Consequences of Contrarian Actions

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

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

AUM, Clients, Redemptions, Patience

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

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

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

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

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

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

Historical Performance Analysis, Luck, Process Over Outcome, Mistakes

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

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

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

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

Psychology, When To Sell, When To Buy

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

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

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

Howard Marks' Book: Chapter 11

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

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

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

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

When To Buy, When To Sell, Catalyst

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

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

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

Tricky part is determining the timing when “the top is reached.” As Stanley Druckenmiller astutely points out: “I never use valuation to time the market…Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction…The catalyst is liquidity…” Unfortunately, neither Druckenmiller nor Marks offers additional insight as to how one should identify the catalyst(s) signaling reversals of the pendulum.

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

When To Buy

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

Gumption is rewarded during periods of uncertainty.

Mistakes

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

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

Expected Return

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

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

An Interview with Bruce Berkowitz - Part 2

Part 2 of portfolio management highlights extracted from an August 2010 WealthTrack interview with Consuelo Mack (in my opinion, WealthTrack really is an underrated treasure trove of investment wisdom). Be sure to check out Part 1.

AUM, Compounding, Subscription, Redemptions

“MACK: There’s a saying on Wall Street...that size is the enemy of performance…

BERKOWITZ: …we think about this every day. And, the important point is that, as the economy still is at the beginning of a recovery, and there's still much to do…we can put the money to work. The danger's going to be when times get better, and there's nothing to do, and the money keeps flocking in. That obviously is going to be a point we're going to have to close down the fund...But of course, it's more than that. Because if we continue to perform, which I hope we do, 16 billion's going to become 32, and 32's going to become 64.”

Berkowitz makes a great point. It’s not just subscriptions and redemptions that impact assets under management. Natural portfolio (upward or downward) compounding will impact AUM as well.

We’ve discussed before: there’s no such thing as a “right” AUM, statically speaking. The “right” number is completely dependent upon opportunities available and market environment.

AUM, Sourcing

"CONSUELO MACK: …as you approached 20 billion under management, has the size affected the way you can do business yet?

BRUCE BERKOWITZ: Yes. It's made a real contribution. How else could we have committed almost $3 billion to GGP, or to have done an American Credit securitization on our own, or help on a transformation transaction with Hertz, or offer other companies to be of help in their capital structure, or invest in CIT, or be able to go in with reasonable size? It's helped, and we think it will continue to help…”

In some instance, contrary to conventional Wall Street wisdom, larger AUM – and the ability to write an extremely large equity check – actually helps source proprietary deals and potentially boost returns.

Diversification, Correlation, Risk

“MACK: Just under 60% of his stock holdings are in companies such as AIG, Citigroup, Bank of America, Goldman Sachs, CIT Group and bond insurer, MBIA…your top 10 holdings…represent two-thirds of your fund, currently?

BERKOWITZ: Yes…we always have focused. And we're very aware of correlations…When times get tough, everything's correlated. So, we're wary. But we've always had the focus. Our top four, five positions have always been the major part of our equity holdings, and that will continue.”

“…the biggest risk would be the correlation risk, that they all don't do well.”

Weirdly, or perhaps appropriately, for someone with such a concentrated portfolio, Berkowitz is acutely aware of correlation risk. Better this than some investors who think they have “diversified” portfolios of many names only to discover that the names are actually quite correlated even in benign market environments.

As Jim Leitner would say, “diversification only works when you have assets which are valued differently…”

Making Mistakes, Sizing

“What worries me is knowing that it's usually a person's last investment idea that kills them…as you get bigger, you put more into your investments. And, that last idea, which may be bad, will end up losing more than what you've made over decades.”

For more on this, be sure to see a WealthTrack interview with Michael Mauboussin in which he discusses overconfidence, and how it can contribute to portfolio management errors such as bad sizing decisions.

Creativity, Team Management, Time Management

“…once we come up with a thesis about an idea, we then try and find as many knowledgeable professionals in that industry, and pay them to destroy our idea…We're not interested in talking to anyone who’ll tell us why we're right. We want to talk to people to tell us why we're wrong, and we're always interested to hear why we're wrong…We want our ideas to be disproven.”

According to a 2010 Fortune Magazine article, there are “20 or so full-time employees to handle compliance, investor relations, and trading. But there are no teams of research analysts.” Instead, “Berkowitz hires experts to challenge his ideas. When researching defense stocks a few years ago, he hired a retired two-star general and a retired admiral to advise him. More recently he's used a Washington lobbyist to help him track changes in financial-reform legislation.”       

This arrangement probably simplifies Berkowitz’s daily firm/people management responsibilities. Afterall, the skills necessary for successful investment management may not be the same as those required for successful team management.

When To Sell, Expected Return, Intrinsic Value, Exposure

“MACK: So, Bruce, what would convince you to sell?

