Stanley Druckenmiller Wisdom - Part 1

Druckenmiller is a legendary investor, and protégé of George Soros, who compounded capital ~30% annualized since 1986 before announcing in 2010 that his Duquesne fund would return all outside investor capital, and morph into a family office. Many of our Readers reside in the House of Value, but I believe that value investors can learn from those with more trading-oriented or macro philosophies – especially in terms of volatility considerations, trade structuring, and capital preservation.

The following portfolio management highlights were extracted from an interview with Stanley Druckenmmiller in Jack D. Schwager’s book The New Market Wizards. Be sure to check out Part 2 & Part 3.

Trackrecord, Capital Preservation, Compounding, Exposure

“Q: Your long-term performance has far surpassed the industry average. To what do you attribute your superior track record?

A: George Soros has a philosophy that I have also adopted: he way to build long-term returns is through preservation of capital and home runs. You can be far more aggressive when you’re making good profits. Many managers, once they’re up 30 or 40 percents, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the convictions, go for a 100 percent year. If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns.”

“Many managers will book their profits when they’re up a lot early in the year. It’s my philosophy, which has been reinforced by Mr. Soros, that when you earn the right to be aggressive, you should be aggressive. The years that you start off with a large gain are the times that you should go for it. Since I was well ahead for the year, I felt that I could afford to fight the market for a while. I knew the bull market had to end, I just didn’t know when. Also, because of the market’s severe overvaluation, I thought that when the bull market did end, it was going to be dramatic.”

We’ve discussed the importance of capital preservation, and its complementary relationship to long-term compounding. Here is Drunkenmiller’s well-articulated version of the same concept…plus a fascinating twist.

As dictated by the Rules of the Game, the scorecard in the investment management world is your trackrecord in the form of calendar year returns. The concept of earning the “right to be aggressive” in certain calendar years echoes in my mind like a siren song, so dangerous yet utterly irresistible.

Most traditional value investors would not dare dream of enacting such a brazen act. But, if you keep an open mind to ponder and digest, it makes a lot of sense.

UPDATE: One Reader (and friend who is very very bright) suggested that the genius behind the "right to be aggressive" derives from its utter contradiction of traditional value doctrine.  Buffett and Munger would say wait for an opportunity and then be aggressive.  Druckenmiller's effectively saying that he doesn't think you can ever truly know when it's a great time....so you wait until you know something for a fact: that you are having a good year.

Expected Return, Opportunity Cost

“…an attractive yield should be the last reason for buying bonds. In 1981 the public sold bonds heavily giving up a 15 percent return for thirty years because they couldn’t resist 21 percent short-term yields. They weren’t thinking about the long term. Now, because money market rates are only 4.5 percent, the same poor public is back buying bonds, effectively lending money at 7.5 percent for thirty years…”

Sadly the situation has deteriorated further. Today, money markets yield ~0% and thirty year bonds pay ~3%.

It’s important to remember that portfolio expected return should not be determined solely based upon returns available today, but also opportunities around the corner, not yet visible. This is what makes opportunity cost so difficult to determine – it's often a gut judgment call that involves predicting the availability of future expected returns.

Team Management

On working with George Soros:

“The first six months of the relationship were fairly rocky. While we had similar trading philosophies, our strategies never meshed. When I started out, he was going to be the coach – and he was an aggressive coach. In my opinion, Gorge Soros is the greatest investor that ever lived. But even being coached by the worlds greatest investor is a hindrance rather than help if he’s engaging you actively enough to break your trading rhythm. You just can’t have two cooks in the kitchen; it doesn’t work. Part of it was my fault because he would make recommendations and I would be intimidated. After all, how do you disagree with a man with a track record like his?

Events came to a head in August 1989 when Soros old out a bond position that I had put on. He had never done that before. To make matters worse, I really had a strong conviction on the trade. Needless to say, I was fairly upset. At that point, we had our first let-it-all-out discussion…Basically, Soros decided that he was going to stay out of m hair for six months.”

Buffett Partnership Letters: 1964 Part 2

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

“If a 20% or 30% drop in the market value of your equity holding (such as BPL) is going to produce emotional or financial distress, you should simply avoid common stock type investments. In the words of the poet – Harry Truman – ‘If you can’t stand the heat, stay out of the kitchen.’ It is preferable, of course, to consider the problem before you enter the ‘kitchen.’

I had a discussion a few months ago with a friend about the difference between “Cash” vs. “CASH.” In my asset allocation context:

• “Cash” is readily deployable into securities and assets when opportunities arise, whereas
• “CASH” should never be exposed to the vicissitudes of any capital market that has any chance of loss (bonds, equity, or otherwise)

People often discuss Buffett’s habit of keeping plenty of cash on the sidelines awaiting opportunities, but they rarely point to the difference between a stash of dry powder ready for redeployment anytime, versus a worst case scenario nest egg that supports basic living necessities.

Based on the quote above, Buffett advised his clients to consider something similar before giving him any capital to manage.

So ask yourself, have you ever considered the difference between “Cash” vs. “CASH,” and if so, do you have a figure in mind? After all, as Buffett suggests, it’s preferable to consider this before entering the heated kitchen of the financial markets.

Expected Return

“The gross profits in many workouts appear quite small. It’s a little like looking for parking meters with some time left on them. However, the predictability coupled with a short holding period produces quite decent average annual rates of return after allowance for the occasional substantial loss.”

As we have discussed in the past, and see again in the quote above, Buffett kept close tabs on the future expected return of his portfolio.

Interestingly, here, he takes this concept one step further by introducing something new. Buffett may have kept some sort of loss provision (either actual or mental) for his basket of “work-out” securities similar to bad debt expense or loan provisions in accrual accounting.

