My New Crush: Stanley Druckenmiller

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

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

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

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

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

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

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

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

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

Mistakes

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

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

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

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

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

Psychology

When asked what qualities he looks for in money managers:

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

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

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

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

Liquidity

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

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

Other

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

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).”

Baupost Letters: 1999

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

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

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

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

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

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

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

Duration, Catalyst

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

Momentum

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

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

Risk, Psychology

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

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

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

When To Buy, Psychology

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

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

Bob Rodriguez’s Diversification Experiment

Below are some portfolio management highlights from a recent interview (July 2013) with Bob Rodriguez and Dennis Bryan of First Pacific Advisors in Value Investor Insight. Especially intriguing is Bob’s description of his ongoing experiment related to the effects of diversification on portfolio returns.

Diversification, Sizing, Volatility

“Your portfolio today has fewer than 30 positions. Is that typical?

DB: Generally speaking, we have 20 to 40 positions, with 40-50% of the portfolio in the top ten. That level of concentration is simply a function of wanting every position to potentially be a difference maker. Philosophically we would have no problem with concentrating even more, but clients often have a problem with the volatility that comes with having fewer holdings.

RR: I actually have an experiment going on this front since June 30, 1984. I have an IRA account that was set up then and over that period has only been invested in stocks that the Capital Fund has owned, but with never more than five holdings at a time. I’ll buy a stock only after the fund buys it and sell only after the fund sells it. From June 30, 1984 to December 31, 2009, when I stepped down from lead management, the Capital Fund had compounded at approximately 15% per year. But this IRA account had a compound rate of return of 24%. I attribute that premium to the higher concentration and to the fact that at no point has this account been affected by the inflows and outflows resulting from others’ emotional decision making. I was the only investor.”

Turnover

“Does the effort to avoid emotional decision-making explain the Capital Fund’s relatively low turnover?

RR: The turnover ratio has averaged 20% since 1986. Part of that is a function of investing with a long time horizon in companies that don’t get better or realize hidden value overnight. Sticking with your conviction in such cases can certainly require patience and discipline that many investors might not have. Low turnover is also related to the fact that we’re slow to transition from companies we own and know intimately to those whose stocks we’re looking to buy and don’t know as well. There’s a transition risk there that we usually address by taking a long time to both scale into something as well as to scale out of it.”

Cash, Liquidity

“Right now we believe the stimulus of lower interest rates has propped up the economy, which props up profits, which props up stock prices. So in our modeling work we’re not taking today as “normal” and going from there. We’re building in the potential impact of interest rates rising, say, and the resulting lower level of economic activity. That type of conservatism in setting our intrinsic values explains why we have 30% of the portfolio today in cash.

RR: You don’t know the value of liquidity until you need it and don’t have it. That’s when people are selling what they can, not what they want to…People today say, “I can’t afford to earn zero return on my cash.” But if you’re a contrarian value investor, you should be used to deploying capital into an area that no one loves and where the consensus can’t understand why anyone in his or her right mind would invest. I would argue that is how people are thinking about holding cash today, which makes us glad we have it.”

Howard Marks' Book: Chapter 14

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 14 “The Most Important Thing Is…Knowing What You Don't Know” Mistakes, Sizing, Diversification, Leverage, Opportunity Cost

“…the biggest problems tend to arise when investors forget about the difference between probability and outcome – that is, when they forget about the limits on foreknowledge:

• when they believe the shape of the probability distribution is knowable with certainty (and that they know it),
• when they assume the most likely outcome is the one that will happen,
• when they assume the expected result accurately represents the actual result, or
• perhaps most important, when they ignore the possibility of improbable outcomes.”

“Investors who feel they know what the future holds will act assertively: making directional bets, concentrating positions, levering holdings, and counting on future growth – in other words, doing things that in the absence of foreknowledge would increase risk. On the other hand, those who feel they don’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possible outcomes.”

“If you know the future, it’s silly to play defense. You should behave aggressively and target the greatest winners; there can be no loss to fear. Diversification is unnecessary, and maximum leverage can be employed. In fact, being unduly modest about what you know can result in opportunity costs (foregone profits). On the other hand…Mark Twain put it best: ‘It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.’”

A few months ago, we wrote about Michael Mauboussin’s discussion on utilizing the Kelly Formula for portfolio sizing decisions. The Kelly Formula is based upon an investor’s estimation of the probability and amount of payoff. However, if the estimation of probability and payoff amount is incorrect, the mistake will impact portfolio performance through position sizing. It’s a symmetrical relationship: if you are right, the larger position size will help performance; if you are wrong, the larger position size will hurt performance.

