Buffett Partnership Letters: 1966 Part 2

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

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

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

“…duration risk is a very real annoyance for the minority equity investor, especially in rising markets. Takeout mergers may increase short-term IRR, but they can decrease overall cash on cash returns. Mergers also result in cash distributions for which minority investors must find additional redeployment options in a more expensive market environment.”

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

Liquidity, When To Buy, When To Sell

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

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

Clients, When To Buy, When To Sell

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

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

When To Buy, When To Sell

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

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

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

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

Control

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

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

An Interview with Bruce Berkowitz - Part 2

Part 2 of portfolio management highlights extracted from an August 2010 WealthTrack interview with Consuelo Mack (in my opinion, WealthTrack really is an underrated treasure trove of investment wisdom). Be sure to check out Part 1.

AUM, Compounding, Subscription, Redemptions

“MACK: There’s a saying on Wall Street...that size is the enemy of performance…

BERKOWITZ: …we think about this every day. And, the important point is that, as the economy still is at the beginning of a recovery, and there's still much to do…we can put the money to work. The danger's going to be when times get better, and there's nothing to do, and the money keeps flocking in. That obviously is going to be a point we're going to have to close down the fund...But of course, it's more than that. Because if we continue to perform, which I hope we do, 16 billion's going to become 32, and 32's going to become 64.”

Berkowitz makes a great point. It’s not just subscriptions and redemptions that impact assets under management. Natural portfolio (upward or downward) compounding will impact AUM as well.

We’ve discussed before: there’s no such thing as a “right” AUM, statically speaking. The “right” number is completely dependent upon opportunities available and market environment.

AUM, Sourcing

"CONSUELO MACK: …as you approached 20 billion under management, has the size affected the way you can do business yet?

BRUCE BERKOWITZ: Yes. It's made a real contribution. How else could we have committed almost $3 billion to GGP, or to have done an American Credit securitization on our own, or help on a transformation transaction with Hertz, or offer other companies to be of help in their capital structure, or invest in CIT, or be able to go in with reasonable size? It's helped, and we think it will continue to help…”

In some instance, contrary to conventional Wall Street wisdom, larger AUM – and the ability to write an extremely large equity check – actually helps source proprietary deals and potentially boost returns.

Diversification, Correlation, Risk

“MACK: Just under 60% of his stock holdings are in companies such as AIG, Citigroup, Bank of America, Goldman Sachs, CIT Group and bond insurer, MBIA…your top 10 holdings…represent two-thirds of your fund, currently?

BERKOWITZ: Yes…we always have focused. And we're very aware of correlations…When times get tough, everything's correlated. So, we're wary. But we've always had the focus. Our top four, five positions have always been the major part of our equity holdings, and that will continue.”

“…the biggest risk would be the correlation risk, that they all don't do well.”

Weirdly, or perhaps appropriately, for someone with such a concentrated portfolio, Berkowitz is acutely aware of correlation risk. Better this than some investors who think they have “diversified” portfolios of many names only to discover that the names are actually quite correlated even in benign market environments.

As Jim Leitner would say, “diversification only works when you have assets which are valued differently…”

Making Mistakes, Sizing

“What worries me is knowing that it's usually a person's last investment idea that kills them…as you get bigger, you put more into your investments. And, that last idea, which may be bad, will end up losing more than what you've made over decades.”

For more on this, be sure to see a WealthTrack interview with Michael Mauboussin in which he discusses overconfidence, and how it can contribute to portfolio management errors such as bad sizing decisions.

Creativity, Team Management, Time Management

“…once we come up with a thesis about an idea, we then try and find as many knowledgeable professionals in that industry, and pay them to destroy our idea…We're not interested in talking to anyone who’ll tell us why we're right. We want to talk to people to tell us why we're wrong, and we're always interested to hear why we're wrong…We want our ideas to be disproven.”

According to a 2010 Fortune Magazine article, there are “20 or so full-time employees to handle compliance, investor relations, and trading. But there are no teams of research analysts.” Instead, “Berkowitz hires experts to challenge his ideas. When researching defense stocks a few years ago, he hired a retired two-star general and a retired admiral to advise him. More recently he's used a Washington lobbyist to help him track changes in financial-reform legislation.”       

This arrangement probably simplifies Berkowitz’s daily firm/people management responsibilities. Afterall, the skills necessary for successful investment management may not be the same as those required for successful team management.

When To Sell, Expected Return, Intrinsic Value, Exposure

“MACK: So, Bruce, what would convince you to sell?

BERKOWITZ: It's going to be a price decision…eventually…at what point our investments start to equate to T-bill type returns.”

As the prices of securities within your portfolio change, so too do the future expected returns of those securities. As Berkowitz points out, if the prices of his holdings climbed high enough, they could “start to equate to T-bill type returns.”

So with each movement in price, the risk vs. reward shifts accordingly. But the main question is what actions you take, if any, between the moment of purchase to when the future expected return of the asset becomes miniscule.

For more on his, check out Steve Romick's thoughts on this same topic. 

UPDATE:

Here’s a 2012 Fortune Magazine interview with Bruce Berkowitz, as he looks back and reflects upon the events that took place in the past 3 years:

Cash, Redemptions, Liquidity, When To Sell

“I always knew we'd have our day of negative performance. I'd be foolish not to think that day would arrive. So we had billions in cash, and the fund was chastised somewhat for keeping so much cash. But that cash was used to pay the outflows, and then when the cash started to get to a certain level, I began to liquidate other positions.”

“The down year was definitely not outside of what I thought possible. I was not as surprised by the reaction and the money going out as I was by the money coming in. When you tally it all up, we attracted $5.4 billion in 2009 and 2010 into the fund and $7 billion went out in 2011. It moves fast.”

Although Berkowitz was cognizant of the potential devastating impact of redemptions and having to liquidate positions to raise cash (as demonstrated by the 2010 interview, see Part 1), he still failed to anticipate the actual magnitude of the waves of redemptions that ultimately hit Fairholme.

I think this should serve as food for thought to all investors who manage funds with liquid redemption terms.

