Look Forward, Not Back

Ted Lucas of Lattice Strategies produces many worthwhile reads (conveniently, they’re all archived on Lattice’s website). The man is so well-read I wonder when he finds time to sleep. In this article, he references Antti Ilmanen’s new book Expected Returns, producing a wonderfully succinct piece highlighting the dangers of “conventional price history-based risk measures,” such as risk models that use historical volatility and historical correlation.

The chaos of 2008 was a fantastic example of the aftermath when investors are lulled into a sense of false comfort by relatively tame levels of historical volatility and low correlation from 2003-2007.

As Lucas eloquently writes:

“If you want to manage portfolio risk one must focus efforts on understanding the implied future expected returns built into how an asset is being valued at any point in time and avoid being lulled into complacency that might be suggested by standard risk models focusing solely on the asset’s recent price history.” 

For additional thoughts on forward-looking expected returns investing, be sure to check out a previous article on Jim Leitner.

Wisdom from Steve Romick: Part 2

Continuation of content extracted from an interview with Steve Romick of First Pacific Advisors (Newsletter Fall 2010) published by Columbia Business School. Please see Part 1 for more details on this series.  

Capital Preservation, Conservatism

“Most of our financial exposure is on the debt side. We were able to buy loans with very strong collateral, which we thought we understood reasonably well, and we stress tested the portfolios to determine what our asset coverage would be in a worst case scenario. We ended up buying things like Ford Credit of Europe, CIT, American General Finance, and International Lease Finance. We discounted the underlying assets tremendously, and in every case we didn‘t think we could lose money so we just kept buying.”

“The biggest lesson I ever learned from Bob is to prepare for the worst and hope for the best.”

Underwriting to an extremely conservative, worst case scenario helps minimize loss while increasingly likelihood of upside. This is similar to advice given by Seth Klarman in a previous interview with Jason Zweig.

Exposure, Intrinsic Value

“A lot of that has been culled back. The yield on our debt book was 23% last year and now it‘s less than 8%.”

The relationship between exposure and intrinsic value has been something we’ve previous discussed, nevertheless it remains an intriguingly difficult topic. Even Buffett ruminated over this in 1958 without providing a clear answer to what he would do.

For example:

Day 1 Asset 1 purchase for $100 Asset 1 is sized at 10% of total portfolio NAV Expected Upside is $200 (+100% from Day 1 price) Expected Downside is $80 (-20% from Day 1 price) Everything else in the portfolio is held as Cash which returns 0%

Day 2 Asset 1’s price increases to $175 Asset 1 is now worth 16.2% of total portfolio NAV (remember, everything else is held as Cash) Expected Upside is now +14.2% ($175 vs. $200) Expected Downside is now -54.2% ($175 vs. $80)

What would you do?

Not only has the risk/reward on Asset 1 changed (+14.2% to -54.2% on Day 2 vs. +100% to -20% on Day 1), it is now also worth a larger percentage of portfolio NAV (16.2% on Day 2 vs. 10.0% on Day 1)

Do you trim the exposure despite the price of Asset 1 not having reached its full expected intrinsic value of $200?

Steve Romick’s words seem to imply that he trimmed his exposure as the positions increased in value.

Risk, Hedging

“You can protect against certain types of risk, not just by hedging your portfolio, but by choosing to buy certain types of companies versus others.”

Practice risk “prevention” by choosing not to buy certain exposures, versus neutralizing risks that have already leaked into the portfolio via hedges (which require additional attention, not to mention option premium).

Howard Marks' Book: Chapter 4

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 4 “The Most Important Thing Is…The Relationship Between Price and Value.” Topics covered: Volatility, Leverage, When To Buy, When To Sell  

Volatility

“…most of the time a security’s price will be affected at least as much – and its short-term fluctuations determined primarily – by two other factors: psychology and technicals…These are nonfundamental factors – that is, things unrelated to value – that affect the supply and demand for securities.”

“Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals…The key is who likes the investment now and who doesn’t. Future price change will be determined by whether it comes to be liked by more people or fewer people in the future.”

“For self-protection, then, you must invest the time and energy to understand market psychology. It’s essential to understand that fundamental value will be only one of the factors determining a security’s price on the day you buy it. Try to have psychology and technicals on your side as well.”

Many investors suffer the vicissitude of volatility and deny they are suffering by clinging to the excuse that short-term price fluctuations are merely temporary impairments of capital.

The movements may be temporary, but temporary movements downward still impact your performance trackrecord, capital reinvestment options, etc., and therefore should not be completely ignored.

Howard Marks is undoubtedly a long-term investor, yet he considers the causes and ramifications of volatility “for self-protection.” Afterall, investing is difficult enough, wouldn’t you rather (attempt to) avoid the headwind of downside volatility if and when possible?

Leverage

“Here the problem is that using leverage – buying with borrowed money – doesn’t make anything a better investment or increase the probability of gains. It merely magnifies whatever gains or losses may materialize. And it introduces the risk of ruin if a portfolio fails to satisfy a contractual value test and lenders can demand their money back at a time when prices and illiquidity are depressed. Over the years leverage has been associated with high returns, but also with the most spectacular meltdowns and crashes.”

What about non-recourse debt? (Ethics aside, of course.) Could non-recourse debt make an investment “better” by skewing the ratio of potential loss (your equity cost basis) vs. potential gain?

When To Buy

“No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.”

“Believe me, there is nothing better than buying from someone who has to sell regardless of price during a crash. Many of the best buys we’ve ever made occurred for that reason.”

“The safest and most potentially profitable thing is to buy something when no one likes it.”

Before buying a security, consider who is selling and reasons why the seller dislikes it enough to sell. The best buying situations involve discoveries of forced/indiscriminate sellers for XYZ reason(s).