Marks’ words echo a similar message. They remind us that an investor’s perception of future risk/reward drives sizing, leverage, and a variety of other portfolio construction and management decisions. If that perception of future risk/reward is correct/incorrect, it will lead to a positive/negative impact on performance, because “tactical decisions like concentration, diversification, and leverage are symmetrical two-way swords.” In order to add value, or generate alpha, an investor must create asymmetry which comes from “superior personal skill.” One interpretation of superior personal skill is correct perception of future risk/reward (and structuring the portfolio accordingly).

Psychology

“Awareness of the limited extent of our foreknowledge is an essential component of my approach to investing.”

“Acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage.”

“No one likes having to invest for the future under the assumption that the future is largely unknowable. On the other hand, if it is, we’d better face up to it and find other ways to cope…Whatever limitations are imposed on us in the investment world, it’s a heck of a lot better to acknowledge them and accommodate them than to deny them and forge ahead.”

Investors must embrace uncertainty and the possibility of unpredictable events. Acknowledgement of “the boundaries of what you can know” won’t make you immune from the possible dangers lurking in the unknown future, but at least you won’t be shocked psychologically if/when they occur.

Macro, Luck, Process Over Outcome

“…the future is unknowable. You can’t prove a negative, and that certainly includes this one. However, I have yet to meet anyone who consistently knows what lies ahead macro-wise. Of all the economists and strategists you follow, are any correct most of the time?”

“…if the forecasters were sometimes right – and right so dramatically – then why do I remain so negative on forecasts? Because the important thing in forecasting isn’t getting it right once. The important thing is getting it right consistently.”

“One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fixed view long enough, you may be right sooner or later. And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did. But that doesn’t mean your forecasts are regularly of any value…It’s possible to be right about the macro-future once in a while, but not on a regular basis. It doesn’t do any good to possess a survey of sixty-four forecasts that includes a few that are accurate; you have to know which ones they are. And if the accurate forecasts each six months are made by different economists, it’s hard to believe there’s much value in the collective forecasts.”

“Those who got 2007-2008 right probably did so at least in part because of a tendency toward negative views. As such, they probably stayed negative for 2009.”

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.”

Michael Price & Portfolio Management

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

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

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

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

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

Sizing, Diversification

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

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

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

When To Sell, Mistakes, Tax

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

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

PM Jar Exclusive Interview With Howard Marks - Part 3 of 5

Below is Part 3 of PM Jar’s interview with Howard Marks, the co-founder and chairman of Oaktree Capital Management, on portfolio management. Part 3: The Intertwining Debate of Diversification and Concentration

“Diversification in itself does not add or subtract value, it only affects the probabilities.”

PM Jar: During times when you are overwhelmed by opportunities, such as in late 2008, do you diversify your portfolio and buy everything that looks attractive, or do you concentrate and buy the one or two most compelling things?

Marks: We’re diversifiers because we’re conservative investors, and one of the hallmarks of conservatism is diversification. The more you bet in each situation, the more you make if you’re right, and the more you lose if you’re wrong. For the diversifier, his highs are less high and his lows are less low. We tend to diversify.

As you describe, in late 2008, when there were a million bargains around, we tended to have a very diverse portfolio. In another period, like 2006, when there aren’t too many bargains around, we may have a more concentrated portfolio (because we can’t find that many attractive things). But our preference is to have a diversified portfolio.

PM Jar: Does your diversification-concentration preference change depending on where you think the pendulum is located across market cycles?

Marks: Our preference doesn’t change. Our preference is to be diversified. However, the ability to have a highly diversified portfolio of attractive securities changes from time to time, and we have to change with it. If you insist on having a highly diversified portfolio in periods when there aren’t many bargains around, then by definition, you have to buy non-bargains, or very risky things.

PM Jar: In 2008, a number of fund managers kept concentrated portfolios of “cheap” names, but concentration did not protect them during the crisis.

Marks: You can’t make any generalizations from 2008. It was an extreme outlier in terms of how bad things got. I wrote a memo in that period, in which I used the section heading “How Bad Is Bad?” People often say, “We want to be prepared for the worst case.” But how bad is the worst case?

2008 was worse than anybody’s worst case. Diversification didn’t work. It didn’t matter whether you were diversified between stocks or bonds, among stocks, or among bonds – everything got hurt. The only things that worked were Treasurys, gold and cash.

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.

Correlation is a funny thing. In theory, every security has a risk and a return. Even if you’re a genius and can quantify the risk and return for every security, you wouldn’t necessarily form a portfolio composed of all the securities that had the best ratio of return to risk, because you have to consider correlation. If something happens in the economy, do they all perform the same or do they perform differently? If you buy 100 securities and they all respond the same way to a given change in the environment, then you don’t have any diversification. But if you have 50 securities which perform differently in response to a given change in the environment, then you do have diversification. It’s not the number of things you own, it’s whether they perform differently. A skillful investor anticipates, understands, and senses correlation.

