More Ray Dalio Wisdom

Additional excerpts from Ray Dalio’s Principles. By presenting thoughts along similar veins by other investors, I do not wish to imply that Dalio’s thoughts are unoriginal. Instead, I am merely attempting to highlight psychological and behavioral commonalities between these investors. Random coincidence that these overlaps exist? Perhaps. But it’s much more fun to contemplate other contributing possibilities. Psychology, Process Over Outcome

“It isn't easy for me to be confident that my opinions are right. In the markets, you can do a huge amount of work and still be wrong. Bad opinions can be very costly. Most people come up with opinions and there’s no cost to them. Not so in the market. This is why I have learned to be cautious. No matter how hard I work, I really can’t be sure. The consensus is often wrong, so I have to be an independent thinker. To make any money, you have to be right when they’re wrong.”

Successful investing often requires the ability to straddle a very thin line between humility (“I could be wrong”) and hubris (“I am right, they are wrong”) – seemingly paradoxical dispositions. Howard Marks dedicated a whole chapter to this concept titled “Knowing What You Don’t Know.”

“I stress-tested my opinions by having the smartest people I could find challenge them so I could find out where I was wrong. I never cared much about others’ conclusions—only for the reasoning that led to these conclusions. That reasoning had to make sense to me. Through this process, I improved my chances of being right, and I learned a lot from a lot of great people. I remained wary about being overconfident, and I figured out how to effectively deal with my not knowing. I dealt with my not knowing by either continuing to gather information until I reached the point that I could be confident or by eliminating my exposure to the risks of not knowing. I wrestled with my realities, reflected on the consequences of my decisions, and learned and improved from this process.”

Asking others to torpedo your thesis and listening to their reasons helps avoid confirmation bias (seeking and retaining only information/facts that support your thesis while ignoring anything to the contrary). An example of this implementation in its extreme: as of 2010, Bruce Berkowitz of Fairholme didn’t employ analysts, and instead hired external experts to challenge his ideas and theses.

When To Buy

“I don’t make an inadvertent bet. I try to limit my bets to the limited number of things I am confident in.”

Charlie Munger once said the following: “…the one thing that all those winning betters in the whole history of people who’ve beaten the pari-mutuel system have is quite simple: they bet very seldom… the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.” Yes, he’s talking about horseracing, but same rules also apply to investing.

Soros’ Alchemy – Chapter 4

Seth Klarman of Baupost wrote in a 1996 Letter that one should always be cognizant of whether seemingly different investments are actually the same bet in order to avoid risk of concentrated exposures. In other words, the task of risk management involves identifying (and if necessary, neutralizing) common risks underlying different portfolio holdings. One such "common denominator" risk that comes to mind (in today's yield-hungry environment) is the availability of credit and its impact on asset and collateral values, which in turn greatly influences returns available to investors holding different securities across the capital structure. Below are some musing on the topic of credit reflexivity / boom and bust cycles from George Soros, derived from his book Alchemy of Finance – Chapter 4: The Credit and Regulatory Cycle.

Macro, Intrinsic Value, Psychology, Risk

“…special affinity between reflexivity and credit. That is hardly surprising: credit depends on expectations; expectations involve bias; hence credit is one of the main avenues that permit bias to play a causal role in the course of events…Credit seems to be associated with a particular kind of reflexive pattern that is known as boom and bust. The pattern is asymmetrical: the boom is drawn out and accelerates gradually; the bust is sudden and often catastrophic…

I believe the asymmetry arises out of a reflexive connection between loan and collateral. In this context I give collateral a very broad definition: it will denote whatever determines the creditworthiness of a debtor, whether it is actually pledged or not. It may mean a piece of property or an expected future stream of income; in either case, it is something on which the lender is willing to place a value. Valuation is supposed to be a passive relationship in which the value reflects the underlying asset; but in this case it involves a positive act: a loan is made. The act of lending may affect the collateral value: that is the connection that gives rise to a reflexive process.”

“The act of lending usually stimulates economic activity. It enables the borrower to consume more than he would otherwise, or to invest in productive assets...By the same token, debt service has a depressing impact. Resources that would otherwise be devoted to consumption or the creation of a future stream of income are withdrawn. As the total amount of debt outstanding accumulates, the portion that has to be utilized for debt service increases."

“In the early stages of a reflexive process of credit expansion the amount of credit involved is relatively small so that its impact on collateral values is negligible. That is why the expansionary phase is slow to start with and credit remains soundly based at first. But as the amount of debt accumulates, total lending increases in importance and begins to have an appreciable effect on collateral values. The process continues until a point is reached where total credit cannot increase fast enough to continue stimulating the economy. By that time, collateral values have become greatly dependent on the stimulative effect of new lending and, as new lending fails to accelerate, collateral values begin to decline. The erosion of collateral values has a depressing effect on economic activity, which in turn reinforces the erosion of collateral values. Since the collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans, which in turn may make the decline more precipitous. That is the anatomy of a typical boom and bust.

Booms and busts are not symmetrical because, at the inception of a boom, both the volume of credit and the value of the collateral are at a minimum; at the time of the bust, both are at a maximum. But there is another factor at play. The liquidation of loans takes time; the faster it has to be accomplished, the greater the effect on the value of the collateral. In a bust, the reflexive interaction between loans and collateral becomes compressed within a very short time frame and the consequences can be catastrophic. It is the sudden liquidation of accumulated positions that gives a bust such a different shape from the preceding boom.