When To Sell, When To Buy

“Since buying from a forced seller is the best thing in our world, being a forced seller is the worst. That means it’s essential to arrange your affairs so you’ll be able to hold on – and not sell – at the worst of times. This requires both long-term capital and strong psychological resources.”

“A ‘top’ in a stock, group or market occurs when the last holdout who will become a buyer does so. The timing is often unrelated to fundamental developments.”

“Well bought is half sold.”

There’s an inherent, inseparable relationship between the act of buying and selling a security.

Buffett Partnership Letters: 1963 Part 2

Continuation in a series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Topics covered include: Benchmark, Hurdle Rate, Expected Return, Volatility, & Team Management.  

Benchmark, Hurdle Rate

“At plus 14% versus plus 10% for the Dow, this six months has been a less satisfactory period than the first half of 1962 when we were minus 7.5% versus minus 21.7% for the Dow.”

“If we had been down 20% and the Dow had been down 30%, this letter would still have begun “1963 was a good year.”

“Our partnership’s fundamental reason for existence is to compound funds at a better-than-average rate with less exposure to long-term loss of capital than the above investment [benchmarks]. We certainly cannot represent that we will achieve this goal. We can and do say that if we don’t achieve this goal over any reasonable period, excluding an extensive speculative boom, we will cease operation.”

“A ten percentage point advantage would be a very satisfactory accomplishment and even a much more modest edge would produce impressive gains…This view (as it has to be guesswork – informed or otherwise) carries with it the corollary that we much expect prolonged periods of much narrower margins over the Dow as well as at least occasional years when our record will be inferior…to the Dow.”

Buffett’s performance goal was relative (10% annual above the Dow), not absolute return. He once again makes a statement about ceasing operation if he doesn’t achieve this goal – the man was determined to add value, not content leaching fees.

But a question continues to tickle my brain:

Why 10% above the Dow? Why not 5% or 15.7%? What is significant about this 10% figure (other than an incredibly ambitious goal)? Buffett plays coy claiming “guesswork – informed or otherwise,” but we know that Buffett was not the random-number-generating-type.

Expected Return, Volatility

“We consider all three of our categories to be good businesses on a long-term basis, although their short-term price behavior characteristics differ substantially in various types of markets.”

“Our three investment categories are not differentiated by their expected profitability over an extended period of time. We are hopeful that they will each, over a ten or fifteen year period, produce something like the ten percentage point margin over the Dow that is our goal. However, in a given year they will have violently differentiated behavior characteristics, depending primarily on the type of year it turns out t be for the stock market generally.”

As we have discussed in the past, Buffett was extremely conscious of the expected return and expected volatility (in a number of different scenarios) of his portfolio positions. For more commentary on this, please see our previous articles on expected return and volatility.

Buffett is “hopeful” that the investments he selects “will each, over a ten or fifteen year period, produce something like the percentage point margin over the Dow that is our goal.”

But how does he determine which investment fits this criteria during the initial diligence process prior to purchase – especially since the Dow itself is perpetually fluctuating?

Team Management

“…the Dempster story in the annual letter, perhaps climaxed by some lyrical burst such as ‘Ode to Harry Bottle.’ While we always had a build-in profit in Dempster because of our bargain purchase price, Harry accounted for several extra serves of dessert by his extraordinary job.”

“Beth and Donna have kept an increasing work load flowing in an excellent manner. During December and January, I am sure they wish they had found employment elsewhere, but they always manage to keep a mountain of work ship-shape…Peat, Marwick, Mitchell has done their usual excellent job of meeting a tough timetable.”

Praise – lay it on thick. The tool of appreciation can perhaps reach the uncharted corners of loyalty in your employees’ hearts where compensation had previously failed.

Wisdom from Steve Romick: Part 1

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

Creativity

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

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

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

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

Time Management

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

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

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

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

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

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

Psychology

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

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

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

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

Buffett Partnership Letters: 1963 Part 1

Continuation in a series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Clients, Leverage, Subscriptions, Redemptions

“We accept advance payments from partners and prospective partners at 6% interest from date of receipt until the end of the year…Similarly, we allow partners to withdraw up to 20% of their partnership account prior to yearend and charge them 6% from date of withdrawal until yearend…Again, it is not intended that partners use us like a bank, but that they use the withdrawal right for unanticipated need for funds.                                     

“Why then the willingness to pay 6% for an advance payment money when we can borrow from commercial banks at substantially lower rates? For example, in the first half we obtained a substantial six-month bank loan at 4%. The answer is that we except on a long-term basis to earn better than 6%...although it is largely a matter of chance whether we achieve the 6% figure in any short period. Moreover, I can adopt a different attitude in the investment of money that can be expected to soon be part of our equity capital than I can on short-term borrowed money.” 

“The advance payments have the added advantage to us of spreading the investment of new money over the year, rather than having it hit us all at once in January.”

Buffett allowed his investors annual windows for subscription and redemption (to add or withdraw capital). However, clients could withdraw capital early at 6% penalty. Clients could also add capital early and receive 6% return.

Paying investors 6% for their advance payments technically constitutes a form of leverage. However, as Buffett points out, not all forms of leverage are created equal. Margin lines are usually short-term with the amount of capital available constantly shifting, tied to value of underlying portfolio holdings which are usually marketable securities. Bank loans have limited duration until the debt must be repaid or terms renegotiated. In contrast to the two previous common forms of leverage, paying investors 6% (or whatever percentage depending on the environment) is most similar to long-term leverage with permanent terms (until the annual subscription window), since the capital will stay, converting from “debt” to an equity investment.

A friend recently relayed a story on Buffett giving advice to an employee departing to start his own fund. Apparently, it was a single piece of information: allow subscriptions and redemptions only one day per year.

