Howard Marks' Book: Chapter 13

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 13 “The Most Important Thing Is…Patient Opportunism” Selectivity, Patience, Cash

“…I want to…point out that there aren’t always great things to do, and sometimes we maximize our contribution by being discerning and relatively inactive. Patient opportunism – waiting for bargains – is often your best strategy.”

“…the investment environment is a given, and we have no alternative other than to accept it and invest within it…Among the value prized by early Japanese culture was mujo. Mujo was defined classically for me as recognition of ‘the turning of the wheel of the law,’ implying acceptance of the inevitability of change, of rise and fall…In other words, mujo means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control. Thus we must recognize, accept, cope, and respond. Isn’t that the essence of investing?...All we can do is recognize our circumstances for what they are and make the best decisions we can, given the givens.”

“Standing at the plate with the bat on your shoulders is Buffett’s version of patient opportunism. The bat should come off your shoulders when there are opportunities for profit with controlled risk., but only then. One way to be selective in this regard is by making every effort to ascertain whether we’re in a low-return environment or a high-return environment.”

In order to practice patient opportunism by implementing standards of selectivity, the investor must first have a method for recognizing & determining the best course of action based on risk-reward opportunities in the past, present, and future.

Selectivity, Clients

“Because they can’t strike out looking, investors needn’t feel pressured to act. They can pass up lot of opportunities until they see one that’s terrific…the only real penalty is for making losing investments…For professional investors paid to manage others’ money, the stakes are higher. If they miss too many opportunities, and if their returns are too low in good times, money managers can come under pressure from clients and eventually lose accounts. A lot depends on how clients have been conditioned.”  

One caveat to the "no called-strikes": clients. For some investors, the client base and permanency of capital will dictate whether or not there are called-strikes in this game. If your investment approach involves waiting for perfect pitches, make sure your clients agree, and double check the rulebook that there are indeed no called-strikes in this game!

Selectivity, Expected Return

“The motto of those who reach for return seems to be: ‘If you can’t get the return you need from safe investments, pursue it via risky investments.”

“It’s remarkable how many leading competitors from our early years as investors are no longer leading competitors (or competitors at all). While a number faltered because of flaws in their organization or business model, others disappeared because they insisted on pursuing high returns in low-return environments.

You simply cannot create investment opportunities when they’re not there. The dumbest thing you can do is to insist on perpetuating high returns – and give back your profits in the process. If it’s not there, hoping won’t make it so.”

Expected return (or future performance) is not a function of wishful thinking, it’s a function of the price you pay for an asset.

Historical Performance Analysis

“In Berkshire Hathaway’s 1977 Annual Report, Buffett talked about Ted Williams – the ‘Splendid Splinter’ – one of the greatest hitters in history. A factor contributed to his success was his intensive study of his own game. By breaking down the strike zone into 77 baseball-sized ‘cells’ and charting his results at the plate, he learned that his batting average was much better when he went after only pitches in his ‘sweet spot.’”

How many Readers have systematically studied your “own game” – the sources of investment performance – good and bad?

Because everyone’s “game” is different, I suspect this exercise will likely vary for each person. I would be curious to hear about the methodologies employed by Readers who conduct this review/analysis on a regular basis.

When To Buy, Liquidity

“The absolute best buying opportunities come when asset holders are forced to sell, and…present in large numbers. From time to time, holders become forced sellers for reasons like these:

• The funds they manage experience withdrawls.
• Their portfolio holdings violate investment guidelines such as minimum credit ratings or position maximums.
• They receive margin calls because the value of their assets fails to satisfy requirements agreed to in contracts with their lenders…

They have a gun at their heads and have to sell regardless of price. Those last three words – regardless of price – are the most beautiful in the world if you’re on the other side of the transaction.”

“…if chaos is widespread, many people will be forced to sell at the same time and few people will be in a position to provide the required liquidity…In that case, prices can fall far below intrinsic value. The fourth quarter of 2008 provided an excellent example of the need for liquidity in times of chaos.”

Ultimately, it’s an imbalance in underlying market liquidity (too many sellers, not enough buyers) that creates bargains so that prices “fall far below intrinsic value.”

The Importance of Knowing Thyself

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

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

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

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

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

Buffett Partnership Letters: 1968 & 1969

During 1969, the Partnership transitioned into Berkshire Hathaway. Therefore this concludes our series on portfolio management and the Buffett Partnership Letters. Please see our previous articles in this series. Control, Hurdle Rate, Compounding, When To Sell

“…controlled companies (which represent slightly over one-third of net assets at the beginning of the year)…we cannot make the same sort of money out of permanent ownership of controlled businesses that can be made from buying and re-selling such businesses, or from skilled investment in marketable securities. Nevertheless, they offer a pleasant long term form of activity (when conducted in conjunction with high grade, able people) at satisfactory rates of return.”

“Particularly outstanding performances were turned in by Associated Cotton Shops, a subsidiary of DRC run by Ben Rosner, and National Indemnity Company, a subsidiary of B-H run by jack Ringwalt. Both of these companies earned about 20% on capital employed in their businesses.”

