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.”

Buffett Partnership Letters: 1967 Part 2

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. For any business, tapping the right client base and keeping those clients happy is crucial. To do so, Buffett believed in the establishment of mutually agreed upon objectives, and keeping his clients abreast of any changes in those objectives.

In 1967, change was indeed in the air. In the passages below, Buffett candidly discusses the rationale and impact of these changes (in both his personal life and the market) with his clients. Such behavior in the investment management industry is rather rare, simply because it risks torpedoing an existing (and very lucrative) business model.

Clients

“…some evolutionary changes in several ‘Ground Rules’ which I want you to have ample time to contemplate before making your plans for 1968. Whereas the Partnership Agreement represents the legal understanding among us, the ‘Ground Rules’ represent the personal understanding and in some way is the more important document.”

“Over the past eleven years, I have consistently set forth as the BPL investment goal an average advantage in our performance of ten percentage points per annum in comparison with the Dow…The following conditions now make a change in yardsticks appropriate:

1. The market environment has changed progressively over the past decade, resulting in a sharp diminution in the number of obvious quantitative based investment bargains available;
2. Mushrooming interest…has created a hyper-reactive pattern of market behavior against which my analytical techniques have limited value; 
3. The enlargement of our capital base to about $65 million when applied against a diminishing trickle of good investment ideas has continued to present…problems…;
4. My own personal interests dictate a less compulsive approach to superior investment results than when I was younger and leaner.

“In my opinion what is resulting is speculation on an increasing scale. This is hardly a new phenomenon; however, a dimension has been added by the growing ranks of professional…investors who feel they must ‘get aboard’…To date it has been highly profitable…Nevertheless, it is an activity at which I am sure I would not do particularly well…It represents an investment technique whose soundness I can neither affirm nor deny. It does not completely satisfy my intellect (or perhaps my prejudices), and most definitely does not fit my temperament. I will not invest my own money based upon such an approach – hence, I will most certainly not do so with your money.

Any form of hyper-activity with large amounts of money in securities markets can create problems for all participants. I make no attempt to guess the actions of the stock market…Even if there are serious consequences results from present and future speculative activity, experience suggests estimates of timing are meaningless…

The above may simply be ‘old fogeyism’ (after all, I am 37). When the game is no longer being played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, etc. I have been scornful of such behavior by others in the past. I have also seen the penalties incurred by those who evaluate conditions as they were – not as they are. Essentially, I am out of step with present conditions. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand (although I find it difficult to apply) even though it may mean foregoing large, and apparently easy, profits to embrace an approach which I don’t fully understand, have not practiced successfully and which, possibly, could lead to substantial permanent loss of capital.”

Psychology, Benchmark

“The final, and most important, consideration concerns personal motivation. When I started the partnership I set the motor that regulated the treadmill at ‘ten points better than the Dow.’ I was younger, poorer and probably more competitive. Even without the three previously discussed external factors making for poorer performance [see bullet points at top], I would still feel that changed personal conditions make it advisable to reduce the speed of the treadmill…

Elementary self-analysis tells me that I will not be capable of less than all-out effort to achieve a publicly proclaimed goal to people who have entrusted their capital to me. All-out effort makes progressively less sense…This may mean activity outside the field of investments or it simply may mean pursuing lines within the investment field that do not promise the greatest economic reward. An example of the latter might be the continued investment in a satisfactory (but far from spectacular) controlled business where I like the people and the nature of the business even though alternative investments offered an expectable higher rate of return. More money would be made buying businesses at attractive prices, then reselling them. However, it may be more enjoyable (particularly when the personal value of incremental capital is less) to continue to own them and hopefully improve their performance, usually in a minor way…

Specifically, our longer term goal will be to achieve the lesser of 9% per annum or a five percentage point advantage over the Dow. Thus, if the Dow averages -2% over the next five years, I would hope to average +3% but if the Dow averages +12%, I will hope to achieve an average of only 9%. These may be limited objectives, but I consider it no more likely that we will achieve even these more modest results under present conditions than I formerly did that we would achieve our previous goal of a ten percentage point average annual edge over the Dow.”

