Howard Marks' Book: Chapter 18

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

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

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

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

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

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

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

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

Mistakes, Creativity, Psychology

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

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

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

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

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

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

Correlation, Diversification, Risk

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

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

Hedging, Expected Return, Opportunity Cost, Fat Tail

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

Montier on Exposures & Bubbles

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

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

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

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

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

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

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

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

Hedging, Fat Tail

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

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

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

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

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

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

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

Expected Return, Capital Preservation

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

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

When To Buy, When To Sell, Psychology

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

Baupost Letters: 2000-2001

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

Volatility, Psychology

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

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

When To Buy, When To Sell, Selectivity

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

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

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

Psychology, When To Buy, When To Sell

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

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

Risk, Expected Return, Cash

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

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

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

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

Benchmark

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

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

Cash, Turnover

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

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

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

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

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

Hedging, Expected Return

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

Elementary Worldly Wisdom – Part 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).”

Klarman’s Margin of Safety: Ch.13 – Part 2

This is a continuation in our series of portfolio construction & management highlights extracted from Seth Klarman's Margin of Safety. In Chapter 13 (Portfolio Management and Trading) - Part 2 below, Klarman shares his thoughts on the illusory nature of liquidity, and the tricky task of knowing when to sell. Liquidity, Catalyst, When To Buy, When To Sell

Liquidity can be illusory. As Louis Lowenstein has stated, ‘In the stock market, there is liquidity for the individual but not for the whole community. The distributable profits of a company are the only rewards for the community.’ In other words, while any one investor can achieve liquidity by selling to another investor, all investors taken together can only be made liquid by generally unpredictable external events such as takeover bids and corporate-share repurchases. Except for such extraordinary transactions, there must be a buyer for every seller of a security."

Liquidity is possible not only through sale of securities, but also through other events & catalysts that result in cash flowing into the portfolio. 

“In times of general market stability the liquidity of a security or class of securities can appear high. In truth liquidity is closely correlated with investment fashion. During a market panic the liquidity that seemed miles wide in the course of an upswing may turn out only to have been inches deep. Some securities that traded in high volume when they were in favor may hardly trade at all when they go out of vogue.”

“For many securities the depth of the market as well as the quoted price is an important consideration. You cannot sell, after all, in the absence of a willing buyer; the likely presence of a buyer must therefore be a factor in the decision to sell. As the president of a small firm specializing in trading illiquid over-the-counter (pink-sheet) stocks once told me: ‘You have to feed the birdies when they are hungry.’”

Historical liquidity does not equal future liquidity. Miscalculation on this front has contributed to a phenomenon eloquently described as “up the stairs, out the window” syndrome.

When To Sell, Expected Return, Risk, Opportunity Cost

“Many investors are able to spot a bargain but have a harder time knowing when to sell. One reason is the difficulty of knowing precisely what an investment is worth. An investor buys with a range of value in mind at a price that provides a considerable margin of safety. As the market price appreciates, however, that safety margin decreases; the potential return diminishes and the downside risk increases. Not knowing the exact value of the investment, it is understandable that an investor cannot be confident in the sell decision as he or she was in the purchase decision.

To deal with the difficulty of knowing when to sell, some investors create results for selling…none of these rules make good sense. Indeed, there is only one valid rule for selling: all investments are for sale at the right price…Decisions to sell, like to buy, must be based upon underlying business value. Exactly when to sell – or buy – depends on the alternative opportunities that are available…It would be foolish to hold out for an extra fraction of a point of gain in a stock selling just below underlying value when the market offers many bargains.”

Awhile ago, we featured an interview with Steve Romick of FPA discussing the sizing & dilemma of whether to sell as price moves closer, though not quite yet, to intrinsic value. Here, Klarman's comment advises investors to also take into consideration "alternative opportunities that are available" during this decision making process.

When To Buy

“In my view, investors should usually refrain from purchasing a ‘full position’ (the maximum dollar commitment they intend to make) in a given security all at once…Buying a partial position leaves reserves that permit investors to ‘average down’ lowering their average cost per share, if prices decline.

