Buffett Partnership Letters: 1961 Part 2

This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. During 1961, Buffett started to write semi-annual letters because his clients told him the annual letter was “a long time between drinks.” The second of the two 1961 letters written is a treasure trove of portfolio management information, so robust in material that the summary (organized by topic) will require multiple installments.

For those interested in Warren Buffett’s portfolio management style, I highly recommend the reading of this second letter in its entirety.

Hurdle Rate, Expected Return, Volatility

“There are bound to be years when we are surpassed by the Dow, but if over a long period we can average ten percentage points per year better than it, I will feel the results have been satisfactory…Specifically, if the market should be down 35% or 40% in a year…we should be down only 15% or 20%. If it is more or less unchanged during the year, we would hope to be up about ten percentage points. If it is up 20% or more, we would struggle to be up as much.”

Buffett had a goal of beating the Dow by 10% annually, on average, over a long period of time. In order to achieve this, he had to seek investments that met a return hurdle of 10% higher than the Dow – no easy feat since the Dow itself is a moving target. Additionally, the portfolio had to have an asymmetric volatility profile that captured the Dow’s upside volatility, but only a fraction of the Dow’s downside volatility. As the history books have shown, he was certainly successful in achieving his goal, but the means of how he did so remains a mystery. I believe that Buffett’s partnership letters, in particular the second 1961 letter, holds some clues.

Part of the answer lies in Buffett’s strategy of segmenting his portfolio and analyzing the return potential and volatility contribution of each portion.

“Our avenues of investment break down into three categories. These categories have different behavior characteristics, and the way our money is divided among them will have an important effect on our results, relative to the Dow in any given year.”

“The generals tend to behave market-wise very much in sympathy with the Dow. Just because something is cheap does not mean it is not going to go down. During abrupt downward movements in the market, this segment may very well go down percentage-wise just as much as the Dow. Over a period of years, I believe the generals will outperform the Dow, and during sharply advancing years like 1961, this is the section of our portfolio that turns in the best results. It is, of course, also the most vulnerable in a declining market.”

“[The work-outs] will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout a year with a large portion of our portfolio in work-outs, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year.” 

“The final category is “control” situations…Such operations should definitely be measured on the basis of several years…the stock may be stagnant market-wise for a long period while we are acquiring. These situations, too, have relatively little in common with the behavior of the Dow.”

“…I am more conscious of the dangers presented at current market levels than the opportunities. Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from these dangers.”

We have written in the past that Buffett thought consciously about the expected return of his portfolio in our post on the 1957 Letter - Part 2, specifically, that he “left nothing to hope or chance, and thought very strategically about position sizing, the annualized expected return of these positions, and the estimated hurdle rate required to outperform his benchmarks by a margin of 10% annually.”

The excerpts from the 1961 letter shown above, clearly demonstrate that he segregated his portfolio into three segments and assigned expected return figures to each. The percentage weighting of these segments then impacted the overall expected return of his portfolio.

Going one step farther, Buffett also monitored the expected volatility– yes, the forward looking volatility – of each of these segments by anticipating how each segment would behaved in different market scenarios relative to his benchmark (the Dow). For example, the “generals” moved in tandem with the Dow, whereas Buffett believed that the “work-outs” had a relatively uncorrelated volatility profile “to a large extent irrespective of the course of the Dow.”

I have written in a previous post on the 1958 Letter - Part 1 that Buffett “never ignored volatility because he recognized the impact of this phenomenon on his performance return stream.” His words above lend confirmation.

Today, Buffett preaches that permanent impairment of capital is what he’s most worried about. Perhaps that’s true for the billionaire Buffett with a permanent capital base and established trackrecord. However, back in the day, he was much more focused on avoiding impairment of capital of any kind – even that temporary type incurred via price movement (i.e., volatility). After all (roughly paraphrasing Buffett’s words, not mine, see quotes above), just because something is cheap, doesn’t mean it can’t go down more.

What's Benchmark Got To Do With It

In the April 14^th edition of the Economist, there’s an article titled Gavea Investments: A Shore Thing, about a $7Bn Brazilian Macro hedge fund run by Arminio Fraga. The following passage grabbed my attention especially after the recent post on Seth Klarman and the topic of a proper benchmark given the increasingly global implications of inflation and foreign exchange. The Economist wrote:

“Running a hedge fund in Brazil is rather different from doing so in other places…Interest rates remain high: the benchmark rate is 9.75%. Local hedge funds report their performance relative to that rate. Gavea keeps around 80% of its book in cash and only takes a position when it strongly believes it can beat the risk-free return.”