We’ve previously written that portfolio capital compounding can be achieved in multiple ways:

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

• Compounding can be achieved by operating entities owned in the portfolio by “reinvesting past earnings back into the same business (or perhaps new business lines). In this respect, the operating business has an advantage over the financial investor, who must constantly search for new opportunities.”

In the quotes above, Buffett was referring to the latter method.

Toward the end of the Partnership, Buffett struggled with the continuous churn & reinvestment process as prices in the marketplace rose and rendered good capital reinvestment opportunities difficult to find. Enter the attractiveness of leaving capital with operating entities (in which he had a controlling stake) that can generate profits (compound) & reinvestment capital, at “satisfactory rates of return,” without Buffett having to watch too closely (provided he found “high grade, able people” to oversee these control investments).

Buffett seemed agnostic between the two as long as the control situations produced “satisfactory rates of return.” As always, the devil lies in the details: what is a “satisfactory rate of return”? Was this figure Buffett’s mental hurdle rate?

Nevertheless, this serves as an useful reminder to investors today that the process of buying and selling assets is not the only way to compound and generate portfolio returns. In fact, sometimes it’s better to hold on to an asset, especially when good reinvestment opportunities are rare.

Process Over Outcome

“It is possible for an old, over-weight ball player, whose legs and batting eye are gone, to tag a fast ball on the nose for a pinch-hit home run, but you don’t change your line-up because of it.”

AUM, Sizing

“…our $100 million of assets further eliminates a large portion of this seemingly barren investment world, since commitments of less than about $3 million cannot have a real impact on our overall performance, and this virtually rules out companies with less than about $100 million of common stock at market value…”

Returning Capital

For those searching for language related to returning capital, the letter dated May 29^th, 1969 is a must read.

Treatise on Equity Risk Premium

Howard Marks recently wrote a letter focusing almost exclusively on equities (March 2013 Letter). Within the letter, he thoroughly explores the equity risk premium – a concept usually taken for granted or as a given figure – in such a thoughtful and intuitive way, that the usually esoteric concept becomes nearly graspable by people (like me) with far less intellectual processing power.

Equity Risk Premium, Risk Free Rate

“The equity risk premium is generally defined as, “the excess return that an individual stock or the overall stock market provides over a risk-free rate.” (Investopedia) Thus it is the incremental return that investors in equities receive relative to the risk-free rate as compensation for bearing the risk involved.”

“…I strongly dislike the use of the present tense...‘The long-term equity risk premium is typically between 4.5% and 5%.’ This suggests that the premium is something that solidly exists in a fixed amount and can be counted on to pay off in the future…

The equity risk premium can actually be defined at least four different ways, I think:

1. The historic excess of equity returns over the risk-free rate.
2. The minimum incremental return that people demanded in the past to make them shift from the risk-free asset to equities.
3. The minimum incremental return that people are demanding today to make them shift away from the risk-free asset and into equities.
4. The margin by which equity returns will exceed the risk-free rate in the future.

The four uses for the term are different and, importantly, all four are applied from time to time. And I’m sure the four uses are often confused. Clearly the import of the term is very different depending on which definition is chosen. The one that really matters, in my opinion, is the fourth: what will be the payoff from equity investing. It’s also the one about which it’s least reasonable to use the word 'is,' as if the risk premium is a fact.”

“There are problems with at least three of the four meanings. Only number one can be measured…What matters for today’s investor isn’t what stocks returned in the past, or what equity investors demanded in the past or think they’re demanding today. What matters is definition number four, what relative performance will be in the future.”

“The bottom line: given that it’s impossible to say with any accuracy what return a stock or the stock market will deliver, it’s equally impossible to say what the prospective equity risk premium is. The historic excess of stock returns over the risk-free rate may tell you the answer according to definition number one, with relevance depending on which period you choose, but it doesn’t say anything about the other three…and especially not number four: the margin by which equity returns will exceed the risk-free rate in the future.”

Marks’ comments touch upon a sensitive nerve in the investment management industry. If existing calculation methods for equity risk premiums are incorrect (ahem, let’s not even get into the calculation for a “normalized forward looking” risk-free-rate), what is implication on discount rates used in so many DCF models around the world?

Alas, false precision is as dangerous as inaccuracy. But this advice doesn’t make for good analyst training manuals.

Portfolio Management

“As Einstein said, in one of my favorite quotes, ‘Not everything that counts can be counted, and not everything that can be counted counts.’”

This quote beautifully summaries why portfolio management is more art than science.

Expected Return

“To me, the answer is simple: the better returns have been, the less likely they are – all other things being equal – to be good in the future. Generally speaking, I view an asset as having a certain quantum of return potential over its lifetime. The foundation for its return comes from its ability to produce cash flow. To that base number we should add further return potential if the asset is undervalued and thus can be expected to appreciate to fair value, and we should reduce our view of its return potential if it is overvalued and thus can be expected to decline to fair value.