It can be seen that the boom/bust sequence is a particular variant of reflexivity. Booms can arise whenever there is a two-way connection between values and the act of valuation. The act of valuation takes many forms. In the stock market, it is equity that is valued; in banking, it is collateral.”

“Busts can be very disruptive, especially if the liquidation of collateral causes a sudden compression of credit. The consequences are so unpleasant that strenuous efforts are made to avoid them. The institution of central banking has evolved in a continuing attempt to prevent sudden, catastrophic contractions in credit. Since a panic is hard to arrest once it has started, prevention is best practiced in the expansionary phase. That is why the role of central banks has gradually expanded to include the regulation of the money supply. That is also why organized financial markets regulate the ratio of collateral to credit.”

“Financial history is best interpreted as a reflexive process in which there are two sets of participants instead of one: competitors and regulators…It is important to realize that the regulators are also participants. There is a natural tendency to regard them as superhuman beings who somehow stand outside and above the economic process and intervene only when the participants have made a mess of it. That is not the case. They also are human, all too human. They operate with imperfect understanding and their activities have unintended consequences.”

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.

Soros’ Alchemy – Chapter 1, Part 3

Continuation in our series of portfolio management highlights from George Soros’ Alchemy of Finance – Chapter 1, Part 3: Soros introduces the theoretical foundations of reflexivity. Psychology, Intrinsic Value

“What makes the participants’ understanding imperfect is that their thinking affects the situation to which it relates…Although there is no reality independent of the participants' perception, there is a reality that is dependent on it. In other words, there is a sequence of events that actually occurs and that sequence reflects the participants' behavior. The actual course of events is likely to differ from the participants' expectations and the divergence can be taken as an indication of the participants' bias. Unfortunately, it can be taken only as an indication – not as the full measure of the bias because the actual course of events already incorporates the effects of the participants' thinking. Thus the participants' bias finds expression both in the divergence between outcome and expectations and in the actual course of events. A phenomenon that is partially observable and partially submerged in the course of events does not lend itself readily to scientific investigation. We can now appreciate why economists were so anxious to eliminate it from their theories. We shall make it the focal point of our investigation.”

“The connection between the participants' thinking and the situation in which they participate can be broken up into two functional relationships. I call the participants' efforts to understand the situation the cognitive or passive function and the impact of their thinking on the real world the participating or active function. In the cognitive function, the participants' perceptions depend on the situation; in the participating function, the situation is influenced by the participants' perceptions. It can be seen that the two functions work in opposite directions: in the cognitive function the independent variable is the situation; in the participating function it is the participants' thinking…

When both functions operate at the same time, they interfere with each other. Functions need an independent variable in order to produce a determinate result, but in this case the independent variable of one function is the dependent variable of the other. Instead of a determinate result, we have an interplay in which both the situation and the participants' views are dependent variables so that an initial change precipitates further changes both in the situation and in the participants' views. I call this interaction ‘reflexivity,’ using the word as the French do when they describe a verb whose subject and object are the same…

This is the theoretical foundation of my approach. The two recursive functions do not produce an equilibrium but a never-ending process of change…When a situation has thinking participants, the sequence of events does not lead directly from one set of facts to the next; rather, it connects facts to perceptions and perceptions to facts in a shoelace pattern. Thus, the concept of reflexivity yields a 'shoelace' theory of history.”

“Returning to economic theory, it can be argued that it is the participants' bias that renders the equilibrium position unattainable. The target toward which the adjustment process leads incorporates a bias, and the bias may shift in the process. When that happens, the process aims not at an equilibrium but at a moving target…

Equilibrium analysis eliminates historical change by assuming away the cognitive function. The supply and demand curves utilized by economic theory are expressions of the participating function only. The cognitive function is replaced by the assumption of perfect knowledge. If the cognitive function were operating, events in the marketplace could alter the shape of the demand and supply curves, and the equilibrium studied by economists need never be reached. How significant is the omission of the cognitive function? In other words, how significant is the distortion introduced by neglecting the participants' bias?

In microeconomic analysis, the distortion is negligible…When it comes to financial markets, the distortion is more serious. The participants' bias is an element in determining prices and no important market development leaves the participants' bias unaffected. The' search for an equilibrium price turns out to be a wild goose chase and theories about the equilibrium price can themselves become a fertile source of bias. To paraphrase J.P. Morgan, financial markets will continue to fluctuate. In trying to deal with macroeconomic developments, equilibrium analysis is totally inappropriate. Nothing could be further removed from reality than the assumption that participants base their decisions on perfect knowledge. People are groping to anticipate the future with the help of whatever guideposts they can establish. The outcome tends to diverge from expectations, leading to constantly changing expectations and constantly changing outcomes. The process is reflexive.”

Soros’ Alchemy – Chapter 1, Part 2

Continuation in our series of portfolio management highlights from George Soros’ Alchemy of Finance - Chapter 1, Part 2: Soros discusses the flaws of human psychology, how it complicates the task of investing in a marketplace of other thinking participants, why historical performance is not indicative of future results. He also explains why the term “alchemy” is in the title of the book. Psychology

“Natural scientists have one great advantage over participants: they deal with phenomena that occur independently of what anybody says or thinks about them. The phenomena belong to one universe, the scientists' statements to another. The phenomena then serve as an independent, objective criterion by which the truth or validity of scientific statements can be judged. Statements that correspond to the facts are true; those that do not are false. To the extent that the correspondence can be established, the scientist's understanding qualifies as knowledge…scientists have an objective criterion at their disposal.