The paperwork, etc. aside, I believe the true rationale behind this advice lies in the last quote shown above. Similar to how advance payments allowed Buffett the advantage of “spreading the investment of new money over the year,” having one subscription/redemption date would allow a portfolio manager to offset capital inflows against capital outflows, thereby decreasing the necessity of having to selling positions to raise liquidity for redemptions and scraping around for new ideas to deploy recent subscriptions. In other words, it minimizes the impact of subscriptions and redemptions on the existing portfolio.

Risk Free Rate, Fee Structure, Hurdle Rate

“…6% is more than can be obtained in short-term dollar secure investments by our partners, so I consider it mutually profitable.”

Not only was 6% the rate applicable to early redemptions or subscriptions, 6% was also the incentive fee hurdle rate, such that if the Partnership returned less than 6%, Buffett would not receive his incentive fee.

Based on the quote above, it would seem in 1963, 6% was approximately the risk free rate. Today (Aug 2012), the rate that can be “obtained in short-term dollar secure investments” is 1% at best.

Some funds still have minimum hurdle rate requirements built into incentive structure (I see this most commonly with private equity / long-term-commitment style vehicles). But most liquid vehicles (e.g., hedge funds) don’t have minimum hurdle rates determining whether they collect incentive fees in any given year.

This makes me wonder: why don’t most liquid funds vehicle fee structures have hurdle rates? It doesn’t seem unreasonable to me that, at a minimum, these funds should have an incentive fee hurdle rate equivalent to the risk-free-rate in any given year.

Tax

“A tremendous number of fuzzy, confused investment decisions are rationalized through so-called ‘tax considerations.’ My net worth is the market value of holdings less the tax payable upon sale. The liability is just as real as the asset unless the value of the asset declines (ouch), the asset is given away (no comment), or I die with it. The latter course of action would appear to at least border on a Pyrrhic victory. Investment decisions should be made on the basis of the most probably compounding of after-tax net worth with minimum risk.”

Taxes made simple by Warren Buffett.

Sadly, many investment funds today fail to consider tax consequences because the clients who matter (the large pensions and foundations) don’t pay taxes. So their smaller taxable clients suffer the consequences of this disregard.

Baupost Letters: 1995

Here is the first installment of a series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts for this series.

When To Buy, Risk

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

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

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

Benchmark, Conservatism, Clients

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

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

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

Selectivity, Cash

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

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

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

Catalyst, Volatility, Special Situations

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

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

Hedging

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

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

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

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

Far from the Madding Crowd

Investing is full of paradoxes. For example, in this zero-sum game, everyday we walk a fine line between arrogance (conviction that we are right) and humility (possibility that we may be wrong). We’ve written in the past about the importance of self-awareness. Self-aware of our mental weakness(es). Self-aware of our (perceived) strengths. Self-aware of how we stack up relative to the competition. But is there a point when we are too self-aware, such that it becomes our enemy?

In a 2011 Fortune article about Bob Rodriguez of First Pacific Advisors (many thanks to my good friend and former colleague Robert Terrell of Karlin Asset Management for sharing this with PM Jar), there’s a part that talks about how Bob was teased as a child and didn't care.

"When Rodriguez was 12, he had a major operation on his teeth that, for two years, left him with a heavy speech impediment. Classmates teased him -- so he gave a speech on the topic of elocution to show that he could make fun of himself. ‘Most people, when they're different, they become self-conscious,’ says Dick [his brother]. ‘Bob hasn't been one to sacrifice his ethics or his intellect to fit in.’"  

Ignoring negativity would definitely be easier if one lacked the self-awareness to realize that others were hurling it in your direction. Whether this is through naiveté or deliberate choice, in terms of investing, is it easier to stick to a contrarian strategy and sustain creativity when you are far away from the madding crowd, either mentally or physically?

Howard Marks' Book: Chapter 3

Below is a continuation of portfolio management highlights from Howard Marks’ recent book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 3 “The Most Important Thing Is…Value”: For anyone who has purchased a security too soon while the price continued to decline, I would highly recommend reading the last few pages of Chapter 3 in its entirety.

Intrinsic Value

“To value investors, an asset isn’t an ephemeral concept you invest in because you think it’s attractive (or think others will find it attractive). It’s a tangible object that should have an intrinsic value capable of being ascertained, and if it can be bought below its intrinsic value, you might consider doing so. Thus, intelligent investing has to be built on estimates of intrinsic value. Those estimates must be derived rigorously, based on all of the available information.”

“…the best candidate for that something tangible is fundamentally derived intrinsic value. An accurate estimate of intrinsic value is the essential foundation for steady, unemotional and potentially profitable investing.”

Intrinsic value is tangible. But does “tangible” and “capable of being ascertained” mean an exact calculated estimation, or is the triangulation of a range considered a good enough estimation of intrinsic value?

The derivation of intrinsic value involves a process, and it is this process as well as the estimation of intrinsic value that injects discipline and governs a number of complex (and often potentially emotionally charged) investment decisions such as when to buy, when to sell, knowing when you’re wrong, etc.

Making Mistakes, When To Buy, When To Sell

“…in the world of investing, being correct about something isn’t at all synonymous with being proved correct right away…”

“…don’t expect immediate success. In fact, you’ll often find that you’ve bought in the midst of a decline that continues. Pretty soon you’ll be looking at losses. And as one of the greatest investment adages reminds us, ‘Being too far ahead of your time is indistinguishable from being wrong.’”    