So – again all other things being equal – when the yearly return on an asset exceeds the rate at which it produces cash flow (or at which the cash flow grows), the excess of the appreciation over that associated with its cash flow should be viewed as either reducing the amount of its undervaluation (and thus reducing the expectable appreciation) or increasing its overvaluation (and thus increasing the price decline which is likely). The simplest example is a 5% bond. Let’s say a 5% bond at a given price below par has a 7% expected return (or yield to maturity) over its remaining life. If the bond returns 15% in the next twelve months, the expected return over its then-remaining life will be less than 7%. An above-trend year has borrowed from the remaining potential. The math is simplest with bonds (as always), but the principle is the same if you own stocks, companies or income-producing real estate.

In other words, appreciation at a rate in excess of the cash flow growth accelerates into the present some appreciation that otherwise might have happened in the future.”

A great explanation for why expected return figures should be ever forward looking, and not based on past performance.

Howard Marks' Book: Chapter 12

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 12 “The Most Important Thing Is…Finding Bargains” Definition of Investing, Portfolio Management, Position Review, Intrinsic Value, Opportunity Cost

“…‘investment is the discipline of relative selection.’” Quoting Sidney Cottle, a former editor of Graham and Dodd’s Security Analysis.

“The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. The raw materials for the process consist of (a) a list of potential investments, (b) estimates of their intrinsic value, (c) a sense for how their prices compare with their intrinsic value, and (d) an understanding of the risk involved in each, and of the effect their inclusion would have on the portfolio being assembled.”

The “process of intelligently building a portfolio” doesn’t end with identifying investments, and calculating their intrinsic values and potential risks. It also requires choosing between available opportunities (because we can’t invest in everything) and anticipating the impact of inclusion upon the resulting combined portfolio of investments. Additionally, there’s the continuous monitoring of portfolio positions – comparing and contrasting between existing and potential investments, sometimes having to make room for new/better investments by “selling the lesser ones.”

It’s worthwhile to point out that intrinsic value is important not only because it tells you when to buy or sell a particular asset, but also because it serves as a way to compare & contrast between available opportunities. Intrinsic value is yet another input into the ever complicated “calculation” for opportunity cost.

Mandate, Risk

“Not only can there be risks investors don’t want to take, but also there can be risks their clients don’t want them to take. Especially in the institutional world, managers are rarely told ‘Here’s my money; do what you want with it.’”

This type of risk avoidance is a form of structural inefficiency caused by mandate restrictions. It creates opportunities for those willing to accept that particular risk and/or don’t have mandate restrictions. A great example: very few investors owned financials in 2009-2010. Fear of the “blackhole” balance sheet was only a partial explanation. During that period, I heard anecdotally that although some institutional fund managers believed the low price more than compensated for the balance sheet risk, they merely didn’t want to have to explain owning financials to their clients.

Pyschology

“…the optimism that drives one to be an active investor and the skepticism that emerges from the presumption of market efficiency must be balanced.”

Wisdom from Peter Lynch

Previously, we summarized an interview with Michael F. Price & an interview with David E. Shaw from Peter J. Tanous’ book Investment Gurus. Below are highlight from yet another fantastic interview, this time with Peter Lynch, the legendary investor who ran Fidelity's Magellan Fund from 1977-1990, compounding at ~30% annually during that period.

When To Buy, Volatility, Catalyst

On technical buy indicators, expected volatility, and catalysts:

“I have traditionally liked a certain formation. It’s what I call the electrocardiogram of a rock. The goes from, say, 50 to 8. It has an incredible crater. Then it goes sideways for a few years between 8 and 11. That’s why I call it the EKG of a rock. It’s never changing. Now you know if something goes right with this company, the stock is going north. In reality, it’s probably just going to go sideways forever. So if you’re right it goes north and if you’re wrong it goes sideways. These stocks make for a nice research list…stocks that have bottomed out...

...When it’s going from 50 to 8, it looks cheap at 15; it looks cheap at 12. So you want the knife to stick in the wood. When it stops vibrating, then you can pick it up. That’s how I see it on a purely technical basis…why the stock is on your research list, not on your buy list. You investigate and you find that of these ten stories, this one has something going on. They’re getting rid of a losing division, one of their competitors is going under, or something else.”

When To Buy

“You could have bought Wal-Mart ten years after it went public…it was a twenty-year-old company. This was not a startup…You could have bought Wal-Mart and made 30 times your money. If you bought it the day it went public you would have made 500 times your money. But you could have made 30 times your money ten years after it went public.”

Many value investors experience difficulty buying assets when prices are moving upward. At those moments, perhaps it’s important to remember to see the forest (ultimate risk-reward) through the trees (an upward moving price).

Expected Return, Fat Tail

“There may be only a few times a decade when you make a lot of money. How many times in your lifetime are you going to make five times on your money?”

