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 2

The following is Part 2 of portfolio management highlights extracted from a gem of a Munger speech given at USC 20 years ago in 1994. It’s long, but contains insights collected over many years by one of the world’s greatest investment minds. Caustically humorous, purely Munger, it is absolutely worth 20 minutes of your day between browsing ESPN and TMZ. Expected Return, Selectivity, Sizing, When To Buy

“…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.

…yet, in investment management, practically nobody operates that way…a huge majority of people have some other crazy construct in their heads. And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they'll come to know everything about everything all the time.”

“How many insights do you need? Well, I'd argue: that you don't need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that's with a very brilliant man—Warren's a lot more able than I am and very disciplined—devoting his lifetime to it. I don't mean to say that he's only had ten insights. I'm just saying, that most of the money came from ten insights.

So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds-against game full of craziness with an occasional mispriced something or other. And you're probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It's just that simple…

Again, this is a concept that seems perfectly obvious to me. And to Warren it seems perfectly obvious. But this is one of the very few business classes in the U.S. where anybody will be saying so. It just isn't the conventional wisdom.

To me, it's obvious that the winner has to bet very selectively. It's been obvious to me since very early in life. I don't know why it's not obvious to very many other people.”

“…investment management…is a funny business because on a net basis, the whole investment management business together gives no value added to all buyers combined. That's the way it has to work…I think a select few—a small percentage of the investment managers—can deliver value added. But I don't think brilliance alone is enough to do it. I think that you have to have a little of this discipline of calling your shots and loading up—you want to maximize your chances of becoming one who provides above average real returns for clients over the long pull.”

“…huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: You're paying less to brokers. You're listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded.”

Tax, Compounding, When To Sell

“Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you're going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum.

In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15%—or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.

Even with a 10% per annum investment, paying a 35% tax at the end gives you 8.3% after taxes as an annual compounded result after 30 years. In contrast, if you pay the 35% each year instead of at the end, your annual result goes down to 6.5%. So you add nearly 2% of after-tax return per annum if you only achieve an average return by historical standards from common stock investments in companies with tiny dividend payout ratios.

…business mistakes that I've seen over a long lifetime, I would say that trying to minimize taxes too much is one of the great standard causes of really dumb mistakes. I see terrible mistakes from people being overly motivated by tax considerations.”

Diversification, Hedging

“…one of the greatest economists of the world is a substantial shareholder in Berkshire Hathaway and has been for a long time. His textbook always taught that the stock market was perfectly efficient and that nobody could beat it. But his own money went into Berkshire and made him wealthy…he hedged his bet.”

If you can hedge without negative consequences, do it. It's likely that the economist's investment in Berkshire was not public knowledge.

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.”

How Selective Is Too Selective?

A very smart friend and I were trading emails recently (comparing notes on a particularly hairy investment) and our conversation veered toward the issue of selectivity in an increasingly expensive and upward moving market. We reminisced about the good ol’ days (2008-2010) when fairly good businesses would trade at 5x FCF, or banks with clean balance sheets and decent ROEs were trading at 50% of book value. Whereas today, the cheap names usually come with patches of ingrown hairs. So I asked him, “Does it bother you that the market is pushing you into hairy stuff like this? Selectivity standards have obviously come down since a few years ago, but how far down are you willing to let them go?”

His answer: “I've been thinking a lot about how the market is pushing us into crappier stuff. The problem is, I think this is closer to normal. 2008 and the following years were something we get only a few times during our careers. Downturns like the summer of 2011 probably happen with more frequency. So in between, we have to figure out how to scrape together money generating ideas. I think this makes your focus on portfolio management more valuable. Portfolio construction is going to be more important.”

All too often we hear cautionary tales of selectivity & patient opportunism, but the actual implementation is far trickier. Howard Marks summed this up nicely a few months ago: “You have to learn lessons from history, but you have to learn the right lessons. The lesson can’t be that we are only going to have a portfolio that can withstand a re-run of 2008, because then you could not have much of a portfolio.” 

Perhaps the take-away here is that greed can lead to sub-optimal results in both directions. Greed in keeping your selectivity standards too high can lead to the risk of returns foregone. Greed in letting your selectivity standards slip as markets & prices move higher can lead to the risk of overloading your portfolio with unmanifested-risk and future losses.

Once again, investing forces us to delicately balance two opposing forces, which brings to mind Charlie Munger's quote: "It’s not supposed to be easy. Anyone who finds it easy is stupid."

