Mauboussin: Frequency vs. Magnitude

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

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

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

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

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

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

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

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

Psychology, Expected Return, Sizing

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

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

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

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

Selectivity, When To Buy, Patience

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

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

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

When To Sell, Psychology, Expected Return

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

Waiting For The Next Train

Following up our recent article on selectivity standards in an upward moving market, below are some comforting words (and/or coping advice) from Mariko Gordon of Daruma Capital derived from her October 2013 Newsletter. “My ruminations on regret are of the bull market variety. Whereas bear markets make me regret owning every single stock in the portfolio, bull markets make me regret every stock we flirted with but didn't buy.

Why? Because it feels like everything we looked at and passed on is up way more than what we own or bought instead. And whether we passed for stupid, the-dog-ate-my-homework reasons or because we thought the price wasn't right, this is what happens in bull markets:

...the stock gets bought out at a ridiculous premium, or ...activist shareholders announce their position the day AFTER we shut the file for good, or ...the stock simply skyrockets, just out of spite.

As the markets rise, great ideas are harder and harder to find. Everything cheap has so much "hair" on it that it makes Chewbacca look as sparse as Kojak (look him up, youngster). Sorting through the "hair" that makes the stock cheap - and therefore unattractive to other investors - is not only time-consuming, it requires the investment equivalent of a hazmat suit.

On the other hand, if a new idea has a timely and compelling investment case, it will be anything but cheap. Even if other investors haven't discovered ALL of its charms, it will be 30% higher just because of the rising tide of the market. We then hesitate to pay up - because we all know what happens when the tide goes out.

Most days, therefore, you're faced with either loading down the portfolio with broken down junk that, while cheap, doesn't represent real value and will sink further or, chasing stocks that have gone parabolic, leading to multiple compression when the inevitable market melt-down happens.

In short, bull markets make you want to grab the nearest bottle of whiskey and listen to Edith Piaf songs until the market rolls over and dies.

Here is how I keep the hounds of bull-market frustration at bay:

• I work on what look to be great businesses, regardless of valuation, figuring that one day we may get our chance.
• I look to see which insiders are buying their stocks, because most of them are now selling faster than you can say hot potato.
• I look to see where there's a management change, because maybe the force will be strong with them, and a piece-of-junk of a business will start to deliver and the stock will levitate.

And, most important of all, every day, without fail, as sacred to me as a bedtime prayer, I think of the following advice: One morning, years ago, I scrambled down the subway steps, only to find the train leaving the station, a pissed off woman cursing up a storm and a homeless guy sitting on a bench. After watching the temper tantrum unfold for a minute, the guy finally said: "Lady, relax. Trains are like men. Another one will come along."

So whenever I think of Piaf songs and of the frustration of the hot stock that got away in this bull market, I remember that patience is needed to get over those heartbreaks. Because another new idea, like trains and men, will come along soon.”

Michael Price & Portfolio Management

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

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

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

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

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

Sizing, Diversification

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

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

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

When To Sell, Mistakes, Tax

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

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

Consequences of Contrarian Actions

Below are excerpts from a speech Bob Rodriguez of First Pacific Advisors gave in May 2009. Quite a few interesting lessons derived from his previous trials and tribulations in dealing with clients and redemptions during periods of contrarian actions and underperformance. Psychology

“I believe I have found success because I have been deeply aware of the need to balance the human emotions of greed and fear. In a word, DISCIPLINE…is a key attribute to becoming a successful investor. I stress that, without a strong set of fundamental rules or a core philosophy, they will be sailing a course through the treacherous investment seas without a compass or a rudder.”

AUM, Clients, Redemptions, Patience

“It seems as though it was a lifetime ago in 1986, when I had few assets under management, and the consultant to my largest account insisted that, if I wanted to continue the relationship, I had to pay to play. I was shocked, dismayed and speechless. Though this would probably have never become public, if I had agreed, how would I have ever lived with myself? By not agreeing, it meant that I would lose nearly 40% of my business. When I was fired shortly thereafter, this termination compromised my efforts in the raising of new money for nearly six years because I could not say why. Despite pain and humiliation, there was no price high enough for me to compromise my integrity. With the subsequent disclosure of improprieties at this municipal pension plan, the cloud of suspicion over me ultimately lifted. I not only survived, I prospered.”