“…very difficult to hold, and to buy more at lower prices (which investors call ‘averaging down’), and especially if the decline proves to be extensive. If you liked it at 60, you should like it more at 50…and much more at 40 and 30. But it’s not that easy. No one’s comfortable with losses and eventually any human will wonder, ‘Maybe it’s not me who’s right. Maybe it’s the market.’ The danger is maximized when they start to think, ‘It’s down so much, I’d better get out before it goes to zero.’ That’s the kind of thinking that makes bottoms…and causes people to sell there.”

“An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse.”

Being “right” versus “wrong” can sometimes simply involve a debate of time semantics.

Dealing with a mistake is often extra difficult because of the behavioral aspects that an investor must overcome, such as self-doubt.

The solution circles back to the idea of process over outcome. An investor can’t control the timing of outcome (price movement), but he/she can control the investment process. So when doubt and other negative emotions reign supreme, the only antidote is to reexamine your process and estimation of intrinsic value.

In the last sentence, Marks cautions against “an incorrect opinion…strongly held.” Behavioral finance calls it “anchoring.” Poker calls it “pot commitment.” Equally important as the reexamination of your investment process and intrinsic value, is the possession of the wisdom to know when to fold a hand, especially when an “incorrect opinion” has occurred.

When To Sell

“Momentum investing might enable you to particulate in a bull market that continues upward, but I see a lot of drawbacks. One is based on economist Herb Stein’s wry observation that ‘if something cannot go on forever, it will stop.’ What happens to momentum investors then? How will this approach help them sell in time to avoid a decline?”

Some say the curse of value investing is that this breed often misses out on the “momentum effect” by selling positions too soon, and that their portfolios fail to participate in raging bull markets.

Howard Marks offers some word of consolation by advising value investors to observe process over outcome, and to not cry over the spilt milk of missing the momentum effect.

Sizing

“Compared to value investing, growth investing centers around trying for big winners. If big winners weren’t in the offing, why put up with the uncertainty entailed in guessing at the future? There’s no question about its: it’s harder to see the future than the present. Thus, the batting average for growth investors should be lower, but the payoff for doing it well might be higher. The return for correctly predicting which companies will come up with the best new drug, most powerful computer or best-selling movies should be substantial.”

Howard Marks astutely commented that the reconciliation between value and growth investing lies in the difference “between value today and value tomorrow.” Is there another possible source of reconciliation in sizing considerations?

The future is harder to predict, therefore the probability of positive outcome is lower for growth positions, while the absolute level of payout is higher. In certain instances, could a portfolio manager mitigate the risk of the lower probability of positive outcome by making the “growth” position a smaller percentage of the portfolio?

Buffett Partnership Letters: 1962 Part 3

This is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please see our previous articles for more details. A slightly off tangent and random fact, in 1962, Buffett into new office space stocked with – hold on to your knickers – “an ample supply of Pepsi on hand.”

Team Management

“On April 17, 1962, I met Harry [Bottle] in Los Angeles, presented a deal which provided for rewards to him based upon our objectives being met, and on April 23^rd he was sitting in the president’s chair in Beatrice. Harry is unquestionably the man of the year. Every goal we have set for Harry has been met, and all the surprises have been on the pleasant side. He has accomplished one thing after another that has been labeled as impossible, and has always taken the tough things first...He likes to get paid well for doing well, and I like dealing with someone who is not trying to figure how to get the fixtures in the executive washroom gold-plated. Harry and I like each other, and his relationship with Buffett Partnership, Ltd. should be profitable for all of us.”

The quote above is the start of Buffett’s tendency to mention and praise employees / operating partners. This habit would continue in his letters over the next 50 years. Here, we see two important items related to team management.

1. Alignment of Interest – “rewards to him based upon our objectives being met,” which included 2,000 options (out of 60,146 total shares outstanding) equating to ~3% ownership, therefore a mutually beneficial relationship that’s “profitable for all…”

2. Appreciation / Praise – an underutilized strategy with the potential to work wonders for talent retention. It’s in each of our natures to want to feel appreciated, and to hear praise. This is something that too often people in the finance industry fail to understand. Throwing money at the problem unfortunately doesn’t work in every instance and instead starts bidding wars for talent (compensation, unfortunately, is not a competitive advantage when it comes to employee retention). There are other subtler and perhaps more effective ways to attract and retain employees.

Sizing

“The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon availability factors…We were fortunate in that we had a good portion of our portfolio in work-outs in 1962. As I have said before, this was not due to any notion on my part as to what the market would do, but rather because I could get more of what I wanted in this category than in generals. This same concentration in work-outs hurt our performance during the market advance in the second half of the year.”

Due to “availability factors,” portfolio sizing involves a certain degree of we-get-lemons-and-therefore-we-make-lemonade.

Although Buffett had the optimal and “actual percentage division among categories” in “some degress[s] planned” in his head, he remained flexible and made do with what market offerings were available at the time.

Buffett Partnership Letters: 1962 Part 2

This is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please see our previous articles for more details. Slightly off tangent random fact: in 1962, Buffett into new office space stocked with – hold on to your knickers – “an ample supply of Pepsi on hand.”

Volatility

“It should be pointed out that Dempster last year was 100% an asset conversion problem and therefore, completely unaffected by the stock market and tremendously affected by our success with the assets. In 1963, the manufacturing assets will still be important, but from a valuation standpoint it will behave considerably more like a general since we will have a large portion of its money invested in generals pretty much identical with those in Buffett Partnership, Ltd…Therefore, if the Dow should drop substantially, it would have a significant effect on the Dempster valuation. Likewise, Dempster would benefit this year from an advancing Dow which would not have been the case most of last year…”

In a previous article (1961 Part 2), we discussed the topics of expected return and expected volatility, where we made the assertion that Buffett was ever conscious of how each security would behave relative to overall markets and in the long-run, and on a forward looking basis.