AUM's Impact On Performance

People often remark that “AUM is the enemy of performance.” But is this truly always the case? Here’s another thought-provoking excerpt from Stephen Duneier of Bija Capital Management that explores the nuances of the AUM-Performance relationship. AUM, Expected Return, Sizing, Selectivity, Liquidity

“Since becoming a portfolio manager more than ten years ago, I have managed as little as $8 million and as much as $910 million. What did I do differently at each extreme? Nothing. On average, I had the same number of trades in the portfolio, structured the positions the same, analyzed the markets the same, generated trade write-ups the same, and in proportion to the overall portfolio, I sized the positions the same. Those are the relevant factors that investors should be asking about when it comes to AuM and here is why. With a minimal amount in AuM, you are clearly not confronted with capacity constraints, therefore you can be highly selective when choosing among opportunities, allowing for optimal portfolio composition. While operating below your capacity constraint, the portfolio composition runs within a fairly steady range. So how do you identify the limits of a PM's capacity? 

Well there are two determinants of capacity. One is internal (mental) and the other is external (market). For those trained as prop traders and PMs within large organizations, you are typically allocated risk rather than capital, which means you think of gains and losses in notional terms. That makes for a difficult adjustment to the world of proportional returns, and particularly shifts in AuM, thereby prematurely capping either AuM growth, or the risk and returns on it. The external constraint is market liquidity per trade or structure. So long as I can maintain the same proportional exposure to a given position, I remain under my capacity limit. Once I have to increase the number of trades in order to maintain the same overall proportional risk exposure, I have breached max capacity for my style. You see, before you reach capacity, you are selecting only the best ideas and expressing them via the optimal structures. You could do more, but you choose not to. When your overall risk budget gets to a point where you cannot maintain the same overall exposure with the same number of trades, you must begin adding less optimal structures and even ideas of lesser conviction. That is the true signal of having breached your maximum capacity.”

Howard Marks' Book: Chapter 13

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

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

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

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

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

Selectivity, Clients

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

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

Selectivity, Expected Return

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

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

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

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

Historical Performance Analysis

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

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

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

When To Buy, Liquidity

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

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

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

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

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

Buffett Partnership Letters: 1965 Part 4

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

“…I believe that we have done somewhat better during the past few years with the capital we have had in the Partnership than we would have done if we had been working with a substantially smaller amount. This was due to the partly fortuitous development of several investments that were just the right size for us – big enough to be significant and small enough to handle.

I now feel that we are much closer to the point where increase sized may prove disadvantageous…What may be the optimum size under some market and business circumstances can be substantially more or less than optimum under other circumstances…as circumstances presently appear, I feel substantially greater size is more likely to harm future results than to help them.”

Asset under management (“AUM”) should not be a stagnant or passive consideration. The AUM is essentially the denominator in the return on equity calculation. The adjustment of AUM relative to portfolio gain and loss will directly impact the trackrecord. The optimal AUM will fluctuate depending on market conditions and/or opportunities available.

However, how to “adjust” AUM is a whole other can of worms.

Historical Performance Analysis, Special Situations, AUM, Expected Return, Hurdle Rate, Sizing, Time Management

“The ‘Workout’ business has become very spasmodic. We were able to employ an average of only $6 million during the year…and this involved only a very limited number of situations. Although we earned about $1,410,000, or about 23 ½% on average capital employed (this is calculated on an all equity basis...), over half of this was earned from one situation. I think it unlikely that a really interesting rate of return can be earned consistently on large sums of money in this business under present conditions.”

Over the previous 10 years, a portion of Buffett’s portfolio was consistently invested in special situations. But we see from that quote above that with AUM increasing, Buffett began to reconsider the allocation to this basket after examining its historical return contribution.

• Does the expected return available meet my minimum return standards (hurdle rate)?
• If so, can I deploy enough capital into the basket such that it contributes meaningfully to portfolio performance and absolute profts? (For example, a 1% allocation that returns 100%, while a return high percentage-wise, adds only a little boost to overall portfolio performance)
• How much of my (or my team’s) time am I will to allocate given the expected return and profits?

Perhaps another interesting lesson is that as AUM shifts, strategies that made sense at one point, may not always be as effective.

Sourcing, Sizing

“I do not have a great flood of good ideas as I go into 1966, although again I believe I have at least several potentially good ideas of substantial size. Much depends on whether market conditions are favorable for obtaining a larger position.”