I hear chatter about “lotto ticket” and “asymmetric risk-reward” ideas all the time. A friend recently joked that he would rather buy actual lotto tickets than the lotto-ticket-ideas because with the former he actually stands a chance of hitting the jackpot.

Apparently, Peter Lynch sort of agrees with my friend. Markets are generally efficient enough that asymmetric risk-reward opportunities rarely occur. The tricky part is discerning between the real deal vs. imitations conjured from misjudgment or wishful thinking analysis.

Diversification, Correlation

“If you buy ten emerging growth funds and all these companies have small sales and are very volatile companies, buying ten of those is not diversification.”

The correlation between assets, not the number of assets, ultimately determines the level of diversification within a portfolio.

Clients

“One out of every hundred Americans was in my fund…For many of these people, $5,000 is half their assets other than their house. And there are people you meet who say we sent our kids to college, or we paid off the mortgage. What I’m saying is that it’s very rewarding to have a fund where you really made a difference in a lot of people’s lives.”

How refreshing. Those who work in the investment management world sometimes forget for whom they toil (beyond numero uno). A job well done could potentially make large positive impacts on the lives of others.

Team Management

On how he’s spending his time after stepping down from managing the Magellan Fund:

“…I work with young analysts. We bring in six new ones a year and I work with them one-on-one.”

Process Over Outcome

On whether Peter Lynch would have pursued an investment career had he lost money in his first stock purchase:

“Well, I guess if I’d lost money over and over again then maybe I would have gone into another field.”

Only in the long-run is outcome indicative of skill.

Mandate

“…I was always upset by the fact that they called Magellan a growth fund. I think that is a mistake. If you pigeonhole somebody and all they can buy are the best available growth companies, what happens if all the grow companies are overpriced? You end up buying the least overpriced ones.”

Observations on Correlation

I recently found an old letter sitting at the bottom of an unread pile of papers. A friend had passed it along with a note commenting “pretty cool…quant/technical work that makes intuitive sense.” Feeling guilty for having forgotten about this for so long, I read through the old letter, and thought the following observation on correlation worthwhile sharing:  “Interestingly we have found that high correlations happen in the most extreme way when macro events dominate (recession, depression or other)… In fact, extreme levels of correlation are reached towards the end of a bear market, most of all. Also…this phenomenon does not occur at the end of bull markets. Things are quite different at that point, as bull markets have strong tendency to become more and more narrow, thus resulting in low – and not high! – correlation between stocks.” 

Something to file away into the mental model archives...

Ruane Cunniff Goldfarb 2012 Annual Letter

Portfolio management highlights extracted from Ruane Cunniff Goldfarb's Sequoia Fund 2012 Annual Letter. These letters always make for pleasant reading, with candid and insightful commentary on portfolio positions and overall market conditions. Risk Free Rate, Discount Rate

“Valuations for stocks are heavily influenced by interest rates, and particularly by the risk-free rate of return on 10-year and 30-year United States Treasury bonds. Relative to the current return on Treasury Bonds, stocks continue to be quite attractive. However, the current risk-free rate of return is not a product of market forces. Rather, it is an instrument of Federal Reserve policy. As long as these policies remain in place, and stocks trade at higher levels of valuation, it will be more difficult for us to find individual stocks that meet our criteria for returns on a risk basis that incorporates substantially higher interest rates than exist currently. Just as we think it would be a mistake for investors to buy bonds at current levels, we believe it would be a mistake for us to buy stocks on the assumption that interest rates remain anywhere near current levels.”

People often equate interest rate risk with bonds, not with equities. As the quote above points out, all assets are to some degree sensitive to changes in interest rates for a variety of reasons. For more on the relationship between equities and interest rates, be sure to read Warren Buffett’s 1977 article How Inflation Swindles the Equity Investor. 

Diversification, Sizing, Volatility

“Though it contradicts academic theory, we believe a concentrated portfolio of businesses that has been intensively researched and carefully purchased will generate higher returns with less risk over time than a diverse basket of stocks chosen with less care. However, a concentrated portfolio may deliver results in an individual year that do not correspond closely to the returns generated by the broader market.”

Diversification (or concentration) and sizing decisions will materially impact the expected volatility of a portfolio, but not always in the manner that academic theory predicts. 

Cash, Expected Return, Volatility

“If it is not already abundantly clear, you should be aware that our large cash position could act as an anchor on returns in a prolonged bull market. Conversely, in a bear market the cash might cushion the fall of stock prices and provide us with flexibility to make new investments.”

Portfolio cash balance is a double edge sword – providing cushion in down markets and acting as performance drag in up markets. In other words, a material cash balance will most definitely impact the expected return and expected volatility of the portfolio, for better or for worse.

Buffett Partnership Letters: 1967 Part 2

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. For any business, tapping the right client base and keeping those clients happy is crucial. To do so, Buffett believed in the establishment of mutually agreed upon objectives, and keeping his clients abreast of any changes in those objectives.