Buffett Partnership Letters: 1964 Part 1

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Given the recent discussions/debates around taxes and potentially shifting tax rates, we thought it appropriate to share some historical Buffett wisdom on the topic.

Tax

“We do not play any games to either accelerated or defer taxes. We make investment decisions based on our evaluation of the most profitable combination of probabilities. If this means paying taxes – fine…”

“More investment sins are probably committed by otherwise quite intelligent people because of ‘tax considerations’ than from any other cause. One of my friends – a noted West Coast philosopher [Charlie Munger] – maintains that a majority of life’s errors are caused by forgetting what one is really trying to do…

What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound…

If gains are involved, changing portfolios involves paying taxes. Except in very unusual cases…the amount of the tax is of minor importance if the difference in expectable performance is significant…

There are only three ways to avoid ultimately paying the tax: (1) die with the asset – and that’s a little too ultimate for me – even the zealots would have to view this ‘cure’ with mixed emotions; (2) give the asset away – you certainly don’t pay any taxes this way, but of course you don’t pay for any groceries, rent, etc., either; and (3) lose back the gain – if your mouth waters at this tax-saver, I have to admire you – you certainly have the courage of your convictions.

So it is going to continue to be the policy of BPL to try to maximize investment gains, not minimize taxes. We will do our level best to create the maximum revenue for the Treasury – at the lowest rates the rules will allow.”

Patience, Sourcing, Liquidity

“…I consider the buying end to be about 90% of this business…These stocks have been bought and are continuing to be bought at prices considerably below their value to a private owner. We have been buying one of these situations for approximately 18 months and both of the others for about a year. It would not surprise me if we continued to do nothing but patiently buy these securities week after week for at least another year, and perhaps even two years or more.”

In Buffett's biography The Snowball, I believe there is an anecdote that Buffett and his associates would go knocking on doors in small towns to seek out shares of XYZ stock for purchase. Based on the quote above, it would take years for him to accumulate full positions. How’s that for patience, not to mention liquidity implications?!

Most public market investors, who invest in liquid securities, don't spent a lot of time focused on sourcing. Could there be a hidden advantage for those who focus on obscure or illiquid issuances, and manage to creatively source them at bargain prices?

Lisa Rapuano Interview Highlights - Part 3

Part 3 of highlights from an insightful interview with Lisa Rapuano, who worked with Bill Miller for many years, and currently runs Lane Five Capital Management. Selectivity, Hurdle Rate, Opportunity Cost, Sizing

“We do not own many stocks, and anything we buy has to improve the overall portfolio and/or be better than something else we already own…I’ll go into portfolio construction in a bit, but the short answer here is that it has to be better than something we already own, or improve the overall risk profile of the portfolio to make it in.”

“The actual position sizing we choose will be based on…the return profile of the name relative to other things in the portfolio as well as on an absolute basis…”

There are a few concepts here – selectivity, opportunity cost, and hurdle rate – all interrelated in the delicate web that is portfolio management.

Selectivity – not all investments reviewed makes it into the portfolio. They are judged against existing positions and other potential candidates.

Opportunity Cost – should I put capital into this idea? How much capital? If I do this, what is the cost of foregoing future opportunities? Calculating this “cost” is a whole other can of worms. See what other investors have to say about opportunity cost. Jim Leitner has some especially interesting thoughts.

Hurdle Rate – based on the quotes above, the hurdle rate could be a return figure or a risk-related figure since whether or not an idea makes it into the portfolio is dependent upon its merits compared to the expected returns and risk of existing portfolio positions.

Curiously, does this mean that an investor’s hurdle rate can be extracted from the expected return profile of his/her current portfolio? In the spirit of bursting gaskets, how then does this “hurdle rate” figure reconcile with the “discount rate” concept that’s frequently used by investors to value companies?

When To Buy, Sizing

“Value investors like I am are usually a bit too early, both on the buy and the sell side. It’s just part of our process…we’ll be buying long before any catalyst is evident (and thus discounted)…we try to mitigate the impact of being early on the buy side, just by recognizing who may be selling…and controlling our position sizing so that as the stock continues to fall we can confidently buy more.”

Important concept: the relationship between sizing decisions and ability/willingness to buy more if the price of a security continues to decline.

When To Sell

“On the sell side, we learned long ago that holding on to terrific businesses a bit longer than our original value might have indicated is usually a good idea. That being said, there are not that many truly terrific businesses, so most should be sold as they approach value.”

Creativity

“Our philosophy remains static but we pride ourselves on being adaptive in process and tactics.”

“…one of our Core Values at Lane Five is to Adapt and Evolve Actively. The tools change and people get smarter and information flows more quickly. To maintain a competitive advantage we have to evolve ahead of the market.”

Howard Marks' Book: Chapter 5 - Part 4

I'm finally back from vacation. In light of recent market volatility and "risk," let's kick off with a continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 5 “The Most Important Thing Is…Understanding Risk” Risk, Intrinsic Value

“…risk of loss does not necessarily stem from weak fundamentals. A fundamentally weak asset – a less-than-stellar company’s stock, a speculative-grade bond or a building in the wrong part of town – can make for a very successful investment if bought at a low-enough price.”

“Theory says high return is associated with high risk because the former exists to compensate for the latter. But pragmatic value investors feel just the opposite: they believe high return and low risk can be achieved simultaneously by buying things for less than they’re worth. In the same way, overpaying implies both low return and high risk.”

There exists an unbreakable relationship between the purchase price (relative to the intrinsic value) of an investment, and the inherent risk of that investment. In other words, a portion of the risk of any asset is price dependent.

Risk

Howard Marks highlights a few other types of risk, beyond is usual loss of capital, etc. Investment risk can take on many other forms – personal and subjective – varying from person, mandate, and circumstance.