“While technology and growth stock investing hysteria were running wild, we did not participate in this madness. Instead, we sold most of our technology stocks. Our ‘reward’ for this discipline was to watch FPA Capital Fund’s assets decline from over $700 million to just above $300 million, through net redemptions, while not losing any money for this period. We were willing to pay this price of asset outflow because we knew that, no matter what, our investment discipline would eventually be recognized. With our reputation intact, we then had a solid foundation on which we could rebuild our business. This cannot be said for many growth managers, or firms, who violated their clients’ trust.”

“Having the courage to be different comes at a steep price, but I believe it can result in deep satisfaction and personal reward. As an example, FPA Capital Fund has experienced heavy net redemptions since the beginning of 2007, totaling more than $700 million on a base of $2.1 billion. My strong conviction that an elevated level of liquidity was necessary, at one point reaching 45%, placed me at odds with many of our shareholders. I estimate that approximately 60% left because of this strategy…We have been penalized for taking precautionary measures leading up to and during a period of extraordinary risk. Though frustrating, in our hearts, we know that our long-term investment focus serves our clients well. I believe the words of John Maynard Keynes…‘Investment based on genuine long-term expectations is so difficult today as to be scarcely practicable,’ and ‘It is the long-term investor, he who most promotes the public interest, who will in practice come in for the most criticism wherever investment funds are managed by committees or boards or banks. For it is the essence of his behavior that he should be eccentric, unconventional, and rash in the eyes of average opinion.’”

“I believe superior long-term performance is a function of a manager’s willingness to accept periods of short-term underperformance. This requires the fortitude and willingness to allow one’s business to shrink while deploying an unpopular strategy.”

As I write this, the world’s smallest violin is playing in the background, yet it must be said: what about clients violating a fund’s trust by redeeming capital at inopportune times to chase performance elsewhere? The trust concept flows both ways.

There will be times in every fund manager’s career when doing what you believe is right will trigger negative consequences. The key is anticipation, preparation, and patience.

Historical Performance Analysis, Luck, Process Over Outcome, Mistakes

“Let’s be frank about last year’s performance, it was a terrible one for the market averages as well as for mutual fund active portfolio managers. It did not matter the style, asset class or geographic region. In a word, we stunk. We managers did not deliver the goods and we must explain why. In upcoming shareholder letters, will this failure be chalked up to bad luck, an inability to identify a changing governmental environment or to some other excuse? We owe our shareholders more than simple platitudes, if we expect to regain their confidence.”

“If they do not reflect upon what they have done wrong in this cycle and attempt to correct their errors, why should their investors expect a different outcome the next time?”

Examine your historical performance not only to provide an explanation to your clients, but also to yourself. For example, was there anything that you could have done to avoid the “stink”?

Rodriquez mentions “bad luck.” During this reflective process (which ideally should occur during times of good and bad performance) it’s important to understand whether the returns resulted due to luck or to skill. See Michael Mauboussin & James Montier’s commentary on Process Over Outcome & Luck.

Psychology, When To Sell, When To Buy

“Investors have long memories, especially when they lose money. As an example, prior to FPA’s acquisition of FPA Capital Fund in July 1984, the predecessor fund was a poster child for bad performance from the 1960s era. Each time the fund hit a $10 NAV, it would get a raft of redemptions since this was its original issue price and investors thought they were now finally even and just wanted out.”

Anchoring is a powerful psychological bias that can compel investors to buy and sell for the wrong reasons, as well as to allow those who recognize the phenomenon to take advantage of the bad decisions of others.

Is the opposite true: investors have short memories when they’re make money?

Howard Marks' Book: Chapter 13

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 13 “The Most Important Thing Is…Patient Opportunism” Selectivity, Patience, Cash

“…I want to…point out that there aren’t always great things to do, and sometimes we maximize our contribution by being discerning and relatively inactive. Patient opportunism – waiting for bargains – is often your best strategy.”

“…the investment environment is a given, and we have no alternative other than to accept it and invest within it…Among the value prized by early Japanese culture was mujo. Mujo was defined classically for me as recognition of ‘the turning of the wheel of the law,’ implying acceptance of the inevitability of change, of rise and fall…In other words, mujo means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control. Thus we must recognize, accept, cope, and respond. Isn’t that the essence of investing?...All we can do is recognize our circumstances for what they are and make the best decisions we can, given the givens.”

“Standing at the plate with the bat on your shoulders is Buffett’s version of patient opportunism. The bat should come off your shoulders when there are opportunities for profit with controlled risk., but only then. One way to be selective in this regard is by making every effort to ascertain whether we’re in a low-return environment or a high-return environment.”