By contrast, the situation to which the participants' thinking relates is not independently given: it is contingent on their own decisions. As an objective criterion for establishing the truth or validity of the participants' views, it is deficient…one can never be sure whether it is the expectation that corresponds to the subsequent event or the subsequent event that conforms to the expectation.

Thinking plays a dual role. On the one hand, participants seek to understand the situation in which they participate; on the other, their understanding serves as the basis of decisions which influence the course of events. The two roles interfere with each other…If the course of events were independent of the participants' decisions, the participants' understanding could equal that of a natural scientist; and if participants could base their decisions on knowledge, however provisional, the results of their actions would have a better chance of corresponding to their intentions. As it is, participants act on the basis of imperfect understanding and the course of events bears the imprint of that imperfection…

Participants have to deal with a situation that is contingent on their own decisions; their thinking constitutes an indispensable ingredient in that situation. Whether we treat it as a fact of a special kind or something other than a fact, the participants' thinking introduces an element of uncertainty into the subject matter…Perhaps the most outstanding example of the observer trying to impose his will on his subject matter is the attempt to convert base metal into gold. Alchemists struggled long and hard until they were finally persuaded to abandon their enterprise…”

Historical Performance

“A world of imperfect understanding does not lend itself to generalizations which can be used to explain and to predict specific events. The symmetry between explanation and prediction prevails only in the absence of thinking participants. Otherwise, predictions must always be conditioned on the participants' perceptions; thus they cannot have the finality which they enjoy in the-D-N model. On the other hand, past events are just as final as in the D-N model; thus, explanation turns out to be an easier task than prediction. Once we abandon the constraint that predictions and explanations are logically reversible, we can build a theoretical framework which is appropriate to the subject matter.”

This is why historical performance is not indicative of future results, and why performance chasing produces sub-optimal results. As Mark Twain said, “History doesn’t repeat itself, but it does rhyme.” It doesn’t repeat because markets are full of thinking participant forever shifting and adjusting their thinking, but it does rhyme because our fundamental psychological pathways remain unchanged over the span of centuries.

Soros' Alchemy - Preface & Intro

Dear Readers, apologies for the length of time since our last article. It’s been a busy year – got married, growing the business, grappling with a large position ruining otherwise healthy year-to-date performance – you know, all the usual life items. We have all experienced situations when the fundamentals of a business are moving in an expected direction, yet the price does not respond in kind. Many moons ago, we highlighted an interview with Stanley Druckenmiller in which he stated:

“…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…”

Very interesting indeed, but also incredibly vague. Thankfully, Druckenmiller’s zen master George Soros has written multiple books. And that’s where we went searching for more detailed explanations on how to gauge supply and demand, the driving forces behind market liquidity and price movement. Without further ado, portfolio management highlights from George Soros’ Alchemy of Finance – Preface & Introduction:

Psychology, Catalyst, Liquidity, Intrinsic Value

“The phenomena studied by social sciences, which include the financial markets, have thinking participants and this complicates matters…the participants views are inherently bias. Instead of a direct line leading from one set of conditions to the next one, there is a constant criss-crossing between the objective, observable conditions and the participant’s observations and vice versa: participants base their decisions not on objective conditions but on their interpretation of those conditions. This is an important point and it has far-reaching consequences. It introduces an element of indeterminacy which renders the subject matter less amendable to…generalizations, predictions, and explanations…”

“It is only in certain…special circumstances that the indeterminacy becomes significant. It comes into play when expectations about the future have a bearing on present behavior – which is the case in financial markets. But even there, some mechanism must be triggered for the participants’ bias to affect not only market prices but the so-called fundamentals which are supposed to determine market prices…My point is that there are occasions when the bias affects not only market prices but also the so-called fundamentals. This is when reflexivity becomes important. It does not happen all the time but when it does, market prices follow a different pattern…they do not merely reflect the so-called fundamentals; they themselves become one of the fundamentals which shape the evolution of prices. This recursive relationship renders the evolution of prices indeterminate and the so-called equilibrium price irrelevant.”

“Natural science studies events that consist of a sequence of facts. When events have thinking participants, the subject matter is no longer confined to facts but also includes the participants' perceptions. The chain of causation does not lead directly from fact to fact but from fact to perception and from perception to fact.”

“Economic theory tries to sidestep the issue by introducing the assumption of rational behavior. People are assumed to act by choosing the best of the available alternatives, but somehow the distinction between perceived alternatives and facts is assumed away. The result is a theoretical construction of great elegance that resembles natural science but does not resemble reality…It has little relevance to the real world in which people act on the basis of imperfect understanding…”

“The generally accepted view is that markets are always right – that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite point of view. I believe that market prices are always wrong in the sense that they present a biased view of the future. But distortion works in both directions: not only do market participants operate with a bias, but their bias can also influence the course of events. This may create the impression that markets anticipate future developments accurately, but in fact it is not present expectations that correspond to future events but future events that are shaped by present expectations. The participants' perceptions are inherently flawed, and there is a two-way connection between flawed perceptions and the actual course of events, which results in a lack of correspondence between the two. I call this two-way connection ‘reflexivity.’”