“Falling short of one’s goal – …a retired executive may need 4 percent…But for a pension fund that has to average 8% per year, a prolonged period returning 6 percent would entail serious risk. Obviously this risk is personal and subjective, as opposed to absolute and objective…Thus this cannot be the risk for which ‘the market’ demands compensation in the form of higher prospective returns.”

“Underperformance – …since no approach will work all the time – the best investors can have some of the greatest periods of underperformance. Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up. (See Warren Buffett and Julian Robertson in 1999.)”

“Career Risk – …the extreme form of underperformance risk…risk that could jeopardize return to an agent’s firing point…”

“Unconventionality – …the risk of being different. Stewards of other people’s money can be more comfortable turning in average performance, regardless of where it stands in absolute terms, than with the possibility that unconventional actions will prove unsuccessful and get them fired.”

“Illiquidity – …being unable when needed to turn an investment into cash at a reasonable price.”

Theory suggests that asset returns compensate for higher “risk.” If this is true, how then do assets compensate for subjective risks that vary from person to person, such as falling short of one’s return goal, or career risk stemming from unconventionality?

This highlights the necessity for portfolio managers to identify and segment risks – objective or subjective & quantitative or qualitative – before implementing risk management or hedging strategies.

Risk, Fat Tail

“‘There’s a big difference between probability and outcome. Probable things fail to happen – and improbable things happen – all the time.’ That’s one of the most important things you can know about investment risk.”

“The fact that an investment is susceptible to a particularly serious risk that will occur infrequently if at all – what I call the improbable disaster – means it can seem safer than it really is.”

“…people often use the terms bell-shaped and normal interchangeably, and they’re not the same…the normal distribution assumes events in the distant tails will happen extremely infrequently, while the distribution of financial developments – shaped by humans, with tendency to go to emotion-driven extremes of behavior – should probably be seen as having ‘fatter’ tails…Now that investing has become so reliant on higher math, we have to be on the lookout for occasions when people wrongly apply simplifying assumptions to a complex world.” 

More Baupost Wisdom

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

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

When To Buy, Conservatism, Barbell

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

When To Buy, Portfolio Review

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

Risk

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

Hedging

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

Hedging, Sizing

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

Cash, AUM

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

Returning Capital, Sizing

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

Leverage

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

Selectivity

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

Time Management, Sizing

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

Team Management

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

Trackrecord

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

Sourcing

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

Decluttering the Portfolio

Many thanks to Lisa Rapuano for telling me about Daruma Capital’s Mariko Gordon, and her humorously insightful letters! This article will undoubtedly be the first of many based on interesting topics extracted from Gordon’s letters. In the August 2012 letter, Gordon discusses portfolio review and its parallels to a massive home cleaning project. For those of us with hoarding tendencies, what is the impact of this psychological behavior on our portfolio management decisions? Gordon offers some wisdom:

“I have been adamant about our ‘no more than 35 stocks’ rule…Whether right or wrong, all of this pruning keeps the portfolio in the here and now, and me actively engaged in the process of evaluating whether every stock is earning its keep. And yet as with clutter, it's easier said than done… [Diversification]

If it's a big winner, it reminds you of how smart you are, and how it made your clients rich. All that warm fuzziness means that when it breaks you will crazy glue it, and never be able to let it go. That, my friends, is how you round trip stocks - the hard part is knowing the difference between an air pocket where you sit tight, and a death spiral, where you pull on the ripcord and bail. [When To Sell]

A loser in the past can likewise cause problems. Like cats, some investors prefer to bury their ‘flops’ rather than be reminded every day that they're idiots. They feel such shame that they immediately sell off a loser, unable to decouple the past enough to soberly recalculate whether the stock represents good value in the present. The fact is, if the portfolio you've been presented by your money manager doesn't include a howler or two, be very suspicious.

Too many howlers, however, may be symptomatic of another problem, this one caused by a manager who can't admit that he or she has made a mistake. These investors stubbornly insist that it's the market that's wrong (again), for disagreeing with his or her brilliant analysis. [Making Mistakes]

So let the past go…But it's not always the past that causes problems. It can also be the future.

An investor can become saddled by a position with enormous potential - potential that always lurks just over the horizon, just out of reach, despite excuse after excuse, inroads by competitors, or evidence that customers have gone on a buying strike. The future becomes a siren song of unfulfilled promise. Profits are always just another quarter away.

Whatever one's personal brand of emotional clutter - past, future, or some of both - it's all garbage. [Psychology]

No matter how elaborate the spreadsheet or how probabilistically the range of outcomes for a stock has been calculated to four decimal places, every attempt to declutter your portfolio must be accompanied by an attempt to declutter your attachment to the glorious past it represents, or the glorious future it will deliver.”

Don't Try This At Home

Last week, a friend and I were musing over whether we would ever put 100% of portfolio NAV into one security. While pondering this question, my mind recalled the following passage that Jeremy Grantham wrote in his 2010 2Q letter on global warming:

“Skeptics argue that this wide range of uncertainty lowers the need to act: “Why spend money when you’re not certain?” But since the penalties rise hyperbolically at the tail, a wider range implies a greater risk (and a greater expected value of the costs).”

In other words, there are those who believe that the probability of catastrophic effects of global warming actually occurring are extremely low, and therefore are against prevention measures. However, if they are wrong and the catastrophic effects of global warming do occur, the consequences are so prohibitively high that humans are unlikely to survive to change their future behavior.

Bear with me, there’s a weird parallel here. Let’s play a game of word replacement.

Excessive portfolio concentration, such as putting 100% of portfolio NAV into one security, usually occurs because the investor believes the probability of a worst case occurring is extremely low. However, if the investor is wrong and the worst case does occur, the consequences are so prohibitively high that the investor (and his/her fund) is unlikely to survive to change future sizing behavior.