In order to practice patient opportunism by implementing standards of selectivity, the investor must first have a method for recognizing & determining the best course of action based on risk-reward opportunities in the past, present, and future.

Selectivity, Clients

“Because they can’t strike out looking, investors needn’t feel pressured to act. They can pass up lot of opportunities until they see one that’s terrific…the only real penalty is for making losing investments…For professional investors paid to manage others’ money, the stakes are higher. If they miss too many opportunities, and if their returns are too low in good times, money managers can come under pressure from clients and eventually lose accounts. A lot depends on how clients have been conditioned.”  

One caveat to the "no called-strikes": clients. For some investors, the client base and permanency of capital will dictate whether or not there are called-strikes in this game. If your investment approach involves waiting for perfect pitches, make sure your clients agree, and double check the rulebook that there are indeed no called-strikes in this game!

Selectivity, Expected Return

“The motto of those who reach for return seems to be: ‘If you can’t get the return you need from safe investments, pursue it via risky investments.”

“It’s remarkable how many leading competitors from our early years as investors are no longer leading competitors (or competitors at all). While a number faltered because of flaws in their organization or business model, others disappeared because they insisted on pursuing high returns in low-return environments.

You simply cannot create investment opportunities when they’re not there. The dumbest thing you can do is to insist on perpetuating high returns – and give back your profits in the process. If it’s not there, hoping won’t make it so.”

Expected return (or future performance) is not a function of wishful thinking, it’s a function of the price you pay for an asset.

Historical Performance Analysis

“In Berkshire Hathaway’s 1977 Annual Report, Buffett talked about Ted Williams – the ‘Splendid Splinter’ – one of the greatest hitters in history. A factor contributed to his success was his intensive study of his own game. By breaking down the strike zone into 77 baseball-sized ‘cells’ and charting his results at the plate, he learned that his batting average was much better when he went after only pitches in his ‘sweet spot.’”

How many Readers have systematically studied your “own game” – the sources of investment performance – good and bad?

Because everyone’s “game” is different, I suspect this exercise will likely vary for each person. I would be curious to hear about the methodologies employed by Readers who conduct this review/analysis on a regular basis.

When To Buy, Liquidity

“The absolute best buying opportunities come when asset holders are forced to sell, and…present in large numbers. From time to time, holders become forced sellers for reasons like these:

• The funds they manage experience withdrawls.
• Their portfolio holdings violate investment guidelines such as minimum credit ratings or position maximums.
• They receive margin calls because the value of their assets fails to satisfy requirements agreed to in contracts with their lenders…

They have a gun at their heads and have to sell regardless of price. Those last three words – regardless of price – are the most beautiful in the world if you’re on the other side of the transaction.”

“…if chaos is widespread, many people will be forced to sell at the same time and few people will be in a position to provide the required liquidity…In that case, prices can fall far below intrinsic value. The fourth quarter of 2008 provided an excellent example of the need for liquidity in times of chaos.”

Ultimately, it’s an imbalance in underlying market liquidity (too many sellers, not enough buyers) that creates bargains so that prices “fall far below intrinsic value.”

Howard Marks' Book: Chapter 11

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 11 “The Most Important Thing Is…Contrarianism” Trackrecord, Clients, Mistakes, Redemptions, Patience

“‘Once-in-a-lifetime’ market extremes seem to occur once every decade or so – not often enough for an investor to build a career around capitalizing on them. But attempting to do so should be an important component of any investor’s approach. Just don’t think it’ll be easy. You need the ability to detect instances in which prices have diverged significantly from intrinsic value. You have to have a strong-enough stomach to defy conventional wisdom…And you must have the support of understanding, patient constituents. Without enough time to ride out the extremes while waiting for reason to prevail, you’ll become that most typical of market victims: the six-foot-tall man who drowned crossing the stream that was five feet deep on average.”

I wonder, if an investor was able to find a firm or client base with patient & long-term focus, could not profiting from “market extremes” be the basis of a very long-term & successful, albeit not headline-grabbing, wealth creation vehicle?

Marks also highlights a very costly mistake – one that has nothing to do with investing, and everything to do with operational structure and business planning. The “most typical” market victim of Marks’ description is one who has misjudged the nature of his/her liabilities vs. portfolio assets. Your patience is not enough. The level of patience of your capital base matters.

When To Buy, When To Sell, Catalyst

“Bull markets occur because more people want to buy than sell, or the buyers are more highly motivated than the sellers…If buyers didn’t predominate, the market wouldn’t be rising…figuratively speaking, a top occurs when the last person who will become a buyer does so. Since every buyer has joined the bullish herd by the time the top is reached, bullishness can go no further and the market is as high as it can go. Buying or holding is dangerous.”