Shifting personal goals and life decisions can materially impact future returns.

Time Management

“When I am dealing with people I like, in businesses I find stimulating (what business isn’t), and achieving worthwhile overall returns on capital employed (say, 10-12%) it seems foolish to rush from situation to situation to earn a few more percentage points. It also does not seem sensible to me to trade known pleasant personal relationships with high grade people, at a decent rate of return, for possible irritation, aggravation or worse at potentially higher returns.”

We’ve heard of the concept of risk-adjusted return. But what about time or aggravation-adjusted return?

Munger Wisdom: 2013 Daily Journal Meeting

Below are my personal notes (portfolio management highlights) from Charlie Munger’s Q&A Session during the 2013 Daily Journal Shareholders Meeting this Wednesday in Los Angeles. Opportunity Cost

After the meeting, I approached Munger to ask him about his thoughts on opportunity cost (a topic that he mentioned numerous times while answering questions, and in previous lectures and speeches).

His response: “Everyone should be thinking about opportunity cost all the time.”

During the Q&A session, Munger gave two investment examples in which he cites opportunity cost.

Bellridge Oil: During the the Wheeler-Munger partnership days, a broker called to offer him 300 shares of Bellridge Oil (trading at 20% of asset liquidation value). He purchased the shares. Soon after, the broker called again to offer him 1500 more shares. Munger didn’t readily have cash available to make the purchase and would have had to (1) sell another position to raise cash, or (2) use leverage. He didn’t want to do either and declined the shares. A year and a half later, Bellridge Oil sold for 35x the price at which the broker offered him the shares. This missed profit could have been rolled into Berkshire Hathaway.

Boston-based shoe supplier to JCPenney: One of the worst investments Berkshire made, for which they gave away 2% of Berkshire stock and received a worthless asset in return.

For both examples, opportunity cost was considered in the context of what "could have been" when combined with the capital compounding that transpired at Berkshire.

Making Mistakes, Liquidity

DRC (Diversified Retailing Company) was purchased by Munger & Buffett in the 1960s with a small bank loan and $6 million of equity. Munger owned 10% so contributed $600,000. But as soon as the ink dried on the contract, they realized that it wasn’t all that great a business due to “ghastly competition.” Their solution? Scrambled to get out as FAST as possible.

Related to this, be sure to read Stanley Druckenmiller’s thoughts on making mistakes and its relationship to trading liquidity (two separate articles).

Generally, humans are bad at admitting our mistakes, which then leads to delay and inaction, which is not ideal. Notice Druckenmiller and Munger come from completely different schools of investment philosophies, yet they deal with mistakes the exact same way – quickly – to allow them to fight another day. Liquidity just happens to make this process easier.

Another Munger quote related to mistakes: “People want hope.” Don’t ever let hope become your primary investment thesis.

“Treat success and failures just the same.” Be sure to “review stupidity,” but remember that it’s “perfectly normal to fail.”

Leverage

Munger told story about press expansion – newspapers paying huge sums for other newspapers – relying largely on leverage given the thesis of regional market-share monopolies. Unfortunately, with technology, the monopolies thesis disintegrated, and the leverage a deathblow.

Perhaps the lesson here is that leverage is most dangerous when coupled with a belief in the continuation of historical status quo.

Luck, Creativity

The masterplan doesn’t always work. Some of life’s success stories derive from situations of people reacting intelligently to opportunities, fixing problems as they emerge, or better yet:

“Playing the big bass tuba in an open field when it happened to rain gold.”

Turnover

Munger’s personal account had zero transactions in 2012.

Psychology

On the decline of the General Motors: “prosperity made them weak.”