These managers you mentioned knew their securities, but they obviously did not accurately estimate how bad things could get in the crisis. As you know from reading my book, one of my favorite adages is: “Never forget the six-foot tall man who drowned crossing the stream that was 5-feet deep on average.” So those guys may have been tall but they didn’t make it across. And if not, then was there anything that they should have done to enable them to get across? But it’s very, very hard to second guess behavior in 2008 because it’s very hard to have a portfolio that would do okay in 2008.

PM Jar: The second to last chapter of your book is titled “Adding Value,” and in it you describe that in order to add value, an investor has to build a portfolio that has asymmetry on the upside versus downside. If you run a concentrated portfolio in a more expensive environment, is that a way to lower downside exposure?

Marks: Concentration is a source of safety only if you have superior insight into what you are doing. If you have no insight, or inferior insight, then concentration is a source of risk. Diversification in itself does not add or subtract value, it only affects the probabilities. Concentration is better if you have superior insight, and diversification is better if you have limited insight. Neither one is better than the other per se. These things are intertwined.

Continue Reading — Part 4 of 5: The Art of Transforming Symmetry into Asymmetry

Bill Lipschutz: Dealing With Mistakes

The following excerpts are derived from Jack Schwager’s interview with Bill Lipschutz in The New Market Wizards. Lipschutz helped build and ran Salomon’s currency desk for many years – here is a 2006 EuroMoney Article with additional background on Bill Lipschutz. There are number of worthwhile portfolio management tidbits here, mainly the relationship between making mistakes, portfolio sizing & exposure, and controlling one’s psychological reactions. Mistake, Liquidity, Psychology, Process Over Outcome

“Missing an opportunity is as bad as being on the wrong side of a trade…”

“…the one time since I first started trading that I was really scared…our position size at the time was larger than normal…the dollar started moving up in New York, and there was no liquidity. Very quickly it was up 1 percent, and I knew that I was in trouble [1% of $3 billion = $30 million loss]…It transpired in just eight minutes. All I wanted to do was to make it through to the Tokyo opening at 7pm for the liquidity…By the time Tokyo opened, the dollar was moving down, so I held off covering half the position as I had previously planned to do. The dollar kept collapsing, and I covered the position in Europe…The reason that I didn’t get out on the Tokyo opening was that it was the wrong trading decision...

…That was the first time it hit home that, in regards to trading, I was really very different from most people around me. Although I was frightened at the time, it wasn’t a fear of losing my job or concern about what other people would think of me. It was a fear that I had pushed the envelope too far – to a risk level that was unacceptable. There was never a question in my mind about what steps needed to be taken or how I should go about it. The decision process was not something that was cloudy or murky in my vision. My fear was related to my judgment being so incorrect – not in terms of market direction (you can get that wrong all the time), but in terms of drastically misjudging the liquidity. I had let myself get into a situation in which I had no control. That had never happened before.”

“Q: Let’s say that the dollar started to go up – that is, in favor of the direction of your trade – but the fundamentals that provided your original premise for the trade has changed. Do you still hold the position because the market is moving in your favor, or do you get out because your fundamental analysis has changed?

A: I would definitely get out. If my perception that the fundamentals have changed is not the market’s perception, then there’s something going on that I don’t understand. You don’t want to hold a position when you don’t understand what’s going on. That doesn’t make any sense.”

Liquidity is your friend when it comes to dealing with mistakes.

Mistakes, Psychology, Sizing, When To Buy, When To Sell, Exposure, Expected Return

“When you’re in a losing streak, your ability to properly assimilate and analyze information starts to become distorted because of the impairment of the confidence factor, which is a by-product of a losing streak. You have to work very hard to restore that confidence, and cutting back trading size helps achieve that goal.”

“Q: For argument’s sake, let’s say that the fundamentals ostensibly don’t change but the dollar starts going down. How would you decide that you’re wrong? What would prevent you from taking an open-ended loss?

A: …if the price action fails to confirm my expectations will I be hugely long? No, I’m going to be flat and buying a little bit on the dips. You have to trade at a size such that if you’re not exactly right in your timing, you won’t be blown out of your position. My approach is to build to a larger size as the market is going my way. I don’t put on a trade by saying, “My God, this is the level; the market is taking off right from here.” I am definitely a scale-in type of trader.

Q: Do you believe your scaling type of approach in entering and exiting positions is an essential element in your overall trading success?