In 1967, change was indeed in the air. In the passages below, Buffett candidly discusses the rationale and impact of these changes (in both his personal life and the market) with his clients. Such behavior in the investment management industry is rather rare, simply because it risks torpedoing an existing (and very lucrative) business model.

Clients

“…some evolutionary changes in several ‘Ground Rules’ which I want you to have ample time to contemplate before making your plans for 1968. Whereas the Partnership Agreement represents the legal understanding among us, the ‘Ground Rules’ represent the personal understanding and in some way is the more important document.”

“Over the past eleven years, I have consistently set forth as the BPL investment goal an average advantage in our performance of ten percentage points per annum in comparison with the Dow…The following conditions now make a change in yardsticks appropriate:

1. The market environment has changed progressively over the past decade, resulting in a sharp diminution in the number of obvious quantitative based investment bargains available;
2. Mushrooming interest…has created a hyper-reactive pattern of market behavior against which my analytical techniques have limited value; 
3. The enlargement of our capital base to about $65 million when applied against a diminishing trickle of good investment ideas has continued to present…problems…;
4. My own personal interests dictate a less compulsive approach to superior investment results than when I was younger and leaner.

“In my opinion what is resulting is speculation on an increasing scale. This is hardly a new phenomenon; however, a dimension has been added by the growing ranks of professional…investors who feel they must ‘get aboard’…To date it has been highly profitable…Nevertheless, it is an activity at which I am sure I would not do particularly well…It represents an investment technique whose soundness I can neither affirm nor deny. It does not completely satisfy my intellect (or perhaps my prejudices), and most definitely does not fit my temperament. I will not invest my own money based upon such an approach – hence, I will most certainly not do so with your money.

Any form of hyper-activity with large amounts of money in securities markets can create problems for all participants. I make no attempt to guess the actions of the stock market…Even if there are serious consequences results from present and future speculative activity, experience suggests estimates of timing are meaningless…

The above may simply be ‘old fogeyism’ (after all, I am 37). When the game is no longer being played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, etc. I have been scornful of such behavior by others in the past. I have also seen the penalties incurred by those who evaluate conditions as they were – not as they are. Essentially, I am out of step with present conditions. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand (although I find it difficult to apply) even though it may mean foregoing large, and apparently easy, profits to embrace an approach which I don’t fully understand, have not practiced successfully and which, possibly, could lead to substantial permanent loss of capital.”

Psychology, Benchmark

“The final, and most important, consideration concerns personal motivation. When I started the partnership I set the motor that regulated the treadmill at ‘ten points better than the Dow.’ I was younger, poorer and probably more competitive. Even without the three previously discussed external factors making for poorer performance [see bullet points at top], I would still feel that changed personal conditions make it advisable to reduce the speed of the treadmill…

Elementary self-analysis tells me that I will not be capable of less than all-out effort to achieve a publicly proclaimed goal to people who have entrusted their capital to me. All-out effort makes progressively less sense…This may mean activity outside the field of investments or it simply may mean pursuing lines within the investment field that do not promise the greatest economic reward. An example of the latter might be the continued investment in a satisfactory (but far from spectacular) controlled business where I like the people and the nature of the business even though alternative investments offered an expectable higher rate of return. More money would be made buying businesses at attractive prices, then reselling them. However, it may be more enjoyable (particularly when the personal value of incremental capital is less) to continue to own them and hopefully improve their performance, usually in a minor way…

Specifically, our longer term goal will be to achieve the lesser of 9% per annum or a five percentage point advantage over the Dow. Thus, if the Dow averages -2% over the next five years, I would hope to average +3% but if the Dow averages +12%, I will hope to achieve an average of only 9%. These may be limited objectives, but I consider it no more likely that we will achieve even these more modest results under present conditions than I formerly did that we would achieve our previous goal of a ten percentage point average annual edge over the Dow.”

Shifting personal goals and life decisions can materially impact future returns.

Time Management

“When I am dealing with people I like, in businesses I find stimulating (what business isn’t), and achieving worthwhile overall returns on capital employed (say, 10-12%) it seems foolish to rush from situation to situation to earn a few more percentage points. It also does not seem sensible to me to trade known pleasant personal relationships with high grade people, at a decent rate of return, for possible irritation, aggravation or worse at potentially higher returns.”

We’ve heard of the concept of risk-adjusted return. But what about time or aggravation-adjusted return?

Howard Marks' Book: Chapter 11

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

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

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

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

When To Buy, When To Sell, Catalyst

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

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

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

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

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

When To Buy

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

Gumption is rewarded during periods of uncertainty.