The language implies that Brazilian hedge funds (regardless of mandate/strategy) use the Brazilian local “risk-free” interest rate as their performance benchmark. In contrast, most US-based hedge funds use domestic equity indices as their performance benchmark (e.g., S&P 500 and Dow)

Over the last 20 years, asset bases have become increasingly diverse and global, as emerging markets have gained prominence and wealth. US-based funds now have many international clients. US-based investors now make international investments (most investment columns seem to advise at least a sliver of international or emerging market allocation).

As East meets West, North meets South, etc., it is time for portfolio managers and fund investors to set aside tradition and industry standard practice, and begin to reconsider the “proper” investment benchmark?

Buffett Partnership Letters: 1961 Part 1

This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. During 1961, Buffett started to write semi-annual letters because his clients told him the annual letter was “a long time between drinks.” The summary below is derived from the first of two letters written about the results of 1961.

Separate Accounts, Fee Structure

The business underwent conversion from multiple separately managed accounts to a pooled partnership vehicle. Buffett grappled with housekeeping issues such as proper allocation of “future tax liability due to unrealized gains” during the transition process since all the different partnerships would contribute different tax liabilities to the new pooled vehicle.

More interesting is the fee structure of the Buffett Partnerships. The new pool vehicle would charge 0% management fees, 25% incentive fee above a 6% hurdle, and “any deficiencies in earnings below the 6% would be carried forward against future earnings, but would not be carried back.”

Previously, the multiple partnerships had a number of different fee structures including:

1. 6% Hurdle, 33.33% incentive fee
2. 4% Hurdle, 25.00% incentive fee
3. 0% Hurdle, 16.67% incentive fee

Additionally, Buffett provides his clients with a unique liquidity mechanism to supplement the annual redemption window:

“The right to borrow during the year, up to 20% of the value of your partnership interest, at 6%, such loans to be liquidated at yearend or earlier. This will add a degree of liquidity to an investment which can now only be disposed of at yearend…I expect this to be a relatively unused provision, which is available when something unexpected turns up and a wait until yearend to liquidate part or all of a partner’s interest would cause hardship.”

AUM

“Estimated total assets of the partnership will be in the neighborhood of $4 million, which enables us to consider investments such as the one mentioned earlier in this letter, which we would have had to pass several years ago.”

Buffett was cognizant of the relationship between AUM and his fund’s investment strategy. I suspect the investment “mentioned earlier in this letter” was an activist situation which required him owning an influential or controlling stake in the company – therefore requiring a minimum amount of capital commitment, now made possible by the higher total partnership assets of $4 million.

Portfolio managers are not the own ones who should monitor the AUM figure. The relevance of the relationship between AUM and a fund’s investment strategy has wider implications. For example, investors who allocate capital to funds should also be monitoring AUM and asking whether the changes in AUM impact a fund’s ability to generate returns due to sizing, strategy shift / drift, changing opportunity sets, etc.

Expected Return, Catalyst, Risk

“We have also begun open market acquisitions of a potentially major commitment which I, of course, hope does nothing marketwise for at least a year. Such a commitment may be a deterrent to short range performance but it gives strong promise of superior results over a several year period combined with substantial defensive characteristics.

The above quote highlights two important portfolio management topics.

First: the concept of “yield to catalyst.” Similar in concept to yield to call or maturity for bonds, it’s the annualized return between today to until the catalyst or price target occurrence – a sort of expected annualized return figure. In this situation, the price target was high enough that even if the security “does nothing for at least a year,” the “superior results over a several year period” was enough to make the investment worthwhile. For his basket of “work-outs” (see our 1957 Part 1 post for more details on this), the price target was usually lower, but the catalyst was usually not far away, therefore the yield to catalyst was still adequately high to justify an investment.

Second: the concept of risk-adjusted return. This one is slightly more difficult to estimate since “risk” is a squishy term and difficult to quantify. In the quote above, Buffett references the “substantial defensive characteristics” of the investment. This indicates that he is measuring the return against the risk profile. Unfortunately, he does not give any details as to how he defines risk, or does that math.

James Montier on Tail Risk Hedging

James Montier always provides a wonderful blend of value and behavioral principles, as well as humor in his written work. His books (I'm the proud owner of a signed copy of Value Investing) and articles are always worthwhile reads (and available for free on the GMO website once you create an account). Here is a tail risk hedging article Montier wrote in June 2011 (around the same time AQR published another piece on tail risk hedging – see our previous post on the AQR piece).