Evaluating your own willingness to average down can help you distinguish prospective investments from speculations. If the security you are considering is truly a good investment, not a speculation, you would certainly want to own more at lower prices.”

Howard Marks' Book: Chapter 15

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 15 “The Most Important Thing Is…Having a Sense for Where We Stand.” Cash, Risk, Opportunity Cost

“The period from 2004 through the middle of 2007 presented investors with one of the greatest opportunities to outperform by reducing their risk, if only they were perceptive enough to recognize what was going on and confident enough to act…Contrarian investors who had cut their risk and otherwise prepared during the lead-up to the crisis lost less in the 2008 meltdown and were best positioned to take advantage of the vast bargains it created.”

The quote above highlights a concept not given enough attention within the investment management industry – a fund manager’s ability to generate outperformance (versus a benchmark or on an absolute basis) derives not only from his/her ability to capture upside return, but also by avoiding downside loss!

Marks’ comment that some investors were “best positioned to take advantage” of newly available bargains reminds us of an interesting theoretical discussion on the value of cash, which it is based on not only what you can earn or purchase with it today, but also on what you can potentially purchase with it in the future. Jim Leitner, a former Yale Endowment Committee Member summarizes this concept best: “…we tend to ignore the inherent opportunity costs associated with a lack of cash…cash affords you flexibility…allocate that cash when attractive opportunities arise…When other assets have negative return forecast…there is no reason to not hold a low return cash portfolio…The correct way to measure the return on cash is more dynamic: cash is bound on the lower side by its actual return, whereas, the upper side possesses an additional element of positive return received from having the ability to take advantage of unique opportunities…Holding cash when markets are cheap is expensive, and holding cash when markets are expensive is cheap.”

Expected Return

“The seven scariest words in the world for the thoughtful investor – too much money chasing too few deals…You can tell when too much money is competing to be deployed…

…It helps to think of money as a commodity…Everyone’s money is pretty much the same. Yet institutions seeking to add to loan volume, and private equity funds and hedge funds seeking to increase their fees, all want to move more of it. So if you want to place more money – that is, get people to go to you instead of your competitors for their financing – you have to make your money cheaper.

One way to lower the price for your money is by reducing the interest rate you charge on loans. A slightly more subtle way is to agree to a higher price for the thing you’re buying, such as by paying a higher price/earnings ratio for a common stock or a higher total transaction price when you’re buying a company. Any way you slice it, you’re settling for a lower prospective return.”

The future expected return of any asset is a direct function of the price that you pay combined with the economic return potential of that asset.

Psychology, Risk, When To Buy, When To Sell

“…even if we can’t predict the timing and extent of cyclical fluctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act accordingly.”

“If we are alert and perceptive, we can gauge the behavior of those around us and from that judge what we should do. The essential ingredient here is inference, one of my favorite words. Everyone sees what happens each day, as reported in the media, But how many people make an effort to understand what those everyday events say about the psyches of market participants, the investment climate, and thus what we should do in response? Simply put, we must strive to understand the implications of what’s going on around us. When others are recklessly confident and buying aggressively, we should be highly cautious; when others are frightened into inaction or panic selling, we should become aggressive.”

“There are few fields in which decisions as to strategies and tactics aren’t influenced by what we see in the environment. Our pressure on the gas pedal varies depending on whether the road is empty or crowded. The golfer’s choice of club depends on the wind. Our decisions regarding outerwear certainly varies with the weather. Shouldn’t our investment actions be equally affected by the investing climate?”

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).

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.”