Buffett Partnership Letters: 1966 Part 1

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

“Proponents of institutional investing frequently cite its conservative nature. If ‘conservatism’ is interpreted to mean ‘productive of results varying only slightly from average experience,’ I believe the characterization is proper…However, I believe that conservatism is more properly interpreted to mean ‘subject to substantially less temporary or permanent shrinkage in value than total experience.’” 

“The first might be better labeled ‘conventionalism’ what it really says is that ‘when others are making money in the general run of securities, so will we and to about the same degree; when they are losing money, we’ll do it at about the same rate.’ This is not to be equated with ‘when others are making it, we’ll make as much and when they are losing it, we will lose less.’ Very few investment programs accomplish the latter – we certainly don’t promise it but we do intend to keep trying.”

Notice Buffett’s definition of conservatism in investing involves both “temporary or permanent shrinkage in value” – this is in contrast to a later Buffett who advises shrugging off temporary shrinkages in value. Why this change occurred is subject to speculation.

The second quote is far more interesting. Buffett links the concept of conservatism with the idea of portfolio volatility upside and downside capture vs. an index (or whatever industry benchmark of your choosing).

Ted Lucas of Lattice Strategies wrote an article in 2010 attributing Warren Buffett’s investment success to Buffett’s ability, over a long period of time, to consistently capturing more upside than downside volatility vs. the S&P 500. Based on the quote above, Buffett was very much cognizant of the idea of portfolio volatility upside vs. downside capture, so Ted Lucas’ assertion may very well be correct.

Sizing, AUM

“In the last three years we have come up with only two or three new ideas a year that have had such an expectancy of superior performance. Fortunately, in some cases, we have made the most of them…It is difficult to be objective about the causes for such diminution of one’s own productivity. Three factors that seem apparent are: (1) a somewhat changed market environment; (2) our increased size; and (3) substantially more competition.

It is obvious that a business based upon only a trickle of fine ideas has poorer prospects than one based upon a steady flow of such ideas. To date the trickle has provided as much financial nourishment as the flow…a limited number of ideas causes one to utilize those available more intensely.”

Sizing is important because when good ideas are rare, you have to make the most of them. This is yet another example of how, when applied correctly, thoughtful portfolio construction & management could enhance portfolio returns.

As AUM increases or declines, and as availability of ideas ebb and flow – both of these factors impact a wide variety of portfolio management decisions.

When To Buy, Intrinsic Value, Expected Return , Opportunity Cost

“The quantitative and qualitative aspects of the business are evaluated and weighted against price, both on an absolute basis and relative to other investment opportunities.”

“…new ideas are continually measured against present ideas and we will not make shifts if the effect is to downgrade expectable performance. This policy has resulted in limited activity in recent years…”

Buffett’s buying decision were based not only on the relationship between purchase price and intrinsic value, but also contribution to total “expectable performance,” and an investment’s merits when compared against “other investment opportunities,” the last of which is essentially an opportunity cost calculation.

Sizing, Diversification

“We have something over $50 million invested, primarily in marketable securities, of which only about 10% is represented by our net investment in HK [Hochschild, Kohn, & Co]. We have an investment of over three times this much in a marketable security…”

Hochschild, Kohn = 10% NAV

Another investment = “three times” size of Hochschild, or ~30% NAV

So we know in 1966, 40% of Buffett’s portfolio NAV is attributable to 2 positions.

Howard Marks' Book: Chapter 8

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

When To Buy, When To Sell

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

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

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

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

Expected Return, When To Buy, When To Sell

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

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

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

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

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

An Interview with Bruce Berkowitz - Part 1

Bruce Berkowitz of Fairholme Funds manages $7Bn+ of assets (this figure is based on fund prospectus disclosures, may not be inclusive of separately managed accounts) and was once named Morningstar’s Manager of the Decade. As you are probably aware, since 2010, it’s been a trying couple of years for Berkowitz. His fund was down 32% in 2011, then rallied ~37% in 2012 -- such volatility is not for the faint of heart!

However, we believe that trying times often reveal wonderful insights into an investor’s investment philosophy (his thoughts on cash are especially interesting). Accordingly, below are portfolio management highlights extracted from an August 2010 WealthTrack interview with Consuelo Mack (which, by the way, is an absolute treasure trove of investment wisdom). For more on Berkowitz, there’s also a thorough Fortune Magazine article from December 2010.

Cash, Liquidity, Redemptions, Expected Return

“MACK: Another Wall Street kind of conventional wisdom is that…you shouldn't hold a lot of cash in equity funds. Well, the Fairholme Fund has a history of holding a lot of cash. And I remember you telling me that cash is your financial valium.

BERKOWITZ: Yes. Well, the worst situation is if you're backed into a corner and you can't get out of it, whether for illiquidity reasons, shareholders may need money, or you have an investment that, as usual, you're a little too early, and you don't have the money to buy more, or you don't have the flexibility. That's a nightmare scenario. And this is nothing new. I mean, the great investors never run out of cash. It's just as simple as that…We haven't re-created the wheel here, but we always want to have a lot of cash, because cash can become awfully valuable when no one else has it.”

I have written in the past about the parallels between operating businesses and the investment management business (i.e., capital reinvestment and compounding).

Cash management is yet another relevant parallel – both should monitor future liquidity obligations, whether it’s client redemptions, debt maturity, potential future asset purchases or expansion opportunities.

Operating businesses have the advantage of term financing that’s permanent for a specified period of time. Most public market investors don’t have this luxury (private equity and real estate investors are more fortunate in this respect), which should compel them to keep even more rainy day cash.

However, as Mack describes, conventional Wall Street wisdom dictates the exact opposite -- that investors should not hold excess cash on the sidelines!

Also, Berkowitz’s last sentence about cash becoming “awfully valuable when no one else has it” implies that the value of cash changes in different market environments. This is in essence a calculation of the future expected return of cash – crazy I know, but similar to an idea echoed by another very smart investor named Jim Leitner, who said:

“The correct way to measure the return on cash is more dynamic: cash is bound on the lower side by its actual return, whereas, the upper side possesses an additional element of positive return received from having the ability to take advantage of unique opportunities.”

For those of you who have not read the pieces on Jim Leitner, a former member of Yale Endowment's Investment Committee, I highly recommend doing so.