A year later, tail risk hedging remains popular. As Montier astutely points out, “The very popularity of the tail risk protection alone should spell caution for investors.” Nevertheless, he gives some practical advice on how to approach with caution, including:

1. “Define your term.” – what exactly are you trying to hedge?
2. Once defined, consider locating alternatives to “hedging” that could help achieve the same result. Montier gives a few examples of how to “hedge” the illiquidity/drawdown risk we experienced in 2008 without actually buying hedges.
3. If buying insurance is the best course of action, be sure to calculate the expected return vs. the cost of insurance. This may require forward looking predictions on how certain existing securities/assets in portfolio will do in a tail event.
4. Last but not least, the most difficult part: getting the timing right.

I will add the following remark skimmed from a previous PIMCO discussion. Be sure to consider your benchmark before indulging in tail risk hedging products. In certain instances, the annual premium of these insurance contracts may be greater than what you can afford. For example, in today’s environment, foundations aiming to achieve CPI + 500 via relatively senior fixed income securities may find it difficult to sacrifice a couple hundred basis points of performance to hedging premium.

Invisible Hands Encore

Many thanks to Adam Bain of CommonWealth Opportunity Capital for tipping PM Jar about this chapter in Steve Drobny’s Invisible Hands. “The Pensioner” interviewed “runs a major portfolio for one of the largest pension funds in the world.” He seems to define risk (for the most part) as volatility. Regardless of whether you agree with this definition, the chapter is a worthwhile read because he brings the “risk” discussion to the forefront of the portfolio construction and management process – whereas many currently approach and manage risk as a byproduct and afterthought.

Oh, and he also provides some very unique thoughts on liquidity and illiquidity.

Risk, Expected Return, Diversification

While focusing too much on the (desired) expected return, say 8% per annum, investors lose sight of the actual level of “risk” assumed in the portfolio. The Pensioner believes that “investors on average, are led astray at the beginning of the portfolio construction process by focusing on a return target…the level of risk assumed to achieve that target becomes secondary.”

Currently, it is “common practice” to allocate capital “based on dollar value as opposed to allocating based on a risk budget. Oftentimes, this can lead to asset allocations that appear diversified but really are not…The goal is to build a portfolio that produces the maximum return per unit of risk.” Some may refer to this as maximizing risk-adjusted return.

A good risk management process should incentivize employees to be “cognizant” of risk, and to focus on “risk-adjusted returns, as opposed to just nominal returns…” and “…trade off between the marginal risk consumed by an investment and the investment’s expected return.” This concept is akin to a business’ focus on net income or cash flow, rather than top line revenues.

“Portfolio managers get themselves into trouble when they look at opportunities as standalone risks. The marginal contribution to overall risk is what is most important.”

In essence, “risk needs to be treated as an input, not an output, to the investment process.”

Risk identification is not always straightforward or all that obvious. For example, certain asset classes traditionally considered “nonequity” (such as private equity, real estate, infrastructure, etc.) actually have very equity-like qualities. Fixed income and credit is “really just a slice of the equity risk premium.”

Liquidity

For those interested in the topic of liquidity and illiquidity, I highly recommend the reading of the Pensioner chapter in its entirety. He presents some very interesting and unique perspectives on how to think about both liquidity and illiquidity in a portfolio context.

Perceptions as well as actual liquidity profiles of assets can change depending on the market environment. For example, in 2008, people learned the hard way when “assets that were liquid in good times…became very illiquid in periods of stress, including external managers who threw up gates, credit derivatives whereby whole tranches became toxic, and even crowded trades such as single stocks chosen according to well-known quantitative screens.”

“Illiquidity risk needs to be recognized for what it is, which is just another risk premium amongst many.” But how do you value this risk? That’s the tricky part, with no exact answer, but fun to think about nonetheless…

“By entering into an illiquid investment, you give up the option to sell at the time of your choosing, and as a result, an opportunity cost is incurred. Illiquidity is essentially a short-put option on opportunity cost and, if you were able to estimate the likelihood and value of all future opportunities, then you could estimate the illiquidity risk premium using standard option pricing theory. Of course, this is almost impossible in practice.” So in order to think about the cost of illiquidity, we must consider opportunity cost. Sound familiar? That’s because opportunity cost is also the essential input for the theoretical valuation of cash. For that, see our post on Jim Leitner, who has some wonderfully insightful thoughts on that subject.

Illiquidity is a “negative externality.” The evidence for this claim lies in 2008, when “many liquid managers were shut down, despite excellent future prospects. This was because clients, desperate to raise capital or cut risk and unable to sell their illiquid assets, sold whatever they were able to.” Therefore, illiquidity impacted not only those assets that were illiquid, but spread to negatively impact other asset classes.