This is a lesson in hubris, and associated behavioral biases, that's definitely applicable to investment management. Investing, perhaps even more so than most businesses, is fiercely competitive. In this zero sum game, the moment we rest on the laurels of past performance success, and become overconfident etc., is the moment future performance decline begins.

Always be aware, and resist behavior slithering in that dangerous direction.

Mandate

Berkshire had “two reasonable options” to deploy capital, into both public and private markets. Munger doesn’t understand why Berkshire’s model hasn’t been copied more often. It makes sense to have a flexible hybrid mandate (or structure) which allows for deployment of capital into wherever assets are most attractive or cheapest.

Clients, Time Management

Most people are too competitive – they want ALL business available, and sometimes end up doing things that are "morally beneath them," and/or abandon personal standards. Plus, general happiness should be a consideration as well.

The smartest people figure out what business they don’t want and avoid all together – which leads to foregoing some degree of business and profit – that’s absolutely okay. This is what he and Buffett have figured out and tried to do over time.

On doing what’s right: He and Buffett fulfill their fiduciary duty in that they “wanted people who we barely know who happen to buy the stock to do well.” Munger doesn’t think there are that many people in the corporate world who subscribe to this approach today.

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: 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 3

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

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

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

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

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

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

Control, Liquidity

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

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

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

Mark to Market, Subscriptions, Redemptions

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

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

Benchmark, Clients

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

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

Time Management, Team Management, Clients

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

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

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

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

Buffett Partnership Letters: 1965 Part 2

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Trackrecord, Compounding, Duration, Special Situations, Time Management

“A disadvantage of this business is that it does not possess momentum to any significant degree. If General Motors accounts for 54% of domestic new car registrations in 1965, it is a pretty safe bet that they are going to come fairly close to that figure in 1966 due to owner loyalties, deal capabilities, productivity capacity, consumer image, etc. Not so for BPL. We start from scratch each year with everything valued at market when the gun goes off…The success of past methods and ideas does not transfer forward to future ones.”

Investing, compounding, and trackrecord creation is a perpetual intellectual treadmill – “We start from scratch each year with everything valued at market when the gun goes off,” and the “success of past methods and ideas” contribute only slightly to future returns.

In 1965-1966, a large portion of Buffett’s portfolio still consisted of generally undervalued minority stakes and special situation workouts.

Though not often highlighted, duration risk is a very real annoyance for the minority equity investor, especially in rising markets. Takeout mergers may increase short-term IRR, but they can decrease overall cash on cash returns. Mergers also result in cash distributions for which minority investors must find additional redeployment options in a more expensive market environment.

Special situations investors have to run even harder on the intellectual treadmill since their portfolios contain a natural ladder of duration as the special situations resolve and “workout.”

All this activity is subject to the 24 hours per day time constraint. How does one maximize portfolio compounding given these obstacles?

I suspect it was mental debates like these that drove Buffett, in later years, to seek out the continuous compounding investments such as Coca Cola, Wells Fargo, etc., to which he could outsource the task of compounding portfolio equity.

Here’s the basic rationale behind the term “outsourced compounding” extracted from an article I wrote a few months ago:

"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.

Operating business achieve compounding 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.

Tom Russo of Gardner Russo & Gardner, quoted above in a November 2011 edition of Value Investor Insight (many thanks to Rafael Astruc of Garrison Securities for tipping PMJar on this), highlights an important and useful shortcut for portfolio managers – why not outsource part of the burden of compounding to the operating businesses in one’s portfolio? (Price dependent, of course.)"

Expected Return, Volatility, Historical Performance Analysis, Process Over Outcome

“…our results, relative to the Dow and other common-stock-form media usually will be better in declining markets and may well have a difficult time just matching such media in very strong markets. With the latter point in mind it might be imagined that we struggled during the first four months of the half to stay even with the Dow and then opened up our margin as it declined in May and June. Just the opposite occurred. We actually achieved a wide margin during the upswing and then fell at a rate fully equal to the Dow during the market decline.