Good ideas, even just a few, when sized correctly will lead to profits.

Conversely, ideas – no matter how good – if sized too small or impossible to obtain in adequate size for the portfolio, won’t make much of a difference.

Selectivity, Sizing, Expected Return, Opportunity Cost, Hurdle Rate, Correlation, Capital Preservation

“We are obviously only going to go to 40% in very rare situations – this rarity, of course, is what makes it necessary that we concentrate so heavily when we see such an opportunity. W probably have had only five or six situations in the nine-year history of the Partnership where we have exceeded 25%. Any such situations are going to have to promise very significantly superior performance relative to the Dow compared to other opportunities available at the time.

They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal (anything can happen on a short-term quotational basis which partially explains the greater risk of widened year-to-year variations in results). In selecting the limit to which I will go in any one investment, I attempt to reduce to a tiny figure the probability that the single investment (or group, if there is intercorrelation) can produce a result for our total portfolio that would be more than ten percentage points poorer than the Dow.”

Buffett’s sizing decisions were selective, and dependent upon a number of conditions, such as:

• The expected return of the potential investment
• The expected return of the potential investment compared with the expected return of the Dow, and other potential investments (this is the opportunity cost and hurdle rate consideration)
• Whether the potential investment is correlated with other current and potential investments
• The possibility of expected loss of the potential investment (capital preservation consideration)

When To Buy

“Our purchase of Berkshire started at a price of $7.60 per share in 1962…the average cost, however, was $14.86 per share, reflecting very heavy purchases in early 1965…”

Buffett was comfortable buying as prices went up. This is in contrast to many value investors who are most comfortable buying on the way down.

Buffett Partnership Letters: 1965 Part 1

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. The 1965 letter is a treasure trove of insightful portfolio management commentary from Warren Buffett. This is the Buffett for purists – the bright, candid young investor, encountering intellectual dilemmas, thinking aloud about creative solutions, and putting to paper the mental debates pulling him one direction and then another. Fascinating stuff!

Portfolio Management, Sizing, Diversification, Expected Return, Risk, Hurdle Rate, Correlation, Selectivity, Psychology

“We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change underlying value of the investment.

We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations. Frankly there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects that range of all possible relative performances, including negative ones, adjusted for the probability of each…) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorrelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage.

It doesn’t work that way.

We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations vary substantially. The question always is, ‘How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?’ This depends to a great degree on the wideness of the spread between the mathematical expectations of number one versus number eight. It also depends upon the probability that number one could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have 0.05 chance of performing fifteen percentage points or more worse than the Dow, and the second might have only 0.01 chance of such performance. The wide range of expectation in the first case reduces the desirability of heavy concentration in it.

The above may make the whole operation sound very precise. It isn’t. Nevertheless, our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations. Imprecise and emotionally influenced as our attempts may be, that is what the business is all about. The results of many years of decision-making in securities will demonstrate how well you are doing on making such calculations – whether you consciously realize you are making the calculations or not. I believe the investor operates at a distinct advantage when he is aware of what path his thought process is following.”

"There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can’t reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation."

Lots of fantastic insights here. The most important take away is that, even for Buffett, portfolio management involves more art than science – it’s imprecise, requiring constant reflection, adaptation, and awareness of ones decisions and actions.

Expected Return, Trackrecord, Diversification, Volatility

“The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable. The greater the number of selections, the less will be the average year-to-year variation in actual versus expected results. Also, the lower will be the expected results, assuming different choices have different expectations of performance.

I am willing to give up quite a bit in terms of leveling of year-to-year results (remember when I talk of ‘results,’ I am talking of performance relative to the Dow) in order to achieve better overall long-term performance. Simply stated, this means I am willing to concentrate quite heavily in what I believe to be the best investment opportunity recognizing very well that this may cause an occasional very sour year – one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater…Looking back, and continuing to think this problem through, I fell that if anything, I should have concentrated slightly more than I have in the past…”

Here, Buffett outlines the impact of diversification on the expected return and expected volatility of a portfolio, as well as the resulting trackrecord.

Consciously constructing a more concentrated portfolio, Buffett was willing to accept a bumpier trackrecord (more volatile returns vs. the Dow) in return for overall higher long-term returns.