So my answer to the question at the very beginning was ‘NO’ I would not put 100% of portfolio NAV into one security because the potential consequences include not only destroying your capital base and trackrecord, but also your reputation.

Interestingly though, if not 100%, what about 95%? 80%? 60%? Where is the cut off for concentration so that it is no longer considered “excessive?”

Update: A Reader, who has spent many years allocating capital and speaking with fund managers, emailed me after reading this article and provided the following piece of interesting information, food for thought:

"My experience over time is whatever a manager picks he always always always lowers with experience...."

Lisa Rapuano Interview Highlights - Part 2

Part 2 of highlights from an insightful interview with Lisa Rapuano, who worked with Bill Miller for many years, and currently runs Lane Five Capital Management. The interview touches upon a number of relevant portfolio management topics. Rapuano has obviously spent hours reflecting and contemplating these topics. A worthwhile read!

Fee Structure

“…I launched my fund [November 2006] with an innovative fee structure – wait three years and then charge only on the positive return over the market…three-year lock up…given the changes in the marketplace we simply did not think a three-year lock-up was a tenable proposition under any circumstances. So…we had to abandon our three-year free structure as well…What I was extraordinary surprised by however, was how little this mattered to many potential investors. There is an institutional imperative that has evolved in hedge funds that is very similar to that which has evolved in long-only funds. Being different, no matter how right it may be, doesn’t help.”

Given my family office background, the fee structure topic has come up frequently especially as it relates to fundraising. One would think that fee discounts should garner more investor interest. Unfortunately, my advice is the same as Rapuano’s: “being different, no matter how right it may be, doesn’t help.”

The average retail investor is usually not sophisticated enough to care about the difference between 1% (management fee) & 15% (incentive fee) versus 2% & 20%. The average institutional investor is merely going through the motions of checking boxes with a “cover your behind” mentality before presenting to committee. So with the exception of sophisticated investors (fewer in number than the unsophisticated), the fee discount really doesn’t make much difference.

In fact, it could potentially hurt fundraising because it begs the additional question: why are you different? With only 60 minutes or so per meeting, it’s likely best to not waste time having to answer this additional question.

Shorting, Team Management, Exposure

“On the short side, we only short for alpha – we do not use shorts to control exposure explicitly or to hedge or control monthly volatility…This model has been chosen very specifically to suit the skills of me and my team. We think being able to short makes us better analysts, it keeps us more honest.”

“We also like the flexibility to hold a lot of cash or be a bit more short when we think there are no great values lying around…we think eliminating the pressure to stay low-exposure (and to therefore often put on very poor shorts) is a good match for our style…”

Rapuano highlights a very important distinction: shorting for alpha vs. shorting to control exposure. I would add a third category: shorting to justify the incentive fee.

Also, it’s an interesting idea to build an investment process that works with the behavioral tendencies of the investment team. I guess the flip-side is to recruit for talent that fits a specific type of investment process.

Making Mistakes, Process Over Outcome

“Then there are the mistake where you just misjudged the situation in your analysis…I thought something was low probability but then it happens…we analyze these types of mistakes, but it’s not a focus on what happened, but simply to make sure we did all the work we could have been expected to do, our judgments were based on sound analysis, and well, sometimes you’re just wrong. There are other mistakes, however, that you can try to eliminate, or at least not repeat.”

“For me, my worst ones have been when I strayed from either my core values or my process. So, when we’ve done something as a ‘trade’ (it just seemed too easy) and not subjected it to the rigors of the process it usually doesn’t work out.”

Mistakes are not just situations when the outcomes are bad (i.e., ideas don’t work out). Do we make a mistake each time we stray from our investment process?

Howard Marks' Book: Chapter 5 - Part 3

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 5 “The Most Important Thing Is…Understanding Risk” No commentary necessary - self explanatory and eloquently written.

Definition of Investing, Risk

“Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable.”

Risk, Process Over Outcome, Luck

“Many futures are possible…but only one future occurs…Many things could have happened in each case in the past, and fact that only one did happen understates the variability that existed.”

“In the investing world, one can live for years off one great coup or one extreme but eventually accurate forecast. But what’s proved by one success? When markets are booming, the best results often go to those who take the most risk. Were they smart to anticipate good times and bulk up on beta, or just congenitally aggressive types who were bailed out by events? Most simply put, how often in our business are people right for the wrong reasons? These are the people Nassim Nicholas Taleb calls 'lucky idiots,' and in the short run it’s certainly hard to tell them from skilled investors.

The point is that even after an investment has been closed out, it’s impossible to tell how much risk it entailed. Certainly the fact that an investment worked doesn’t mean it wasn’t risky, and vice versa. With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities (many of them unpleasant)? And ditto for a loser: how do we ascertain whether it was a reasonable but ill-fated venture, or just a wild stab that deserved to be punished?

Did the investor do a good job of assessing the risk entailed? That’s another good question that’s hard to answer. Need a model? Think of the weatherman. He says there’s a 70 percent chance of rain tomorrow. It rains; was he right or wrong? Or it doesn’t rain; was he right or wrong? It’s impossible to assess the accuracy of probability estimates other than 0 and 100 except over a very large number of trials.”

Lisa Rapuano Interview Highlights - Part 1

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

Portfolio Management

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

Expected Return, Diversification, Sizing

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

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

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

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

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

Correlation, Leverage

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

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

Time Management, Sizing

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

Superinvestors of Graham-and-Doddsville

The following portfolio management related excerpts are extracted from Superinvestors of Graham-and-Doddsville, an article based on a speech Warren Buffett gave at Columbia Business School on May 17, 1984  

Risk, Expected Return. Volatility

“Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, ‘I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million.’ I would decline – perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice – now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.

One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now so the person who would have paid $400 million would not have been crazy.