I don’t mention this because I am proud of such performance – on the contrary. I would prefer it if we had achieved our gain in the hypothesized manner. Rather, I mention it for two reasons: (1) you are always entitled to know when I am wrong as well as right; and (2) it demonstrates that although we deal with probabilities and expectations, the actual results can deviate substantially from such expectations, particularly on a short-term basis.”

Buffett wanted to correctly anticipate not only the expected return, but also the expected volatility of his portfolio. He was not “proud” when the return pattern of the portfolio vs. his index (Dow) did not occur according to his prediction (even though he still beat the index by a wide 9.6% margin during the first 6 months of the year) – “I would prefer it if we had achieved our gain in the hypothesized manner.”

This demonstrates that Buffett was not singularly focused on outcome, but process as well. He wanted to understand why the unexpected (albeit good) outcome occurred despite a process that should have led to something different.

Also, notice that the good outcome did not provide any sense of comfort and lead Buffett to ignore the anomaly in expected volatility. Over the years, I’ve noticed that many investors only dissect downside return anomalies and completely ignore upside return anomalies. Buffett’s actions here show that it’s important to understand both directionally because a rouge variable that causes unexpected upside patterns could just as easily reverse course and lead to unexpected poor results.

Lastly, I want to point out that the key to understanding sources of portfolio return and volatility requires the dissection of historical performance returns. For more on this, check out our discussion on the 1964 letter Part 3.

Planting Seeds of Expected Return

We have been reading (and thoroughly enjoying) the humorously insightful letters of Daruma Capital’s Mariko Gordon (who manages ~$2Bn in a small-cap concentrated strategy). In her Feb 2010 letter, Gordon muses upon the source of portfolio returns (and consequently future portfolio expected return). As we have written in the past, future portfolio returns do not magically materialize via spontaneous generation. Investing amounts roughly to opportunity farming – you reap what you sow, and any harvest of returns is the culmination of past labor.

Gordon thoughtfully considers the topic and its relationship to other aspects of the investment management process, such as time allocation:

“I was explaining our process for finding new ideas when I had this epiphany: Oil and gas companies use the drill bit to grow revenues; portfolio managers use new ideas to generate additional returns in a portfolio. Both work hard to keep a constant pressure - a steady flow - of hydrocarbons or ideas, as the case may be.

In stock picking, however, maintaining the new idea pressure on a portfolio is largely fiction - markets don't strictly follow the laws of physics (too many human beings involved). And so, while we aim for a steady, garden hose stream of new ideas, they tend to make themselves available between the two extremes of ‘fire hose’ and ‘dripping faucet.’

When markets are cheap, we have more ideas than time; triage of the best is the way we add value. When markets are expensive and ideas are scarce, we get the job done by scouring efficiently, patiently and thoroughly.

Yes, we're always on the lookout for new ideas to put pressure on our existing positions…After all, in any given portfolio, on any given day, there are positions that are working, those that are mistakes, and those that are getting long in the tooth. But steady new idea pressure a la hydrostasis? Fairy tales.

And that's the point. Because in our experience, both investors and clients find comfort in believing that there exists a steady flow of new ideas. But we shouldn't collude in that desire for comfort. The commonly asked question, ‘Where do your new ideas come from?’ is largely missing the bigger, more essential point:

Given the cycle of floods and droughts in investment idea generation, what really matters is having a sound strategy for uncovering the best when ideas are as plentiful as mushrooms after a rain, and locating the gems when the pendulum inevitably swings back the other way.”