“The ultimately most profitable investment actions are by definition contrarian: you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high).”

“Accepting contrarianism is one thing; putting it into practice is another. On one hand, we never know how far the pendulum will swing, when it will reverse, and how far it will then go in the opposite direction. On the other hand, we can be sure that, once it reaches an extreme position, the market eventually will swing back toward the midpoint (or beyond)…Even when an excess does develop, it’s important to understand that ‘overpriced’ is incredibly different from ‘going down tomorrow.’ Markets can be over- or underpriced and stay that way – or become more so – for year.”

Tricky part is determining the timing when “the top is reached.” As Stanley Druckenmiller astutely points out: “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…” Unfortunately, neither Druckenmiller nor Marks offers additional insight as to how one should identify the catalyst(s) signaling reversals of the pendulum.

I have also heard many value investors bemoan that they often sell too soon (because they base sell decisions on intrinsic value estimates), and miss out on the corresponding momentum effect. (See Chris Mittleman discussion). The solution involves adjusting sell decision triggers to include psychological tendency. But this solution is a delicate balance because you don’t want to stick around too long and get caught with the hot potato at the end when ‘the last person who will become a buyer does so” and “bullishness can go no further.”

When To Buy

“…one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left.”

Gumption is rewarded during periods of uncertainty.

Mistakes

“You must do things…because you know why the crowd is wrong. Only then will you be able to hold firmly to your views and perhaps buy more as your positions take on the appearance of mistakes and as losses accrue rather than gains.”

In this business, mistake & profit are exact and opposite mirror images between buyer and seller. Frankly, at times, it’s difficult to distinguish between temporary impairments vs. actual mistakes.

Expected Return

“…in dealing with the future, we must think about two things: (a) what might happen and (b) the probability that it will happen.”

For Marks, future expected return is a probably-adjusted figure.

Baupost Letters: 1996

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.

Risk, Sizing, Diversification, Psychology

In 1996, Baupost had a number of investments in the former Soviet Union. Klarman managed the higher level of risk of these investments by limiting position sizing such that if the total investment went to zero, it would not have a materially adverse impact on the future of the fund.

“Unfamiliarity” is a risk for any new investment. Klarman approaches new investments timidly to ensure that there isn’t anything that he’s missing. He does so by controlling sizing and sometimes diversifying across a number of securities within the same opportunity set.

Baupost mitigates risk (partially) by:

• Sizing slowly and diversifying with basket approach (at least initially)
• Balancing arrogance with humility. Always be aware of why an investment is available at a bargain price, and your opinion vs. the market. Investing is a zero-sum game, and each time you make a purchase, you’re effectively saying the seller is wrong.

Reading in between the lines, the Russian investments must have held incredibly high payoff potential (in order to justify the amount of time and effort spent on diligence). Smaller position sizing may decrease risk but it also decreases the potential return contribution to the overall portfolio.

Interestingly, this method of balancing risk and return through position sizing and diversification is more akin to venture capital than the traditional value school. For example, recently, investors have been buzzing about a number of Klarman’s biotech equity positions (found on his 13F filing). I’ve heard through the grapevine that these investments were structured like a venture portfolio – the expectation is that some may crash to zero, while some may return many multiples the original investment. Therefore, those copying Klarman’s purchases should proceed with caution, especially given Klarman’s history of making private investments not disclosed on 13F filings.

Diversification

Klarman believes in sufficient but not excessive diversification.

This may explain the rationale behind why Klarman has been known to purchase baskets of individual securities for the same underlying bet – see venture portfolio discussion above.

Correlation, Risk

Always cognizant of whether seemingly different investments are actually the same bet to avoid risk of concentrated exposures.

Mandate, Trackrecord

Baupost has a flexible investment mandate, to go anywhere across asset classes, capital structure, geographies, etc., which allows it to differentiate from the investment fund masses. Opportunities in different markets happen at different times, key is to remain adaptive and ready for opportunity sets when they become available.

The flexible mandate is helpful in smoothing the return stream of the portfolio, and consequently, the trackrecord. Baupost can deploy capital to where opportunities are available in the marketplace, therefore ensuring a (theoretically) steadier stream of future return potential. This is in contrast to funds that cannot take advantage of opportunities outside of their limited mandate zones.

Liquidity

Klarman is willing to accept illiquidity for incremental return.

