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.”

Stanley Druckenmiller Wisdom - Part 3

Here is Part 3 of portfolio management highlights extracted from an interview with Stanley Druckenmmiller in Jack D. Schwager’s book The New Market Wizards. Be sure to check out the juicy bits from Part 1 and Part 2. Druckenmiller is a legendary investor, and protégé of George Soros, who compounded capital ~30% annualized since 1986 before announcing in 2010 that his Duquesne fund would return all outside investor capital, and morph into a family office.

Liquidity, Making Mistakes, Position Review

“The wonderful thing about our business is that it’s liquid, and you can wipe the slate clean on any day.”

Liquidity makes it easier to change your mind and to deal with mistakes. This is why people talk about the “liquidity premium.” Theoretically, this flexibility is worth something. But how does one place a value or price upon liquidity (or illiquidity for that matter)? The Pensioner in Drobny’s book Invisible Hands has some interesting thoughts on this.

Our next point on liquidity has to do with a comment that Seth Klarman made about “re-buying the portfolio each day” and the related implications (of opportunity cost, hurdle rate, etc.).

For example: Prices in the marketplace are constantly shifting. Does your portfolio currently offer the best risk-reward profile given present market conditions, or can you improve it by buying or selling certain securities/assets? Mariko Gordon of Daruma Capital has some really interesting insights on portfolio review, decluttering, and improvement (made possible by liquidity).

Remember, investors of private assets do not have this luxury – so take advantage of liquidity wisely.

Sourcing, Liquidity, When To Buy

Q: Did you have any difficulty putting on a position of that size? A: No, I did it over a few days’ time. Also, putting on the position was made easier by the generally bearish sentiment at the time.

People often say that historical returns are not indicative of future performance.

Well, this is also true for trading liquidity: historical liquidity levels are not indicative of future liquidity.

Liquidity is not stagnant! What is liquid today may not be liquid tomorrow, and vice versa. This is why I find it funny when people reference historical trading liquidity. I’ve seen securities seesaw from trading a miniscule 30,000 shares a day, to more than 1MM shares a day.

Also, to Druckenmiller’s point, the time to buy (or sell) is often when there’s a liquidity imbalance somewhere in the marketplace. Liquidity imbalances have the ability to drive prices down (or up).

Volatility, Catalyst, Liquidity

“…I focus my analysis on seeking to identify the factors that were strongly correlated to a stock’s price movement as opposed to looking at all the fundamentals. Frankly, even today, many analysts still don’t know what makes their particular stocks go up and down.”

“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…” 

Look for reasons behind price movement (volatility), such as liquidity imbalances as mentioned above.

More Baupost Wisdom

Before my November vacation, I will leave you with a juicy Baupost piece compiled through various sources that shall remain confidential. Instead of the usual excerpts or quotes, below are summaries of ideas and concepts. Creativity, Making Mistakes

• False precision is dangerous. Klarman doesn’t believe that a computer can be programmed to invest the way Baupost does. (Does this mean their research, portfolio monitoring, and risk management process does not involve computers? Come to think of it, that would be pretty cool. Although it would make some administrative tasks more difficult, are computers truly necessary for the value-oriented fundamental investor?)
• Investing is a highly creative process, that’s constantly changing and requiring adaptations
• One must maintain flexibility and intellectual honesty in order to realize when a mistake has been made, and calibrate accordingly
• Mistakes are also when you’re not aware of possible investment opportunities because this means the sourcing/prioritization process is not optimal

When To Buy, Conservatism, Barbell

• Crisis reflection – they invested too conservatively, mainly safer lower return assets (that would have been money good in extremely draconian scenarios). Instead, should have taken a barbell approach and invested at least a small portion of the portfolio into assets with extremely asymmetric payoffs (zero vs. many multiples)

When To Buy, Portfolio Review

• They are re-buying the portfolio each day – an expression that you’ve undoubtedly heard from others as well. It’s a helpful concept that is sometimes forgotten. Forces you to objectively re-evaluate the existing portfolio with a fresh perspective, and detachment from any existing biases, etc.

Risk

• They try to figure out how “risk is priced”
• Risk is always viewed on an absolute basis, never relative basis
• Best risk control is finding good investments

Hedging

• Hedges can be expensive. From previous firm letters, we know that Baupost has historically sought cheap, asymmetric hedges when available. The takeaway from this is that Baupost is price sensitive when it comes to hedging and will only hedge selectively, not perpetually
• Prefer to own investments that don’t require hedges, there is no such thing as a perfect hedge
• Bad hedges could make you lose more than notional of original investment

Hedging, Sizing

• In certain environments, there are no cheap hedges, other solution is just to limit position sizing

Cash, AUM

• Ability to hold cash is a competitive advantage. Baupost is willing to hold up to 50% cash when attractive opportunities are not available
• The cash balance is calculated net of future commitments, liabilities, and other claims. This is the most conservative way.
• Reference to “right-sizing” the business in terms of AUM. They think actively about the relationship between Cash, AUM, and potentially returning capital to investors.