BERKOWITZ: It's going to be a price decision…eventually…at what point our investments start to equate to T-bill type returns.”

As the prices of securities within your portfolio change, so too do the future expected returns of those securities. As Berkowitz points out, if the prices of his holdings climbed high enough, they could “start to equate to T-bill type returns.”

So with each movement in price, the risk vs. reward shifts accordingly. But the main question is what actions you take, if any, between the moment of purchase to when the future expected return of the asset becomes miniscule.

For more on his, check out Steve Romick's thoughts on this same topic. 

UPDATE:

Here’s a 2012 Fortune Magazine interview with Bruce Berkowitz, as he looks back and reflects upon the events that took place in the past 3 years:

Cash, Redemptions, Liquidity, When To Sell

“I always knew we'd have our day of negative performance. I'd be foolish not to think that day would arrive. So we had billions in cash, and the fund was chastised somewhat for keeping so much cash. But that cash was used to pay the outflows, and then when the cash started to get to a certain level, I began to liquidate other positions.”

“The down year was definitely not outside of what I thought possible. I was not as surprised by the reaction and the money going out as I was by the money coming in. When you tally it all up, we attracted $5.4 billion in 2009 and 2010 into the fund and $7 billion went out in 2011. It moves fast.”

Although Berkowitz was cognizant of the potential devastating impact of redemptions and having to liquidate positions to raise cash (as demonstrated by the 2010 interview, see Part 1), he still failed to anticipate the actual magnitude of the waves of redemptions that ultimately hit Fairholme.

I think this should serve as food for thought to all investors who manage funds with liquid redemption terms.

An Interview with Bruce Berkowitz - Part 1

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

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

Cash, Liquidity, Redemptions, Expected Return

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

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

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

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

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

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

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

“The correct way to measure the return on cash is more dynamic: cash is bound on the lower side by its actual return, whereas, the upper side possesses an additional element of positive return received from having the ability to take advantage of unique opportunities.”

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

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

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

The first part is self-explanatory.

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

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

Buffett Partnership Letters: 1965 Part 3

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

“When such a controlling interest is acquired, the assets and earnings power of the business become the immediate predominant factors in value. When a small minority interest in a company is held, earning power and assets are, of course, very important, but they represent an indirect influence on value which, in the short run, may or may not dominate the factors bearing on supply and demand which result in price.”

“Market price, which governs valuation of minority interest positions, is of little or no importance in valuing a controlling interest…When a controlling interest is held, we own a business rather than a stock and a business valuation is appropriate.”

Today, people often reference Buffett’s advice about owning a “business,” not just a “stock.” It’s interesting to note that a prerequisite, at the origin of this advice, involves having a “controlling interest.”

Only to investors with control, do earnings power and assets become the predominant determinants of value. Otherwise, for minority investors, outside factors (such as supply and demand) will impact price movement, which in turn will determine portfolio value fluctuations.

This is strangely similar to Stanley Druckenmiller’s advice: “Valuation only tells me how far the market can go once a catalyst enters the picture...The catalyst is liquidity.” Druckenmiller’s “catalyst” is Buffett’s “factors bearing on supply and demand which result in price.”

Control, Liquidity

“A private owner was quite willing (and in our opinion quite wise) to pay a price for control of the business which isolated stock buyers were not willing to pay for very small fractions of the business.

There’s a (theoretical) Control Premium. There’s also a (theoretical) Liquidity Premium. So (theoretically) the black sheep is the minority position that’s also illiquid.

Then again, all this theoretical talk doesn’t amount to much because investment success is price dependent. Even a minority illiquid position purchased at the right price could be vastly profitable.

Mark to Market, Subscriptions, Redemptions

“We will value our position in Berkshire Hathaway at yearend at a price halfway between net current asset value and book value. Because of the nature of our receivables and inventory this, in effect, amounts to valuation of our current assets at 100 cents on the dollar and our fixed assets at 50 cents on the dollar. Such a value, in my opinion, is fair to both adding and withdrawing partners. It may be either higher or lower than market value at the time.”

We discussed in the past the impact of mark to market decision, and why it’s relevant to those seeking to invest/redeem with/from fund vehicles that contain quasi-illiquid (or esoteric difficult to value) investments yet liquid subscriptions and redemption terms (e.g., hedge funds, certain ETFs and Closed End Funds). Click here, and scroll to section at bottom ,for more details.

Benchmark, Clients

“I certainly do not believe the standards I utilize (and wish my partners to utilize) in measuring my performance are the applicable ones for all money managers. But I certainly do believe anyone engaged in the management of money should have a standard of measurement, and that both he and the party whose money is managed should have a clear understanding why it is the appropriate standard, what time period should be utilized, etc.”