Mistakes

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

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

Expected Return

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

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

Low Net Exposure Won’t Save You

I’ve been noticing quite a few 2009-vintage long/short equity hedge funds (the 137% gross, 42% net exposure variety) with steadily expanding capital bases, via both portfolio compounding and capital inflows. The latter is understandable given the spectacular return trackrecords of these funds. Yet, ever the skeptic anytime I observe capital chasing performance, I’d like to share an anecdote with my Readers. A few weeks ago, I met someone who relayed the following Stanley Druckenmiller story (for more on Stanley Druckenmiller, be sure to check out these articles):

In 2007, a list of hedge funds was shown to Stanley Druckenmiller and his opinion of those managers requested. Glancing at the list, Druckenmiller pointed to a few and said, “These guys will blow up. They don’t understand that when things get bad, they need to take down gross, not just net.” Lo and behold, the predictions of Druckenmiller once again proved true – those funds blew up in 2008.

Regardless of whether the story is actually true or false, I think it still conveys a valuable point. In extreme environments, the leverage associated with high gross exposure is dangerous, even if you carry a low level of net exposure, because the underlying assets will behave erratically as historical correlations breakdown.

How many of these newly minted 2009-vintage long/short, high gross low net, equity funds, with swollen egos after years of outperformance, will know/remember this when the storms approach? Only time will tell.

The Inner vs. Outer Scorecard

We all have egos in the psychological sense – defined as “a person’s sense of self-esteem or self-importance.” It’s the degree that denotes the positive or negative association that’s often attached to the term “ego.” There are two passages below, one from Howard Marks and the other from Warren Buffett, that share a common denominator: the role of ego upon an individual’s investment philosophy & decisions.

Howard Marks (The Most Important Thing, Chapter 10):

“…thoughtful investors can toil in obscurity, achieving solid gains in the good years and losing less than others in the bad. They avoid sharing in the riskiest behavior because they’re so aware of how much they don’t know and because they have their egos in check. This, in my opinion, is the greatest formula for long-term wealth creation – but it doesn’t provide much ego gratification in the short-term. It’s just not that glamorous to follow a path that emphasizes humility, prudence, and risk control. Of course, investing shouldn’t be about glamour, but often it is.”

Warren Buffett (The Snowball, Chapter 3):

“The big question about how people behave is whether they’ve got an Inner Scorecard or an Outer Scorecard. It helps if you can be satisfied with an Inner Scorecard. I always posed it this way. I say: ‘Lookit. Would you rather be the world’s greatest lover, but have everyone think you’re the world’s worst lover? Or would you rather be the world’s worst lover but have everyone think you’re the world’s greatest lover?’ Now that’s an interesting question.

Here’s another one. If the world couldn’t see your results, would you rather be thought of as the world’s greatest investor but in reality have the world’s worst record? Or be thought of as the world’s worst investor when you were actually the best?

In teaching your kids, I think the lesson they’re learning at a very, very early age is what their parents put the emphasis on. If all the emphasis is on what the world’s going to think about you, forgetting about how you really behave, you’ll end up with an Outer Scorecard. Now, my dad: He was a hundred percent Inner Scorecard guy.

He was really a maverick. But he wasn’t a maverick for the sake of being a maverick. He just didn’t care what other people thought. My dad taught me how life should be lived…”

Also, notice Marks’ statement that the best method of wealth creation is capturing portfolio return (volatility) asymmetry: “solid gains in the good years [compounding] and losing less than others [capital preservation] in the bad.” I think Buffett would agree with this approach - see Buffett 1966 Part 1 article. 

Howard Marks' Book: Chapter 10

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

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

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

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

Mistakes, Psychology

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

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

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

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

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

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

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

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

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

Psychology, When To Buy, When To Sell

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

Mistakes

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

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

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

Luck, Process Over Outcome

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

There’s Something About Humility

Readers know that I’m a fan of Ted Lucas of Lattice Strategies. He recently wrote a piece (Applied Risk Strategy 1-21-13 - Humble Confidence and Creativity) discussing the impact of overconfidence on performance, as well as why a good risk management process should involve anticipating how assets behave in certain environments (in other words, predicting future volatility) – a task that requires both creativity and humility (awareness of what you don’t know). Psychology

“Indicators of overconfidence (said differently, lack of humility):

• Self-serving attribution bias – people attributing success to their own dispositions and skills, while attributing failure to external forces or bad luck
• Self-centric bias – individuals overestimating their contribution when taking part in an endeavor involving other participants
• Prediction overconfidence – the overestimation of the accuracy of one’s predictions
• Illusion of control – belief that one has more influence than is the case over the outcome of a random or partially random event.”

Interestingly, in the study referenced, the results showed that neither overconfidence nor over-trepidation were conducive to superior performance in the future. Perhaps we are at our decision making best when striking a fair balance between "gumption" (as Charlie Munger calls it) and healthy skepticism.

Risk, Volatility, Creativity, Psychology

“We need to look no further than the financial crisis five years ago to conclude that statistical artifacts like an asset’s historical beta or volatility – which are, respectively, the orthodox risk measures employed in Modern Portfolio Theory and its handmaiden tool, mean-variance optimization – fail to capture many far more critical elements of risk… A comprehensive philosophy of risk also seeks to understand the conditional dynamics of risk as the backdrop evolves – how do assets respond during varying risk regimes (particularly the most turbulent periods), and across changing macroeconomic contexts?”