Returning Capital, Sizing

• Returning capital sounds simplistic enough, but in reality it’s quite a delicate dance. For example, if return cash worth 25% of portfolio, then capital base just shrank and all existing positions inadvertently become larger % of NAV.

Leverage

• Will take on leverage for real estate, especially if it is cheap and non-recourse

Selectivity

• Only 1-2% of deals/ideas looked at ultimately purchased for portfolio (note: not sure if this figure is real estate specific)

Time Management, Sizing

• Intelligent allocation of time and resources is important. It doesn’t make sense to spend a majority of your (or team’s) time on positions that end up only occupying 30-50bps of the portfolio
• Negative PR battles impact not only reputation, they also take up a lot of time – better to avoid those types of deals
• Klarman makes a distinction between marketing operations (on which he spends very little time) and investment operations (on which he spend more time).

Team Management

• There is a weekly meeting between the public and private group to share intelligence and resources – an asset is an asset, can be accessed via or public or private markets – doesn’t make sense to put up wall between public vs. private.
• Every investment professional is a generalist and assigned to best opportunity – no specialization or group barriers.
• Culture! Culture! Culture! Focus on mutual respect, upward promotion available to those who are talented, and alignment of interest
• Baupost has employees who were there for years before finally making a large investment – key is they don’t mind cost of keeping talented people with long-term payoff focus
• Succession planning is very important (especially in light of recent Herb Wagner departure announcement)
• The most conservative avenue is adopted when there is a decision disagreement
• They have a team of people focused on transaction structuring

Trackrecord

• Baupost invests focusing on superior long-term returns, not the goal of ending each year with a positive return. We have talked about this before, in relation to Bill Miller’s trackrecord – despite having little logical rationale, an investor’s performance aptitude is often measured by calendar year end return periods. Here, Klarman has drawn a line in the sand, effective saying he refuses to play the calendar year game

Sourcing

• Differentiated sourcing creates opportunities via better pricing, less competition, etc. Learned from Michael Price (or perhaps Max Heine’s playbook) – focused on differentiated sourcing, something that public investors generally don’t think about.

Decluttering the Portfolio

Many thanks to Lisa Rapuano for telling me about Daruma Capital’s Mariko Gordon, and her humorously insightful letters! This article will undoubtedly be the first of many based on interesting topics extracted from Gordon’s letters. In the August 2012 letter, Gordon discusses portfolio review and its parallels to a massive home cleaning project. For those of us with hoarding tendencies, what is the impact of this psychological behavior on our portfolio management decisions? Gordon offers some wisdom:

“I have been adamant about our ‘no more than 35 stocks’ rule…Whether right or wrong, all of this pruning keeps the portfolio in the here and now, and me actively engaged in the process of evaluating whether every stock is earning its keep. And yet as with clutter, it's easier said than done… [Diversification]

If it's a big winner, it reminds you of how smart you are, and how it made your clients rich. All that warm fuzziness means that when it breaks you will crazy glue it, and never be able to let it go. That, my friends, is how you round trip stocks - the hard part is knowing the difference between an air pocket where you sit tight, and a death spiral, where you pull on the ripcord and bail. [When To Sell]

A loser in the past can likewise cause problems. Like cats, some investors prefer to bury their ‘flops’ rather than be reminded every day that they're idiots. They feel such shame that they immediately sell off a loser, unable to decouple the past enough to soberly recalculate whether the stock represents good value in the present. The fact is, if the portfolio you've been presented by your money manager doesn't include a howler or two, be very suspicious.

Too many howlers, however, may be symptomatic of another problem, this one caused by a manager who can't admit that he or she has made a mistake. These investors stubbornly insist that it's the market that's wrong (again), for disagreeing with his or her brilliant analysis. [Making Mistakes]

So let the past go…But it's not always the past that causes problems. It can also be the future.

An investor can become saddled by a position with enormous potential - potential that always lurks just over the horizon, just out of reach, despite excuse after excuse, inroads by competitors, or evidence that customers have gone on a buying strike. The future becomes a siren song of unfulfilled promise. Profits are always just another quarter away.

Whatever one's personal brand of emotional clutter - past, future, or some of both - it's all garbage. [Psychology]

No matter how elaborate the spreadsheet or how probabilistically the range of outcomes for a stock has been calculated to four decimal places, every attempt to declutter your portfolio must be accompanied by an attempt to declutter your attachment to the glorious past it represents, or the glorious future it will deliver.”