Asymmetry comes from alpha, from superior personal skill.”

Marks: Everything in investing is a two-way sword – a symmetrical two-way sword. If you turn cautious and raise cash, it will help you if you are right, and hurt you if you are wrong. If tactical decisions like concentration, diversification, and leverage are symmetrical two-way swords, then where does asymmetry come from? Asymmetry comes from alpha, from superior personal skill.

Superior investors add value in a number of ways, such as security selection, knowing when to drop down in quality and when to raise quality, when to concentrate and when to diversify, when to lever and when to delever, etc. Most of those things come under the big heading of knowing when to be aggressive and when to be defensive. The single biggest question is when to be aggressive and when to be defensive.

I believe very strongly that investors have to balance two risks: the risk of losing money and the risk of missing opportunity. The superior investor knows when to emphasize the first and when to emphasize the second – when to be defensive (i.e., to worry primarily about the risk of losing money) and when to be aggressive (i.e., to worry primarily about the risk of missing opportunity). In the first half of 2007, you should have worried about losing money (there was not much opportunity to miss). And in the last half of 2008, you should have worried about missing opportunity (there wasn’t much chance of losing money). Knowing the difference is probably the most important of all the important things.

PM Jar: How do you think about the opportunity cost when balancing these two risks? Is it historical or forward looking?

Marks: If you bought A, your opportunity cost is what you missed by not holding B. That’s historical. Similarly, when you look forward, you can take an infinite number of different actions in putting together your portfolio.Opportunity cost is what you could lose by doing what you’re doing, as opposed to other things that you could have done.

Opportunity cost is a sophisticated sounding way to address the risk of doing something versus the risk of not doing it. This is how we decide whether and how to invest: If I buy it, could I lose money? If I don’t buy it, could I miss out on something? If I buy a little, should I have bought a lot? If I bought a lot, should I have bought a little?

Investing is an art form in the sense that it can’t be mechanized. There is no formula or rule that works – it’s all feel. You get the inputs, analyze them, turn the crank, get numbers out – but they are only guesswork. Anything about the future is only a guess. The best investing is done by people who make the best subjective judgments.

Anyone who thinks they are going to make all decisions correctly is crazy. But if you make mistakes, you have to learn from them. Otherwise you’re making another huge mistake if you ignore the learning opportunity. One of my favorite sayings is, “Experience is what you got when you didn’t get what you wanted.”

Continue Reading — Part 5 of 5: Creating Your Own Art

Baupost Letters: 1998

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.

Hedging, Opportunity Cost, Correlation

Mid-fiscal year through 4/30/98, Klarman substantially increased exposure to disaster insurance (mainly out of the money U.S. equity put options + hedges against rising interest rates and currency fluctuations) because of his fear of a severe market correction and economic weakness. To maintain these hedges, Klarman stated he was willing to give up a portion of portfolio upside in return for protection against downside exposure. For fiscal year ended 10/31/98, these hedges accounted for a -2.8% performance drag.

The performance drag and mistake occurred as a result of expensive & imperfect hedges:

• cheapest areas of the market (small-cap) became cheaper (Baupost’s portfolio long positions were mainly small cap)
• most expensive areas of the market (large-cap) went to the moon (Baupost’s portfolio hedges were mostly large cap)

In assessing the performance results, Klarman stated that he did not believe he was wrong to hedge market exposures, his mistake was to use imperfect hedges, which resulted in him losing money on both his long positions and his hedges at the same time. Going forward, he would be searching for more closely correlated hedges.

In many instances, hedging is a return detractor. The trick is determining how much return you are willing to forego (premium spent and opportunity cost of that capital) in order to maintain the hedge, and how well that hedge will actually protect (or provide uncorrelated performance) when you expect it to work.

The only thing worse than foregoing return via premium spent and opportunity cost, is finding out in times of need that your hedges don’t work due to incorrect anticipation of correlation between your hedges and the exposure you are trying to hedge. That’s exactly what happened to Baupost in 1998.

Catalyst, Volatility, Expected Return, Duration

Attempting to reduce Baupost’s dependence on the equity market for future results, and the impact of equity market movement on Baupost’s results, Klarman discusses the increase of catalyst/event-driven positions (liquidations, reorganizations) within the portfolio, which are usually less dependent on the vicissitudes of the stock market for return realization.