This makes total sense, but the tricky part is matching portfolio sources (client time horizon, level of patience, and fund redemption terms) with uses (liquidity profile of investments). Illiquidity should not be accept lightly, and has been known to cause problems for even the most savvy of investors (for example: see 2003 NYTimes article on how illiquidity almost destroyed Bill Ackman & David Berkowitz in the early stages of their careers).

Patience

For international exposure [Russia], Baupost spent 7 years immersed in research, studying markets, meeting with managements, making toe-hold investments to observe, hired additional members of investment team (sent a few analysts to former Soviet Union, on the ground, for several months) to network & build foreign sell-side & counterparty relationships.

Selectivity, Cash

Buy securities if available at attractive prices. Sell when securities no longer cheap. Go to cash when no opportunities are available.

We’ve discussed the concept of selectivity standards in the past, and whether these standards shift in different market environments. For Klarman, it would seem his selectivity standards remained absolute regardless of market environment.

Hedging

Baupost will always hedge against catastrophic or sustained downward movement in the market. This can be expensive over time, but will persist and remains part of investment strategy.

Klarman embedded hedging as an integrated “process” that’s part of the overall investment strategy. This way, Baupost is more likely to continue buying hedges even after years of premium bleed. This also avoids “giving up” just as disaster is about to hit. For more on this topic, be sure to check out the AQR tail risk hedging piece we showcased a few months ago.

Buffett Partnership Letters: 1964 Part 1

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Given the recent discussions/debates around taxes and potentially shifting tax rates, we thought it appropriate to share some historical Buffett wisdom on the topic.

Tax

“We do not play any games to either accelerated or defer taxes. We make investment decisions based on our evaluation of the most profitable combination of probabilities. If this means paying taxes – fine…”

“More investment sins are probably committed by otherwise quite intelligent people because of ‘tax considerations’ than from any other cause. One of my friends – a noted West Coast philosopher [Charlie Munger] – maintains that a majority of life’s errors are caused by forgetting what one is really trying to do…

What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound…

If gains are involved, changing portfolios involves paying taxes. Except in very unusual cases…the amount of the tax is of minor importance if the difference in expectable performance is significant…

There are only three ways to avoid ultimately paying the tax: (1) die with the asset – and that’s a little too ultimate for me – even the zealots would have to view this ‘cure’ with mixed emotions; (2) give the asset away – you certainly don’t pay any taxes this way, but of course you don’t pay for any groceries, rent, etc., either; and (3) lose back the gain – if your mouth waters at this tax-saver, I have to admire you – you certainly have the courage of your convictions.

So it is going to continue to be the policy of BPL to try to maximize investment gains, not minimize taxes. We will do our level best to create the maximum revenue for the Treasury – at the lowest rates the rules will allow.”

Patience, Sourcing, Liquidity

“…I consider the buying end to be about 90% of this business…These stocks have been bought and are continuing to be bought at prices considerably below their value to a private owner. We have been buying one of these situations for approximately 18 months and both of the others for about a year. It would not surprise me if we continued to do nothing but patiently buy these securities week after week for at least another year, and perhaps even two years or more.”

In Buffett's biography The Snowball, I believe there is an anecdote that Buffett and his associates would go knocking on doors in small towns to seek out shares of XYZ stock for purchase. Based on the quote above, it would take years for him to accumulate full positions. How’s that for patience, not to mention liquidity implications?!

Most public market investors, who invest in liquid securities, don't spent a lot of time focused on sourcing. Could there be a hidden advantage for those who focus on obscure or illiquid issuances, and manage to creatively source them at bargain prices?

Poetic Inspiration from EIC

Many thanks to Jim Barksdale, the thoughtful Founder of Equity Investment Corporation in Atlanta, for sharing this Robert Frost poem with PM Jar. That’s right, Jim has effectively applied poetry to investing – bravo! A Drumlin Woodchuck - Robert Frost

My own strategic retreat Is where two rocks almost meet, And still more secure and snug, A two-door burrow I dug.

With those in mind at my back I can sit forth exposed to attack As one who shrewdly pretends That he and the world are friends.

All we who prefer to live Have a little whistle we give, And flash, at the least alarm We dive down under the farm.

We allow some time for guile And don't come out for a while Either to eat or drink. We take occasion to think.

And if after the hunt goes past And the double-barreled blast (Like war and pestilence And the loss of common sense),

If I can with confidence say That still for another day, Or even another year, I will be there for you, my dear,

It will be because, though small As measured against the All, I have been so instinctively thorough About my crevice and burrow.