More Baupost Wisdom

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

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

When To Buy, Conservatism, Barbell

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

When To Buy, Portfolio Review

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

Risk

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

Hedging

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

Hedging, Sizing

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

Cash, AUM

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

Returning Capital, Sizing

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

Leverage

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

Selectivity

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

Time Management, Sizing

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

Team Management

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

Trackrecord

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

Sourcing

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

Lisa Rapuano Interview Highlights - Part 1

Recently, I was lamenting the lack of female representation in investment management. Then in conversation, a friend reminded me of this insightful interview with Lisa Rapuano, who worked with Bill Miller for many years, and currently runs Lane Five Capital Management. The interview touches upon a number of relevant portfolio management topics. Rapuano has obviously spent hours reflecting and contemplating these topics. A worthwhile read!

Portfolio Management

“I think that most investors spend way too much time talking about stocks and way too little talking about portfolio construction.”

Expected Return, Diversification, Sizing

“I’ve learned that you have to have a lot of different risk-reward profiles in your portfolio. You’ll have some things you think can go up 25% but you don’t think can go down very much. You’ll have things that can go up 50% but might go down 30%. Others can go up ten times, but may go down 75%. I try to manage the proper mix of all those. You just can’t have a portfolio where you say everything is priced to have 25% upside with little downside. What’s going to happen is that you’re going to be wrong about two of them and they go down 50% and you’re screwed because nothing else has enough upside to make it up.”

“A word on concentration. You can take it too far. I know there are manager out there who get enthralled with the Kelly Formula and start putting out 25% or 50% positions because this one is REALLY the best. That just defies common sense. Anyone can be wrong, and any outcome can happen, even if it seems low probability. Keeping a minimum 20 name portfolio with about 5% as a normal position keeps you from making those kinds of mistakes.”

I thought the idea of maintaining a variety of expected returns in one’s portfolio was particularly interesting. People frequently discuss diversification in types of ideas/assets, but not often diversification in expected return profiles.

Also, there is wisdom in her caution against blindly using the Kelly Formula (even if you don’t agree with her advice for a 20 position portfolio). Blindly following any rule is simply a bad idea. Putting 25-50% of your portfolio into one security can be pretty painful if/when you are wrong (which happens occasionally even to the best investors).

However, that doesn’t mean one should never put 25-50% of the portfolio into one position. The important takeaway here is maintaining flexibility, being prepared (especially mentally) for the possibility that you could be wrong, and having a “break the glass” contingency plan just in case the worst materializes.

Correlation, Leverage

“We tend to run about 70-100% net long, with a maximum of 100% gross long. Since we run a very concentrated long-term fund on the long side, we believe that going over 100% gross long isn’t prudent.”

Concentration (and thus high portfolio asset correlation) and leverage is a potent combination – the result is likely in the extremes of (1) homerun good or (2) disastrously bad.

Time Management, Sizing

“A new position has to be compelling enough to put at least 3% of the fund in, or it’s not worth dabbling in.”

Wisdom from Steve Romick: Part 1

The content below is extracted from an interview with Steve Romick of First Pacific Advisors (Newsletter Fall 2010) published by Columbia Business School. Be sure to browse the other quarterly newsletters containing interviews with well-known investors. Many thanks to my friend Janice Davies of Karlin Asset Management for tipping PM Jar on this useful link. For more information on Steve Romick and FPA's investment philosophy, explore the FPA website – there’s a wealth of information from old letters, speech transcripts, etc.

Creativity

“I felt that most mutual funds were style box constrained, and didn't take advantage of a deep toolbox…I didn't think there were a lot of public funds out there that invested in such diverse asset classes, but felt that such a vehicle made sense for people. For years, I had to fight the idea that I was a style box manager.”

We’ve previously discussed how the investment management business is no different from a business that makes widgets. It is important to consider one’s competitive advantage vs. the competition, which in Romick’s case is differentiation through creativity of investment mandate.

Romick’s Crescent Fund has the ability implement a variety of investment strategies – such as buying residential whole loans, investing with a community bank private fund, shorting securities, etc. – in a go anywhere opportunistic approach. His mutual fund peers, with their mandate restrictions, are usually not allowed to take advantage of this “deep toolbox.”