Catalysts are a way to control volatility and better predict the expected return of portfolio holdings. Catalysts also create duration for the equity investor, such that once the catalyst occurs and returns are achieved, investors generally must find another place to redeploy the capital (or sit in cash).

Cash

Klarman called cash balances in rising markets “cement overshoes.” At mid-year 4/30/98, Baupost held ~17% of the portfolio in cash because Klarman remained confident that cash becomes more valuable as fewer and fewer investors choose to hold cash. By mid-December 1998, Baupost’s cash balance swelled to ~35% of NAV.

Risk, Opportunity Cost, Clients, Benchmark

In the face a strong bull market, Klarman cites the phenomenon of formerly risk-averse fund managers adopting the Massachusetts State Lottery slogan (“You gotta play to win”) for their investment guidelines because the biggest risk is now client firing the manager, instead of potential loss of capital.

Klarman observes the psychological reason behind this behavior: “Very few professional investors are willing to give up the joy ride of a roaring U.S. bull market to stand virtually alone against the crowd…the comfort of consensus serving as the ultimate life preserver for anyone inclined to worry about the downside. As small comfort as it may be, the fact that almost everyone will get clobbered in a market reversal makes remaining fully invested an easy relative performance decision.”

The moral of the story here: it’s not easy to stand alone against waves of public sentiment. For more on this, see Bob Rodriguez experience on the consequences of contrarian actions & behavior.

When the world is soaring, to hold large amounts of cash and spending performance units on hedges could lead to serious client-rebellion and business risk. I do not mean to imply that it’s wrong to hold cash or hedge the portfolio, merely that fund managers should be aware of possible consequences, and makes decisions accordingly.

Expected Return, Intrinsic Value

Klarman discusses how given today’s high equity market levels, future long-term returns will likely be disappointing because future returns have been accelerated into the present and recent past.

Future returns are a function of asset price vs. intrinsic value. The higher prices rise (even if you already own the asset), the lower future returns will be (assuming price is rising faster than asset intrinsic value growth). For a far more eloquent explanation, see Howard Mark’s discussion of this concept. 

Howard Marks' Book: Chapter 12

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 12 “The Most Important Thing Is…Finding Bargains” Definition of Investing, Portfolio Management, Position Review, Intrinsic Value, Opportunity Cost

“…‘investment is the discipline of relative selection.’” Quoting Sidney Cottle, a former editor of Graham and Dodd’s Security Analysis.

“The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. The raw materials for the process consist of (a) a list of potential investments, (b) estimates of their intrinsic value, (c) a sense for how their prices compare with their intrinsic value, and (d) an understanding of the risk involved in each, and of the effect their inclusion would have on the portfolio being assembled.”

The “process of intelligently building a portfolio” doesn’t end with identifying investments, and calculating their intrinsic values and potential risks. It also requires choosing between available opportunities (because we can’t invest in everything) and anticipating the impact of inclusion upon the resulting combined portfolio of investments. Additionally, there’s the continuous monitoring of portfolio positions – comparing and contrasting between existing and potential investments, sometimes having to make room for new/better investments by “selling the lesser ones.”

It’s worthwhile to point out that intrinsic value is important not only because it tells you when to buy or sell a particular asset, but also because it serves as a way to compare & contrast between available opportunities. Intrinsic value is yet another input into the ever complicated “calculation” for opportunity cost.

Mandate, Risk

“Not only can there be risks investors don’t want to take, but also there can be risks their clients don’t want them to take. Especially in the institutional world, managers are rarely told ‘Here’s my money; do what you want with it.’”

This type of risk avoidance is a form of structural inefficiency caused by mandate restrictions. It creates opportunities for those willing to accept that particular risk and/or don’t have mandate restrictions. A great example: very few investors owned financials in 2009-2010. Fear of the “blackhole” balance sheet was only a partial explanation. During that period, I heard anecdotally that although some institutional fund managers believed the low price more than compensated for the balance sheet risk, they merely didn’t want to have to explain owning financials to their clients.

Pyschology

“…the optimism that drives one to be an active investor and the skepticism that emerges from the presumption of market efficiency must be balanced.”