To fans of this approach, I offer two points of caution:

• Increased concentration does not automatically equate to higher returns in the long-term – this is also governed by accurate security selection, or as Buffett puts it, “the various expectations of choices available”
• Notice, at this juncture in 1965-1966, Buffett has a 10-year wildly superior trackrecord. This is perhaps why short-term volatility no longer concerned him (or his clients) as much. If your fund (and client base) is still relatively new, think carefully before emulating.

Baupost Letters: 1996

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

Risk, Sizing, Diversification, Psychology

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

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

Baupost mitigates risk (partially) by:

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

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

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

Diversification

Klarman believes in sufficient but not excessive diversification.

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

Correlation, Risk

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

Mandate, Trackrecord

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

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

Liquidity

Klarman is willing to accept illiquidity for incremental return.

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

Patience

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

Selectivity, Cash

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

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

Hedging

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

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

Howard Marks' Book: Chapter 6 - Part 2

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 6 “The Most Important Thing Is…Recognizing Risk” Marks does a fantastic job illustrating the impact of the (low) risk free rate on portfolio expected risk & return, position selectivity, hurdle rate & opportunity cost.

Expected Return, Hurdle Rate, Opportunity Cost, Risk Free Rate, Selectivity

“The investment thought process is a chain in which each investment sets the requirement for the next…The interest rate on the thirty-day T-bill might have been 4 percent. So investors, says, ‘If I’m going to go out five years, I want 5 percent. And to buy the ten-year note I have to get 6 percent.’ Investors demand a higher rate to extend maturity because they’re concerned about the risk to purchasing power, a risk that is assumed to increase with time to maturity. That’s why the yield curve, which in reality is a portion of the capital markets line, normally slopes upward with the increase in asset life.

Now let’s factor in credit risk. ‘If the ten-year Treasury pays 6 percent, I’m not going to buy a ten-year single-A corporate unless I’m promised 7 percent.’ This introduces the concept of credit spread. Our hypothetical investor wants 100 basis points to go from a ‘guvvie’ to a ‘corporate’…

What if we depart from investment-grade bonds? ‘I’m not going to touch a high yield bond unless I get 600 over a Treasury note of comparable maturity.’ So high yield bonds are required to yield 12 percent, for a spread of 6 percent over the [ten-year] Treasury note, if they’re going to attract buyers.

Now let’s leave fixed income altogether. Things get tougher, because you can’t look anywhere to find the prospective return on investments like stocks (that’s because, simply put, their returns are conjectural, not ‘fixed’). But investors have a sense for these things. ‘Historically S&P stocks have returned 10 percent, and I’ll buy them only if I think they’re going to keep doing so…And riskier stocks should return more; I won’t buy on the NASDAQ unless I think I’m going to get 13 percent.’

From there it’s onward and upward. ‘If I can get 10 percent from stocks, I need 15 percent to accept the illiquidity and uncertainty associated with real estate. And 25 percent if I’m going to invest in buyouts…and 30 percent to induce me to go for venture capital, with its low success ratio.’

That’s the way it’s supposed to work…a big problem for investment returns today stems from the starting point for this process: The riskless rate isn’t 4 percent; it’s close to 1 percent…Typical investors still want more return if they’re going to accept time risk, but with the starting point at 1+ percent, now 4 percent is the right rate for the ten-year (not 6 percent)…and so on. Thus, we now have a capital market line…which is (a) at a much lower level and (b) much flatter.”

“…each investment has to compete with others for capital, but this year, due to low interest rates, the bar for each successively riskier investment has been set lower than at any time in my career.” Most investors have, at some point, gone through a similar thought process:

• Should I make this investment?
• What is the minimum return that will compel me to invest? (For discussion purposes, we’ll call this the Hurdle Rate.)
• How do I determine my hurdle rate?

Based on the quotes above, the hurdle rate is determined based upon a mixture of considerations including: (1) the risk-free rate (2) the expected return of other available investments or asset classes, and (3) perhaps a measure of opportunity cost (for which the calculation opens a whole new can of worms).

In essence, this is a selectivity exercise, comparing the expected returns between possible investment candidates along the “risk” spectrum. After all, “each investment has to compete with others for capital” because we can’t invest in everything.

Howard Marks highlights a problematic phenomenon of recent days: the declining risk-free-rate pushing down the starting point for this exercise, and consequently the entire minimum return requirement (hurdle rate) curve for investors.