Although this freedom to roam mandate may seem like common sense (and more frequently observed with hedge funds), it is still a rarity in today’s institutional mutual fund world, let alone back in the early 1990s.

Time Management

“I realized that you can’t wear all the hats well, and I was wearing too many hats. I wanted to just focus on investing. I wanted someone to insulate me from the marketing and back office. It just took too much time away from the portfolio.”

On why he joined FPA after running his own money management firm for a few years. Romick was wise in recognizing his strength as an investor and potential weakness (or perhaps just low interest level) in dealing with marketing and back office operations.

I have often told people that the investment management business is a 3-legged-stool with each leg representing:

1. Investing
2. Operations
3. Marketing / Client Management

In my previous position at a large single family office with substantial external manager allocations, I had the benefit of meeting many bright investors who left existing employers to launch their own funds. The common denominator for success was surprisingly not investment acumen (of course that helps), it was thoughtful consideration of all three legs of the stool.

With a finite 24 hours in a day, any extra time spent on operations or marketing, equates to less time spent on investing. Few people manage to successfully juggle all three roles. For those who cannot, or prefer not to juggle, the key is to not underestimate the importance of operations and marketing when building an investment management business, and seek help / external expertise when necessary, as Romick did.

Psychology

“Honestly, people shouldn't have given me money then [when he started his own money management firm in 1990]. With what I know now, and what I thought I knew then, it’s such a vast difference. People took a chance on me…I’m better now than I was then. I think that in the money management business, knowledge is cumulative, or rather should be cumulative rather than repetitive, and one should improve the longer one is in the business. I’m much more comfortable wearing the skin of an investor than I was back then. I guess I was too ignorant to realize that when I was younger.”

“G&D: In your first letter in 1993, you wrote that you often found niche companies with excellent track records that Wall Street has yet to discover. Is it worth your time looking for these opportunities now that you have $4 billion under management?                

SR: I think that I was naïve. What is really undiscovered? I think it's morphed from undiscovered to unloved or misunderstood. There aren’t that many undiscovered names out there.”

Other well-known investors have discussed the importance of awareness in the past. Unfortunately, self-awareness is difficult to learn. An effort can be made, but perhaps it merely leads us to think that we are self-aware. Often times, only the benefit of time and experience can reveal to us the mistakes/naiveté of our past/youth.

Buffett Partnership Letters: 1962 Part 1

This is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please see our previous articles for more details. There are 3 separate letters detailing the occurrences of 1962:

• July 6, 1962 – interim (mid-year) letter
• December 24, 1962 – brief update with preliminary tax instructions
• January 18, 1963 – annual (year-end) letter

A slightly off tangent random fact: in 1962, Buffett into new office space stocked with – hold on to your knickers – “an ample supply of Pepsi on hand.”

Benchmark

“In outlining the results of investment companies, I do so not because we operate in a manner comparable to them or because our investments are similar to theirs. It is done because such funds represent a public batting average of professional, highly-paid investment management handling a very significant $20 billion of securities. Such management, I believe, is typical of management handling even larger sums. As an alternative to an interest in the partnership, I believe it reasonable to assume that many partners would have investments managed similarly.”

We’ve discussed in the past the importance of choosing a benchmark. It seems Buffett chose to benchmark himself against the Dow and a group of investment companies not because of similarities in style, but because they represented worthy competition (a group of smart, well-paid, people with lots of resources) and realistic alternatives to where Buffett’s clients would otherwise invest capital.

“Our job is to pile up yearly advantage over the performance of the Dow without worrying too much about whether the absolute results in a given year are a plus or a minus. I would consider a year in which we were down 15% and the Dow declined 25% to be much superior to a year when both the partnership and the Dow advanced 20%.”

Interestingly, the quote above implies that Buffett focused on relative, not absolute performance.