Liquidity, Trackrecord, Volatility

Ironically, the illiquid nature and lack of pricing availability of some assets actually improved the volatility profile and trackrecords of some managers due to the “artificial” smoothing provided by the delay in mark to market. So there you have it: illiquid assets can sometimes be used to game the system for both returns and volatility. Disclaimer: PM Jar is not recommending that our Readers try this at home.

Volatility

PM Jar usually does not highlight mathematical or formulaic concepts. But the unique nature of this concept merits a quick paragraph or two.

Many have characterized the events of 2008 as “nonnormal.” But the Pensioner claims that 2008 events were not “exceedingly ‘fat’ or nonnormal…rather, they exhibited nonconstant volatility…A risk system capable of capturing short-term changes in risk would have gone a long way to reduce losses in 2008.”

The book provides the following explanation for stochastic volatility:

“Stochastic volatility models are used to evaluate various derivatives securities, whereby – as their name implied – they treat the volatility of the underlying securities as a random process. Stochastic volatility models attempt to capture the changing nature of volatility over the life of the derivative contract, something that the traditional Black-Scholes model and other constant volatility models fail to address.”

Inflation

All assets respond to inflation over the long-term – for better or for worse. However, in the near-term, some assets we commonly believe to be hedges to inflation often don’t work out as expected. For example, “Real estate and equities...get hit hard by unexpected inflation because even though they have real cash flow, they are still businesses, and the central bank response to inflation is to raise rates to slow demand.”

Leverage

The term leverage generally has a negative connotation, but in his mind, there are 4 different types of leverage – some good, some bad:

1. “Using leverage to hedge liabilities” – GOOD
2. “Using leverage to improve the diversification of a portfolio” – GOOD
3. “Levering risky positions to generate even high expected returns” – BAD
4. “Using off-balance sheet hidden leverage to make risky assets even riskier (i.e., private equity)” – BAD

It’s not leverage itself that’s bad, it’s how you use it – similar to how “guns don’t kill people, people kill people.”

Accounting Leverage – the type of leverage that “shows up directly on a fund’s balance sheet,” such as margin, repo or derivative transactions.

Economic Leverage – the leverage “born indirectly by the fund through some other entity.” Examples include highly levered public securities owned by the fund, or private equity allocations that have highly leveraged underlying holdings.

Hedging

When people hedge to put a floor on near-term returns, it entails “costs to the fund over the long-term because I am essentially buying insurance on my job and billing my employer for the premium.”

Klarman-Zweig Banter: Part 2

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

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

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

Team Management

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

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

Michael Price, Creativity

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

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

Risk, Creativity

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

Capital Preservation, Conservatism

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

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

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

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

Foreign Exchange, Benchmark, Inflation

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

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

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

Klarman-Zweig Banter: Part 1

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

Volatility

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

Intrinsic Value, Exposure

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

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

Shorting

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

Leverage

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

Cash

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

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

AUM

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

Returning Capital

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

Redemptions

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

Clients

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

Ideal clients have two characteristics:

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

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

Buffett Partnership Letters: 1959 & 1960

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

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

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

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

Separate Accounts, Time Management

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

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

Activism

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

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

Lessons from Jim Leitner - Part 3 of 3

Here is Part 3 on the wonderfully insightful interview in Steve Drobny's book The Invisible Hands with Jim Leitner, who runs Falcon Investment Management, and was previously a member of Yale Endowment's Investment Committee. Leitner is an investor who has spent considerable time contemplating the science and art of investing, making money opportunistically across all asset classes, unconstrained, focused on finding the right price and structure, not losing money...and remaining humble (an increasingly rare quality in our industry).

His very clearly articulated thoughts about hedging, risk management, cash, and a number of other topics are profound. Below is Part 3 of a summary of those thoughts (please also see Part 1 and Part 2). I would highly recommend the reading of the actual chapter in its entirety.

Definition of Investing

“Investing is the art and science of extracting risk premia from financial markets over time.”

Risk, Preservation of Capital, Volatility

The risk management process starts with what you buy and how you structure those “themes and trades.” Jim manages his portfolio with a particular focus on the downside, where he “never wants to lose more than 20 percent and structures his portfolio to make sure that under no possible scenario can he ever exceed this loss threshold.”

People have a tendency to spend “more time thinking about returns than about how to manage downside risk. The investment process seems to be driven by a need to generate certain returns rather than a need to avoid absolute levels of loss on deployed capital.”

Jim gives a number of reasons why it’s important to preserve capital and limit downside volatility.