“Making an investment decision is like formulating a scientific hypothesis and submitting it to a practical test. The main difference is that the hypothesis that underlies an investment decision is intended to make money and not to establish a universally valid generalization. Both activities involve significant risk, and success brings a corresponding reward-monetary in one case and scientific in the other. Taking this view, it is possible to see financial markets as a laboratory for testing hypotheses, albeit not strictly scientific ones. The truth is, successful investing is a kind of alchemy. Most market participants do not view markets in this light. That means that they do not know what hypotheses are being tested…”

“…I did not play the financial markets according to a particular set of rules; I was always more interested in understanding the changes that occur in the rules of the game. I started with hypotheses relating to individual companies; with the passage of time my interests veered increasingly toward macroeconomic themes. This was due partly to the growth of the fund and partly to the growing instability of the macroeconomic environment.”

“Most of what I know is in the book, at least in theoretical form. I have not kept anything deliberately hidden. But the chain of reasoning operates in the opposite direction: I am not trying to explain how to use my approach to make money; rather, I am using my experiences in the financial markets to develop an approach to the study of historical processes in general and the present historical moment…If I did not believe that my investment activities can serve that purpose, I would not want to write about them. As long as I am actively engaged in business, I would be better off to keep them a trade secret. But I would value it much more highly than any business success if I could contribute to an understanding of the world in which we live or, better yet, if I could help to preserve the economic and political system that has allowed me to flourish as a participant.”

Macro

“Monetary and real phenomena are connected in a reflexive fashion; that is, they influence each other mutually. The reflexive relationship manifests itself most clearly in the use and abuse of credit. Loans are based on the lender's estimation of the borrower's ability to service his debt. The valuation of the collateral is supposed to be independent of the act of lending; but in actual fact the act of lending can affect the value of the collateral. This is true of the individual case and of the economy as a whole. Credit expansion stimulates the economy and enhances collateral values; the repayment or contraction of credit has a depressing influence both on the economy and on the valuation of the collateral.”

“Periodic busts have been so devastating that strenuous efforts have been made to prevent them. These efforts have led to the evolution of central banking and of other mechanisms for controlling credit and regulating economic activity. To understand the role of the regulators it must be realized that they are also participants: their understanding is inherently imperfect and their actions have unintended consequences.”

My New Crush: Stanley Druckenmiller

I have a new (intellectual) crush: Stanley Druckenmiller. If you don’t share my feelings, you will after you read his Jan 2015 speech at the Lost Tree Club. Portfolio management related excerpts below: Diversification, Sizing

“I think diversification and all the stuff they're teaching at business school today is probably the most misguided concept...And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that's kind of the way my philosophy evolved, which was if you see - only maybe one or two times a year do you see something that really, really excites you. And if you look at what excites you and then you look down the road, your record on those particular transactions is far superior to everything else, but the mistake I'd say 98 percent of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.”

“…you don't need like 15 stocks or this currency or that. If you see it, you got to go for it because that's a better bet than 90 percent of the other stuff you would add onto it.” “So, how did I meet George Soros? I was developing a philosophy that if I can look at all these different buckets and I'm going to make concentrated bets, I'd rather have a menu of assets to choose from to make my big bets and particularly since a lot of these assets go up when equities go down, and that's how it was moving.

And then I read The Alchemy of Finance because I'd heard about this guy, Soros. And when I read The Alchemy of Finance, I understood very quickly that he was already employing an advanced version of the philosophy I was developing in my fund. So, when I went over to work for George, my idea was I was going to get my PhD in macro portfolio manager and then leave in a couple years or get fired like the nine predecessors had. But it's funny because I went over there, I thought what I would learn would be like what makes the yen goes up, what makes the deutsche mark move, what makes this, and to my really big surprise, I was as proficient as he was, maybe more so, in predicting trends.

That's not what I learned from George Soros, but I learned something incredibly valuable, and that is when you see it, to bet big. So what I had told you was already evolving, he totally cemented. I know we got a bunch of golfers in the room. For those who follow baseball, I had a higher batting average; Soros had a much bigger slugging percentage. When I took over Quantum, I was running Quantum and Duquesne. He was running his personal account, which was about the size of an institution back then, by the way, and he was focusing 90 percent of his time on philanthropy and not really working day to day. In fact a lot of the time he wasn't even around.

And I'd say 90 percent of the ideas he were [ph.] using came from me, and it was very insightful and I'm a competitive person, frankly embarrassing, that in his personal account working about 10 percent of the time he continued to beat Duquesne and Quantum while I was managing the money. And again it's because he was taking my ideas and he just had more guts. He was betting more money with my ideas than I was.

Probably nothing explains our relationship and what I've learned from him more than the British pound. So, in 1992 in August of that year my housing analyst in Britain called me up and basically said that Britain looked like they were going into a recession because the interest rate increases they were experiencing were causing a downturn in housing. At the same time, if you remember, Germany, the wall had fallen in '89 and they had reunited with East Germany, and because they'd had this disastrous experience with inflation back in the '20s, they were obsessed when the deutsche mark and the [unint.] combined, that they would not have another inflationary experience. So, the Bundesbank, which was getting growth from the [unint.] and had a history of worrying about inflation, was raising rates like crazy. That all sounds normal except the deutsche mark and the British pound were linked. And you cannot have two currencies where one economic outlook is going like this way and the other outlook is going that way.