Consequences of Contrarian Actions

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

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

AUM, Clients, Redemptions, Patience

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

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

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

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

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

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

Historical Performance Analysis, Luck, Process Over Outcome, Mistakes

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

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

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

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

Psychology, When To Sell, When To Buy

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

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

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

The Importance of Knowing Thyself

Readers know that I’m a fan of Mariko Gordon of Daruma Capital. Below is an excerpt from her recent March 2013 Letter. Although she is referring specifically to equities, I think her comments are applicable to all portfolio assets. Lao Tzu wrote that “He who knows others is wise; he who knows himself is enlightened.” This letter perfectly showcases why I’m a fan of Gordon. She is already a successful investor running a successful investment management firm. Yet she never stops searching for incremental knowledge – of herself, her results, her surrounding environment – striving for improvement. She is aware of the competitive nature of this business, and how she fits into that landscape. There are no illusions here…or at least that’s the goal. All that we are, as it pertains to investing (and sometimes even personal tendencies), is stripped bare and evaluated for the good and the unpleasant. The willingness to withstand such scrutiny, and reexamination year after year, is the mark of great investors.

Mistakes, Process Over Outcome, Psychology, When To Sell, When To Buy

“The investment case must be made in a completely detached way. A stock doesn't care whether you own it or not, or whether you had a good or bad "relationship" with it during the course of your ownership. A stock is not your friend. It doesn't give a crap about you, and you should reciprocate that indifference.

All of my investment process mistakes (as opposed to all my bad outcomes - this is an important distinction, as one can have bad outcomes despite a good process) have always come from a place of emotion. Every single one, whether it was a purchase or a sale.

By contrast, my best decisions in fraught times have been when I have accessed that place of flow and clarity by being entirely detached emotionally. It turns out that for someone who tends to be very expressive and prone to hyperbolic language, I can be quite cold blooded and calculating when I need to be, for the good of the portfolio.”

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.

Howard Marks' Book: Chapter 11

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

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

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

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

When To Buy, When To Sell, Catalyst

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

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

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

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

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

When To Buy

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

Gumption is rewarded during periods of uncertainty.

Mistakes

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

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

Expected Return

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

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

Howard Marks' Book: Chapter 10

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 10 “The Most Important Thing Is…Combating Negative Influences” Mistakes, Portfolio Management, Psychology

“Why do mistakes occur? Because investing is an action undertaken by human beings, most of whom are at the mercy of their psyches and emotions. Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology. To say this another way, many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”

Marks’ comments perfectly describe why portfolio management is so difficult. The portfolio management decisions that occur after idea diligence & analysis are more art than science – intangible, manifesting differently for each person depending on his/her mental makeup. This also makes it particularly susceptible to the infiltration of psychological behavioral biases.

This underlies my assertion that merely having good ideas is not enough. In order to differentiate from the competition and to drive superior performance, investors also need to focus on portfolio management, and face the associated (and uniquely tailored) psychological obstacles.

Mistakes, Psychology

“The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing – these factors are near universal. Thus they have a profound collective impact on most investors and most markets. The result is mistakes, and those mistakes are frequent, widespread and recurring.”

Howard Marks provides a few psychological factors that lead to mistakes: 

1. Greed – “Money may not be everyone’s goal for its own sake, but it is everyone’s unit of account…Greed is an extremely powerful force. It’s strong enough to overcome common sense, risk aversion, prudence, caution, logic, memory of painful past lessons, resolve, trepidation and all the other elements that might otherwise keep investors out of trouble.” 

2. Fear – “The counterpart of greed…the term doesn’t mean logical, sensible risk aversion. Rather, fear – like greed – connotes excess…more like panic. Fear is overdone concern that prevents investors from taking constructive action when they should.” 

3. Willing Suspension of Disbelief – “…people’s tendency to dismiss logic, history, and time-honored norms…Charlie Munger gave me a great quotation…from Demosthenes: ‘Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true’…the process of investing requires a strong dose of disbelief…Inadequate skepticism contributes to investment losses.” I wonder, is denial then just a more extreme form of confirmation bias? 

4. Conformity/Herding Behavior – “…even when the herd’s view is clearly cockeyed…Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense.” 

5. Envy – “However negative the force of greed might be…the impact is even strong when they compare themselves to others…People who might be perfectly happy with their lot in isolation become miserable when they see others do better. In the world of investing, most people find it terribly hard to sit by and watch while others make more money than they do.” 