So the following questions emerge:

• Is your minimum return requirement (hurdle rate) curve relative or absolute vs. the crowd?
• If relative, do you join the crowd and lower your minimum return hurdle rate?
• Just a little, you say? Is there a point at which you draw the proverbial line in the sand and say “no further” because everyone has lost their minds?
• Do you then go to cash? Is there any another alternative? Are you prepared to miss out on potential returns (as other investors continue to decrease their hurdle rates and chase assets/investments driving prices even higher)?

Wait, this sounds very familiar. Remember our Part 1 discussion on “risk manifestation” due to irrational market participant behavior and high asset prices?

Risk, Expected Return

“…the herd is wrong about risk at least as often as it is about return.”

We have often discussed the concept of expected return (a forward looking prediction on future return outcome), but we have been remiss in discussing the concept of expected risk (a forward looking prediction on future risk outcome).

Misguided predictions of either expected return or expected risk have the potential to torpedo investment theses.

Lisa Rapuano Interview Highlights - Part 3

Part 3 of highlights from an insightful interview with Lisa Rapuano, who worked with Bill Miller for many years, and currently runs Lane Five Capital Management. Selectivity, Hurdle Rate, Opportunity Cost, Sizing

“We do not own many stocks, and anything we buy has to improve the overall portfolio and/or be better than something else we already own…I’ll go into portfolio construction in a bit, but the short answer here is that it has to be better than something we already own, or improve the overall risk profile of the portfolio to make it in.”

“The actual position sizing we choose will be based on…the return profile of the name relative to other things in the portfolio as well as on an absolute basis…”

There are a few concepts here – selectivity, opportunity cost, and hurdle rate – all interrelated in the delicate web that is portfolio management.

Selectivity – not all investments reviewed makes it into the portfolio. They are judged against existing positions and other potential candidates.

Opportunity Cost – should I put capital into this idea? How much capital? If I do this, what is the cost of foregoing future opportunities? Calculating this “cost” is a whole other can of worms. See what other investors have to say about opportunity cost. Jim Leitner has some especially interesting thoughts.

Hurdle Rate – based on the quotes above, the hurdle rate could be a return figure or a risk-related figure since whether or not an idea makes it into the portfolio is dependent upon its merits compared to the expected returns and risk of existing portfolio positions.

Curiously, does this mean that an investor’s hurdle rate can be extracted from the expected return profile of his/her current portfolio? In the spirit of bursting gaskets, how then does this “hurdle rate” figure reconcile with the “discount rate” concept that’s frequently used by investors to value companies?

When To Buy, Sizing

“Value investors like I am are usually a bit too early, both on the buy and the sell side. It’s just part of our process…we’ll be buying long before any catalyst is evident (and thus discounted)…we try to mitigate the impact of being early on the buy side, just by recognizing who may be selling…and controlling our position sizing so that as the stock continues to fall we can confidently buy more.”

Important concept: the relationship between sizing decisions and ability/willingness to buy more if the price of a security continues to decline.

When To Sell

“On the sell side, we learned long ago that holding on to terrific businesses a bit longer than our original value might have indicated is usually a good idea. That being said, there are not that many truly terrific businesses, so most should be sold as they approach value.”

Creativity

“Our philosophy remains static but we pride ourselves on being adaptive in process and tactics.”

“…one of our Core Values at Lane Five is to Adapt and Evolve Actively. The tools change and people get smarter and information flows more quickly. To maintain a competitive advantage we have to evolve ahead of the market.”

More Baupost Wisdom

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

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

When To Buy, Conservatism, Barbell

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

When To Buy, Portfolio Review

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

Risk

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

Hedging

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

Hedging, Sizing

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

Cash, AUM

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

Returning Capital, Sizing

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

Leverage

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

Selectivity

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

Time Management, Sizing

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

Team Management

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

Trackrecord

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

Sourcing

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

Baupost Letters: 1995

Here is the first installment of a 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 for this series.

When To Buy, Risk

In a previous article on The Pensioner in Steve Drobny’s book Invisible Hands, we discussed how most people analyze risk as an afterthought once a portfolio has been constructed (whether by identifying factors, or by analyzing the resulting return stream), and not usually as an input at the beginning of the portfolio construction process.

Klarman’s discusses how risk can slip into the portfolio through the buying process, for example, when investors purchase securities too soon and that security continues to decline in price.

This would support the idea of controlling risk at the start, not just the end. To take this notion further, if risk can sneak in through the buying process, can it also do so during the diligence process, the fundraising process (certain types of client, firm liquidity risk), etc.?