Now if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million and $80 million.”

Risk and reward is not always positively correlated, as traditional financial theory seems to suggest. (For further elaboration on this relationship, be sure to read Chapter 5 of Howard Marks’ book.)

On volatility, although Buffett doesn’t use historical volatility (historical beta) as a measure of risk when determining which securities to purchase, he never explicitly says that investors should ignore future volatility.

Perhaps this is the distinction – observed historical volatility vs. anticipation of future volatility – that reconciles value investing and volatility (price movement) considerations.

Historical volatility should not play a central role in investment decisions (because historical volatility is a bad predictor of future outcome). However, investors (even those from Graham-&-Doddsville) should pay attention to and anticipate future volatility because it impacts the portfolio return stream, as well as other cash, opportunity cost, and firm management considerations.

Expected Return, AUM

“When I wound up Buffett Partnership I asked Bill [Ruane] if he would set up a fund to handle all of our partners so he set up the Sequoia Fund…Bill was the only person I recommended to my partners, and I said at the time that if he achieved a four point per annum advantage over the Standard & Poor’s, that would be solid performance. Bill has achieved well over that, working with progressively larger sums of money. That makes things much more difficult. Size is the anchor of performance. There is no question about it.”

During the Partnership days (starting around 1957), Buffett’s goal was to beat the Dow by 10% annually over a long period of time. By 1970, based on the quote above, Buffett thought a 4% annual outperformance over the S&P would be “solid.”

The decline in expected return is either an indication that (1) Buffett believed he could achieve higher returns than Bill Ruane, or (2) Buffett’s portfolio expected return changes with the market environment – with the latter as the more probable explanation.

This idea of shifting expected return is directly applicable to the “equities = annual 8% return” mentality that’s still prevalent among investors today, and fueling all sorts of problems. Ahem, pensions. Future investment returns are a function of market environments and available purchase price, not previously determined or historical return rates – this is true for all investors, including Warren the Great.

Interestingly, Buffett’s expected return figure seems to have declined even further in recent days. At the 2012 Berkshire meeting, to roughly paraphrase Buffett (based on notes taken by Ben Claremon, the Innoculated Investor):

“Todd [Combs] and Ted [Weschler] get a few million dollars in salary and then get 10% of how much they beat the S&P by. This is measured on a rolling, 3 year basis.”

The margin of outperformance above the S&P or Dow has now altogether disappeared. Today, the goal is simply to beat the index.

On AUM, Buffett knew/believed from the very beginning (we see evidence of this circa 1963 in the Partnership letters) that increasing assets under management can lead to declining performance. We see this again above in this statement that “size is the anchor of performance.”

So, why then did Berkshire get so big? Or was this AUM-Performance rule only true “on average,” and talented investors were exempt?

Howard Marks' Book: Chapter 5 - Part 2

The following excerpt from Howard Marks' book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 5 “The Most Important Thing Is…Understanding Risk,” is one of the best clarifications on the relationship between risk and return that I have ever read. Risk, Expected Return

“…when you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return…Clearly, return tells just half of the story, and risk assessment is required.”

“…‘capital markets line’ that slopes upward to the right, indicating the positive relationship between risk and return…the familiar graph…is elegant in its simplicity. Unfortunately, many have drawn from it an erroneous conclusion…if riskier investments reliable produced higher returns, they wouldn’t be riskier! The correct formulation is that in order to attract capital, riskier investments have to offer the prospect of higher returns, or higher promised returns, or higher expected returns. But there’s absolutely nothing to say those higher prospective returns have to materialize.”

“Riskier investments are those for which the outcome is less certain. That is, the probability distribution of return is wider…The traditional risk/return graph is deceptive because it communicates the positive connection between risk and return but fails to suggest the uncertainty involved. It has brought a lot of people a lot of misery through its unwavering intimation that taking more risk leads to making more money. I hope my version of the graph [see above] is more helpful. It’s meant to suggest both the positive relationship between risk and expected return and the fact that uncertainty about the return and the possibility of loss increase as risk increases.”

Howard Marks' Book: Chapter 5 - Part 1

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 5 “The Most Important Thing Is…Understanding Risk” This is the first of three chapters to which Howard Marks dedicates to the topic of Risk. For those interested in Marks' thoughts on risk, these chapters are absolute must-reads.

Topics covered in this installment: Risk, Volatility

Risk, Volatility

“According to the academicians who developed capital market theory, risk equal volatility, because volatility indicates the unreliability of an investment. I take great issue with this definition. It is my view that…academicians settled on volatility as the proxy for risk as a matter of convenience. They needed a number for their calculations that was objective and could be ascertained historically and extrapolated into the future. Volatility fits the bill, and most of the other types of risk do not. The problem  with all of this, however, is that I just don’t think volatility is the risk most investors care about…I’ve never heard anyone at Oaktree – or anywhere else, for that matter – say, ‘I won’t buy it, because its price might show big fluctuations,’ or ‘I won’t buy it, because it might have a down quarter.’…To me, ‘I need more upside potential because I’m afraid I could lose money’ makes an awful lot more sense than ‘I need more upside potential because I’m afraid the price may fluctuate.’”

To be fair, Oaktree and most private equity investors have semi-permanent long-term capital (thanks to the lock-up terms). Most public market fund managers do not have this luxury, and are more vulnerable to the vagaries of short-term volatility that can lead to other types of risks such as “underperformance risk” and “career risk” (Marks discusses both later on). The public market fund managers themselves may not fear volatility, but in the instance the underlying client base loses patience and demands the return of capital via redemptions, volatility becomes a very real risk in the form of permanent impairment of capital.