When To Buy, Intrinsic Value, Cash, Expected Return, Hurdle Rate, Opportunity Cost

“We don't predict. We price. So if timing the market means we buy stressed securities when their prices are way down, then yes. Guilty as charged. But, again, we're trying to compare what we're paying for something, versus what we think, over time, we're going to get for the cash we're paying. And, we try not to have too many predetermined notions about what it's going to be.”

The first part is self-explanatory.

In the second portion, when Berkowitz refers to comparing “what we’re paying for something, versus what we think, over time, we’re going to get for the cash we’re paying,” he’s inherently talking about a hurdle rate and opportunity cost calculation that’s going to determine whether it’s worthwhile to purchase a particular asset.

The purchase decision is not solely driven by price vs. intrinsic value. There’s an additional factor that’s slightly more intangible, because its calculation involves predicting both the future expected return of cash (see above), as well as the future expected return of XYZ under evaluation.

Buffett Partnership Letters: 1965 Part 4

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

“…I believe that we have done somewhat better during the past few years with the capital we have had in the Partnership than we would have done if we had been working with a substantially smaller amount. This was due to the partly fortuitous development of several investments that were just the right size for us – big enough to be significant and small enough to handle.

I now feel that we are much closer to the point where increase sized may prove disadvantageous…What may be the optimum size under some market and business circumstances can be substantially more or less than optimum under other circumstances…as circumstances presently appear, I feel substantially greater size is more likely to harm future results than to help them.”

Asset under management (“AUM”) should not be a stagnant or passive consideration. The AUM is essentially the denominator in the return on equity calculation. The adjustment of AUM relative to portfolio gain and loss will directly impact the trackrecord. The optimal AUM will fluctuate depending on market conditions and/or opportunities available.

However, how to “adjust” AUM is a whole other can of worms.

Historical Performance Analysis, Special Situations, AUM, Expected Return, Hurdle Rate, Sizing, Time Management

“The ‘Workout’ business has become very spasmodic. We were able to employ an average of only $6 million during the year…and this involved only a very limited number of situations. Although we earned about $1,410,000, or about 23 ½% on average capital employed (this is calculated on an all equity basis...), over half of this was earned from one situation. I think it unlikely that a really interesting rate of return can be earned consistently on large sums of money in this business under present conditions.”

Over the previous 10 years, a portion of Buffett’s portfolio was consistently invested in special situations. But we see from that quote above that with AUM increasing, Buffett began to reconsider the allocation to this basket after examining its historical return contribution.

• Does the expected return available meet my minimum return standards (hurdle rate)?
• If so, can I deploy enough capital into the basket such that it contributes meaningfully to portfolio performance and absolute profts? (For example, a 1% allocation that returns 100%, while a return high percentage-wise, adds only a little boost to overall portfolio performance)
• How much of my (or my team’s) time am I will to allocate given the expected return and profits?

Perhaps another interesting lesson is that as AUM shifts, strategies that made sense at one point, may not always be as effective.

Sourcing, Sizing

“I do not have a great flood of good ideas as I go into 1966, although again I believe I have at least several potentially good ideas of substantial size. Much depends on whether market conditions are favorable for obtaining a larger position.”

Good ideas, even just a few, when sized correctly will lead to profits.

Conversely, ideas – no matter how good – if sized too small or impossible to obtain in adequate size for the portfolio, won’t make much of a difference.

Selectivity, Sizing, Expected Return, Opportunity Cost, Hurdle Rate, Correlation, Capital Preservation

“We are obviously only going to go to 40% in very rare situations – this rarity, of course, is what makes it necessary that we concentrate so heavily when we see such an opportunity. W probably have had only five or six situations in the nine-year history of the Partnership where we have exceeded 25%. Any such situations are going to have to promise very significantly superior performance relative to the Dow compared to other opportunities available at the time.

They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal (anything can happen on a short-term quotational basis which partially explains the greater risk of widened year-to-year variations in results). In selecting the limit to which I will go in any one investment, I attempt to reduce to a tiny figure the probability that the single investment (or group, if there is intercorrelation) can produce a result for our total portfolio that would be more than ten percentage points poorer than the Dow.”

Buffett’s sizing decisions were selective, and dependent upon a number of conditions, such as:

• The expected return of the potential investment
• The expected return of the potential investment compared with the expected return of the Dow, and other potential investments (this is the opportunity cost and hurdle rate consideration)
• Whether the potential investment is correlated with other current and potential investments
• The possibility of expected loss of the potential investment (capital preservation consideration)

When To Buy

“Our purchase of Berkshire started at a price of $7.60 per share in 1962…the average cost, however, was $14.86 per share, reflecting very heavy purchases in early 1965…”

Buffett was comfortable buying as prices went up. This is in contrast to many value investors who are most comfortable buying on the way down.

The Math of Compounding

Here is an interesting piece from Ted Lucas of Lattice Strategies (2010 Q4 The Oracle of...Risk Management) on the complementary relationship between compounding and capital preservation, plus a few other insightful topics of discussion. Compounding, Capital Preservation

“Losses are linear, but the appreciation required to recover from losses scales exponentially as they deepen.

Thought experiment: Imagine a portfolio that was down 20% during the 2008 implosion, versus a portfolio that was down 40%. In the 2009 rebound, assume the first portfolio recovered by 25%, while the second rebounded by 40%. At the end of the two periods, the first portfolio would be back to its starting point, while the second – after knocking the lights out in 2009 – would still be down 16%, requiring another 19% gain to get back to even (i.e., a 40% gain on 60 cents on the dollar yields 84 cents; to get 84 cents back to a full dollar requires a 19% gain).

The key takeaway? Avoiding big drawdowns – and thereby limiting the destructive force of negative compounding and unleashing the power of positive compounding – is the critical driver of long-term returns.”

Simple concept, yet often ignored by investors. This is something that those with trading backgrounds do better than traditional value investors. For additional mindblowingly good commentary on this topic, be sure to read Stanley Druckenmiller’s (protégé of George Soros) thoughts on capital preservation and compounding.