6. Ego – To a certain extent this is self-explanatory, but I will further explore this topic in another article in relation to Buffett’s concept of the “inner” vs. “outer-scorecard.” 

7. Capitulation – “…a regular feature of investor behavior late in cycles. Investors hold on to their conviction as long as they can, but when the economic and psychological pressure become irresistible, they surrender and jump on the bandwagon.” 

Psychology, When To Buy, When To Sell

“What, in the end, are investors to do about these psychological urges that push them toward doing foolish things? Learn to see them for what they are; that’s the first step toward gaining the courage to resist. And be realistic. Investors who believe they’re immune to the forces describes in this chapter do so at their own peril…Believe me, it’s hard to resist buying at the top (and harder still to sell) when everyone else is buying…it’s also hard to resist selling (and very though to buy) when the opposite is true at the bottom and holding or buying appears to entail the risk of total loss.”

Mistakes

“In general, people who go into the investment business are intelligent, educated, informed and numerate. They master the nuances of business and economics and understand complex theories. Many are able to reach reasonable confusion about value and prospects. But then psychology and crowd influences move in…The tendency toward self-doubt combines with news of other people’s successes to form a powerful force that makes investors do the wrong thing, and it gains additional strength as these trends go on longer.”

“Inefficiencies – mispricings, and misperceptions, mistakes that other people make – provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from others, you need to be on the right side of those mistakes.”

Investing is a selfish zero-sum game. Mistakes, on the part of some, must occur in order for others to generate profits. Mistakes of others = your opportunity 

Luck, Process Over Outcome

During the Tech Bubble,“Tech stock investors were lauded by the media for their brilliance. The ones least restrained by experience and skepticism – and thus making the most money – were often in their thirties, even their twenties. Never was it pointed out that they might be beneficiaries of an irrational market rather than incredible astuteness.”

Howard Marks' Book: Chapter 9

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 9 “The Most Important Thing Is…Awareness of the Pendulum” Psychology, Risk, When To Buy, When To Sell

As the title of this chapter gives away, much of Marks’ comments emphasize the importance of awareness of market participants’ psychology, specifically their attitudes toward risk, which creates optimal conditions for buying or selling (depending on the “location” of the pendulum). For more on this, be sure to read a previous discussion on Howard Marks’ concept of the “perversity of risk” and resulting risk manifestation.

“Investment markets follow a pendulum-like swing:

• Between euphoria and depression;
• Between celebrating positive developments and obsessing over negatives…
• Between overpriced and underpriced.”

“…the pendulum also swings with regard to greed versus fear; willingness to view things through an optimistic or a pessimistic lens; faith in developments that are on-the-come; credulousness versus skepticism; and risk tolerance versus risk aversion.

The swing in the last of these – attitudes toward risk – is a common thread that runs through many of the market’s fluctuations. Risk aversion is THE essential ingredient in a rational market…and the position of the pendulum with regard to it is particularly important. Improper amounts of risk aversion are key contributors to the market excesses of bubble and crash.”

When To Buy

“Major bottoms occur when everyone forgets that the tide also comes in. Those are the times we live for.”

“The swing back from the extreme is usually more rapid – and thus takes much less time – than the swing to the extreme.”

The comment regarding the speed of swing back from the extremes is interesting.

Mariko Gordon of Daruma Capital (who writes wonderfully insightful and entertaining letters) once pointed out that opportunities “tend to make themselves available between the two extremes of ‘fire hose’ and ‘dripping faucet’ and that what ultimately 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.”

I think both Marks and Gordon would agree that it’s not only the ability to identify when the pendulum reaches the extremes that counts, but also the ability to act quickly and take advantage of those rare and fleeting moments.

Catalyst

“The market has a mind of its own, and its changes in valuation parameters, caused primarily by changes in investor psychology (not changes in fundamentals), that account for most short-term changes in security prices. This psychology, too, moves like a pendulum.”