His comments above on Dempster again demonstrate this, by focusing on the underlying drivers of price movement, not just categorical surfaces. Because the name of a security hasn’t changed, doesn’t mean that everything about it stays the same.

As background, in 1962, Buffett installed as the new CEO of Dempster (a control position where Buffett owned a majority stake) Harry Bottle who successfully transformed the assets of Dempster from Inventory, Receivables, and PPE into mostly Cash and Marketable Securities.

In 1962, the valuation of Dempster was mostly unaffected by the bear market that year since the assets consisted of inventory, receivables, etc. With the asset conversion, in 1963 and beyond, the valuation of Dempster would be far more sensitive to market swings since “a large portion of its money” was “invested in generals pretty much identical to those in” the Partnership.

“Our target is an approximately ½% decline for each 1% decline in the Dow, and if achieved, means we have a considerably more conservative vehicle for investment in stocks than practically any alternative.”

Here we see an explicit goal outlined for portfolio downside volatility. Notice, this is only a downside volatility goal, with no stipulations about upside volatility.

Everyone talks about volatility as a bad, bad thing. In truth, people really only hate portfolio downside volatility, and welcome extreme high upside volatility in their portfolios.

Liquidity, Mark to Market, Volatility

“The figures for our performance involve no change in the valuation of our controlling interest in Dempster Mill Manufacturing Company, although developments in recent months point toward a probable high realization.” (As of 6/30/1962)

“When control of a company is obtained, obviously what then becomes all-important is the value of assets, not the market quotation for a piece of paper (stock certificate). Last year, our Dempster holding was valued by applying what I felt were appropriate discounts to the various assets.”

Control of Dempster was achieved in 1961, therefore, the mark to market on Dempster (at year-end 1961) was based on balance sheet liquidation of assets (marked at discounts to face value) and liabilities (100% face value), not market quotations.

During the first six months of 1962, the Dow returned -21.7%, while the Partnership outperformed substantially returning -7.5%.

At the end of 1961, Dempster was ~22% of Partnership NAV, which no doubt helped bolster performance when the market took a nosedive. However, had the market taken off for the moon instead, Buffett’s position in Dempster would have negatively impacted performance.

Illiquid positions can decrease portfolio volatility on both the upside and the downside, thus be sure to utilize securities of this breed (the proverbial double-edged sword) with caution.

Compounding Outsourced

“I’m a value investor, which says I want to buy 50-cent dollars, but given my firm’s predilection for serving the needs of taxable investors, I also want that dollar to tax-efficiently compound in value over long periods of time. That means the businesses must have great capacity to reinvest, which is not all that common...I want our money to work for us – in essence, I am passing through to our portfolio-company management much of my obligation to reinvest.”     –Tom Russo Albert Einstein called The Rule of 72 the “Ninth Wonder of the World” and supposedly said this rule (not E = MC^2) was the greatest mathematical discovery of all time .

Compounding is an integral part of investing, no matter how you define investing, your strategy or approach – similar to how Islam, Christianity, and Judaism all share the commonality of monotheism.

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

Operating business achieve compounding by reinvesting past earnings back into the same business (or perhaps new business lines). In this respect, the operating business has an advantage over the financial investor, who must constantly search for new opportunities.

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

For example, Warren Buffett figured this out early and part of Berkshire’s success lies in the entity’s ability to constantly reinvest and compound capital, through a wide variety and extensive network of investment securities and operating companies – a broadened horizon of opportunities versus what is commonly available to the usual financial investor.

Last but not least, outsourced compounding via operating business reinvestment also minimizes tax leakage. Not too shabby: less work AND less taxes.

Buffett Partnership Letters: 1962 Part 1

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

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

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

Benchmark

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

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

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

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

Trackrecord

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

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

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

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

Clients, Time Management

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

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

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

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

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

It's Still A People Business

I recently read an interview in Inc. Magazine on leadership and people management with Bob Sutton, a Stanford professor. Sutton's audience is mainly corporations and other businesses, but his comments are directly applicable to the investment management business. After all, whether we like it or not, the investment management business is still a business that employs people. Even if you run a small firm with 1 employee (not including yourself), you still need to manage your working relationship with that other individual (whether he/she be analyst or partner).

The article starts off a little slow – feel free to skip directly to the section starting with the word Authoritarian. From there, it’s all good stuff. Some highlights include:

• The best “coaches have to be schizophrenic. There are prima donnas you have to make feel terrible to get them going. And other players who lack self-esteem that need to be built up. So, half the time, he’s being an asshole, and half the time he’s being a nice guy. That’s because he really understands the people he works with.”
• The best leaders are “moderately assertive” and are “good at reading a situation to know when to turn up the volume in terms of getting in people’s faces” and when to get out of the way.
• Research has demonstrated that people prefer hierarchy to anarchy. In most instances, a good leader considers input from others but ultimately steps up and makes the decision.
• Leadership doesn’t mean absolutely having to make a decision for decision’s sake, and that the lack of decision-making is okay in certain circumstances, such as when there are no good solutions available to a problem.

A portfolio manager needs to be able to effectively manage and motivate his/her team to achieve results. Currently, compensation is the most commonly used management and motivation tool in our industry. But the effectiveness of that tool only goes as far as a higher offer elsewhere – hence the high turnover rate at some firms. A team that is continuously turning over is disruptive to the investment process.

Buffett understood, very early on, the importance of managing and motivating people through praise and appreciation (more details to come in a future article). There are undoubtedly other methods that also work well. PM Jar will attempt to feature more articles in the future discussing effective team management methods relevant to portfolio managers.

Wisdom from David E. Shaw: Part 2

Here is Part 2 of our summary (focused on portfolio management tid bits, of course) of an interview with David E. Shaw in Peter J. Tanous’ book Investment Gurus. For additional background and context, please see Part 1.  