So, in August of 1 92 there was 7 billion in Quantum. I put a billion and a half, short the British pound based on the thesis I just gave you. So, fast-forward September, next month. I wake up one morning and the head of the Bundesbank, Helmut Schlesinger, has given an editorial in the Financial Times, and I'll skip all the flowers. It basically said the British pound is crap and we don't want to be united with this currency. So, I thought well, this is my opportunity. So, I decided I'm going to bet like Soros bets on the British pound against the deutsche mark.

It just so happens he's in the office. He's usually in Eastern Europe at this time doing his thing. So, I go in at 4:00 and I said, ‘George, I'm going to sell $5.5 billion worth of British pounds tonight and buy deutsche marks. Here's why I'm doing it, that means we'll have 100 percent of the fund in this one trade.’ And as I'm talking, he starts wincing like what is wrong with this kid, and I think he's about to blow away my thesis and he says, ‘That is the most ridiculous use of money management I ever heard. What you described is an incredible one-way bet. We should have 200 percent of our net worth in this trade, not 100 percent. Do you know how often something like this comes around? Like one or 20 years. What is wrong with you?’ So, we started shorting the British pound that night. We didn't get the whole 15 billion on, but we got enough that I'm sure some people in the room have read about it in the financial press.”

Mistakes

“I've thought a lot of things when I'm managing money with great, great conviction, and a lot of times I'm wrong. And when you're betting the ranch and the circumstances change, you have to change, and that's how I've always managed money.”                “I made a lot of mistakes, but I made one real doozy. So, this is kind of a funny story, at least it is 15 years later because the pain has subsided a little. But in 1999 after Yahoo and America Online had already gone up like tenfold, I got the bright idea at Soros to short internet stocks. And I put 200 million in them in about February and by mid-march the 200 million short I had lost $600 million on, gotten completely beat up and was down like 15 percent on the year. And I was very proud of the fact that I never had a down year, and I thought well, I'm finished.

So, the next thing that happens is I can't remember whether I went to Silicon Valley or I talked to some 22-year-old with Asperger's. But whoever it was, they convinced me about this new tech boom that was going to take place. So I went and hired a couple of gun slingers because we only knew about IBM and Hewlett-Packard. I needed Veritas and Verisign. I wanted the six. So, we hired this guy and we end up on the year - we had been down 15 and we ended up like 35 percent on the year. And the Nasdaq's gone up 400 percent.

So, I'll never forget it. January of 2000 I go into Soros's office and I say I'm selling all the tech stocks, selling everything. This is crazy. [unint.] at 104 times earnings. This is nuts. Just kind of as I explained earlier, we're going to step aside, wait for the net fat pitch. I didn't fire the two gun slingers. They didn't have enough money to really hurt the fund, but they started making 3 percent a day and I'm out. It is driving me nuts. I mean their little account is like up 50 percent on the year. I think Quantum was up seven. It's just sitting there.

So like around March I could feel it coming. I just - I had to play. I couldn't help myself. And three times during the same week I pick up a - don't do it. Don't do it. Anyway, I pick up the phone finally. I think I missed the top by an hour. I bought $6 billion worth of tech stocks, and in six weeks I had left Soros and I had lost $3 billion in that one play. You asked me what I learned. I didn't learn anything. I already knew that I wasn't supposed to do that. I was just an emotional basket case and couldn't help myself. So, maybe I learned not to do it again, but I already knew that.”

Probably one of the few people in this world who knows what it feels like to lose $3 billion dollars in a single day. For additional reading, please see our previous article titled Mistakes of Boredom.

Psychology

When asked what qualities he looks for in money managers:

“Number one, passion. I mentioned earlier I was passionate about the business. The problem with this business if you're not passionate, it is so invigorating to certain individuals, they're going to work 24/7, and you're competing against them. So, every time you buy something, one of them is selling it. So, if you're with one of the lazy people or one of the people that are just doing it for the money, you're going to get run over by those people.

The other characteristic I like to look for in a money manager is when I look at their record, I immediately go to the bear markets and see how they did. Particularly given sort of the five-year outlook I've given, I want to make sure I've got a money manager who knows how to make money and manage money in turbulent times, not just in bull markets.

The other thing I look for…is open-mindedness and humility. I have never interviewed a money manager who told you he'd never made a mistake, and a lot of them do, who didn't stink. Every great money manager I've ever met, all they want to talk about is their mistakes. There's a great humility there. But and then obviously integrity because passion without integrity leads to jail. So, if you want someone who's absolutely obsessed with the business and obsessed with winning, they're not in it for the money, they're in it for winning, you better have somebody with integrity.”

“If you're early on in your career and they give you a choice between a great mentor or higher pay, take the mentor every time. It's not even close. And don't even think about leaving that mentor until your learning curve peaks. There's just nothing to me so invaluable in my business, but in many businesses, as great mentors. And a lot of kids are just too short-sighted in terms of going for the short-term money instead of preparing themselves for the longer term.”

Liquidity

“…earnings don't move the overall market…focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets.”

However, to borrow from Soros’ reasoning within the Alchemy of Finance, one could argue that anticipated earnings influence market participant behavior and therefore influence liquidity.

Other

“…never, ever invest in the present. It doesn't matter what a company's earning, what they have earned. He taught me that you have to visualize the situation 18 months from now, and whatever that is, that's where the price will be, not where it is today…you have to look to the future. If you invest in the present, you're going to get run over.”