Risk

“…hopefully we can agree that losing money is the risk people care about most…An important question remains: how do they measure that risk? First, it clearly is…a matter of opinion: hopefully an educated, skillful estimate of the future, but still just an estimate. Second, the standard for quantification is nonexistent. With any given investment, some people will think the risk of high and others will think it is low.”

“…risk and the risk/return decision aren’t ‘machinable,’ or capable of being turned over to a computer…Ben Graham and David Dodd put it this way more than sixty years ago…‘the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulations.’”

“The bottom line is that, looked at prospectively, much of risk is subjective, hidden, and unquantifiable. Where does that leave us? If the risk of loss can’t be measured, quantified or even observed – and if it’s consigned to subjectivity – how can it be dealt with? Skillful investors can get a sense for the risk present in a given situation…There have been many efforts of late to make risk assessment more scientific. Financial institutions routinely employ quantitative “risk managers” separate from their asset management teams and have adopted computer models such as “value at risk” to measure the risk in a portfolio…In my opinion, they’ll never be as good as the best investors’ subjective judgment.”

Qualitative vs. Quantitative. Both worthy adversaries, each camp with its prolific heroes.

It’s likely that successful quantitative investors (such as David E. Shaw who utilize computerized risk optimizers) would disagree with Marks’ statement above, that risk management entails more art than science. But the secretive nature of their algorithms and risk models make it difficult to comprehend how the successful quants are able to quantify risk via “machinable” methodologies contrary to the opinions of Howard Marks, Ben Graham, and David Dodd.

Ruane Cunniff Goldfarb Investor Day

The following excerpts (of Q&A) were extracted from the Ruane Cunniff Goldfarb Investor Day Transcript. For those with a little free time, I highly recommend the reading of the entire transcript. These guys are masters at dissecting businesses and identifying the heart of any topic. Psychology, Creativity

Question:

About 36 years ago, shortly before Benjamin Graham passed away, he did an interview for the Financial Analysts Journal…This is before the explosion of information, ETFs, mutual funds. Asked if he advised “careful study of and selectivity among” individual stocks in constructing a portfolio, he answered, “In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a good deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in light of the enormous amount of research now being carried on,” — 1976 we are talking about — “I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent, I'm on the side of the ‘efficient market’ school of thought now generally accepted by the professors.” I'm just wondering if you would comment on that and how the investment industry has changed over that period of time.

Greg Alexander:

...I would add — that it is a funny thing — I have kids 14 and 11, and I think that the next generation will go about their decision making maybe differently than us. They have every expectation that they can go and spend an hour on the Internet and become semi-expert on anything that they are interested in, whether it is figuring out how to do a Rubik’s cube, which I remember looking at and not having the least idea. But with all the information, the timeless human struggle remains judgment, the ability to think long term when there are problems that are short term, and whether we see something solid where everyone perceives uncertainty — many factors of that nature. Looking in new areas where people have not thought so much, there are many factors like that, that are timeless. I always tell people there will be men and women on the moon but we still will not understand the guy next door.

Activism

Question:

Would you be kind enough to share with us the philosophy of some of your adventures in corporate governance?

David Poppe:

I think as we said in the letter that we wrote to clients a few weeks ago, the goal is really to own best-of-breed world-class companies and to be positive and passive shareholders. Ideally for us we are going to spend a lot of time on research on the front end. We are going to identify a business that we love and a management team that we think is really strong. Then we are going to make an investment. Afterwards, I would not say we are going to go away, but we are going to be quiet. We are going to own it and if we get everything right, we are going to own it for a really long time. Where you have to get involved, you really need sharp elbows and you need a different kind of personality than we have. It's a different — I don't want to say effort level — but different relationship…So hopefully we are not going to have a lot of adventures in corporate governance if we are doing our jobs really well.

Team Management

David Poppe:

We do allow the analysts to trade in their own accounts; they do have personal accounts. They can buy things that we do not own in Sequoia, but I do not think they do so often. The only time that really comes up is when Bob and I reject something for Sequoia and the analyst strongly believes that it was a great idea, and he did a lot of work on it and feels good about it. We think that is an appropriate outlet for frustration.

Buffett Partnership Letters: 1963 Part 4

Continuation in a series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Compounding, Capital Preservation

“Since the whole subject of compounding has such as crass ring to it, I will attempt to introduce a little class into this discussion by turning to the art world. Francis I of France paid 4,000 ecus in 1540 for Leonardo da Vinci’s Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the ecu, 4,000 converted out to abut $20,000.

If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000.00. That’s $1 quadrillion…all from 6%.

…there are other morals to be drawn here. One is the wisdom of living a long time. The other impressive factor is the swing produced by relatively small changes in the rate of compound.”

“If, over a meaningful period of time, Buffett Partnership can achieve an edge of even a modest number of percentage points over the major investment media, its function will be fulfilled.”

Starting around the early 1960s, Buffett discusses the concept of compounding more frequently – perhaps because he’s become increasingly interested in its power. After all, an author’s words often reflect the subject most prevalent in his/her mind.

We likewise believe that compounding is an important, yet under-discussed, area of investment management. The entire investment management industry stems from the belief in (oneself or others) the ability to compound capital at a higher rate than “average” (however you define “average”).

Our industry often profiles the “flavors of the week,” putting those with spectacular short-term returns on display. Unfortunately, investor prone to spectacular upside returns, are sometimes also prone to disastrous drawdowns.

Which brings to my mind the trackrecord of a well-known oil and gas investor. His long-term trackrecord was spectacular (something in the range of 20-30%+ annually for 20+ years) until he became enamored with natural gas (in all fairness, he may yet be proven correct in the “long-run”). In either 2009 or 2010 (when the price of natural gas plummeted) he produced a -97% year. Yep, minus ninety-seven percent.