1. Psychological – the emotional damage and potential impact on decision making, associated with large losses even if they’re unrealized or not permanent. He talks about not being willing to lose more than 10% in any given month, no more than 20% in any given year – these figures were determined based on personal “psychological recognition.”
2. Career Risk – investors and bosses may not care that your losses are unrealized or not permanent
3. Negative Compounding – After a drawdown, the law of mathematics makes it an uphill battle to get back to even. For example, when an investor is down 40%, it means he/she would need to make 67% to breakeven. This doesn’t account for any cash outflows/redemptions, which makes it even more difficult to get back to breakeven $ wise.

“While I am not sure what my focus on truncating downside risk has cost me over time in terms of lost opportunity, I am certain that I have not maximized return. But at least I can be sure that I will be around for future opportunities.”

Diversification

As a part of his process, he tries to identify crowded trades, securities, assets, “even portfolio approaches” because “…diversification only works when you have assets which are valued differently…If everything is expensive, everything will go down, so it doesn’t really matter if you own different things for diversification’s sake.”

Lesson from 2007-2008: “At the beginning of this period, all risk assets were no longer cheap. There was no real diversification in owning a portfolio of overvalued assets. This is the true lesson. Overvaluation becomes a risk factor that must be addressed directly in portfolio construction.”

Lessons from Jim Leitner - Part 2 of 3

Here is Part 2 on the wonderfully insightful interview in Steve Drobny's book The Invisible Hands with Jim Leitner, who runs Falcon Investment Management, and was previously a member of Yale Endowment's Investment Committee. Leitner is an investor who has spent considerable time contemplating the science and art of investing, making money opportunistically across all asset classes, unconstrained, focused on finding the right price and structure, not losing money...and remaining humble (an increasingly rare quality in our industry).

His very clearly articulated thoughts about hedging, risk management, cash, and a number of other topics are profound. Below is Part 2 of a summary of those thoughts (please also see Part 1 and Part 3). I would highly recommend the reading of the actual chapter in its entirety.

Hedging, Leverage, Creativity

Summarized below is a wonderful example of Jim’s differentiated and creative thought process.

Conventional wisdom cautions investors to avoid leverage because it is considered more “risky.” This is generally true if you’re employing leverage to purchase additional positions that have similar correlation/volatility profiles to existing positions.

But what if you used leverage “to purchase only those assets which, at least historically, have had negative correlations” to the existing portfolio holdings? Theoretically, this additional leverage should not increase the “riskiness” of the total portfolio because in the event of a market drawdown, the asset purchased on leverage will increase in value thus avoiding the margin call and downward spiral generally associated with leveraged portfolios in bear markets.

One example Jim gives is a levered (via the repo market) position long government bonds, an asset class that tends to rally when equity markets hiccup.

Usually, hedges and insurance protection cost money to purchase which in turn causes number of problematic issues (for more on this topic, please see a whitepaper published by AQR). But what if we could find a hedge that pays us instead? Although rare, it’s possible. In the example above, “bonds can be repo’d at the cash rate and have a risk premium over cash, over time the cost of such insurance should actually be a positive to the fund.” In other words, the interest received from the bonds purchased is greater than the interest paid on cash borrowed to purchase those bonds.

Lessons from Jim Leitner - Part 1 of 3

In Steve Drobny’s book The Invisible Hands, there’s a wonderfully insightful interview with Jim Leitner, who heads up Falcon Investment Management, and was previously a member of Yale Endowment's Investment Committee. Leitner is an investor who has spent considerable time contemplating the science and art of investing, making money opportunistically across all asset classes, unconstrained, focused on finding the right price and structure, not losing money...and remaining humble (an increasingly rare quality in our industry).

His very clearly articulated thoughts about hedging, risk management, cash, and a number of other topics are profound. Below is Part 1 (please also see Part 2 and Part 3) of a summary of those thoughts. I would highly recommend the reading of the actual chapter in its entirety.

Cash, Opportunity Cost, Liquidity, Derivatives

“Cash always gives the lowest return when modeling on a backward-looking basis.” This is why endowments, etc. tend to hold very little cash, because they construct their portfolio allocations looking backwards, based on historical returns.

But if we construct our portfolio allocations on a forward looking basis, “…cash is the essential asset. When other assets have negative return forecast…there is no reason to not hold a low return cash portfolio.”

Also, by looking backward, we tend to ignore the “inherent opportunity costs associated with a lack of cash…cash affords you flexibility…can allocate that cash when attractive opportunities arise.”

“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.” As equity or other assets get more expensive, it’s important to hold more “cash and cash-like assets” because it decreases the potential for downside volatility.

It’s important to have cash on hand in case assets or securities become cheap because redeeming from existing allocations or selling existing positions takes time.

Hedge funds and some investors that use derivatives and swaps have the ability to gain large notional exposures (via these derivatives) while holding cash in reserve – a nice luxury.