Munger Wisdom: 2013 Daily Journal Meeting

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

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

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

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

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

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

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

Making Mistakes, Liquidity

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

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

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

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

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

Leverage

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

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

Luck, Creativity

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

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

Turnover

Munger’s personal account had zero transactions in 2012.

Psychology

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

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

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

Mandate

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

Clients, Time Management

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

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

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

Howard Marks' Book: Chapter 9

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

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

“Investment markets follow a pendulum-like swing:

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

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

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

When To Buy

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

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

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

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

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

Catalyst

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

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

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

Risk, Expected Return, Capital Preservation, Opportunity Cost

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

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

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

Baupost Letters: 1997

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

Mandate, Trackrecord, Expected Return

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

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

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

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

Cash, Expected Return, Risk Free Rate

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

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

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

Hedging, Cash

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

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

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

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

Cash, Opportunity Cost

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

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

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

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

Derivatives, Leverage

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

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

When To Buy

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

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

Capital Preservation, Compounding,

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

Volatility

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

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

A Little Bit of History Repeating

In 1977, Warren Buffett wrote an article for Fortune Magazine titled “How Inflation Swindles the Equity Investor.” In the article, Buffett outlines the parallels between equities and bonds, and the impact of interest rates & inflation movements on both asset classes.

Given the interest rate and inflation debate raging today, I thought it worthwhile to revisit and study what had transpired in the past.

Interestingly, if we applied the lessons of this 1977 article to today's environment, contrary to the article’s title, it actually bodes well for future equity prices (see bold below), especially those companies compounding and reinvesting earnings rather than paying dividends.

Inflation, Duration, Compounding, Opportunity Cost

“It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment…When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner…For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities…

…I believe…that stocks, in economic substances, are really very similar to bonds. I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact no varied much at all…in the aggregate, the return on book value tends to keep coming back to a level around 12 percent. It shows no signs of exceeding that level significantly in inflationary years…

For the moment, let’s think of those companies, not as listed stocks, but as productive enterprises. Let’s also assume that the owners of those enterprises had acquired them at book value. In that case, their own return would have been around 12 percent too. And because the return has been so consistent, it seems reasonable to think of it as an ‘equity coupon’…

Of course, there are some important differences between the bond and stock forms. For openers, bonds eventually come due. It may require a long wait, but eventually the bond investor gets to renegotiate the terms of his contract. If current and prospective rates of inflation make his old coupon look inadequate, the can refuse to play further unless coupons currently being offered rekindle his interest…

Stocks on the other hand, are perpetual. They have a maturity date of infinity. Investors in stocks are stuck with whatever return corporate America happens to earn. If corporate America is destined to earn 12 percent, then that is the level investors must learn to live with. As a group, stock investors can neither opt out nor renegotiate…Individual companies can be sold or liquidated and corporations can repurchase their own shares; on the balance however, new equity flotations and retained earnings that the equity capital locked up in the corporate system will increase.

So, score one for the bond form. Bond coupons eventually will be renegotiated; equity ‘coupons’ won’t…

There is another major difference between the garden variety of bond and or new exotic 12 percent ‘equity bond’ that comes to the Wall Street costume ball dressed in a stock certificate.

In the usual case, a bond investor receives his entire coupon in cash and is left to reinvest it as best he can. Our stock investor’s equity coupon, in contrast, is partially retained by the company and is reinvested at whatever rates the company happens to be earning. In other words, going back to our corporate universe, part of the 12 percent earned annually is paid out in dividends and the balance is put right back into the universe to earn 12 percent also.”

Here is where things get interesting: 

“This characteristic of stocks – the reinvestment of part of the coupon – can be good or bad news, depending on the relative attractiveness of that 12 percent. The news was very good indeed in, the 1950’s and early 1960’s. With bonds yielding only 3 or 4 percent, the right to reinvest automatically a portion of the equity coupon at 12 percent was of enormous value. Note that investors could not just invest their own money and get that 12 percent return. Stock prices in this period raged far above book value…You can’t pay far above par for a 12 percent bond and earn 12 percent for yourself.

But on their retained earnings, investors could earn 12 percent. In effect, earnings retention allowed investors to buy at book value part of an enterprise that, in the economic environment then existing, was worth a great deal more than book value.