Volatility

Using Warren Buffett andBerkshire’s historical price performance, Lucas also discusses volatility, and the concepts of upside and downside capture. (I should highlight that the concept of volatility or beta only makes sense when there is an underlying benchmark or index for comparison.)

As you well know, the world has been taught to avoid “volatility.” What terrible advice! One should only avoid downside volatility, and wholeheartedly embrace upside volatility. After all, the holy grail of all portfolios would provide super efficient upside capture and little or no downside capture.

Benchmark

Additionally, Lucas warns about the dangers of certain industry benchmarking practices which are not conducive to maximum return compounding because fan portfolio managers’ need to keep inline with the benchmark (or a particular index), and therefore exacerbate the likelihood of loss.

“It is the ‘shape’ of returns through a market cycle that is of infinitely greater importance than relative benchmark outperformance over a short time window. How does this factor into building resilient, long-term investment strategies? When constructing portfolios, investors would be well served by a willingness to trade off some upside during positive markets in order to disproportionately mitigate the downside experienced during negative periods. While this may not sound like a blinding insight, it is hard to reconcile this idea with an industry where strategies are promoted – and often chosen – based on relative benchmark outperformance over short time windows, typically when conditions are conducive to a particular strategy.”

Buffett Partnership Letters: 1965 Part 3

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

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

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

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

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

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

Control, Liquidity

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

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

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

Mark to Market, Subscriptions, Redemptions

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

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

Benchmark, Clients

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

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

Time Management, Team Management, Clients

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

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

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

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

Howard Marks' Book: Chapter 7

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 7 “The Most Important Thing Is…Recognizing Risk” Risk, Capital Preservation, Compounding

“…Warren Buffett, Peter Lynch, Bill Miller and Julian Robertson. In general their records are remarkable because of their decades of consistency and absence of disasters, not just their high returns.”

“How do you enjoy the full gain in up markets while simultaneously being positioned to achieve superior performance in down markets? By capturing the up-market gain while bearing below-market risk…no mean feat.”

“The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.”

The resilient yet participatory portfolio (this term was stolen from a very smart man named Ted Lucas at Lattice Strategies in San Francisco) – a rare creature not easily found. We know it exists because a legendary few, such as those listed above, have found it before. How to find it for ourselves remains the ever perplexing question.

Our regular Readers know that we’re obsessed with the complementary relationship between capital preservation and compounding. For more on this, be sure to check out commentary from Stanley Druckenmiller and Warren Buffett – yes, two very different investors.

Conservatism, Hedging

“Since usually there are more good years in the markets than bad years, and since it takes bad years for the value of risk control to become evident in reduced losses, the cost of risk control – in the form of return foregone – can seem excessive. In good years in the market, risk-conscious investors must content themselves with the knowledge that they benefited from its presence in the portfolio, even though it wasn’t needed…the fruits…come only in the form of losses that don’t happen.”

People talk a lot about mitigating risk in the form of hedging. But what about remaining conservatively positioned (such as having more cash) and incurring the cost of lower portfolio returns? Isn’t the “return foregone” in this case akin to hedging premium?

Conservatism, Fat Tail

“It’s easy to say that they should have made more conservative assumptions. But how conservative? You can’t run a business on the basis of worst-case assumptions. You won’t be able to do anything. And anyway, a ‘worst-case assumption’ is really a misnomer; there’s no such thing, short of a total loss…once you grant that such a decline can happen – for the first time – what extent should you prepare for? Two percent? Ten? Fifty?”

“Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so. Once in a while, a ‘black swan’ will materialize. But if in the future we always said, ‘We can’t do such-and-such, because the outcome could be worse than we’ve ever seen before,” we’d be frozen in inaction.

So in most things, you can’t prepare for the worst case. It should suffice to be prepared for once-in-a-generation events. But a generation isn’t forever, and there will be times when that standard is exceeded. What do you do about that? I’ve mused in the past about how much one should devote to preparing for the unlikely disaster. Among other things, the events of 2007-2008 prove there’s no easy answer.”

Risk, Making Mistakes, Process Over Outcome

“High absolute return is much more recognizable and titillating than superior risk-adjusted performance. That’s why it’s high-returning investors who get their pictures in the papers. Since it’s hard to gauge risk and risk-adjusted performance (even after the fact), and since the importance of managing risk is widely underappreciated, investors rarely gain recognition for having done a great job in this regard. That’s especially true in good times.”

“Risk – the possibility of loss – is not observable. What is observable is loss, and generally happens only when risk collides with negative events…loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment.”

“…the absence of loss does not necessarily mean the portfolio was safely constructed…A good builder is able to avoid construction flaws, while a poor builder incorporates construction flaws. When there are no earthquakes, you can’t tell the difference…That’s what’s behind Warren Buffett’s observation that other than when the tide goes out, we can’t tell which swimmers are clothed and which are naked.”

Good risk management = implementing prevention measures.

Once planted, the seeds of risk can remain dormant for years. Whether or not they sprout into loss depends on the environment and its conditions.

In other words, mistakes that result in losses are often made long before losses occur. Although loss was not the ultimate outcome does not mean mistakes were not made.

Buffett Partnership Letters: 1965 Part 2

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Should I Sell This Thing?

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

When To Sell, Psychology

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

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

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

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

When To Sell, Making Mistakes, Opportunity Cost

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

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

Buffett Partnership Letters: 1965 Part 1

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. The 1965 letter is a treasure trove of insightful portfolio management commentary from Warren Buffett. This is the Buffett for purists – the bright, candid young investor, encountering intellectual dilemmas, thinking aloud about creative solutions, and putting to paper the mental debates pulling him one direction and then another. Fascinating stuff!

Portfolio Management, Sizing, Diversification, Expected Return, Risk, Hurdle Rate, Correlation, Selectivity, Psychology

“We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change underlying value of the investment.

We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations. Frankly there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects that range of all possible relative performances, including negative ones, adjusted for the probability of each…) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorrelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage.

It doesn’t work that way.

We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations vary substantially. The question always is, ‘How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?’ This depends to a great degree on the wideness of the spread between the mathematical expectations of number one versus number eight. It also depends upon the probability that number one could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have 0.05 chance of performing fifteen percentage points or more worse than the Dow, and the second might have only 0.01 chance of such performance. The wide range of expectation in the first case reduces the desirability of heavy concentration in it.