“Frankly I have several selfish reasons for insisting that we apply a yardstick and that we both utilize the same yardstick. Naturally, I get a kick out of beating part…More importantly, I ensure that I will not get blamed for the wrong reasons (having losing years) but only for the right reasons (doing poorer than the Dow). Knowing partners will grade me on the right basis helps me do a better job. Finally, setting up the relevant yardsticks ahead of time insures that we will all get out of this business if the results become mediocre (or worse). It means that past successes cannot cloud judgment of current results. It should reduce the chance of ingenious rationalizations of inept performance.”

Time Management, Team Management, Clients

“…our present setup unquestionably lets me devote a higher percentage of my time to thinking about the investment process than virtually anyone else in the money management business. This, of course, is the result of really outstanding personnel and cooperative partners.”

The skill set required for client servicing is completely different from the skills required for investment management. But unfortunately, most investors/funds have clients that require servicing.

Some are fortunate enough to have team resources that shoulder the majority of client obligations. Yet, the client component never disappears completely. Disappearance may be wishful thinking, though minimization is certainly a possibility.

Reflect upon your procedures and processes – what changes could you implement in order to make a claim similar to the one that Buffett makes above?

Buffett Partnership Letters: 1963 Part 1

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

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

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

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

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

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

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

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

Risk Free Rate, Fee Structure, Hurdle Rate

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

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

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

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

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

Tax

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

Taxes made simple by Warren Buffett.

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

Klarman-Zweig Banter: Part 1

Seth Klarman of Baupost is a great investor. Jason Zweig is a great writer. When combined, we get a great Klarman-Zweig Interview published Fall 2010 in the Financial Analyst Journal (Volume 66 Number 5) by the CFA Institute. Here is Part 1 of tidbits from that conversation. Part 2 is available here.

Volatility

Graham and Dodd’s works help Klarman “think about volatility in marks as being in your favor rather than as a problem.” Volatility is a good thing because it creates opportunities and bargains.

Intrinsic Value, Exposure

“A tremendous disservice is perpetrated by the idea that stocks are for the long run” because most people don’t have enough staying power or a long time horizon to actually implement this belief. “The prevailing view has been that the market will earn a high rate of return if the holding period is long enough, but entry point is what really matters.”

“If we buy a bond at 50 and think it’s worth par in three years but it goes to 90 the year we bought it, we will sell it because the upside/downside has totally changed. The remaining return is not attractive compared with the risk of continuing to hold.”

Shorting

Baupost does not sell short because the “market is biased upward over time…the street is biased toward the bullish side.” But this also means that there are more “low-hanging fruit on the short side.”

Leverage

“We do not borrow money. We don’t use margin.” However, it should be pointed out that Baupost has substantial private real estate investments, many of which would employ leverage or financing. Perhaps it’s the non-recourse nature of real estate financing that distinguishes whether Klarman is willing to employ leverage. In addition, Baupost does engage in derivative transactions (such as interest rate options) that are quasi forms of leverage (e.g., premiums in return for large notional exposure).

Cash

The “inability to hold cash and the pressure to be fully invested at all times meant that when the plug was pulled out of the tub, all boats dropped as the water rushed down the drain.”

“We are never fully invested if there is nothing great to do…we always have cash available to take advantage of bargains – we now have about 30 percent cash across our partnerships – and so if clients ever feel uncomfortable with our approach, they can just take their cash back.”

AUM

“…probably number one in my mind most of the time – how to think about firm size and assets under management. Throughout my entire career, I have always thought size was a negative. Large size means small ideas can’t move the needle as much…As we entered the chaotic period of 2008…for the first time in eight years, we went to our wait list...We got a lot of interesting phone calls from people who needed to move merchandise in a hurry – some of it highly illiquid…So, to have a greater amount of capital available proved to be a good move.”

Returning Capital

“…I think returning cash is probably one of the keys to our future success in that it lets us calibrate our firm size so that we are managing the right amount of money, which isn’t necessarily the current amount of money.”

Redemptions

“Not only are actual redemptions a problem, but also the fear of redemptions, because the money manager’s behavior is the same in both situations.” In preparation for, or the mere threat of possible redemptions, may prompt a manager to start selling positions at exactly the wrong time in an effort to make the portfolio more liquid.

Clients

“Having great clients is the real key to investment success. It is probably more important than any other factor…We have emphasized establishing a client base of highly knowledgeable families and sophisticated institutions…”

Ideal clients have two characteristics:

1. “…when we think we’ve had a good year, they will agree.”
2. “…when we call to say there is an unprecedented opportunity set, we would like to know that they will at least consider adding capital rather than redeeming.”

“Having clients with that attitude allowed us to actively buy securities through the fall of 2008, when other money managers had redemptions and, in a sense, were forced not only to not buy but also to sell their favorite ideas when they knew they should be adding to them.”