Rules of the Game

A recent discussion led me to remember a WSJ article I read a few months ago on Bill Miller’s incredible trackrecord of beating the S&P 500 for 15 consecutive years. The author of the article pointed out the following:

"Mr. Miller's long spell of winning years was to some degree a quirk of calendars. Over the course of his streak, there were plenty of 12-month periods ending in a month other than December when the fund trailed its benchmark."

Performance and trackrecord is usually judged on an annual calendar year basis. Convention dictates that the annual return period fall between January 1^st and December 31^st. There is no particular reason behind this convention. Ironically, most of the large university endowments, such as Yale and Harvard, have return periods that end in June each year.

Whether you like it or not, for investors currently managing capital (especially those hoping to woo additional capital), there are definitely rules to this game. Hopefully keeping in mind the rules makes the game easier to play.

Poetic Inspiration from EIC

Many thanks to Jim Barksdale, the thoughtful Founder of Equity Investment Corporation in Atlanta, for sharing this Robert Frost poem with PM Jar. That’s right, Jim has effectively applied poetry to investing – bravo! A Drumlin Woodchuck - Robert Frost

My own strategic retreat Is where two rocks almost meet, And still more secure and snug, A two-door burrow I dug.

With those in mind at my back I can sit forth exposed to attack As one who shrewdly pretends That he and the world are friends.

All we who prefer to live Have a little whistle we give, And flash, at the least alarm We dive down under the farm.

We allow some time for guile And don't come out for a while Either to eat or drink. We take occasion to think.

And if after the hunt goes past And the double-barreled blast (Like war and pestilence And the loss of common sense),

If I can with confidence say That still for another day, Or even another year, I will be there for you, my dear,

It will be because, though small As measured against the All, I have been so instinctively thorough About my crevice and burrow.

Buffett Partnership Letters: 1958 Part 2

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

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

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

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

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

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

Intrinsic Value, Exposure, Opportunity Cost

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

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

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

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

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

Buffett Partnership Letters: 1958 Part 1

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

“…widespread public belief in the inevitability of profits from invest in stocks will led to eventual trouble…prices, not intrinsic value in my opinion, of even undervalued securities can be expected to be substantially affected.”

Price does not always equal intrinsic value, and the resulting impact is volatility due to price, not intrinsic value, movement. Unlike some value investors today, Buffett (especially in the Partnership days) never ignored volatility because he recognized the impact of this phenomenon on his performance return stream. Instead, he anticipated sources of possible price volatility and stood with cash or “work-outs” ready to deploy in case price, not intrinsic value, declined. Please see the 1957 Part 1 and 1957 Part 2 commentary for more details on “work-outs.”

Diversification, Liquidity, Catalyst, Activism

“Commonwealth only had about 300 stockholders and probably averaged two trades or so per month…”

“Over a period of a year or so, we were successful in obtaining about 12% of the bank at a price averaging about $51 per share…our block of stock increased in value as its size grew, particularly after we became the second largest stockholder with sufficient voting power to warrant consultation on any merger proposal.”

“This new situation is somewhat larger than Commonwealth and represents about 25% of the assets of the various partnerships. While the degree of undervaluation is no greater than in many other securities we own…we are the largest stockholder and this has substantial advantages many times in determining the length of time required to correct the undervaluation.”

“To the extent possible…I am attempting to create my own work-outs by acquiring large positions in several undervalued securities.”

Not surprisingly, Buffett was never one to preach the merits of diversification or liquidity, even in the pre-Berkshire days when he did not have permanent capital. (Side Note: At the 2012 DJCO Shareholders’ Meeting, Charlie Munger stated that the Volcker Rule would actually improve the markets by decreasing trading liquidity.) He seemed unafraid of liquidity constraints created by little/no trading activity, holding 12% of total shares outstanding of a company, or making a single position 25% of portfolio NAV.

In the Partnership days, Buffett conducted some degree of shareholder activism (this was to change down the road). In certain instances, he held the belief that the value of a holding increased once a large enough stake was accumulated due to the intangible control premium and higher potential to create your own catalyst, thereby controlling the expected annualized return.