Benchmark, Conservatism, Clients

Baupost is focused on absolute, not relative performance against the S&P 500.

Similar to what Buffett says about conservatism, Klarman believes that the true test for investors occurs during severe down markets. Unfortunately, the cost of this conservatism necessary to avoid losses during these difficult times is underperformance during market rallies.

Klarman also deftly sets the ground rules and client expectations, such that if they did not agree with his philosophy of conservatism and underperformance during bull markets, they were more than welcomed to take their money and put it with index funds.

Selectivity, Cash

We’ve discussed in the past the concept of selectivity– a mental process that occurs within the mind of each investor, and that our selectivity criteria could creep in either direction (more strict or lax) with market movements.

Klarman is known for his comfort with holding cash when he cannot find good enough ideas. This would imply that his level of selectivity does not shift much with market movements.

The question then follows: how does one ensure that selectivity stays constant? This is easily said in theory, but actual implementation is far more difficult, especially when one is working with a large team.

Catalyst, Volatility, Special Situations

Following in the tradition of Max Heine and Michael Price, Klarman invested in special situations / catalyst driven positions, such as bankruptcies, liquidations, restructurings, tender offers, spinoffs, etc.

He recognized the impact of these securities on portfolio volatility, both the good (cushioning portfolio returns during market declines by decoupling portfolio returns from overall market direction) and the bad (relative underperformance in bull markets).

Hedging

Many people made money hedging in 2008. In the true spirit of performance chasing, hedging remains ever popular today, 4 years removed from the heart of financial crisis.

Hopefully, our Readers have read our previous article on hedging, and the warnings from other well-known investors (such as AQR and GMO) to approach with caution. I believe that hedging holds an important place in the portfolio management process, but investors should hold no illusion that hedging is ever profitable.

For example, even the great Seth Klarman has lost money on portfolio hedges. However, he continues to hedges with out-of-the-money put options to protect himself from market declines.

The moral of the story: be sure to carefully consider the purpose of hedges and the eventual implementation process, especially in the context of the entire portfolio as a whole.

Buffett Partnership Letters: 1958 Part 2

This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. Selectivity, Hurdle Rate, Risk

“The higher level of the market, the fewer the undervalued securities and I am finding some difficulty in securing an adequate number of attractive investments. I would prefer to increase the percentage of our assets in work-outs, but these are very difficult to find on the right terms.”

All investors practice some degree of selectivity, since not all ideas/securities/assets we examine makes it into our portfolios. Selectivity implies that, for each of us, there exists some form of selection criteria (e.g., hurdle rate, risk measurement, good management, social responsibility, etc.).

In 1958, Buffett talks about finding it difficult to locate “attractive investments” on the “right terms” as the market got more expensive. Perhaps it’s a comfort to know that Buffett grappled with problems just like the rest of us mere mortals!

Jokes aside, as markets rise, what happens to our standards of selectivity? Do we change our usual parameters (whether consciously or subconsciously) – such as changing the hurdle rate or risk standards?

It’s a dynamic and difficult reality faced by all investors at some point in our careers, made more relevant today as markets continue to rally. I believe how each of us copes and adapts in the face of rising asset prices (and whether we change our selectivity criteria) separates the women from the girls.

Intrinsic Value, Exposure, Opportunity Cost

“Unfortunately we did run into some competition on buying, which railed the price to about $65 where we were neither buyer nor seller.”

“Late in the year we were successful in finding a special situation where we could become the largest holder at an attractive price, so we sold our block of Commonwealth obtaining $80 per share…It is obvious that we could still be sitting with $50 stock patiently buying in dribs and drags, and I would be quite happy with such a program…I might mention that the buyer of the stock at $80 can expect to do quite well over the years. However, the relative undervaluation at $80 with an intrinsic value of $135 is quite different from a price $50 with an intrinsic value of $125, and it seemed to me that our capital could better be employed in the situation which replaced it.”

Once a security has been purchased, the risk-reward shifts with each price movement. Any degree of appreciation naturally makes it a larger % of NAV, alters portfolio exposures, and changes the theoretical amount of opportunity cost (to Buffett’s point of his “capital could better be employed” in another situation).

So what actions does a portfolio manager take, if any, when a security appreciates but has not reached the target price, to a place where it’s neither too cheap nor too expensive, where we are “neither buyer nor seller”?

Unfortunately, Buffett offers no solutions in the 1958 letter. Any thoughts and suggestions from our Readers?