The above may make the whole operation sound very precise. It isn’t. Nevertheless, our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations. Imprecise and emotionally influenced as our attempts may be, that is what the business is all about. The results of many years of decision-making in securities will demonstrate how well you are doing on making such calculations – whether you consciously realize you are making the calculations or not. I believe the investor operates at a distinct advantage when he is aware of what path his thought process is following.”

"There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can’t reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation."

Lots of fantastic insights here. The most important take away is that, even for Buffett, portfolio management involves more art than science – it’s imprecise, requiring constant reflection, adaptation, and awareness of ones decisions and actions.

Expected Return, Trackrecord, Diversification, Volatility

“The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable. The greater the number of selections, the less will be the average year-to-year variation in actual versus expected results. Also, the lower will be the expected results, assuming different choices have different expectations of performance.

I am willing to give up quite a bit in terms of leveling of year-to-year results (remember when I talk of ‘results,’ I am talking of performance relative to the Dow) in order to achieve better overall long-term performance. Simply stated, this means I am willing to concentrate quite heavily in what I believe to be the best investment opportunity recognizing very well that this may cause an occasional very sour year – one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater…Looking back, and continuing to think this problem through, I fell that if anything, I should have concentrated slightly more than I have in the past…”

Here, Buffett outlines the impact of diversification on the expected return and expected volatility of a portfolio, as well as the resulting trackrecord.

Consciously constructing a more concentrated portfolio, Buffett was willing to accept a bumpier trackrecord (more volatile returns vs. the Dow) in return for overall higher long-term returns.

To fans of this approach, I offer two points of caution:

• Increased concentration does not automatically equate to higher returns in the long-term – this is also governed by accurate security selection, or as Buffett puts it, “the various expectations of choices available”
• Notice, at this juncture in 1965-1966, Buffett has a 10-year wildly superior trackrecord. This is perhaps why short-term volatility no longer concerned him (or his clients) as much. If your fund (and client base) is still relatively new, think carefully before emulating.

Baupost Letters: 1996

Continuation in our series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts, only our interpretive summaries, for this series.

Risk, Sizing, Diversification, Psychology

In 1996, Baupost had a number of investments in the former Soviet Union. Klarman managed the higher level of risk of these investments by limiting position sizing such that if the total investment went to zero, it would not have a materially adverse impact on the future of the fund.

“Unfamiliarity” is a risk for any new investment. Klarman approaches new investments timidly to ensure that there isn’t anything that he’s missing. He does so by controlling sizing and sometimes diversifying across a number of securities within the same opportunity set.

Baupost mitigates risk (partially) by:

• Sizing slowly and diversifying with basket approach (at least initially)
• Balancing arrogance with humility. Always be aware of why an investment is available at a bargain price, and your opinion vs. the market. Investing is a zero-sum game, and each time you make a purchase, you’re effectively saying the seller is wrong.

Reading in between the lines, the Russian investments must have held incredibly high payoff potential (in order to justify the amount of time and effort spent on diligence). Smaller position sizing may decrease risk but it also decreases the potential return contribution to the overall portfolio.

Interestingly, this method of balancing risk and return through position sizing and diversification is more akin to venture capital than the traditional value school. For example, recently, investors have been buzzing about a number of Klarman’s biotech equity positions (found on his 13F filing). I’ve heard through the grapevine that these investments were structured like a venture portfolio – the expectation is that some may crash to zero, while some may return many multiples the original investment. Therefore, those copying Klarman’s purchases should proceed with caution, especially given Klarman’s history of making private investments not disclosed on 13F filings.

Diversification

Klarman believes in sufficient but not excessive diversification.

This may explain the rationale behind why Klarman has been known to purchase baskets of individual securities for the same underlying bet – see venture portfolio discussion above.

Correlation, Risk

Always cognizant of whether seemingly different investments are actually the same bet to avoid risk of concentrated exposures.

Mandate, Trackrecord

Baupost has a flexible investment mandate, to go anywhere across asset classes, capital structure, geographies, etc., which allows it to differentiate from the investment fund masses. Opportunities in different markets happen at different times, key is to remain adaptive and ready for opportunity sets when they become available.

The flexible mandate is helpful in smoothing the return stream of the portfolio, and consequently, the trackrecord. Baupost can deploy capital to where opportunities are available in the marketplace, therefore ensuring a (theoretically) steadier stream of future return potential. This is in contrast to funds that cannot take advantage of opportunities outside of their limited mandate zones.

Liquidity

Klarman is willing to accept illiquidity for incremental return.

This makes total sense, but the tricky part is matching portfolio sources (client time horizon, level of patience, and fund redemption terms) with uses (liquidity profile of investments). Illiquidity should not be accept lightly, and has been known to cause problems for even the most savvy of investors (for example: see 2003 NYTimes article on how illiquidity almost destroyed Bill Ackman & David Berkowitz in the early stages of their careers).

Patience

For international exposure [Russia], Baupost spent 7 years immersed in research, studying markets, meeting with managements, making toe-hold investments to observe, hired additional members of investment team (sent a few analysts to former Soviet Union, on the ground, for several months) to network & build foreign sell-side & counterparty relationships.

Selectivity, Cash

Buy securities if available at attractive prices. Sell when securities no longer cheap. Go to cash when no opportunities are available.

We’ve discussed the concept of selectivity standards in the past, and whether these standards shift in different market environments. For Klarman, it would seem his selectivity standards remained absolute regardless of market environment.

Hedging

Baupost will always hedge against catastrophic or sustained downward movement in the market. This can be expensive over time, but will persist and remains part of investment strategy.

Klarman embedded hedging as an integrated “process” that’s part of the overall investment strategy. This way, Baupost is more likely to continue buying hedges even after years of premium bleed. This also avoids “giving up” just as disaster is about to hit. For more on this topic, be sure to check out the AQR tail risk hedging piece we showcased a few months ago.