A Page From Cornwall Capital's Playbook

In his book The Big Short, Michael Lewis chronicles how Cornwall correctly predicted and benefited from the subprime housing crisis, via a "Fat Tail." While reading the book, I remember thinking that the approach was different from many other funds that I've encountered. Some tidbits that particularly resonated were the following:

Fat Tail ≠ Probability of Positive Outcome is High

Fat Tail actually implies:

• Low Probability of Positive Outcome, but…
• Positive Outcome is more probable than market expectations (therefore the ratio of expected return relative to cost is asymmetric and attractive)

Upon further reflection, I wondered if Cornwall’s approach could be beneficial to more traditional investors, such as:

• Being creative and looking for other non-traditional securities through which to express certain views and convictions
• Spending more time to understand how certain securities, options, hedges, or derivative structures are priced by the market and sellers – thus understanding the counterparty’s motivation and rationale (remember, it’s a zero-sum game)
• Paying closer attention to the ratio of Expected Return vs. Cost (both actual and opportunity)
• Effectively utilizing and sizing Fat Tails (instances where the probability of occurrence is low, but the ratio of Expected Return to Cost is asymmetrically high) in a portfolio context

Above all, investors should remember that Fat Tails are usually rare occurrences because it involves not only the formation of a view/conviction, but also the identification of an attractively priced security (with asymmetrically high reward relative to cost) to express that view/conviction. Post the subprime crisis, there have been no shortage of views and convictions (hyperinflation, European CDS, etc.), but few securities priced to offer the type of asymmetric reward required to achieve "Fat Tail" status.

Good Deed or Good Tax Planning?

A few weeks ago, the WSJ featured an article titled “A Class Move for an Office” about Bank of America donating an office building in Wilmington, Delaware to a local charter school. “Wilmington’s central business district’s fourth-quarter office vacancy rate stood at 20%…The four-quarter national average was 17.3%. Bank of America weighted a number of options before opting to donate the 282,000 square feet of space, including selling it.”

The article seems to hint at this but, does not state it outright, or perhaps I’m just more cynical than the journalist. I believe BAC was greatly incentivized to donate the building for the following reasons:

• The expected sale price was substantially lower than the mark of the building currently on its balance sheet, and would have resulted in a charge to its ever precious equity capital.
• Perhaps there is less scrutiny by the IRS than the OCC/FDIC/Fed on mark to market, thus the current unrealistic mark for the building actually becomes a greater than “fair value” tax benefit.

Of course I am by no means an accounting expert, and would welcome Reader commentary on the actual accounting treatment for the sale vs. donation scenarios.

Regardless, this article led me to wonder, could other investors (especially those that hold illiquid/private assets) emulate this tactic employed by BAC and be better off donating certain assets, particularly in situations where:

• Investors/funds make annual charitable donations anyway
• The asset is a long-term cash drain (e.g., non/negative-cash flowing real estate with high maintenance expenses in a market a long way from recovery, time share condos, etc.)
• Sale of that asset would lead to additional (cash) losses, transaction fees, and/or become the source of much aggravation and headache

Buffett Partnership Letters: 1957 Part 2

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

“…if the market should go considerably higher our policy will be to reduce our general issues as profits present themselves and increase the work-out portfolio.”

His describes the “general issues” basket – mostly undervalued securities with no catalyst – in greater detail in later letters.

Interestingly, the quote implies that Buffett used his “work-out” basket as a quasi-cash equivalent. Theoretically, when a security has little/no downside capture, assuming there’s enough trading volume and liquidity, it can be utilized in a portfolio context as a quasi-cash equivalent with upside potential. This allows the portfolio manager to decrease exposure as underlying markets get expensive, while squeezing out some return potential greater than pure cash yields. Should the underlying market decline, accumulated performance is preserved as the “work-out” basket does not decline, and could be sold to serve as a source of liquidity to purchase other (now cheap) securities that have declined with the market.

A useful tactic for investors who wish to decrease exposure when markets get frothy, but don't want to blatantly lag if the rally continues. Of course, this is all predicated upon one's ability to identify "work-out" securities with 1957 attributes. Please see our 1957: Part 1 discussion for more details.

Sizing, Expected Return, Hurdle Rate

“One of these positions accounts for between 10% and 20% of the portfolio of the various partnerships and the other accounts for about 5%...will probably take in the neighborhood of three to five years of work but they presently appear to have potential for a high average annual rate of return…”

“Earlier I mentioned our largest position which comprised 10% to 20% of the assets of the various partnerships. In time I plan to have this represent 20% of the assets of all partnerships but this cannot be hurried.”

“Over the years, I will be quite satisfied with a performance that is 10% per year better than the Averages…Our performance, relatively, is likely to be better in a bear market than in a bull market…In a year when the general market had a substantial advance I would be well satisfied to match the advance of the Averages.”

Buffett left nothing to hope or chance, and thought very strategically about position sizing, the annualized expected return of these positions, and the estimated hurdle rate required to outperform his benchmarks by a margin of 10% annually.