Trackrecord

“Please keep in mind my continuing admonition that six-months’ or even one-year’s results are not to be taken too seriously. Short periods of measurement exaggerated chance fluctuations in performance… experience tends to confirm my hypothesis that investment performance must be judged over a period of time with such a period including both advancing and declining markets…While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance…If any three-year or longer period produces poor results, we all should start looking around for other places to have our money.”

In other words, short-term performance doesn’t mean anything so don’t let it fool you into a false sense of investment superiority. A three-year trackrecord is the absolute minimum upon which results should be judged, although five or more years is best in Buffett’s opinion. Additionally, the last sentence seems to imply that Buffett was willing to shut down the Partnership if return goals were not met.

“If you will…shuffle the years around, the compounded result will stay the same. If the next four years are going to involve, say, a +40%, -30%, +10%, and -6%, the order in which they fall is completely unimportant for our purposes as long as we all are around all the end of the four years.”

Food for thought: the order of annual return occurrence doesn’t impact the final compounding result (as long as you stick around for all the years). Not sure what the investment implications are, just a fun fact I guess – one that makes total sense once Buffett has pointed it out. Basic algebra dictates that the sequential order of figures in a product function doesn’t change the result.

Clients, Time Management

“Our attorneys have advised us to admit no more than a dozen new partners (several of whom have already expressed their desire) and accordingly, we have increased the minimum amount for new names to $100,000. This is a necessary step to avoid a more cumbersome method of operation.”

“…I have decided to emphasize certain axioms on the first pages. Everyone should be entirely clear on these points…this material will seem unduly repetitious, but I would rather have nine partners out of ten mildly bored than have one out of ten with any basic misconceptions.”

Each additional moment spent on client management, is a moment less on investing.

Keeping down the number of clients keeps things simple operationally – at least according to Buffett. I have heard contradicting advice from some fund managers who claim to prefer a larger number of clients (something about Porter’s Five Forces related to Customer Concentration).

For his existing clients, Buffett smartly set ground rules and consistently reminded his clients of these rules, thereby dispelling any myths or incorrect notions and (hopefully) preventing future misunderstandings.

Klarman-Zweig Banter: Part 2

Here is Part 2 of tidbits from a conversation between Seth Klarman and Jason Zweig. Part 1 and the actual text of the interview is available here. Time Management

“…sourcing of opportunity…a major part of what we do – identifying where we are likely to find bargains. Time is scarce. We can’t look at everything.”

“...we also do not waste a lot of time keeping up with the latest quarterly earnings of companies that we are very unlikely to ever invest in. Instead, we spent a lot of time focusing on where the misguided selling is, where the redemptions are happening, where the overleverage is being liquidated – and so we are able to see a flow of instruments and securities that are more likely to be mispriced, and that lets us be nimble.

Team Management

“…we are not conventionally organized. We don’t have a pharmaceutical analyst, an oil and gas analyst, a financials analyst. Instead, we are organized by opportunity.” Examples include spinoffs, distressed debt, post-bankruptcy equities.

During the recruiting and screening process, Baupost looks for “intellectual honesty…we work hard to see whether people can admit mistakes…We ask a lot of ethics-related questions to gauge their response to morally ambiguous situations. We also look for ideational fluency, which essentially means that someone is an idea person…do they immediately have 10 or 15 different ideas about how they would want to analyze it – threads they would want to pull a la Michael Price…we are looking for people who have it all: ethics, smarts, work ethic, intellectual honesty, and high integrity.”

Michael Price, Creativity

Mike taught him the importance of an endless drive to get information and seek value, as well as creativity in seeking opportunities.

“I remember a specific instance when he found a mining stock that was inexpensive. He literally drew a detailed map – like an organization chart – of interlocking ownership and affiliates, many of which were also publicly traded. So, identifying one stock led him to a dozen other potential investments. To tirelessly pull treads is the lesson that I learned from Mike Price.”