A: I think it has enabled me to stay with long-term winners much longer than I’ve seen most traders stay with their positions. I don’t have a problem letting my profits run, which many traders do. You have to be able to let your profits run. I don’t think you can consistently be a winning trader if you’re banking on being right more than 50% of the time. You have to figure out how to make money being right only 20 to 30 percent of the time.”

Very interesting way to think about overall expected return of a portfolio – how to make profits if you are right only 20-30% of the time. This highlights the concept that in investing, it doesn’t matter how often you are right or wrong, what ultimately matters is how much you make when you are right and how much you lose when you are wrong.

Volatility, Exposure, Correlation

“…playing out scenarios is something that I do all the time. That is a process a fundamental trader goes through constantly. What if this happens? What if this doesn’t happen? How will the market respond? What level will the market move to…

…Generally speaking, I don’t think good traders make gut or snap decisions – certainly not traders who last very long. For myself, any trade idea must be well thought out and grounded in reason before I take the position. There are a host of reasons that preclude a trader from making a trade on a gut decision. For example, before I put on a trade, I always ask myself, ‘If this trade does wrong, how do I get out?’ That type of question becomes much more germane when you’re trading large position sizes. Another important consideration is the evaluation of the best way to express a trade idea. Since I usually tend not to put on a straight long or short position, I have to give a lot of thought as to what particular option combination will provide the most attractive return/risk profile, given my market expectations. All of these considerations, by definition, preclude gut decisions.”

Is not “playing out scenarios” within one’s mind a form of attempting to anticipate possible scenarios of expected volatility?

Trade structuring is an under-discussed topic. Many people buy or short things without understanding/considering the true exposure – standalone and/or when interacting with existing portfolio positions. In the words of Andy Redleaf of Whitebox, “The really bad place to be is where all too many investors find themselves much of the time, owning the wrong things by accident. They do want to own something in particular; often they want to own something quite sensible. They end up owning something else instead.”

Sizing, Psychology

“Q: Beside intelligence and extreme commitment, are there any other qualities that you believe are important to excel as a trader?”

A: Courage. It’s not enough to simply have the insight to see something apart from the rest of the crowd, you also need to have the courage to act on it and to stay with it. It’s very difficult to be different from the rest of the crowd the majority of the time, which by definition is what you’re doing if you’re a successful trader.”

Also true for fundamental investors.

Risk, Diversification, Exposure

“Q: How did the sudden demise of your personal account change you as a trader?

A: I probably became more risk-control oriented. I was never particularly risk averse…There are a lot of elements to risk control: Always know exactly where you stand. Don’t concentrate too much of your money on one big trade or group of highly correlated trades. Always understand the risk/reward of the trade as it now stands, not as it existed when you put the position on. Some people say, ‘I was only playing with the market’s money.’ That’s the most ridiculous thing I ever heard.”

Team Management

“…John [Gutfreund of Salomon Brothers] could smell death at a hundred paces. He didn’t need to know what your position was to know…how it was going. He could tell the state of your equity by the amount of anxiety he saw in your face.”

Time Management

“By the way, when I talk about working hard, I meant commitment and focus; it has nothing to do with how many hours you spend in the office.”

More Than You Know: Chapter 1

Below are numerous psychological gems extracted from Chapter 1 of More Than You Know by Michael Mauboussin. Also be sure to check out his thoughts on Process Over Outcome. Psychology, Sizing

“The behavioral issue of overconfidence comes into play here. Research suggests that people are too confident in their own abilities and predictions. As a result, they tend to project outcome ranges that are too narrow. Numerous crash-and-burn hedge fund stories boil down to committing too much capital to an investment that the manager overconfidently assessed. When allocating capital, portfolio managers need to consider that unexpected events do occur.”

“…we often believe more information provides a clearer picture of the future and improves our decision making. But in reality, additional information often only confuses the decision-making process. Researchers illustrated this point with a study of horse-race handicappers. They first asked the handicappers to make race predictions with five pieces of information. The researchers then asked the handicappers to make the same predictions with ten, twenty, and forty pieces of information for each horse in the race…even though the handicappers gained little accuracy by using the additional information, their confidence in their predictive ability rose with the supplementary data.”

Too much incremental information can lead to a false sense of comfort, overconfidence bias, and too narrow outcome ranges.

Given our psychological propensity for overconfidence and too narrow outcome predictions, does this mean portfolio sizing decisions should be based not only on what we know, but also on what we don’t know? As if investing wasn’t hard enough already…

Psychology, Expected Return

“Probabilities alone are insufficient when payoffs are skewed…another concept from behavioral finance: loss aversion. For good evolutionary reasons, humans are averse to loss when they make choices between risky outcomes. More specifically, a loss has about two and a half times the impact of a gain of the same size. So we like to be right and hence often seek high-probability events. A focus on probability is sound when outcomes are symmetrical, but completely inappropriate when payoffs are skewed…So some high-probability propositions are unattractive, and some low-probability propositions are very attractive on an expected-value basis.”