The Sugar Cookie

Many moons ago, we shared with you this matrix highlighting the importance of focusing on process over outcome.

In every investor’s lifetime, there will inevitably be one or more instances of “bad breaks” – when the investment process was solid, but the outcome was nonetheless bad. If that has ever happened to you, then you know what it feels like to be a sugar cookie.

What the heck is a sugar cookie? Here is the definition as explained by Naval Admiral William H. McRaven in a recent speech given at the University of Texas:

“Several times a week, the instructors would line up the class and do a uniform inspection.  It was exceptionally thorough. Your hat had to be perfectly starched, your uniform immaculately pressed and your belt buckle shiny and void of any smudges. But it seemed that no matter how much effort you put into starching your hat, or pressing your uniform or polishing your belt buckle--- it just wasn't good enough. The instructors would fine ‘something’ wrong.

For failing the uniform inspection, the student had to run, fully clothed into the surf zone and then, wet from head to toe, roll around on the beach until every part of your body was covered with sand. The effect was known as a ‘sugar cookie.’ You stayed in that uniform the rest of the day, cold, wet and sandy. There were many a student who just couldn't accept the fact that all their effort was in vain. That no matter how hard they tried to get the uniform right, it was unappreciated.

Those students didn't make it through training. Those students didn't understand the purpose of the drill.  You were never going to succeed.  You were never going to have a perfect uniform. Sometimes no matter how well you prepare or how well you perform you still end up as a sugar cookie. It's just the way life is sometimes. If you want to change the world get over being a sugar cookie and keep moving forward.”

Mistakes of Boredom

Flying back to Los Angeles after Christmas, somewhere over New Mexico, I rediscovered an article written by Ted Lucas of Lattice Strategies in 2011, quoting mathematician and logician Blaise Pascal’s Pensées on the psychological propensity of humans to seek out diversion and action, and the boredom caused by inaction:

“Sometimes, when I set to thinking about the various activities of men, the dangers and troubles which they face in court, or in war, giving rise to so many quarrels and passions…I have often said that the sole cause of man’s unhappiness is that he does not know how to stay quietly in his room…

Imagine any situation you like, add up all the blessings with which you could be endowed, to be king is still the finest thing in the world; yet if you imagine one with all the advantages to his rank, but no means of diversion, left to ponder and reflect on what he is, this limp felicity will not keep him going…with the result that if he is deprived of so-called diversion he is unhappy, indeed more unhappy than the humblest of subjects who can enjoy sport and diversion.

The only good thing for men therefore is to be diverted from thinking of what they are, either by some occupation which takes their mind off it, or by some novel and agreeable passion which keeps them busy . . . in short it is called diversion.”

If true, as asset prices move ever higher, this psychological tendency has immense implications on investment decisions. Avoiding overvalued assets/securities and holding cash may be easier said than done, for psychological reasons beyond whether or not your mandate/investors allow you to hold cash.

Perhaps it’s time to convince your boss that a paid vacation / sabbatical to pursue distractions (other than investing) during expensive market environments may actually help improve performance returns by avoiding mistakes born of boredom.

Howard Marks' Book: Chapter 18

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 18 “The Most Important Thing Is…Avoiding Pitfalls” Risk, Volatility

“…trying to avoid losses is more important than striving or great investment successes. The latter can be achieved some of the time, but the occasional failures may be crippling. The former can be done more often and more dependably…and with consequences when it fails that are more tolerable…A portfolio that contains too little risk can make you underperform in a bull market, but no one ever went bust from that; there are far worse fates.”

“You could require your portfolio to do well in a rerun of 2008, but then you’d hold only Treasurys, cash and gold. Is that a viable strategy? Probably not. So the general rule is that it’s important to avoid pitfalls, but there must be a limit. And the limit is different for each investor.”

Volatility, Psychology, Trackrecord, When To Buy, When To Sell, Clients

“…almost nothing performed well in the meltdown of 2008…While it was nigh onto impossible to avoid declines completely, relative outperformance in the form of smaller losses was enough to let you do better in the decline and take grater advantage of the rebound.”

“In periods that are relatively loss free, people tend to think of risk as volatility and become convinced they can live with it. If that were true, they would experience markdowns, invest more at the lows and go on to enjoy the recovery, coming out ahead in the long run. But if the ability to live with volatility and maintain one’s composure has been overestimated—and usually it has—that error tends to come to light when the market is a its nadir. Loss of confidence and resolve can cause investors to sell at the bottom, converting downward fluctuations into permanent losses and preventing them from participating fully in the subsequent recovery. This is the great error in investing—the most unfortunate aspect of pro-cyclical behavior—because of its permanence and because it tends to affect large portions of portfolios.”

“While it’s true that you can’t spend relative outperformance, human nature causes defensive investors and their less traumatized clients to derive comfort in down markets when they lose less than others. This has two very important effects. First, it enables them to maintain their equanimity and resist the psychological pressures that often make people sell at lows. Second, being in a better frame of mind and better financial condition, they are more able to profit from the carnage by buying at lows. Thus, they generally do better in recoveries.”

Volatility is not the true risk; the true risk lies in what investors do / how they behave during volatile periods.

Mistakes, Creativity, Psychology

“One type of analytical error…is what I call ‘failure of imagination’…being unable to conceive of the full range of possible outcomes or not fully understanding the consequences of the more extreme occurrences.”