“Effective risk allocation – the primary driver of long-term portfolio returns – is at heart a design problem…The most productive efforts here are likely to be those benefiting from the constraint of personal and predictive humility and the cultivation of humility’s companion, expanded creativity.”

For risk management, Lucas advocates that investors pay attention to how “assets respond during varying risk regimes” – something I interpret as anticipating future volatility. Not an easy task and one best approached with healthy doses of both creativity, and humility (awareness of what you don’t know).

Buffett Partnership Letters: 1967 Part 1

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

“…although I consider myself to be primarily in the quantitative school…the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a ‘high-probability insight.’ This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and of course, no insight is required on the quantitative side…So the really big money tends to be made by investors who are right on the qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.

Such statistical bargains have tended to disappear over the years…Whatever the cause, the result has been the virtual disappearance of the bargain issue as determined quantitatively – and thereby of our bread and butter.”

Rome wasn’t built in one day. Neither was Warren Buffett’s investment philosophy. Here, he is debating the merits of quantitative vs. qualitative analysis. In the 1966 & 1967 letters, we see Buffett gradually shifting his investment philosophy, drawing closer to the qualitative analysis for which he’s now famous, under the influence of Charlie Munger.

The necessity of this debate grew as AUM increased and markets got more expensive (disappearance of the quantitative "bread and butter"), and as Buffett considered next steps in career progression. By the end of 1967, he had proven that he can compound capital in a treadmill, fund-style vehicle, but what next, especially as the market environment became difficult and opportunities rare? (More on this in Part 2)

Today, it’s difficult to imagine the Oracle’s investment philosophy ever requiring improvement or change, but here we see evidence that suggests it has indeed evolved over the years. The ability to adapt & improve is what separates the one-trick ponies from the great investors of today and tomorrow.

This brings us to a corollary that’s very much applicable to the asset allocation and investment management world. During the fund manager evaluation process, most clients and allocators focus intensely on historical performance trackrecords because they believe it’s an indicator of potential future performance.

But by focusing on historical figures, it’s possible to lose sight of a very important variable: change.

Our personalities and investment philosophies are products of circumstance, in life and in investing – sensitive to external influences, personal or otherwise. Examples include: emergence of new competition, availability of opportunity sets, increased personal wealth, marriage & family, purchase of baseball teams, drug habits, etc. Even great investors like Warren Buffett have evolved over the years to accommodate those influences.

It would be wise to pay attention to external influences and agents of change (the qualitative) during the fund manager evaluation process, and not rely solely on the historical trackrecord (the quantitative). 

Cash, Liquidity, Volatility

As of November 1^st 1967, “we have about $20 million invested in controlled companies, but we also have over $16 million in short-term governments. This makes a present total of over $36 million which clearly will not participate in any upward movement the stock market may have.”

Around this time, BPL had ~$70MM AUM. This means cash accounted for 23% of NAV, and control positions for 29% of NAV.

The control positions likely had very limited liquidity if Buffett needed to sell. This leads me to wonder if the high cash balance was kept for reasons other than dry powder for future opportunities, such as protection against possible investor redemptions. (Remember, at this juncture, Buffett did not yet have permanent capital).

Also, notice that Buffett’s is very much aware of the expected volatility of his portfolio vs. his benchmark – that over 50% ($36MM) of the portfolio will likely not participate in any upward market movement.

Expected Return, Volatility

“We normally enter each year with a few eggs relatively close to hatching; the nest is virtually empty at the moment. This situation could change very fast, or might persist for some time.”

Quoting Ben Graham: “‘Speculation is neither illegal, immoral nor fattening (financially).’ During the past year, it was possible to become fiscally flabby through a steady diet of speculative bon-bons. We continue to eat oatmeal but if indigestion should set in generally, it is unrealistic to expect that we won’t have some discomfort.”

Expected Return ≠ Expected Volatility

Making Mistakes

“Experience is what you find when you’re looking for something else.”

Probable Munger-ism.

Munger Wisdom: 2013 Daily Journal Meeting

Below are my personal notes (portfolio management highlights) from Charlie Munger’s Q&A Session during the 2013 Daily Journal Shareholders Meeting this Wednesday in Los Angeles. Opportunity Cost

After the meeting, I approached Munger to ask him about his thoughts on opportunity cost (a topic that he mentioned numerous times while answering questions, and in previous lectures and speeches).

His response: “Everyone should be thinking about opportunity cost all the time.”

During the Q&A session, Munger gave two investment examples in which he cites opportunity cost.

Bellridge Oil: During the the Wheeler-Munger partnership days, a broker called to offer him 300 shares of Bellridge Oil (trading at 20% of asset liquidation value). He purchased the shares. Soon after, the broker called again to offer him 1500 more shares. Munger didn’t readily have cash available to make the purchase and would have had to (1) sell another position to raise cash, or (2) use leverage. He didn’t want to do either and declined the shares. A year and a half later, Bellridge Oil sold for 35x the price at which the broker offered him the shares. This missed profit could have been rolled into Berkshire Hathaway.