Stanley Druckenmiller once commented that: “I never use valuation to time the market…Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction…The catalyst is liquidity…”

Is investor psychology (one of) the initial catalyst(s) that impacts liquidity, which then drives valuation?

Risk, Expected Return, Capital Preservation, Opportunity Cost

“In my opinion, the greed/fear cycle is caused by changing attitudes toward risk. When greed is prevalent, it means investors feel a high level of comfort with risk and the idea of bearing it in the interest of profit. Conversely, widespread fear indicates a high level of aversion to risk. The academics consider investors’ attitudes toward risk a constant, but certainly it fluctuates greatly. Finance theory is heavily dependent on the assumption that investors are risk-averse. That is, they ‘disprefer’ risk and must be induced – bribed – to bear it, with high expected returns.”

“…I’ve recently boiled down the main risks in investing to…: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both. In an ideal world, investors would balance these two concerns…In 2005, 2006, and early 2007, with things going so swimmingly and the capital markets wide open, few people imagined that losses could lie ahead. Many believed risk had been banished. Their only worry was that they might miss an opportunity; if Wall Street came out with a new financial miracle and other investors bought and they didn’t…since they weren’t concerned about losing money, they didn’t insist on low purchase prices, adequate risk premiums or investor protection. In short, they behaved too aggressively.”

2005-2007 provides a great example of how misjudgments in risk and expected return can also cloud estimations of opportunity cost (which is a function of expected risk and return predictions). This caused investors to think the opportunity cost of not investing high – when in fact the exact opposite was true – leading to detrimental results.

Buffett Partnership Letters: 1966 Part 2

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

“An even more dramatic example of the conflict between short term performance and the maximization of long term results occurred in 1966. Another party, previously completely unknown to me, issued a tender offer which foreclosed opportunities for future advantageous buying…If good ideas were dime a dozen, such a premature ending would not be so unpleasant…However, you can see how hard it is to develop replacement ideas…we came up with nothing during the remainder of the year despite lower stock prices, which should have been conducive to finding such opportunities.”

We previously wrote about “duration risk” for the equity investor in relation to Buffett’s 1965 letter:

“…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.”

Here is Buffett openly articulating this exact problem one year later in 1966. While increased short-term returns are good, duration creates other unwanted headaches such as finding appropriate reinvestment opportunities.

Liquidity, When To Buy, When To Sell

“Who would think of buying or selling a private business because of someone’s guess on the stock market? The availability of a quotation for your business interest (stock) should always be an asset to be utilized if desired. If it gets silly enough in either direction, you take advantage of it. Its availability should never be turned into a liability whereby its periodic aberrations in turn formulate your judgments.”

Market liquidity should be used as an advantage. It’s important to harness the power of liquidity in an effective & productive manner. Of course, leave it to us humans to turn something positive into a force of self-destruction!

Clients, When To Buy, When To Sell

Next time your clients ask you to time the market, be sure to read the following script prepared by Warren Buffett:

“I resurrect this ‘market-guessing’ section only because after the Dow declined from 995 at the peak in February to about 865 in May, I received a few calls from partners suggesting that they thought stocks were going a lot lower. This always raises two questions in my mind: (1) if they knew in February that the Dow was going to 865 in May why didn’t they let me in on it then; and (2) if they didn’t know what was going to happen during the ensuing three months back in February, how do they know in May? There is also a voice or two after any hundred point or so decline suggesting we sell and wait until the future is clearer. Let me again suggest two points: (1) the future has never been clear to me (give us a call when the next few months are obvious to you – or, for that matter, the next few hours); and, (2) no one ever seems to call after the market has gone up one hundred points to focus my attention on how unclear everything is, even though the view back in February doesn’t look so clear in retrospect.”

When To Buy, When To Sell

“We don’t buy and sell stocks based upon what other people think the stock market is going to do (I never have an opinion) but rather upon what we think the company is going to do. The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right. In other words, we tend to concentrate on what should happen, not when it should happen.”