“Another important pitfall…is the failure to recognize market cycles and manias and move in the opposite direction. Extremes in cycles and trends don’t occur often, and thus they’re not a frequent source of error, but they give rise to the largest errors.”

“…when the future stops being like the past, extrapolation fails and large amounts of money are either lost or not made…the success of your investment actions shouldn’t be highly dependent on normal outcomes prevailing; instead, you must allow for outliers…"

“…the third form of error doesn’t consist of doing the wrong thing, but rather of failing to do the right thing. Average investors are fortunate if they can avoid pitfalls, whereas superior investors look to take advantage of them…a different kind of mistake, an error of omission, but probably one most investors would be willing to live with.”

“The essential first step in avoiding pitfalls consists of being on the lookout for them…learning about pitfalls through painful experience is of only limited help. The key is to try to anticipate them…The markets are a classroom where lesson are taught every day. The keys to investment success lie in observing and learning.”

“The fascinating and challenging thing is that the error moves around. Sometimes prices are too high and sometimes they’re too low. Sometimes the divergence of prices from value affects individual securities or assets and sometimes whole markets – sometimes one market and sometimes another. Sometimes the error lies in doing something and sometimes in not doing it, sometimes in being bullish and sometimes in being bearish…avoiding pitfalls and identifying and acting on error aren’t susceptible to rules, algorithms, or roadmaps. What I would urge is awareness, flexibility, adaptability and a mind-set that is focused on taking cues from the environment.”

Correlation, Diversification, Risk

“There’s another important aspect of failure of imagination. Everyone knows assets have prospective returns and risks, and they’re possible to guess at. But few people understand asset correlation: how one asset will react to a change in another, or that two assets will react similarly to a change in a third. Understanding and anticipating the power of correlation – and thus the limitations of diversification – is a principal aspect of risk control and portfolio management, but it’s very hard to accomplish…Investors often fail to appreciate the common threads that run through portfolios.”

“Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem. It’s easier to assess the return and risk of an investment than to understand how it will move relative to others. Correlation is often underestimated, especially because of the degree to which it increases in crisis. A portfolio may appear to be diversified as to asset class, industry and geography, but in tough times, non-fundamental factors such as margin calls, frozen markets and a general risk in risk aversion can become dominant, affecting everything similarly.”

Hedging, Expected Return, Opportunity Cost, Fat Tail

“…a dilemma we have to navigate. How much time and capital should an investor devote to protecting against the improbable disaster? We can insure against every extreme outcome…But doing so will be costly, and the cost will detract form investment returns when that protection turns out not to have been needed…and that’ll be most of the time.”

Howard Marks’ Book: Chapter 17

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

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

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

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

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

Capital Preservation, Volatility, Diversification, Leverage

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

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

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

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

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

Psychology, Luck, Process Over Outcome

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

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

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

Psychology, Trackrecord

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

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

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

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

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

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

Montier on Exposures & Bubbles

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

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

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

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

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

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

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

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

Hedging, Fat Tail

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

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

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

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

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

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

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

Expected Return, Capital Preservation

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

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

When To Buy, When To Sell, Psychology

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

Baupost Letters: 2000-2001

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

Volatility, Psychology

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

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

When To Buy, When To Sell, Selectivity

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

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

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

Psychology, When To Buy, When To Sell

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

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

Risk, Expected Return, Cash

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

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

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

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

Benchmark

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

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

Cash, Turnover

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

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

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

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

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

Hedging, Expected Return

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

Elementary Worldly Wisdom - Part 3

The following is Part 3 of portfolio management highlighted extracted from a gem of a Munger speech given at USC nearly a decade ago. It’s long, but contains insights collected over many years by one of the greatest investment minds in this century. Caustically humorous (purely Munger), it is absolutely worth 20 minutes of your day between browsing ESPN and TMZ. Psychology

“…the nature of human psychology is such that you'll torture reality so that it fits your models, or at least you'll think it does…‘To the man with only a hammer, every problem looks like a nail.’”

“…the great useful model, after compound interest, is the elementary math of permutations and combinations…people can't naturally and automatically do this. If you understand elementary psychology, the reason they can't is really quite simple: The basic neural network of the brain is there through broad genetic and cultural evolution. And it's not Fermat/Pascal. It uses a very crude, shortcut-type of approximation. It's got elements of Fermat/Pascal in it. However, it's not good.

So you have to learn in a very usable way this very elementary math and use it routinely in life—just the way if you want to become a golfer, you can't use the natural swing that broad evolution gave you. You have to learn—to have a certain grip and swing in a different way to realize your full potential as a golfer.

If you don't get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an asskicking contest. You're giving a huge advantage to everybody else.

One of the advantages of a fellow like Buffett, whom I've worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations...”

“There's not a person in this room viewing the work of a very ordinary professional magician who doesn't see a lot of things happening that aren't happening and not see a lot of things happening that are happening. And the reason why is that the perceptual apparatus of man has shortcuts in it.

The brain cannot have unlimited circuitry. So someone who knows how to take advantage of those shortcuts and cause the brain to miscalculate in certain ways can cause you to see things that aren't there…your brain has a shortage of circuitry and so forth—and it's taking all kinds of little automatic shortcuts… just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations.”