Risk, Hedging

“The purpose of a portfolio optimizer is to trade off risk and return in some predefined way, and to try to come up with a portfolio that’s close as possible to optimal in terms of those risk/return criteria…The optimizer knows things like transaction costs, the hedging of various risk factors…So it constructs a portfolio that is nearly optimal with respect to some risk/reward criterion, and then it modifies it continuously as new data come in…As an example of what such a program might do, the optimizer might find that one security looks under-priced relative to all these other different instruments, but if I actually bought that security, then I would have to much exposure to automobile stocks, and I would also tend to be short interest rates. I might also be making an implicit bet on economic cyclicality, and if the economy started to go bad, I might lose money that way.”

“…in practice you never really look at an isolated trade. You have to look at the whole universe. We use an optimizer that takes into consideration all the factors we know about…both for predicting profit and also for minimizing various sorts of risk. That doesn’t mean eliminating them. It’s the sort of thing you were describing, where you analyze the influences on a given stock, get information on all of the related stocks, bonds, options and so forth, and then construct a portfolio that tries to get as many of those risk factors as possible to cancel out. But it doesn’t happen in a simple way. Everything relates to everything else.”

The Optimizer is a computer software/algorithm programmed to understand the relationship between risk and return. How those terms and that relationship is defined, remains a mystery. Shaw is very secretive about their process. Nevertheless, the computer constructs the portfolio based on certain risk/reward factors – an idea akin to how fundamental human investors approach portfolio construction.

No (wo)man is an island. Similarly, no risk is an island. In the integrated world of today’s market economy, all risks are related in some way, which makes identification and hedging of risk factors an extremely difficult and delicate task. To “simplify” this process, Shaw talks about getting “as many of those risk factors as possible to cancel out” thus hopefully decreasing the number of transactions necessary to implement a hedging program and thus lowering associated costs as well.

Discount Rate, Opportunity Cost

“…the optimizer also knows about the cost of capital, and it’s not likely to get very excited about something that would tie up a lot of capital for a long period of time.”

What exactly constitutes the discount rate or cost of capital? For companies, it’s the weighted average cost of capital (WACC). One could argue that the calculation of this figure is quite fuzzy, especially with the presence of equity in the capital base. And moving further along the complexity scale, what is the cost of capital for (unlevered) investors?

If we removed from our minds the WACC formula carved deep from years of textbook finance training, the concept of cost of capital becomes quite interesting to think about.

Shaw references how The Optimizer associates the cost of capital with time. Based on traditional finance theory, this is because investors have a time preference of receiving cash today vs. tomorrow, and thus need to be compensated for the time delay. Traditionally, the risk-free-rate is used as the compensation figure. However, if we use the risk-free-rate, how then do you calculate the cost of capital for a portfolio of various international assets (where the risk-free-rate of the underlying holdings varies by country)? Do you take into account the effect of currency fluctuations for each country?

I have also heard some people reference the cost of capital as an opportunity cost figure. If so, does it change based on available returns provided by other opportunities? But if the cost of capital is a relative figure, how then do we calculate the cost of capital for those other investments? It becomes a rather recursive process…

However intangible, and regardless of differing definitions and calculation methodologies for the cost of capital, it is still a very real and necessary consideration in the investment, and portfolio management process. Stay tuned for some juicy bits on discount rate / cost of capital from Seth Klarman.

Howard Marks' Book: Chapter 2

Below is a continuation of portfolio management highlights from Howard Marks’ recent book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 2 “Understanding Market Efficiency (and It’s Limitation)”: Risk

“I have my own reservations about the theory [efficient market hypothesis], and the biggest one has to do with the way it links return and risk…Once in a while we experience periods when everything goes well and riskier investments deliver the higher returns they seem to promise. Those halcyon periods lull people into believing that to get higher returns, all they have to do is make riskier investments. But they ignore something that is easily forgotten in good times: this can’t be true, because if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier. Every once in a while, then, people learn an essential lesson. They realize that nothing – and certainly not the indiscriminate acceptance of risk – carries the promise of a free lunch, and they’re reminded of the limitations of investment theory.”

More Risk ≠ More Return

Psychology

“…one stands out as particularly tenuous: objectivity. Human beings are not clinical computing machines. Rather, most people are driven by greed, fear, envy and other emotions that render objectivity impossible and open the door for significant mistakes.”

Self-awareness. So important, yet again, so intangible – just like the creativity component.

I often tell people that half the investment battle actually takes place in your mind, not the marketplace. Controlling your bias, fears, vanity (my favorite, and most deadly investing original sin “I’m right, the market is just stupid.”), etc. takes an incredible amount of discipline. But before discipline can work its magic, self-awareness must first exist to identify the problem.

Wisdom from David E. Shaw: Part 1

Previously, we summarized an interview with Michael F. Price from Peter J. Tanous’ book Investment Gurus. We now move to the near opposite end of the investment style spectrum, to an interview in the same book with David E. Shaw, the ingenious and unorthodox founder of D.E. Shaw, a well-known and renowned quant fund. Although Shaw runs a quant strategy, he provides a number of unique perspectives within the chapter that I believe valuable to traditional fundamental investors. After all, cross pollination and being open to new ideas is a good thing.

Creativity

Tanous: David, there’s something else that comes up when you talk to a lot of the successful managers. Many of them, especially the ones who are clearly superior to their peers, may well have a sixth sense of some sort, in additional to their other qualities. Now they’re all very smart, they’re all very disciplined, they’re all focused, but you wonder if there isn’t an undefinable something extra at work. I suppose instinct and intuition…

Shaw: I think you’re talking about what I think of as a sort of “right brain” thought process…What we do is similar to what a classical natural scientist does. You go out there and study some set of phenomena. Then, using that sort of experienced-based pattern recognition and creative thought that’s so hard to describe, you formulate a well-defined hypothesis about what may be going on…One thing I think is often misunderstood, not just about our type of business but about the nature of science in general, is that the hardest part, the part that really distinguishes a world-class scientist from a knowledgeable laboratory technician, is that right-brain, creative part. 