This is similar to Bruce Berkowitz’s comments about not predicting, but pricing.

In the last sentence, Buffett states that he only cares about “what should happen, not when it should happen.” Is this actually true? Buffett, of all people, understood very clearly the impact of time on annualized return figures. 

In fact, BPL’s return goal was 10% above the Dow annually. In order to achieve this, Buffett had to find investments that provided, on average, annual returns 10% greater than the Dow.

Control

“Market price, while used exclusively to value our investments in minority positions, is not a relevant factor when applied to our controlling interests. When our holdings go above 50%, or a smaller figure if representing effective control, we own a business not a stock, and our method of valuation must therefore change. Under scoring this concept is the fact that controlling interests frequently sell at from 60% to 500% of virtually contemporaneous prices for minority holdings.”

There is such a thing as a control premium – theoretically.

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.

Howard Marks' Book: Chapter 8

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 8 “The Most Important Thing Is…Being Attentive to Cycles”  

When To Buy, When To Sell

“Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.”

“Cycles are self-correcting…because trends create the reasons for their own reversals. Thus, I like to say success carries within itself the seeds of failure, and failure the seeds of success.”

“…every decade or so, people decide cyclicality is over. They think either the good times will rool on without end or the negative trends can’t be arrested. At such times they talk about ‘virtuous cycles’ or ‘vicious cycles’…‘this time it’s different’…should strike fear – and perhaps suggest an opportunity for profit…it’s essential that you be able to recognize this form of error when it arises.”

Curiously, why is “every decade” the magic number?

Expected Return, When To Buy, When To Sell

These cycles at their core are driven by return expectations – correct and incorrect:

• The economy moves into a period of prosperity.
• Providers of capital thrive, increasing their capital base.
• Because bad news is scarce, the risks entailed in lending and investing seems to have shrunk.
• Risk averseness disappears.
• Financial institutions move to expand their businesses – that is, to provide more capital.
• They compete for market share by lower demanded returns…lower credit standards, providing more capital for a given transaction and easing covenants.

As the Economist said… ‘the worst loans are made at the best of times.’ This leads to capital destruction – that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital. When this point is reached, the up-leg described above – the rising part of the cycle – is reversed.

•  Losses cause lenders to become discouraged and shy away.
• Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.
• Less capital is made available – and at the trough of the cycle, only to the most qualified of borrowers, if anyone.
• Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.
• This process contributes to and reinforces the economic contraction.

Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled.

Should I Sell This Thing?

Investors often obsess over the correct moments to purchase securities/assets, but discuss less frequently the circumstances and nuances of selling. A friend sent me this Wall Street Transcript interview with Christopher Mittleman awhile back. In the interview, Mittleman provides some very thoughtful insights, especially when to sell securities. A quick and worthwhile read.

When To Sell, Psychology

“…we won’t reflexively sell it because a lot of times what happens is that I may think the stock is worth a particular price, but it may continue to advance much higher than my fair value estimate. And that often occurs because my estimates tend to be on the conservative side.

So what I found through experience is that I should be somewhat slow to sell in a situation driven solely by a rising stock price, because there will generally be a good deal of positive momentum occurring in the stock. I know it sounds strange that a value investor is talking about momentum and things of that nature, but when you are value-oriented you tend to be buying stocks when they are on the decline. And there is a certain amount of negative momentum with that, and it usually behooves you to buy them slowly…When we sell stocks that have been great successes, it’s usually the opposite that occurs. And it’s typically prudent to sell the stock slowly.

Notice, Mittleman is aware of his inclination to estimate too conservatively and adjusts his investment process accordingly to counter this behavioral tendency.

This is similar to advice that Michael Mauboussin recently gave on how to control one’s investment biases.

When To Sell, Making Mistakes, Opportunity Cost

“…we will sell something more precipitously if we think the price has moved into really untenable levels. We are not shy about selling out of positions when I see an extreme in the opposite direction or if the fundamentals appear to be deteriorating.