Mauboussin on Portfolio Management

Michael Mauboussin, author & former Chief Investment Strategist at Legg Mason, recently joined Consuelo Mack for an interview on WealthTrack (one of my favorite resources for interesting conversations with interesting people; the transcripts are economically priced at $4.99 per episode). Their conversation touched upon a number of relevant portfolio management topics. For those of you with more time, I highly recommend listening/watching/reading the episode in its entirety. Luck, Process Over Outcome, Portfolio Management, Psychology

“MAUBOUSSIN: …luck is very important, especially for short-term results...everyone’s gotten better, and as everyone’s gotten better, skills become more uniform. There’s less variance or difference between the best and the worst. So even if luck plays the same role, lesser variance in skill means batting averages come down…So I call it the paradox of skill, because it says more skill actually leads to more luck in results…

MACK: So what are the kind of skills that we look at that would differentiate an investor from the pack, from the rest of the Street?

MAUBOUSSIN: …when you get to worlds that are probabilistic like money management where what you do, you don’t really know what the outcome is going to be, then it becomes a process and, to me, successful investing has three components to the process. The first would be analytical, and analytical to me means finding stocks for less than what they’re worth, or in the jargon means getting an investment edge, and second and related to that is putting them into the portfolio at the proper weight. So it’s not just finding good investment ideas, but it’s how you build a portfolio with those investment ideas. And by the way, a lot of people in the financial community focus on buying attractive stocks, but the structure is actually really important as well…the portfolio positioning, I think there’s room for improvement there.”           

When dealing with probabilistic predictions, such as in investing, one must focus on process, not outcome. (For more on this, be sure to check out Howard Marks’ discussion on “many futures are possible, but only one future occurs.”)

As our Readers know, PMJar seeks to emphasize the importance of portfolio management within the investment process. We are glad to see validation of this view from a premier investor such as Michael Mauboussin – that successful investing requires “not just finding good investment ideas, but how you build a portfolio with those investment ideas.”

One other corollary from the quote above – investing is a zero sum game. In order to make profits, you need to be better than the “average” market participant. But over time, ripe investment profits have lured the brightest talent from all corners of world professions and consequently, the “average” intelligence of investors has increased. This means that the qualifications necessary to reach “average” status has inconveniently increased as well.

Here’s an exercise in self-awareness: where do you fit in – below, at, or above average – versus other fellow investors?

Luck, Process Over Outcome, Sizing, Psychology

“MAUBOUSSIN: This is such an interesting question, because if you look into the future and say to people, “Hey, future outcomes are a combination of skill and luck,” everybody gets that. Right? Everybody sort of understands that’s the case, but when looking at past results, we have a much more difficult time, and I think the answer to this comes from actually neuroscience. Brain scientists have determined that there’s part of your left hemisphere in your brain which they call the interpreter, and the interpreter’s job is when it sees an effect, it makes up a cause and, by the way, the interpreter doesn’t know about skill and luck, so if it sees an effect that’s good, let’s say good results, it says, “Hey, that must be because of skill,” and then your mind puts the whole issue to rest. It just sets it aside. So we have a natural sort of module in our brain that associates good results with skill. We know it’s not always the case for the future, but once it’s done, our minds want to think about it that way.

MACK: Therefore, do we repeat, when we’ve had a success that we attribute to our skill, do we constantly repeat those same moves in order to get the same result?

MAUBOUSSIN: I think it kind of gets to one of the biggest mistakes you see in the world of investing…this is a pattern we’ve seen not only with individuals but also institutions: buying what’s hot and inversely often getting rid of what’s cold, and that ultimately is very poor for investor results. It’s about a percentage point per year reduction in long-term results for individual investors because of this effect of buying high and selling low.

…one would be over confidence. We tend to be very over confident in our own capabilities. You can show this with simple little tests, and the way that tends to show up in investing is people, when they’re projecting out into the future, they’re much more confident about the range of outcomes, so they make a very narrow range of outcomes rather than a much broader range of outcomes. So there would be one example, over confidence, and its manifestation...

...try to weave into your process tools and techniques to manage and mitigate them. I don’t think you can ever fully eradicate them, but just be aware of them and learning about them. So for example, in the over confidence, you can start to use tools to better calibrate the future, for example, using past data or making sure you’re pushing out your ranges appropriately. So there are, in every case, some tools to help you manage that."

An interesting observation on our brain’s inability to distinguish between luck vs. skill in a historical context, which explains our natural tendency to chase performance return trends.

In addition to projecting a narrow range of outcomes, overconfidence is deadly in another way – overconfidence in sizing. For example, after hitting a couple winners (mostly due to luck), an investor says “Hey, I’m really good at this. I really should have made those previous investments bigger bets. Next time.” And so, the overconfident investor sizes up the next few investments. But luck fails to appear, and the damage hurts far more because these bets were sized greater.

But worry not, salvation does exist. If investors are able to identify and become aware of their behavioral biases, they can work to control and counter the associated negative effect.

Macro

CONSUELO MACK: What’s interesting is we’ve just come through a period where we’ve heard over and over again that macro matters...I’ve had a lot of value investors come on who have very good long-term track records, saying, ‘You know what? I didn’t used to pay attention to the macro. Now I really have to pay attention. It really matters.’

MICHAEL MAUBOUSSIN: The first thing I would say about this, is this is an area of prediction that’s been very well studied, and my favorite scientist on this is a psychologist named Phil Tetlock at University of Pennsylvania who did an exhaustive study of predictions in social, political, and economic outcomes, and what he found, I think, beyond a shadow of a doubt is that experts are very poor at predicting the future. So while I know people are worries about getting whipsawed by macro events, the evidence that anybody can anticipate exactly what’s going to happen next is very, very weak. So that’s the first thing, is just to be very reserved about your belief in your ability to anticipate what’s going to happen next…Obviously, you want to be mindful of macro. I don’t want to say you be dismissive of it. I would say macro aware, but in some ways macro agnostic.”

Risk Free Rate, Equity Risk Premium

“The most interesting anomaly that I see continues to be what is high equity risk premium. So in plain words, you think of a risk-free rate of return. In the United States, a 10-year Treasury note is a good proxy for that…about a 1.8% yield. An equity risk premium is the return above and beyond that you would expect for taking on additional risk on equities. Now, over the long haul, that equity risk premium has been about three or four percent, something like that, and today, by most reckoning, it’s a lot closer to six percent. It’s very, very high.”