Certainty and being “right,” does not always equate to profits. Paraphrasing the great Stan Druckenmiller, being right or wrong doesn’t matter, it’s how much you make when you’re right and how much you lose when you’re wrong that ultimately matters in investing.

Team Management, Psychology

“…the way decisions are evaluated affects the way decisions are made.”

“One of my former students, a very successful hedge fund manager, called to tell me that he is abolishing the use of target prices in his firm for two reasons. First, he wants all of the analysts to express their opinions in expected value terms, an exercise that compels discussion about payoffs and probabilities. Entertaining various outcomes also mitigates the risk of excessive focus on a particular scenario -- a behavioral pitfall called “anchoring.”

Second, expected-value thinking provides the analysts with psychological cover when they are wrong. Say you’re an analyst who recommends purchase of a stock with a target price above today’s price. You’re likely to succumb to the confirmation trap, where you will seek confirming evidence and dismiss or discount disconfirming evidence.

If, in contrast, your recommendation is based on an expected-value analysis, it will include a downside scenario with an associated probability. You will go into the investment knowing that the outcome will be unfavorable some percentage of the time. This prior acknowledgement, if shared by the organization, allows analysts to be wrong periodically without the stigma of failure.”

Risk

“The only certainty is that there is no certainty. This principle is especially true for the investment industry, which deals largely with uncertainty…With both uncertainty and risk, outcomes are unknown. But with uncertainty, the underlying distribution of outcomes is undefined, while with risk we know what that distribution looks like. Corporate undulation is uncertain; roulette is risky…"

How interesting, some people associated risk with uncertainty, but Mauboussin highlights an interesting nuance between the two.

Mauboussin on Position Sizing

Below are excerpts from an article written by Michael Mauboussin in 2006 on the importance of position sizing (Size Matters). For fans of the Kelly formula, this is a must-read. Mauboussin highlights a few very important flaws of the Kelly formula when applied to our imperfect, non-normally distributed world of investing. Sizing, Diversification

“To suppose that safety-first consists in having a small gamble in a large number of different [companies] where I have no information to reach a good judgment, as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment policy. -- John Maynard Keynes, Letter to F.C. Scott, February 6, 1942”

“As an investor, maximizing wealth over time requires you to do two things: find situations where you have an analytical edge; and allocate the appropriate amount of capital when you do have an edge. While Wall Street dedicates a substantial percentage of time and effort trying to gain an edge, very few portfolio managers understand how to size their positions to maximize long-term wealth.”

“Position size is extremely important in determining equity portfolio returns. Two portfolio managers with the same list and number of stocks can generate meaningfully different results based on how they allocate the capital among the stocks. Great investors don’t stop with finding attractive investment opportunities; they know how to take maximum advantage of the opportunities. As Charlie Munger says, good investing combines patience and aggressive opportunism.”

This is consistent with my belief that investors can differentiate himself/herself from the pack by going beyond security selection, and applying superior portfolio management tactics.

Sizing, Expected Return, Fat Tails, Compounding, Correlation

“We can express the Kelly formula a number of ways. We’ll follow Poundstone’s exposition: Edge / Odds = F

Here, edge is the expected value of the financial proposition, odds reflect the market’s expectation for how much you win if you win, and F represents the percentage of your bankroll you should bet. Note that in an efficient market, there is no edge because the odds accurately represent the probabilities of success. Hence, bets based on the market’s information have zero expected value (this before the costs associated with betting) and an F of zero…if there is a probability of loss, even with a positive expected value economic proposition, betting too much reduces your expected wealth.”

"Though basic, this illustration draws out two crucial points for investors of all stripes: • An intelligent investor needs an edge (a view different than that of the market); and • An investor needs to properly allocate capital to maximize value when an investment idea does appear."

“In the stock market an investor faces many more outcomes than a gambler in a casino…Know the distribution. Long-term stock market investing differs from casino games, or even trading, because outcomes vary much more than a simple model suggests. Any practical money management system faces the challenge of correcting for more complicated real-world distributions. Substantial empirical evidence shows that stock price changes do not fall along a normal distribution. Actual distributions contain many more small change observations and many more large moves than the simple distribution predicts. These tails play a meaningful role in shaping total returns for assets, and can be a cause of substantial financial pain for investors who do not anticipate them.”

“…the central message for investors is that standard mean/variance analysis does not deal with the compounding of investments. If you seek to compound your wealth, then maximizing geometric returns should be front and center in your thinking…For a geometric mean maximization system to work, an investor has to participate in the markets over the long term. In addition, the portfolio manager must be able to systematically identify investment edges—points of view different than that of the market and with higher expected returns. Finally, since by definition not all market participants can have an edge, not all investors can use a Kelly system. In fact, most financial economists believe markets to be efficient. For them, a discussion of optimal betting strategy is moot because no one can systematically gain edges.”