Too often, investors are anchored to certain return figures (e.g., 8-15%+ for equities, etc.) regardless of current market conditions and entry price. Unpleasant negative surprises would occur less often if investors followed Buffett’s approach in examining portfolio holdings, percentage exposures, and assigning realistic expected returns based on present market conditions.

I do not wish to imply that the expected return of a portfolio can be extracted via a scientific formula involving the calculation of a weighted average return figure – false precision is equally as dangerous as false expectations. However, I do believe that knowing the general direction of potential future portfolio returns can be helpful in setting realistic expectations for portfolio managers, external fund investors, and assist with other portfolio related decisions such as fundraising, headcount expansion, etc.

Separate Accounts

“All three of the 1956 partnerships showed a gain during the year amounting to about 6.2%, 7.8%, and 25% on yearend 1956 net worth. Naturally a question is created as to the vastly superior performance of the last partnership, particularly in the mind of the partners of the first two. This performance emphasizes the importance of luck in the short run, particularly in regard to when funds are received. The third partnership was started in the latest in 1956 when the market was at a lower level and when several securities were particularly attractive. Because of the availability of funds, large positions were taken in these issues. Whereas the two partnerships formed earlier were already substantially invested so that they could only take relatively small positions in these issues.”

For those who manage separate accounts and have received inquiries from clients regarding performance discrepancies related to fund flow / timing differences, feel free to tell them that this would happen even if Buffett managed their account. Perhaps not in those exact words, but I thought to include this quote in case a Reader finds it useful.

Buffett Partnership Letters: 1957 Part 1

I have often told people that the Buffett Partnership Letters is my favorite investment book. As a young investor (26 years old when he started in 1956), Buffett was nimble, opportunistic, and far more candid in his discussion of ideas and portfolio management techniques. The Partnership Letters and the early Berkshire letters are a treasure trove of information, revealing the staggering genius behind the simple folksy manner he employs for mass media. Summaries and excerpts related to portfolio management will be posted in series form over the next few months. I hope our Readers will enjoy them. I will certainly enjoy going back through and articulating my thoughts in written form.

It may surprise some Readers that Warren Buffett was not always a “buy and hold” investor. Wait until you read the letter in which he talks about drinking – I hope you’re sitting down – Pepsi!

Special Situations, Volatility

“My view of the general market level is that it is priced above intrinsic value…Even a full-scale bear market, however, should not hurt the market value of our work-outs substantially."

“A work-out is an investment which is dependent upon a specific corporate action for its profit rather than a general advance in the price of the stock as in the case of undervalued situations. Work-outs come about through: sales, mergers, liquidations, tenders, etc. In each case, the risk is that something will upset the applecart and cause the abandonment of the planned action, not that the economic picture will deteriorate and stocks decline in general.”  

Buffett’s “work-out” names muted (improved) the volatility profile of the return stream while providing upside potential – offering upside capture with little or no downside capture – in essence the “holy grail” security of every portfolio manager’s dream.

Fast forward 55 years, our industry now uses the term “special situations” and “event driven” to describe Buffett’s “work-outs.”

I suspect the arbitrage and special situations space back in 1957 was a lot less competitive, and investors could extract decent returns with minimal downside exposure to overall markets.

Today, many investors hold work-out / special situations / event driven securities in their portfolios. As a result of the competitive nature of the investment management industry, these types of securities either (1) no longer shield portfolios from market volatility as effectively as in 1957 or (2) do not provide the upside return potential as they once did.

With all that said, I still believe that Buffett’s technique is valuable today because his general rationale for holding uncorrelated “work-outs” in a portfolio still holds true. Investors just need to think more creatively and seek “work-outs” disguised in different forms – beyond the special situation securities in which event driven investors usually traffic.

AQR Tail Risk Hedging Whitepaper

Tail risk hedging (and hedging in general) has been a hot topic of discussion in recent years. With the market rally and the VIX back down to historically low levels (~15 as of this writing), I thought it appropriate to share a paper published by AQR Capital Management in the Summer 2011 (AQR Tail Risk Hedging Whitepaper). Many thanks to the Reader who was kind enough to share this with PM Jar.

Note to Readers: AQR often defines risk as volatility. Regardless of whether you agree with this definition, the paper is a worthwhile read as AQR makes astute and interesting observations.

For example, hedging has a number of implementation challenges:

• How much one is comfortable losing (and over what period of time)
• Sizing the hedge appropriately relative to the notional value one wishes to protect
• The psychological difficulty in sticking to an insurance program after years of negative performance

Most importantly, if the goal for hedging is to alter the volatility profile of the portfolio return stream, the paper outlines a number other methods to achieve that goal without spending protection premium.