It was a situation that left very little to be said for cash dividends and a lot to be said for earnings retention. Indeed, the more money that investors thought likely to be reinvested at the 12 percent rate, the more valuable they considered their reinvestment privilege, and the more they were willing to pay for it…

If, during this period, a high-grade, noncallable, long-term bond with a 12 percent coupon had existed, it would have sold far above par. And if it were a bond with a further unusual characteristic – which was that most of the coupon payments could be automatically reinvested at par in similar bonds – the issue would have commanded an even greater premium. In essence, growth stocks retaining most of their earnings represented just such a security. When their reinvestment rate on the added equity capital was 12 percent while interest rates generally were around 4 percent, investors became very happy – and, of course, they paid happy prices.

Looking back, stock investors can think of themselves in the 1946-1956 period as having been ladled a truly bountiful triple dip. First, they were the beneficiaries of an underlying corporate return on equity that was far above prevailing interest rates. Second, a significant portion of that return was reinvested for them at rates that were otherwise unattainable. And third, they were afforded an escalating appraisal of underlying equity capital as the first two benefits became widely recognized. This third dip meant that, on top of the basic 12 percent or so earned by corporations on their equity capital, investors were receiving a bonus as the Dow Jones Industrials increased in price from 138 percent book value in 1946 to 220 percent in 1966…

This heaven-on-earth situation finally was ‘discovered’ in the mid-1960’s by many major investing institutions. But just as these financial elephants began trampling on one another in their rush to equities, we entered an era of accelerating inflation and higher interest rates. Quite logically, the marking-up process began to reverse itself. Rising interest rates ruthlessly reduced the value of all existing fixed coupon investments. And as long-term corporate bond rates began moving up (eventually reaching the 10 percent area), both the equity return of 12 percent and the reinvestment ‘privilege’ began to look different.

Stocks are quite properly though of as riskier than bonds…they come equipped with infinite maturities. (Even your friendly broker wouldn’t have the nerve to peddle a 100-year bond, if he had any available, as ‘safe.’) Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return – and 12 percent on equity versus, say 10 percent on bonds issued by the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.”

As Mark Twain said, “history does not repeat itself, but it does rhyme.” Food for thought. 

Buffett Partnership Letters: 1966 Part 1

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

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

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

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

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

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

Sizing, AUM

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

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

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

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

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

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

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

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

Sizing, Diversification

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

Hochschild, Kohn = 10% NAV

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

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

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.

Should I Sell This Thing?

Investors often obsess over the correct moments to purchase securities/assets, but discuss less frequently the circumstances and nuances of selling. A friend sent me this Wall Street Transcript interview with Christopher Mittleman awhile back. In the interview, Mittleman provides some very thoughtful insights, especially when to sell securities. A quick and worthwhile read.

When To Sell, Psychology

“…we won’t reflexively sell it because a lot of times what happens is that I may think the stock is worth a particular price, but it may continue to advance much higher than my fair value estimate. And that often occurs because my estimates tend to be on the conservative side.

So what I found through experience is that I should be somewhat slow to sell in a situation driven solely by a rising stock price, because there will generally be a good deal of positive momentum occurring in the stock. I know it sounds strange that a value investor is talking about momentum and things of that nature, but when you are value-oriented you tend to be buying stocks when they are on the decline. And there is a certain amount of negative momentum with that, and it usually behooves you to buy them slowly…When we sell stocks that have been great successes, it’s usually the opposite that occurs. And it’s typically prudent to sell the stock slowly.

Notice, Mittleman is aware of his inclination to estimate too conservatively and adjusts his investment process accordingly to counter this behavioral tendency.

This is similar to advice that Michael Mauboussin recently gave on how to control one’s investment biases.

When To Sell, Making Mistakes, Opportunity Cost

“…we will sell something more precipitously if we think the price has moved into really untenable levels. We are not shy about selling out of positions when I see an extreme in the opposite direction or if the fundamentals appear to be deteriorating.

Clearly, any meaningful deteriorating in the fundamentals would be a trigger for us to sell. Sometimes this occurs before we have made profit in the stock, so we will exit the position at a loss…we make sure that we don’t fall in love with individual stocks. We try to hold stocks as long [as] we can, simply because we’ve found that by holding we usually get better returns…The other reason for selling a stock would be if there was a better opportunity that came around…in order to make room for the better opportunity.”