Food for thought: does analyst = laboratory technician vs. portfolio manager = world-class scientist?

Here, creativity again rears its head – from an investor that runs a completely different strategy from some of the others that we’ve covered, such as Howard Marks, in reference to what makes investors successful.

As someone who has spent countless hours speaking with different fund/portfolio managers, I suspect the reason why creativity keeps creeping up is in part due to the competitive nature of our business. The defensive moat described by Buffett is just as important for the investment management business as it is for a business that makes widgets. Creativity allows an investor to stay one step ahead, to discover unique mispricings before the crowd, and thus efficiency, closes in.

Unfortunately, there is no formula for creativity in the investment or portfolio management process. In fact, once verbalized, the concept of a formula for creativity sounds quite absurd! Alas, perhaps there’s hope in that the intangible creative process could be taught or learned over time?

Team Management

“What we care about most is finding, literally, the very best people in the world for whatever the position is…We spend an unbelievable amount of money on recruitment, relative to our total operational budget. In particular, we spend a lot identifying the very best people in the world in whatever category that interest us. In fact, we’ll often start way before the point where we really need someone.”

Buffett Partnership Letters: 1961 Part 4

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. For those interested in Warren Buffett’s portfolio management style, I highly recommend the reading of the second 1961 letter in its entirety, and to check out our previous posts on 1961.

Conservatism

“Many people some years back thought they were behaving in the most conservative manner by purchasing medium or long-term municipal or government bonds. This policy has produced substantial market depreciation in many cases, and most certainly has failed to maintain or increase real purchasing power.”

“You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you…You will be right, over the course of many transactions, if your hypothesis is correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”

“I might add that in no way does the fact that our portfolio is not conventional provide that we are more conservative or less conservative than standard methods of investing. This can only be determined by examining the methods or examining the results. I feel the most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets.”

Conservatism ≠ Buying “Conservative” Securities

Food for thought: currently (today’s date is 6/23/12), millions of retirees and older individuals in America hold bonds and other fixed income securities believing that they are investing “conservatively.” In light of current bond market conditions, where the 10-Year Treasury and 30-Year Treasury yields 1.67% and 2.76% respectively, is it time for people to reconsider the traditional definition of conservatism and conservative allocation? The bond example recounted by Buffett sounds hauntingly familiar. According to history, it ended badly for bond holders the last time around.

Buffett also highlights the importance of focus on conservatism inherent in the investment process, that of objective fact gathering and interpretation “through knowledge and reason.”

Interestingly, the last quote above implies that Buffett believed “evaluation of performance in down markets” an adequate measure of conservatism. Another name for this measurement is called drawdown analysis, and drawdown analysis is very much a measure of volatility (i.e., temporary impairment of capital). How then, does this view reconcile with his later comments about temporary vs. permanent impairments of capital?

Clients, Benchmark

“The outstanding item of importance in my selection of partners, as well as in my subsequent relations with them, has been the determination that we use the same yardstick. If my performance is poor, I expect partners to withdraw…The rub, then, is in being sure that we all have the same ideas of what is good and what is poor. I believe in establishing yardsticks prior to the act; retrospectively, almost anything can be made to look good in relation to something or other.”

“While the Dow is not perfect (nor is anything else) as a measure of performance, it has the advantage of being widely known, has a long period of continuity, and reflects with reasonable accuracy the experience of investors generally with the market…most partners, as an alternative to their investment in the partnership would probably have their funds invested in a media producing results comparable to the Dow, therefore, I feel it is a fair test of performance.”

For any business, tapping the right client base and keeping those clients happy is crucial. Buffett advises the establishment of a mutually agreed upon objective (i.e., benchmark), so that the client and portfolio manager can mutually agree whether performance during any given period is “good” or “poor.” Coincidentally, this is similar to what Seth Klarman advises during an interview with Jason Zweig.

This is why the benchmark is so important – it is the mechanism through which clients can decide if a portfolio manager is doing a good or bad job. Picking the right benchmark is the tricky part…

Clients

“With over 90 partners…”

For those of you wondering how many clients Buffett had in his partnerships at the end of 1961, there you go!

Trackrecord, Mark To Market, Liquidity

“Presently, we own 70% of the stock of Dempster with another 10% held by a few associates. With only 150 or so other stockholders, a market on the stock is virtually non-existent…Therefore, it is necessary for me to estimate the value at yearend of our controlled interest. This is of particular importance since, in effect, new partners are buying in based upon this price, and old partners are selling a portion of their interest based upon the same price…and at yearend we valued our interest at $35 per share. While I claim no oracular vision in a matter such as this, I believe this is a fair valuation to both new and old partners.”

With such a large, illiquid controlling stake, Buffett had difficulty determining the “fair” mark to market for Dempster. Dilemmas such as this are still commonplace today, especially at funds that invest in illiquid or private companies.

As Buffett points out, the mark directly impacts new and old investors who wish to invest or redeem capital from the fund. Anyone who invests in a fund of this type should carefully diligence the mark to market methodology before investing (and redeeming) capital.

There’s another more murky dimension, the investment management industry’s dirty little secret: difficulty in determining an accurate mark makes it possible for funds to “jimmy” the mark and therefore influence the performance trackrecord / return stream reported to investors.