Notice in order for the Kelly Formula to work effectively, the devil (as usual) lies in the details. Get the odds wrong, or get the edge wrong, the sizing allocation will be wrong, which can reduce your expected wealth.

Another question that I’ve been pondered is how the Kelly formula/criterion accounts for correlation between bets. Unlike casino gambling, probability outcomes in investing are often not independent events.

Psychology, Volatility

“The higher the percentage of your bankroll you bet (f from the Kelly formula) the larger your drawdowns.

Another important lesson from prospect theory—and a departure from standard utility theory—is individuals are loss averse. Specifically, people regret losses roughly two to two and a half times more than similar-sized gains. Naturally, the longer the holding period in the stock market the higher the probability of a positive return because stocks, in aggregate, have a positive expected value. Loss aversion can lead investors to suboptimal decisions, including the well-documented disposition effect.

Investors checking their portfolios frequently, especially volatile portfolios, are likely to suffer from myopic loss aversion. The key point is that a Kelly system, which requires a long-term perspective to be effective, is inherently very difficult for investors to deal with psychologically.”

“Applying the Kelly Criterion is hard psychologically. Assuming you do have an investment edge and a long-term horizon, applying the Kelly system is still hard because of loss aversion. Most investors face institutional and psychological constraints in applying a Kelly-type system.”

Buffett Partnership Letters: 1968 & 1969

During 1969, the Partnership transitioned into Berkshire Hathaway. Therefore this concludes our series on portfolio management and the Buffett Partnership Letters. Please see our previous articles in this series. Control, Hurdle Rate, Compounding, When To Sell

“…controlled companies (which represent slightly over one-third of net assets at the beginning of the year)…we cannot make the same sort of money out of permanent ownership of controlled businesses that can be made from buying and re-selling such businesses, or from skilled investment in marketable securities. Nevertheless, they offer a pleasant long term form of activity (when conducted in conjunction with high grade, able people) at satisfactory rates of return.”

“Particularly outstanding performances were turned in by Associated Cotton Shops, a subsidiary of DRC run by Ben Rosner, and National Indemnity Company, a subsidiary of B-H run by jack Ringwalt. Both of these companies earned about 20% on capital employed in their businesses.”

We’ve previously written that portfolio capital compounding can be achieved in multiple ways:

• “Compounding can be achieved by the portfolio manager / investor when making investments, which then (hopefully) appreciates in value, and the repetition of this cycle through the reinvestment of principal and gains. However, this process is limited by time, resources, availability of new ideas to reinvest capital, etc.”

• Compounding can be achieved by operating entities owned in the portfolio by “reinvesting past earnings back into the same business (or perhaps new business lines). In this respect, the operating business has an advantage over the financial investor, who must constantly search for new opportunities.”

In the quotes above, Buffett was referring to the latter method.

Toward the end of the Partnership, Buffett struggled with the continuous churn & reinvestment process as prices in the marketplace rose and rendered good capital reinvestment opportunities difficult to find. Enter the attractiveness of leaving capital with operating entities (in which he had a controlling stake) that can generate profits (compound) & reinvestment capital, at “satisfactory rates of return,” without Buffett having to watch too closely (provided he found “high grade, able people” to oversee these control investments).

Buffett seemed agnostic between the two as long as the control situations produced “satisfactory rates of return.” As always, the devil lies in the details: what is a “satisfactory rate of return”? Was this figure Buffett’s mental hurdle rate?

Nevertheless, this serves as an useful reminder to investors today that the process of buying and selling assets is not the only way to compound and generate portfolio returns. In fact, sometimes it’s better to hold on to an asset, especially when good reinvestment opportunities are rare.

Process Over Outcome

“It is possible for an old, over-weight ball player, whose legs and batting eye are gone, to tag a fast ball on the nose for a pinch-hit home run, but you don’t change your line-up because of it.”

AUM, Sizing

“…our $100 million of assets further eliminates a large portion of this seemingly barren investment world, since commitments of less than about $3 million cannot have a real impact on our overall performance, and this virtually rules out companies with less than about $100 million of common stock at market value…”

Returning Capital

For those searching for language related to returning capital, the letter dated May 29^th, 1969 is a must read.