Historically (depending on time period examined), equity risk premium is normally 3-4%, versus ~6% today. But does this mean that today’s equity risk premium is abnormally high? Or was the historical equity risk premium just abnormally low?

What is the qualitative explanation behind the figure for the “normal” equity risk premium? Must it hold true into perpetuity?

Howard Marks' Book: Chapter 6 - Part 2

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 6 “The Most Important Thing Is…Recognizing Risk” Marks does a fantastic job illustrating the impact of the (low) risk free rate on portfolio expected risk & return, position selectivity, hurdle rate & opportunity cost.

Expected Return, Hurdle Rate, Opportunity Cost, Risk Free Rate, Selectivity

“The investment thought process is a chain in which each investment sets the requirement for the next…The interest rate on the thirty-day T-bill might have been 4 percent. So investors, says, ‘If I’m going to go out five years, I want 5 percent. And to buy the ten-year note I have to get 6 percent.’ Investors demand a higher rate to extend maturity because they’re concerned about the risk to purchasing power, a risk that is assumed to increase with time to maturity. That’s why the yield curve, which in reality is a portion of the capital markets line, normally slopes upward with the increase in asset life.

Now let’s factor in credit risk. ‘If the ten-year Treasury pays 6 percent, I’m not going to buy a ten-year single-A corporate unless I’m promised 7 percent.’ This introduces the concept of credit spread. Our hypothetical investor wants 100 basis points to go from a ‘guvvie’ to a ‘corporate’…

What if we depart from investment-grade bonds? ‘I’m not going to touch a high yield bond unless I get 600 over a Treasury note of comparable maturity.’ So high yield bonds are required to yield 12 percent, for a spread of 6 percent over the [ten-year] Treasury note, if they’re going to attract buyers.

Now let’s leave fixed income altogether. Things get tougher, because you can’t look anywhere to find the prospective return on investments like stocks (that’s because, simply put, their returns are conjectural, not ‘fixed’). But investors have a sense for these things. ‘Historically S&P stocks have returned 10 percent, and I’ll buy them only if I think they’re going to keep doing so…And riskier stocks should return more; I won’t buy on the NASDAQ unless I think I’m going to get 13 percent.’

From there it’s onward and upward. ‘If I can get 10 percent from stocks, I need 15 percent to accept the illiquidity and uncertainty associated with real estate. And 25 percent if I’m going to invest in buyouts…and 30 percent to induce me to go for venture capital, with its low success ratio.’

That’s the way it’s supposed to work…a big problem for investment returns today stems from the starting point for this process: The riskless rate isn’t 4 percent; it’s close to 1 percent…Typical investors still want more return if they’re going to accept time risk, but with the starting point at 1+ percent, now 4 percent is the right rate for the ten-year (not 6 percent)…and so on. Thus, we now have a capital market line…which is (a) at a much lower level and (b) much flatter.”

“…each investment has to compete with others for capital, but this year, due to low interest rates, the bar for each successively riskier investment has been set lower than at any time in my career.” Most investors have, at some point, gone through a similar thought process:

• Should I make this investment?
• What is the minimum return that will compel me to invest? (For discussion purposes, we’ll call this the Hurdle Rate.)
• How do I determine my hurdle rate?

Based on the quotes above, the hurdle rate is determined based upon a mixture of considerations including: (1) the risk-free rate (2) the expected return of other available investments or asset classes, and (3) perhaps a measure of opportunity cost (for which the calculation opens a whole new can of worms).

In essence, this is a selectivity exercise, comparing the expected returns between possible investment candidates along the “risk” spectrum. After all, “each investment has to compete with others for capital” because we can’t invest in everything.

Howard Marks highlights a problematic phenomenon of recent days: the declining risk-free-rate pushing down the starting point for this exercise, and consequently the entire minimum return requirement (hurdle rate) curve for investors.

So the following questions emerge:

• Is your minimum return requirement (hurdle rate) curve relative or absolute vs. the crowd?
• If relative, do you join the crowd and lower your minimum return hurdle rate?
• Just a little, you say? Is there a point at which you draw the proverbial line in the sand and say “no further” because everyone has lost their minds?
• Do you then go to cash? Is there any another alternative? Are you prepared to miss out on potential returns (as other investors continue to decrease their hurdle rates and chase assets/investments driving prices even higher)?

Wait, this sounds very familiar. Remember our Part 1 discussion on “risk manifestation” due to irrational market participant behavior and high asset prices?

Risk, Expected Return

“…the herd is wrong about risk at least as often as it is about return.”

We have often discussed the concept of expected return (a forward looking prediction on future return outcome), but we have been remiss in discussing the concept of expected risk (a forward looking prediction on future risk outcome).

Misguided predictions of either expected return or expected risk have the potential to torpedo investment theses.

Howard Marks' Book: Chapter 6 - Part 1

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 6 “The Most Important Thing Is…Recognizing Risk” Risk, Intrinsic Value, Psychology

“Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do.”

“It’s also ephemeral and unmeasurable. All this makes it very hard to recognize, especially when emotions are running high. But recognize it we must.”

“…the theorist thinks return and risk are two separate things, albeit correlated, the value investors thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming primarily from high prices. Thus, awareness of the relationship between price and value – whether for a single security or an entire market – is an essential component of dealing successfully with risk….Dealing with this risk starts with recognizing it.”

“High risk, in other words, comes primarily with high prices.”

“…the degree of risk present in a market derives from the behavior of the participants, not from securities, strategies and institutions.”

“The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it. Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the ‘perversity of risk.’”

“No matter how good fundamentals may be, humans exercising their greed and propensity to err have the ability to screw things up.” As Marks points out, there exists an unbreakable relationship between the purchase price (relative to the intrinsic value) of an investment, and the level of risk within an investment. In other words, a portion of the risk of any investment is price dependent.

But price is a moving target, nudged around by the actions of market participants. Therefore, there’s also a link between the behavior of market participants and the manifestation of risk.