Clearly, any meaningful deteriorating in the fundamentals would be a trigger for us to sell. Sometimes this occurs before we have made profit in the stock, so we will exit the position at a loss…we make sure that we don’t fall in love with individual stocks. We try to hold stocks as long [as] we can, simply because we’ve found that by holding we usually get better returns…The other reason for selling a stock would be if there was a better opportunity that came around…in order to make room for the better opportunity.”

Stanley Druckenmiller Widsom - Part 2

Here is Part 2 of portfolio management highlights extracted from an interview with Stanley Druckenmmiller in Jack D. Schwager’s book The New Market Wizards. Be sure to check out the juicy bits from Part 1. Druckenmiller is a legendary investor, and protégé of George Soros, who compounded capital ~30% annualized since 1986 before announcing in 2010 that his Duquesne fund would return all outside investor capital, and morph into a family office.

Portfolio Management

“I’ve learned many things from him [George Soros], but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

This is the very essence of portfolio management. We all have endless opinions on ideas, inflation, direction of markets, etc. But it's what we do with these opinions - the conversion into P&L and trackrecord - that ultimately determines our success or failure as investors.

In this industry, sometimes people become obsessed with "being right" or "proven right" - which is likely a natural behavioral tendency. But I agree with Druckenmiller, it doesn't matter if you're right or wrong. When utilized skillfully, portfolio management has the ability to amplify correctness and mute errors.

When To Buy, When To Sell, Sizing

“Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.”

Making Mistakes, When To Sell

“Soros is also the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.”

Closing out a losing position takes a lot of courage. It is usually a task that is easier said than done because it goes against our natural psychological tendency to avoid confronting or admitting our mistakes. The act of selling a losing position echoes of finality – no hope for a brighter outcome just around the corner, no possibility of savaging the situation.

However, there are also benefits. As Druckenmiller points out, it lets you walk away to fight another day – perhaps at an easier battle. Also, it frees up mental and time capacity in not having to babysit that losing position.

Ask yourself honestly: how much time did you spend in the chaotic era of 2008-2009 babysitting losers vs. concentrating on finding new opportunities?

Cash

“By mid-1981, stocks were up to the top of their valuation range, while at the same time, interest rates had soared to 19 percent. It was one of the more obvious sell situations in the history of the market. We went into a 50% percent cash position, which, at the time, I thought represented a really dramatic step. Then we got obliterated in the third quarter of 1981…Well, we got obliterated on the 50 percent position we still held.”

“You have to understand that I was unbelievably bearish in June 1981. I was absolutely right in that opinion, but we still ended up losing 12 percent during the third quarter. I said to my partner, ‘This is criminal. We have never felt more strongly about anything than the bear side of this market and yet we ended up down for the quarter.’ Right then and there, we changed our investment philosophy so that if we ever felt that bearish about the market again we would go to a 100 percent cash position.”

Below, I highlight two sides to this perennial cash debate:

(Some) Fund Managers say: My goal is to compound capital (and to build an awesome trackrecord). Holding a cash balance makes sense at certain times of the cycle, such as when I don’t see any worthwhile opportunities (2005-2007), and this will prevent (temporary) impairments of capital. However, I will stay vigilant with both eyes open, and redeploy the moment opportunities reemerge. If you leave the cash with me, I won’t have to spend time raising capital at exactly the moment when I should be spending all of my time focused on investing (2008-2009).

(Some) Clients say: I am fully aware of market cycles and the merits of holding cash while waiting for better bargains. However, when I gave your fund capital to invest, I have already allotted for a cash balance elsewhere in my overall portfolio. If you move toward cash, it skews my actual cash exposure to higher than anticipated within my asset allocation. Therefore, I want you to be fully invested at all times.

There is no right or wrong answer here – both sides have valid points. At its core, this debate originates from a mandate communication issue. Before taking on a client, make sure he/she understands your views on cash balance. Before allocating capital to a fund, make sure the “cash mandate” complements your asset allocation strategy.