Ruane Cunniff Goldfarb 2012 Annual Letter

Portfolio management highlights extracted from Ruane Cunniff Goldfarb's Sequoia Fund 2012 Annual Letter. These letters always make for pleasant reading, with candid and insightful commentary on portfolio positions and overall market conditions. Risk Free Rate, Discount Rate

“Valuations for stocks are heavily influenced by interest rates, and particularly by the risk-free rate of return on 10-year and 30-year United States Treasury bonds. Relative to the current return on Treasury Bonds, stocks continue to be quite attractive. However, the current risk-free rate of return is not a product of market forces. Rather, it is an instrument of Federal Reserve policy. As long as these policies remain in place, and stocks trade at higher levels of valuation, it will be more difficult for us to find individual stocks that meet our criteria for returns on a risk basis that incorporates substantially higher interest rates than exist currently. Just as we think it would be a mistake for investors to buy bonds at current levels, we believe it would be a mistake for us to buy stocks on the assumption that interest rates remain anywhere near current levels.”

People often equate interest rate risk with bonds, not with equities. As the quote above points out, all assets are to some degree sensitive to changes in interest rates for a variety of reasons. For more on the relationship between equities and interest rates, be sure to read Warren Buffett’s 1977 article How Inflation Swindles the Equity Investor. 

Diversification, Sizing, Volatility

“Though it contradicts academic theory, we believe a concentrated portfolio of businesses that has been intensively researched and carefully purchased will generate higher returns with less risk over time than a diverse basket of stocks chosen with less care. However, a concentrated portfolio may deliver results in an individual year that do not correspond closely to the returns generated by the broader market.”

Diversification (or concentration) and sizing decisions will materially impact the expected volatility of a portfolio, but not always in the manner that academic theory predicts. 

Cash, Expected Return, Volatility

“If it is not already abundantly clear, you should be aware that our large cash position could act as an anchor on returns in a prolonged bull market. Conversely, in a bear market the cash might cushion the fall of stock prices and provide us with flexibility to make new investments.”

Portfolio cash balance is a double edge sword – providing cushion in down markets and acting as performance drag in up markets. In other words, a material cash balance will most definitely impact the expected return and expected volatility of the portfolio, for better or for worse.

36South: Profiting from the Tails

Many have read about Cornwall Capital (I wrote about them awhile back), a firm that successfully profited from shorting subprime CDS. Those who enjoyed the Cornwall Capital piece are in for a treat. Below are highlights extracted from an Eurekahedge interview with Richard Hollington of 36South, a hedge fund that also specializes in profiting from volatility and tail risk. This piece is a little longer than our usual articles. There is a lot of good commentary below on how to source, execute, size, and manage portfolio hedges. However, reading this article does not a hedging expert make. In other words, I don’t recommend trying this at home.

Hedging, Derivatives, Fat Tail, Barbell, Sizing, Expected Return, Volatility

“The underlying philosophy is that markets are rational most of the time but 5% of the time rationality gets thrown out of the window, whether because people have made money too easily and become complacent or have lost money too quickly and are so distressed that they are off-loading assets below their intrinsic worth. The emphasis of this approach is market psychology. We search for fear, greed, hysteria and mania. We sell into a bubble about to burst and buy into a post-crash recovery. Bubbles as we know, can take time to play themselves out over an extended period of time and their turning points are normally associated with high volatility. This makes the method of investing in an opportunity critical. Normally it is better to wait until the bubble is bursting as the markets tend to go a lot higher or lower than one thinks. The downside to this is that the move might be over in a short period of time.”

“Our investment methodology is to BUY ONLY long dated “out-of-the-money” options. This methodology has some excellent features…these options can return multiples of the original investment. We look for options that have the potential to return between 5 and 10 times the original investment. Because of their high reward characteristics, only 10-20% of the fund need be invested in these options to achieve our target returns of 15-25%. Our worst case loss is thus known, being the amount invested in options…Our rationale here is that one can never get killed jumping out of a basement window!”

“We zero in on…situations by using our in-house developed ‘Quadrivium’ Methodology. Quadrivium literally means where four rivers meet and a strategy which conforms to criteria required in each of the four circles in our approach will be selected to form a portion of our risk portfolio. The four criteria are used in conjunction with each other in order to ‘ensure that one reality respects all other realities’ as Charlie Munger put it so well. These criteria are:

• Volatility has already been covered. We ensure the option (using volatility as a proxy) is cheap enough to provide the leverage we require for the level of risk.
• The next criterion is to look at the technical picture of the market to seek confirmation that there is potential for market movement to the extent and in the direction that we require to attain a multiple return on the option price.
• The next criterion is fundamentals in that market/asset/option to corroborate our view. We have developed a framework of economic indicators that we monitor in each of the markets we have selected to trade. We are specifically looking for flaws in the structure of markets which are caused by government policy and supply demand imbalances.
• The next step in the process is based on the sentiment prevailing in the market that we wish to trade. Sentiment often becomes deeply entrenched at market tops and bottoms to the extent that supporters of the status quo can become aggressive in defense of their beliefs. In order to gauge the prevailing sentiment in the market we use Internet searches for key words and couple this with feedback obtained from diverse media coverage. These media opinions can reflect ‘irrational exuberance’ or deep-seated pessimism on a particular stock, index, commodity or currency. These quotations from seasoned professionals in the financial markets encapsulate the essence of this driver of our trading philosophy.”