So the curious bug wonders, is the existence of risk absolute? Or does it only emerge under certain circumstances, such as when market participants drive asset prices sky high? Marks calls the latter the “perversity of risk” – a monster of our own creation.

If risk does manifest only at certain times due to market participant behavior, then in order to recognize risk, we must keep an acute awareness of not only our own actions, but also our surroundings and the actions of other market participants (as it relates to price vs. intrinsic value).

Stanley Druckenmiller Wisdom - Part 3

Here is Part 3 of portfolio management highlights extracted from an interview with Stanley Druckenmmiller in Jack D. Schwager’s book The New Market Wizards. Be sure to check out the juicy bits from Part 1 and Part 2. 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.

Liquidity, Making Mistakes, Position Review

“The wonderful thing about our business is that it’s liquid, and you can wipe the slate clean on any day.”

Liquidity makes it easier to change your mind and to deal with mistakes. This is why people talk about the “liquidity premium.” Theoretically, this flexibility is worth something. But how does one place a value or price upon liquidity (or illiquidity for that matter)? The Pensioner in Drobny’s book Invisible Hands has some interesting thoughts on this.

Our next point on liquidity has to do with a comment that Seth Klarman made about “re-buying the portfolio each day” and the related implications (of opportunity cost, hurdle rate, etc.).

For example: Prices in the marketplace are constantly shifting. Does your portfolio currently offer the best risk-reward profile given present market conditions, or can you improve it by buying or selling certain securities/assets? Mariko Gordon of Daruma Capital has some really interesting insights on portfolio review, decluttering, and improvement (made possible by liquidity).

Remember, investors of private assets do not have this luxury – so take advantage of liquidity wisely.

Sourcing, Liquidity, When To Buy

Q: Did you have any difficulty putting on a position of that size? A: No, I did it over a few days’ time. Also, putting on the position was made easier by the generally bearish sentiment at the time.

People often say that historical returns are not indicative of future performance.

Well, this is also true for trading liquidity: historical liquidity levels are not indicative of future liquidity.

Liquidity is not stagnant! What is liquid today may not be liquid tomorrow, and vice versa. This is why I find it funny when people reference historical trading liquidity. I’ve seen securities seesaw from trading a miniscule 30,000 shares a day, to more than 1MM shares a day.

Also, to Druckenmiller’s point, the time to buy (or sell) is often when there’s a liquidity imbalance somewhere in the marketplace. Liquidity imbalances have the ability to drive prices down (or up).

Volatility, Catalyst, Liquidity

“…I focus my analysis on seeking to identify the factors that were strongly correlated to a stock’s price movement as opposed to looking at all the fundamentals. Frankly, even today, many analysts still don’t know what makes their particular stocks go up and down.”

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

Look for reasons behind price movement (volatility), such as liquidity imbalances as mentioned above.

Buffett Partnership Letters: 1964 Part 3

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Historical Performance Analysis, Process Over Outcome, Psychology

“…the workouts (along with controls) saved the day in 1962, and if we had been light in this category that year, our final results would have been much poorer, although still quite respectable considering market conditions during the year…In 1963 we had one sensational workout which greatly influenced results, and generals gave a good account of themselves, resulting in a banner year. If workouts had been normal, (say, more like 1962) we would have looked much poorer compared to the Dow…Finally, in 1964 workouts were a big drag on performance.”

There is a chart in the January 18, 1965 partnership letter, in which Buffett breaks down the performance of Generals vs. Workouts for 1962-1964, and discusses the return attribution of each category in different market environments.

Most investors conduct some form of historical performance review, on a quarterly or annual basis. It’s an important exercise for a variety of reasons:

• To better understand your sources of historical return – performance analysis forces you to examine the relationship between your process vs. the outcome. Was the outcome as expected? If not, do changes need to be made to the process?
• To help you and your team become more self-aware – what you do well, badly, and perhaps reveal patterns of behavioral strength and weakness (here's an article about an interesting firm that offers this analysis)
• Team Compensation
• Highlight necessary adjustment to the portfolio and business
• Etc.

The investment management world spends a lot of time scrutinizing the operations of other businesses. Shouldn’t we apply the same magnifying glass to our own?

Sizing, Catalyst, Hedging, Activism, Control

“What we really like to see in situations like the three mentioned above is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it…Such activity should usually result in either appreciation of market prices from external factors or the acquisition by us of a controlling position in a business at a bargain price. Either alternative suits me.”

“Many times…we have the desirable ‘two strings to our box’ situation where we should either achieve appreciation of market prices from external factors or from the acquisition of control positions in a business at a bargain price. While the former happens in the overwhelming majority of cases, the latter represents an insurance policy most investment operations don’t have.”

Buffett discusses the phenomenon known as the “two strings” on his bow which allowed for heavy concentration in a few positions. The potential to (eventually) acquire a controlling stake in the underlying company served has an “insurance policy” via the creation of a catalyst after asserting control. (Some may argue that activism is applicable here as well. However, we tread cautiously on this train of thought because activism by no means entails a 100% success rate.)

It’s important to understand that control is not an option available to all investors. Therefore, when sizing positions, one should reconsider the exact emulation of Buffett’s enthusiastic buying as price continues to decline, and concentrated approach.

Interestingly, if a controlling stake in a company serves as an insurance policy (as Buffett describes it), is ‘control’ a type of portfolio hedge?

Activism, Control

“We have continued to enlarge the positions in the three companies described in our 1964 midyear report where we are the largest stockholders…It is unlikely that we will ever take a really active part in policy-making in any of these three companies…”

Control ≠ Activism

Conservatism

“To too many people conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional or an unconventional approach, per se, is conservative.”

“Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. In some corner of the world they are probably still holding regular meetings of the Flat Earth Society.”

“We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t. A public opinion poll is no substitute for thought. When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case – whether conventional or unconventional – whether others agree or disagree – we feel we are progressing in a conservative manner.”

Stanley Druckenmiller Widsom - Part 2

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

Portfolio Management

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

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

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

When To Buy, When To Sell, Sizing

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

Making Mistakes, When To Sell

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

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

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

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

Cash

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

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

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

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

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

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

Planting Seeds of Expected Return

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

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

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

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

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

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

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

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