Unfortunately, the law of compounding hath no pity. If you invested $1,000 with him at the very beginning, compounded at 25% for 20 years, but stayed around to experience the -97% return, the investment that was worth $86,736 in year 20 was now only worth $2,602 in year 21 (which doesn’t include the fees you paid over the years, so chances are, you’ve actually experienced loss of principal).

Remember, it was the tortoise, not the hare, who won the race. A 1-2% outperformance relative to “average” may seem negligible in the short-term, but over the course of many years, the absolute dollar contribution of that excess margin of return becomes substantial. It never hurts to remind your investors, every once in awhile, as Buffett did.

Reflections by Anonymous

A friend sent me a fund letter a few months ago, and I ruminated over whether to post the following excerpt. Ultimately, I felt compelled to share it with our Readers given its beautifully written and reflective thoughts. It indirectly illustrates the competitive nature of this business. The author of this article (and many more just like him, or perhaps more intelligent) is your daily competition in this zero sum game. For anyone who believes that he/she has an edge, it would serve him/her well to reconsider that belief – again surfaces our daily struggle for self-awareness, and the delicate balance between arrogance and humility.

Creativity, Psychology

“I meet a lot of inquisitive and extremely intelligent people in this business and I have come to think that maybe this is something of a problem. Perhaps they are just too smart. Perhaps they just try too hard. Rightly or wrongly, the highest return on intellectual capital of any endeavour in the world today comes from the management of other people’s money. So it is entirely rational (especially if you have never met a hedge fund manager) to assume the industry attracts the brightest, smartest minds. The beautiful mind, if you will. But I am not aiming to outsmart George, Stan, Julian, Bruce or the others. I do not think it is logical to try and outsmart the smartest people. Instead, my weapons are irony and paradox. The joy of life is partly in the strange and unexpected. It is in the constant exclamation ‘Who would have thought it?’

Why did ten year treasuries yield 14% under the vice like grip of iron-man Volker but yield just 1.8% under the bookish and most definitely Weimar-like Bernanke? Why does France in 2012 flirt with the notion of electing a socialist president intent on reducing the retirement age, imposing a top rate of tax of 75% and increasing the size of the public sector? Why do we hang on the every word of elected politicians when Luxembourg’s prime minister Jean Claude Junker openly admits, ‘When it becomes serious, you have to lie’?

You cannot make stuff like this up. It is simply too absurd.

That is perhaps a long way of saying that existentialism is alive and well in the 21st century. For, if the last ten years have taught me anything, it must be that the French philosopher Albert Camus, in his search for an understanding of the principals of ethics that can shape and form our behaviour, may have surreptitiously provided us with three basic principles for macro investing. I am perhaps doing him a gross injustice, but I would summarise as follows: God is dead, life is absurd and there are no rules. In other words, you are on your own and you must take ownership of your own destiny.

For me this has always meant being detached from the sell-side community. It is not a question of respect, it is just that I prefer not to engage in their perpetual dialogue of determining where the 'flow' is. I cannot be reached by telephone. I suspect that I am one of the few CIOs who does not maintain daily correspondence with investment bankers and their specialist hedge fund sales teams. Not one buddy, not one phone call, not one instant message. I am not seeking that kind of 'edge.' [Redacted fund name] occupies an area outside the accepted belief system.

          ‘I have striven not to laugh at human actions,           not to weep at them,           not to hate them, but to understand them’           --Baruch Spinoza, Tractatus Politicus, 1676

I attempt to cultivate my own insights and to recognise the precarious uncertainty of global macro trends. I attempt to observe such things first hand through my extensive travel…and seek to understand their significance by investigating how previous societies coped under similar circumstances. But first and foremost, I am always preoccupied with the notion that I just do not have the answer. I am not blessed with the notion of certainty. Someone once said we should think of the world as a sentence with no grammar. If we do I see my job as putting in the punctuation. But above all, my job is to make money.”

More from Ted Lucas

In this piece, Ted Lucas of Lattice Strategies discusses the relationship between correlation and diversification, as well as the intricate task of building investment portfolios that remain resilient during market drawdowns, yet retain upside participation during bull markets. To explore some of his other writings, they are all archived on Lattice Strategies’ website.Risk, Capital Preservation, Compounding

“But ‘risk management’ on its own is an abstraction, as is ‘beating the market’ over a short time period, if the end goal is to generate a real capital growth over a longer time window…For an asset manager seeking to generate long-term real growth of capital, the design problem is creating a portfolio structure that can both withstand periods of market turbulence and capture returns when they are available.”

Lucas highlights a very real dilemma for all investors: the tricky task of reconciling the goals of capital growth (compounding) with capital preservation. The frequently mentioned “abstraction” of “risk management” is merely a tool available to each investor to be incorporated, if and when necessary, to assist with this task.

Correlation, Diversification

Prior to the financial crisis in 2008, people believed that correlations between asset classes had “decoupled” given new breakthroughs on how risk was redistributed in the financial and economic markets, etc. Investors paid dearly for this assumption when many asset classes (equity, high yield, real estate, commodities, etc.) originally believed to be uncorrelated, all plummeted in value at the same time.

With investors still licking 2008 wounds, the opposite is now occurring. As Lucas writes, “There is much recent discussion about asset correlations rising to such elevated levels that diversification has been rendered useless.”

Correlation of assets/securities has a meaningful impact on the effects of diversification. Afterall, as Jim Leitner astutely points out, “diversification only works when you have assets which are valued differently…” Therefore, if all the assets/securities in your portfolio are highly correlated, diversification would be rendered useless regardless of how many positions you hold.

Lucas believes that investor fear of high asset correlations are overdone. I don’t have enough evidence to either agree or disagree with this view. However, the investing masses have a tendency to project the near-term past into the long-term future, and today’s assumptions about elevated levels of asset correlation could very well be overdone.