“Since we know exactly what the current option portfolio is worth we can safely say that this is the absolute worst-case meltdown in the fund based on market risk. This would be an extremely unlikely scenario because long dated options always have some time value and it would mean all positions have moved against us in all asset markets and volatilities have collapsed at the same time. We manage each option on a stop-loss methodology. The stop-loss is based on the number of times the initial option premium multiplies. The first stop is instituted when the option premium has increased three fold. At this level a 60% stop on the option price is registered. As it moves to four times, the stop is tightened to 50% and so on until a maximum of eight times when the stop will be 10%. At this point in time the option has earned the right to discretionary stop-loss status as long as it does not hit the 10% in place. A profit target is then calculated which is based on a three standard deviation move above the 200-day moving average. We will also sell options which have only a year to run if they have not achieved the minimum 3-fold increase and are still worth something.”

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.

Buffett Partnership Letters: 1966 Part 1

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

“Proponents of institutional investing frequently cite its conservative nature. If ‘conservatism’ is interpreted to mean ‘productive of results varying only slightly from average experience,’ I believe the characterization is proper…However, I believe that conservatism is more properly interpreted to mean ‘subject to substantially less temporary or permanent shrinkage in value than total experience.’” 

“The first might be better labeled ‘conventionalism’ what it really says is that ‘when others are making money in the general run of securities, so will we and to about the same degree; when they are losing money, we’ll do it at about the same rate.’ This is not to be equated with ‘when others are making it, we’ll make as much and when they are losing it, we will lose less.’ Very few investment programs accomplish the latter – we certainly don’t promise it but we do intend to keep trying.”

Notice Buffett’s definition of conservatism in investing involves both “temporary or permanent shrinkage in value” – this is in contrast to a later Buffett who advises shrugging off temporary shrinkages in value. Why this change occurred is subject to speculation.

The second quote is far more interesting. Buffett links the concept of conservatism with the idea of portfolio volatility upside and downside capture vs. an index (or whatever industry benchmark of your choosing).

Ted Lucas of Lattice Strategies wrote an article in 2010 attributing Warren Buffett’s investment success to Buffett’s ability, over a long period of time, to consistently capturing more upside than downside volatility vs. the S&P 500. Based on the quote above, Buffett was very much cognizant of the idea of portfolio volatility upside vs. downside capture, so Ted Lucas’ assertion may very well be correct.

Sizing, AUM

“In the last three years we have come up with only two or three new ideas a year that have had such an expectancy of superior performance. Fortunately, in some cases, we have made the most of them…It is difficult to be objective about the causes for such diminution of one’s own productivity. Three factors that seem apparent are: (1) a somewhat changed market environment; (2) our increased size; and (3) substantially more competition.

It is obvious that a business based upon only a trickle of fine ideas has poorer prospects than one based upon a steady flow of such ideas. To date the trickle has provided as much financial nourishment as the flow…a limited number of ideas causes one to utilize those available more intensely.”

Sizing is important because when good ideas are rare, you have to make the most of them. This is yet another example of how, when applied correctly, thoughtful portfolio construction & management could enhance portfolio returns.

As AUM increases or declines, and as availability of ideas ebb and flow – both of these factors impact a wide variety of portfolio management decisions.

When To Buy, Intrinsic Value, Expected Return , Opportunity Cost

“The quantitative and qualitative aspects of the business are evaluated and weighted against price, both on an absolute basis and relative to other investment opportunities.”

“…new ideas are continually measured against present ideas and we will not make shifts if the effect is to downgrade expectable performance. This policy has resulted in limited activity in recent years…”

Buffett’s buying decision were based not only on the relationship between purchase price and intrinsic value, but also contribution to total “expectable performance,” and an investment’s merits when compared against “other investment opportunities,” the last of which is essentially an opportunity cost calculation.

Sizing, Diversification

“We have something over $50 million invested, primarily in marketable securities, of which only about 10% is represented by our net investment in HK [Hochschild, Kohn, & Co]. We have an investment of over three times this much in a marketable security…”

Hochschild, Kohn = 10% NAV

Another investment = “three times” size of Hochschild, or ~30% NAV

So we know in 1966, 40% of Buffett’s portfolio NAV is attributable to 2 positions.

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.