Howard Marks' Book: Chapter 1

In his recent book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Howard Marks of Oaktree writes about a lot of different investment topics. I’ve done my best to lift out relevant portfolio management details. Without further ado, below are highlights from Chapter 1, titled “The Most Important Thing Is…Second-Level Thinking.” Portfolio Management

“Because investing is at least as much art as it is science, it’s never my goal – in this book or elsewhere – to suggest it can be routinized. In fact, one of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.”

Successful investing involves equal parts sniffing out ideas, effective diligence, and thoughtful portfolio management. Marks’ comments may not have been written to pertain specifically to the portfolio management process, but it certainly applies.

It’s difficult to routinize portfolio management since the process differs by person and by strategy. Tug on one side of the intricate web and you change the outcome in several other areas. Portfolio management, like the “investing” in Marks’ words, is an art, not the science – distilled into a perfectly eloquent formula or model as many academics and theorists have attempted to extract. (Ironically, Howard Marks and I were both educated at the University of Chicago.) Art demands some degree of inherent messiness – constant changes, tweaks, paint everywhere. Art, like portfolio management, requires practice, dedication, and reflection over time.

Creativity

“No rule always works…An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed. And if others emulate an approach, that will blunt its effectiveness.”

“Unconventionality shouldn’t be a goal in itself, but rather a way of thinking. In order to distinguish yourself from others, it helps to have ideas that are different and to process those ideas differently.”

Investment performance is ever forward looking. A strategy or idea that’s worked in the past may or may not provide the same success in the future. Marks’ comments regarding the importance of creativity have broad applications – from idea sourcing to the diligence process to portfolio management technique.

Maintaining that creative spirit, staying one step ahead of the competition (sounds oddly like running a business, doesn’t it?) is crucial to generating superior investment returns over the long run.

Definition of Investing, Benchmark

“In my view, that’s the definition of successful investing: doing better than the market and other investors.”

Here, the definition of successful investing depends upon “doing better than” a certain “market” or “other investors.”

In order to “do better” than something, an investor must identify that something ahead of time – whether it be a single market index or a bundle of indices and other competing funds.

We’ve discussed the topic of benchmarks in the past (see benchmark tag). For example, during the Partnership days, Buffett used the Dow as his primary benchmark, but also showed investors his performance against a group of well-known mutual and closed end funds. Some Brazilian hedge funds use the local risk-free-rate as their benchmark.

The point is: your choice of benchmark can vary, just make sure that you’ve at least made a choice.

Buffett Partnership Letters: 1961 Part 3

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. For those interested in Warren Buffett’s portfolio management style, I highly recommend the reading of the second 1961 letter in its entirety, and to check out our previous posts on 1961.

Sizing

“The first section consists of generally undervalued securities (hereinafter called “generals”)…Over the years, this has been our largest category of investment…We usually have fairly large portions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen.”

“…and probably 40 or so securities.”

Today, people often reference Buffett’s concentrated portfolio approach for sizing advice. Although Buffett wasn’t shy about pressing his bets when opportunity knocked (Dempster Mill was 21% of the total Partnership NAV), he didn’t always run an extremely concentrated portfolio, at least not in the partnership days.

The “generals” portion had 5-6 positions consisting of 5-10% each, and another 10-15 smaller positions. So the “generals” segment as a whole comprised approximately 25-60% of NAV in 15-20 or more positions. Also, see discussion on diversification of “generals” below.

The “work-out” segment usually had 10-15 positions (see next section).

At the end of 1961, his portfolio consisted of ~40 securities.

Catalyst, Diversification, Expected Return

“The first section consists of generally undervalued securities (hereinafter called “generals”) where we have nothing to say about corporate policies and no time table as to when the undervaluation may correct itself…Sometimes these work out very fast; many times they takes years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid…This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential.”

“Our second category consists of “work-outs.” These securities whose financial results depend on corporate action…with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc. lead to works-outs…At any given time, we may be in ten to fifteen of these, some just beginning and others in the late stage of their development.”

“Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low…for a long period, this might very well happen.”

Catalysts helped Buffett “predict within reasonable error limits, when [he] will get how much and what might upset the applecart.” Put differently, catalysts enhanced the likelihood of value appreciation and accuracy of expected returns.

In his “generals” basket, to compensate for the lack of catalysts (and inability to predict when price would reach fair value), Buffett employed diversification unconventionally. Investors usually diversify portfolio positions to mitigate portfolio losses. Here, Buffett applies the concept of diversification to portfolio upside potential through his “diversity of commitments.” By spreading his bets, Buffett smoothed the upside potential of his “general” positions over time – a few “generals” would inevitably encounter the catalyst and move toward fair value each year.

Lastly, Buffett believed that the lack of catalyst creates opportunity. As long as investors are short-term results driven, this tenet will remain true. He sometimes took advantage by acquiring large enough stakes in these no-catalyst-generals and creating his own catalyst through activism.

Leverage

“We believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior. Results, excluding the benefits derived from the use of borrowed money, usually fall in the 10% to 20% range. My self-imposed limit regarding borrowing is 25% of partnership net worth. Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs.”

Here we observe the first evidence of Buffett employing leverage, nor was this to be the last. Despite warning others against the dangers of leverage, Buffett embraced leverage prudently his entire life – from the very beginning of the partnership, to his investments in banking and insurance, to the core spread structure of Berkshire Hathaway today.

Why he imposed the 25% limit figure, I do not know. (It would certainly be interesting to find out.) I suspect it is because he utilized leverage exclusively for the “work-out” segment which was a smaller portion of the portfolio. Also, the “work-outs” were already returning 10-20% unlevered, so leverage was not always necessary to achieve his return goal of 10% above the Dow.

Intrinsic Value, When to Sell

“We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner.”

Don’t be too greedy.