Regardless of whether you believe today’s asset correlations are high or low, the takeaway is that your view on future asset/security correlations will (or at least it should) influence your portfolio allocation decisions, because it directly impacts diversification and the volatility profile of your return stream.

Definition of Investing

“Here is a basic idea: the purpose of investing is to grow whatever capital is invested in real terms.”

Wisdom from Steve Romick: Part 3

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.  

Creativity, Team Management

“G&D: We also noticed that you recently hired Elizabeth Douglass, a former business journalist with the LA Times, which we found interesting – can you talk about that decision?

SR: We are trying to do due diligence in a deeper way and get information that may not be easily accessible. For example, with Aon, Elizabeth will help us track down people who used to work for Aon and get their phone numbers…So, she is an investigative journalist for us, a data synthesizer, research librarian and just a great resource to have.”

During my tenure at the multi-billion family office, my colleagues and I used to joke about Manager Bingo. Instead of numbers, on a bingo card, we’d write certain buzz words – “private equity approach to public market investing,” “long-term focus,” “margin of safety,” “bottom-up stock selection with top-down macro overlay” etc. – you get the idea. In meetings, each time a manager mentioned one of these buzz words/concepts, we’d check off a box. Blackouts were rare, though not impossible, depending on the manager.

But I digress. In the marketing materials of most funds, there’s usually a paragraph or sentence dedicated to “proprietary diligence methodology” or something to that effect. Most never really have anything close to “proprietary” – just the usual team of analysts running models, following earnings, and setting up expert network calls with the same experts as the competition.

Here, Steve Romick describes an interesting approach: a “research librarian” and detective to organize and track down new resources that others on Wall Street have not previously tapped, thus potentially uncovering fresh information and perspective. This is not the first time I’ve heard of investment management firms hiring journalists, but the practice is definitely not commonplace. Kudos on creativity and establishing competitive advantage!

Benchmark, Hurdle Rate

“Beating the market is not our goal. Our goal is to provide, over the long term, equity-like returns with less risk than the stock market. We have beaten the market, but that‘s incidental. We don‘t have this monkey on our back to outperform every month, quarter, and year. If we think the market is going to return 9% and we can buy a high-yield bond that’s yielding 11.5% and we’re confident that the principal will be repaid in the next three years, we‘ll take that…We are absolute value investors. We take our role as guardians of our clients’ capital quite seriously. If we felt the need to be fully invested at all times, then we would have to accept more risk than I think we need to.”

Romick’s performance benchmark is absolute value driven, not to outperform the “market”. I wonder, what is a adequate figure for “long term, equity-like returns?” Is this figure, then, the hurdle rate that determines whether or not an investment is made?

Volatility

“Fortunately, people are emotional and they make visceral decisions. Such decisions end up manifesting themselves in volatility, where things are oversold and overbought.”

Emotions and investor psychology causes volatility (Howard Marks would agree with this), which is a blessing to the patient, rational investor who can take advantage when “things are oversold or overbought.”

Foreign Exchange

“The government is doing its best to destroy the value of the US dollar. We have made efforts to de-dollarize our portfolio, taking advantage of other parts of the world that have better growth opportunities than the US with more exposure to currencies other than our own.”

Inflation

“We are seeking those companies that are more protected should inflation be more than expected in the future…We are looking for companies where we feel the pricing power would offset the potential rise in input costs. That leads us to a whole universe of companies, while keeping us away from others.”

Buffett Partnership Letters: 1963 Part 3

Continuation in a series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Topics covered include: When To Buy, When To Sell, Activism, Catalyst, AUM When To Buy, Activism, Catalyst, Control

“…controls develop from the general category. They results from situations where a cheap security does nothing price-wise for such an extended period of time that we are able to buy a significant percentage of the company’s stock…Whether we become active or remain relatively passive at this point depends upon our assessment of the company’s future and the management’s capabilities.”

“We do not want to get active merely for the sake of being active. Everything else being equal I would much rather let others do the work. However, when an active role is necessary to optimize the employment of capital, you can be sure we will not be standing in the wings.”

“Active or passive, in a control situation there should be a built-in profit…Our willingness and financial ability to assume a controlling position gives us two-way stretch on many purchases in our group of generals. If the market changes its opinion for the better, the security will advance in price. If it doesn’t, we will continue to acquire stock until we can look to the business itself rather than the market for vindication of our judgment.” 

Warren Buffett is renowned for his strong stomach, and willingness to continuously purchase and ingest increasing stakes as falling prices deter others. I believe the quote above holds the rationale behind this courageous behavior.

I think it's important to point out, that for each purchasing quest as the price falls, there exists a tipping point – the point at which Buffett obtains a controlling position – such that if the market continues to undervalue the asset, he will “look to the business itself rather than the market for vindication,” thus unlocking value by enacting his own catalyst as a control/majority investor.

Many investors attempt to emulate Buffett’s strong-stomach approach. However, I would advise caution to those investors with limited cash resources or asset under management, without which investors could end up with too much of his/her portfolio in a minority stake of an asset that remains perpetually undervalued.

AUM

“Our rapid increase in assets always raises the question of whether this will result in a dilution of future performance. To date, there is more of a positive than inverse correlation between size of the Partnership and its margin over the Dow…Larger sums may be an advantage at times and a disadvantage at others. My opinion is that our present portfolio could not be improved if our assets were $1 million or $5 million. Our idea inventory has always seemed to be 10% ahead of our bank account. If that should change, you can count on hearing from me.”

I have heard it remarked that capital is the enemy of return. This is true under many circumstances, however in some instances, as Buffett outlines above, a large capital base has its benefits. For example, see our discussion above on When To Buy, Activism, Catalyst, and Control.

When To Sell

“Our business is making excellent purchases – not making extraordinary sales.”