“We are all influenced—subconsciously and to some extent consciously—by what we see others do and approve. Therefore, if everybody's buying something, we think it's better. We don't like to be the one guy who's out of step. Again, some of this is at a subconscious level and some of it isn't. Sometimes, we consciously and rationally think, "Gee, I don't know much about this. They know more than I do. Therefore, why shouldn't I follow them?"

Team Management, Psychology

“…this knowledge, by the way, can be used to control and motivate other people...”

“Personally, I've gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things—which by and large are useful, but which often misfunction.

One approach is rationality—the way you'd work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions—many of which are wrong.”

“If people tell you what you really don't want to hear what's unpleasant—there's an almost automatic reaction of antipathy. You have to train yourself out of it. It isn't foredestined that you have to be this way. But you will tend to be this way if you don't think about it.

Television was dominated by one network—CBS in its early days. And Paley was a god. But he didn't like to hear what he didn't like to hear. And people soon learned that. So they told Paley only what he liked to hear. Therefore, he was soon living in a little cocoon of unreality and everything else was corrupt…You get a lot of dysfunction in a big fat, powerful place where no one will bring unwelcome reality to the boss.”

Team Management

“Carl Braun…His rule for all the Braun Company's communications was called the five W's—you had to tell who was going to do what, where, when and why. And if you wrote a letter or directive in the Braun Company telling somebody to do something, and you didn't tell him why, you could get fired. In fact, you would get fired if you did it twice.

You might ask why that is so important? Well, again that's a rule of psychology. Just as you think better if you array knowledge on a bunch of models that are basically answers to the question, why, why, why, if you always tell people why, they'll understand it better, they'll consider it more important, and they'll be more likely to comply. Even if they don't understand your reason, they'll be more likely to comply.

So there's an iron rule that just as you want to start getting worldly wisdom by asking why, why, why, in communicating with other people about everything, you want to include why, why, why. Even if it's obvious, it's wise to stick in the why.”

“The great defect of scale, of course, which makes the game interesting—so that the big people don't always win—is that as you get big, you get the bureaucracy. And with the bureaucracy comes the territoriality—which is again grounded in human nature.

And the incentives are perverse. For example, if you worked for AT&T in my day, it was a great bureaucracy. Who in the hell was really thinking about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-basket into somebody else's in-basket. But, of course, it isn't. It's not done until AT&T delivers what it's supposed to deliver. So you get big, fat, dumb, unmotivated bureaucracies.

They also tend to become somewhat corrupt. In other words, if I've got a department and you've got a department and we kind of share power running this thing, there's sort of an unwritten rule: ‘If you won't bother me, I won't bother you and we're both happy.’ So you get layers of management and associated costs that nobody needs. Then, while people are justifying all these layers, it takes forever to get anything done. They're too slow to make decisions and nimbler people run circles around them.

The constant curse of scale is that it leads to big, dumb bureaucracy—which, of course, reaches its highest and worst form in government where the incentives are really awful. That doesn't mean we don't need governments—because we do. But it's a terrible problem to get big bureaucracies to behave. So people go to stratagems. They create little decentralized units and fancy motivation and training programs…But bureaucracy is terrible.... And as things get very powerful and very big, you can get some really dysfunctional behavior.”

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.”

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?”

An Anecdotal Gem

The following anecdote comes from WkndNotes by Eric Peters (a treasure trove of humor and investment insight) and touches upon Tesla. Our readers know that PM Jar does not discuss ideas, and we have no intention of jumping into the Tesla debate or to declare ourselves Musk-lovers. The reason why we are showcasing this excerpt is because reading it, especially the last sentence, struck a chord. Enjoy. " 'Driverless electric Tesla’s, powered by Google, dispatched by Uber will shuttle people around continuously – the technology already exists, this future is inevitable,' explained the brilliant macro CIO, basking in California’s bright sunlight, whisking me 20yrs forward. Of course, regulations need to catch up. They will. 'And annual car sales will collapse from today’s 100mm pace to just 20mm.' You see automobiles are driven only 3% of the time, meaning the world needs far fewer once we harness technology to utilize them more efficiently, continuously. 'In that future, with Tesla as the world’s #2 auto company, it’ll be worth $100bln versus today’s $20bln market cap.' He’s owned Tesla for years, but is now nearly flat, waiting for a pull back. 'Most buyers today think it will be another BMW and with that rather modest ambition, it’s now aggressively priced.' Anyhow, the world is changing rapidly. Accelerating. So equity investors clamor to buy disruptive companies that’ll shape it, drive it. 'Maynard Keynes said in 100yrs, people will need to work 4hrs per week to meet their needs, and here we are.' Naturally, the growth in our 'needs' has far outpaced productivity gains. So we’re working harder than ever. But a radically new phase has begun, where robotics dominate production, services too. Thus the owners of capital and machines will accumulate vastly disproportionate wealth, while the middle class sinks. The poor drown. And governments race to redistribute or face riots, revolution. 'Viewed in this context, Obama-care was inevitable.' So I asked what theme most interests him. You see, he’s developed a series of simple rules to identify errors people make in their investment theses. 'I’m looking for opportunities in areas distorted by people who are afraid of change, yearning for things that are simply never coming back.' "

Baupost Letters: 1999

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

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

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

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

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

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

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

Duration, Catalyst

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

Momentum

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

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

Risk, Psychology

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

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

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

When To Buy, Psychology

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

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

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.”