Risk, Creativity

The process of risk management is not always straightforward and requires creative thought. “An investor needed to put the pieces together, to recognize that a deteriorating subprime market could lead to problems in the rest of the housing markets and, in turn, could blow up many financial institutions. If an investor was unable to anticipate that chain of events, then bank stocks looked cheap and got cheaper.”

Capital Preservation, Conservatism

“Avoiding round trips and short-term devastation enables you to be around for the long term.”

“We have picked our poison. We would rather underperform in a huge bull market than get clobbered in a really bad bear market.”

During 2008, Baupost employed a strategy of identifying opportunities by underwriting to a depression scenario. “We began by asking, ‘Is there anything we can buy and still be fine in the midst of a depression?’ Our answer was yes…Ford bonds had an amazing upside under almost any scenario – if default rates only quadrupled (rather than octupled, as we assumed) to 20%, the bonds were worth par – and thus appeared to have a depression-proof downside.”

“Our goal is not necessarily to make money so much as to do everything we can to protect client purchasing power and to offset, as much as possible, a large decline in market value in the event of another severe global financial crisis…we also want to avoid the psychological problem of being down 30 or 40 percent and then being paralyzed.”

Foreign Exchange, Benchmark, Inflation

“We judge ourselves in dollars. Our clients are all effectively in the United States…we hedge everything back to dollars.” Michael Price used to do the same. Please see an earlier post on an interview given by Michael Price.

“When Graham was talking about safety of principal, he was not referring to currency. He wasn’t really considering that the currency might be destroyed, but we know that can happen, and has happened many times in the 20^th century.”

Klarman is worried “about all paper money,” and has also mentioned Baupost’s goal to “protect client purchasing power.” Does he mean purchasing power on a global basis? Which brings forth an interesting dilemma: as the world becomes increasingly connected, and clients become increasingly global, will return benchmarks still be judged in US dollars and US-based inflation metrics?

Buffett Partnership Letters: 1959 & 1960

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

“My continual objective in managing partnership funds is to achieve a long-term performance record superior to that of the Industrial Average…Unless we do achieve this superior performance there is no reason for existence of the partnerships.”

The term “benchmark” is often associated with relative performance. I believe that “benchmark” has a much wider definition and purpose – as a goal of sorts for each portfolio manager.

Early on, Buffett recognized the importance of identifying a benchmark and set investor expectations accordingly. Without a proper benchmark and reasonable investor expectations, there exists greater risk for potential discord and misunderstanding, as well as the risk of a portfolio manager shooting the proverbial arrow and painting the bull’s eye around where the arrow lands.

Separate Accounts, Time Management

“…the family is growing. There has been no partnership which has had a consistently superior or inferior record compared to our group average, but there has been some variance each year despite my efforts to keep all partnerships invested in the same securities and in about the same proportions. This variation, of course, could be eliminated by combining the present partnerships into one large partnership. Such a move would also eliminate much detail and a moderate amount of expense…Frankly, I am hopeful in doing something along this line in the next few years…”

Buffett grappled with the issue of having separate accounts versus a single pooled vehicle. A pooled vehicle would have eliminated investor questions about discrepancies in partnership returns. It also would have saved a great deal of time and effort in dealing with the operational details of having to oversee multiple accounts vs. the ease of managing one single vehicle. Given the scarcity of time each day, the topic of effective time management is one that will continue to receive coverage in future posts at PM Jar.

Activism

“Last year mention was made of an investment which accounted for a very high and unusual proportion (35%) of our net assets along with the comment that I had some hope this investment would be concluded in 1960…Sanborn Map Co. is engaged in the publication and continues revision of extremely detailed maps of all cities in the United States…”

Today, Buffett no longer discusses individual ideas or the rationale behind his thesis and analysis. This was not the case back in the Partnership days. In the 1960 Letter, there is a very detailed account of an activist position he took in Sanborn Map Co. which accounted for ~35% of the NAV of the partnerships and involved contentious negotiations with the Board of Directors.