Boston-based shoe supplier to JCPenney: One of the worst investments Berkshire made, for which they gave away 2% of Berkshire stock and received a worthless asset in return.

For both examples, opportunity cost was considered in the context of what "could have been" when combined with the capital compounding that transpired at Berkshire.

Making Mistakes, Liquidity

DRC (Diversified Retailing Company) was purchased by Munger & Buffett in the 1960s with a small bank loan and $6 million of equity. Munger owned 10% so contributed $600,000. But as soon as the ink dried on the contract, they realized that it wasn’t all that great a business due to “ghastly competition.” Their solution? Scrambled to get out as FAST as possible.

Related to this, be sure to read Stanley Druckenmiller’s thoughts on making mistakes and its relationship to trading liquidity (two separate articles).

Generally, humans are bad at admitting our mistakes, which then leads to delay and inaction, which is not ideal. Notice Druckenmiller and Munger come from completely different schools of investment philosophies, yet they deal with mistakes the exact same way – quickly – to allow them to fight another day. Liquidity just happens to make this process easier.

Another Munger quote related to mistakes: “People want hope.” Don’t ever let hope become your primary investment thesis.

“Treat success and failures just the same.” Be sure to “review stupidity,” but remember that it’s “perfectly normal to fail.”

Leverage

Munger told story about press expansion – newspapers paying huge sums for other newspapers – relying largely on leverage given the thesis of regional market-share monopolies. Unfortunately, with technology, the monopolies thesis disintegrated, and the leverage a deathblow.

Perhaps the lesson here is that leverage is most dangerous when coupled with a belief in the continuation of historical status quo.

Luck, Creativity

The masterplan doesn’t always work. Some of life’s success stories derive from situations of people reacting intelligently to opportunities, fixing problems as they emerge, or better yet:

“Playing the big bass tuba in an open field when it happened to rain gold.”

Turnover

Munger’s personal account had zero transactions in 2012.

Psychology

On the decline of the General Motors: “prosperity made them weak.”

This is a lesson in hubris, and associated behavioral biases, that's definitely applicable to investment management. Investing, perhaps even more so than most businesses, is fiercely competitive. In this zero sum game, the moment we rest on the laurels of past performance success, and become overconfident etc., is the moment future performance decline begins.

Always be aware, and resist behavior slithering in that dangerous direction.

Mandate

Berkshire had “two reasonable options” to deploy capital, into both public and private markets. Munger doesn’t understand why Berkshire’s model hasn’t been copied more often. It makes sense to have a flexible hybrid mandate (or structure) which allows for deployment of capital into wherever assets are most attractive or cheapest.

Clients, Time Management

Most people are too competitive – they want ALL business available, and sometimes end up doing things that are "morally beneath them," and/or abandon personal standards. Plus, general happiness should be a consideration as well.

The smartest people figure out what business they don’t want and avoid all together – which leads to foregoing some degree of business and profit – that’s absolutely okay. This is what he and Buffett have figured out and tried to do over time.

On doing what’s right: He and Buffett fulfill their fiduciary duty in that they “wanted people who we barely know who happen to buy the stock to do well.” Munger doesn’t think there are that many people in the corporate world who subscribe to this approach today.

Howard Marks' Book: Chapter 9

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

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

“Investment markets follow a pendulum-like swing:

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

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

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

When To Buy

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

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

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

Mariko Gordon of Daruma Capital (who writes wonderfully insightful and entertaining letters) once pointed out that opportunities “tend to make themselves available between the two extremes of ‘fire hose’ and ‘dripping faucet’ and that what ultimately matters is “having a sound strategy for uncovering the best when ideas are as plentiful as mushrooms after a rain, and locating the gems when the pendulum inevitably swings back the other way.”

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

Catalyst

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

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

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

Risk, Expected Return, Capital Preservation, Opportunity Cost

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

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

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

Baupost Letters: 1997

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.

Mandate, Trackrecord, Expected Return

For the past several years, Klarman had invested heavily into Baupost’s international efforts/infrastructure because he believed that opportunities in the U.S. marketplace were less attractive than those found abroad, due to increased competition and higher market valuations.

Did Baupost’s flexible investment mandate give it an advantage in trackrecord creation and return generation?

For example, a healthcare fund cannot start investing in utilities because the latter provides better risk-reward, whereas Baupost can invest wherever risk-reward is most attractive.

The trackrecord creation and return generation possibilities for those with more restrictive mandates are bound by the opportunities available within the mandate scope. Baupost, on the other hand, has the freedom to roam to wherever pastures are greenest.

Cash, Expected Return, Risk Free Rate

In the category of largest gains, there was a $2.2MM gain for “Yield on Cash and Cash Equivalents” which at the end of Fiscal Year 1997 (October 31, 1997) consisted of $39MM or 25.5% of NAV.

In 1997, cash earned 5-6% ($2.2MM divided by $39MM) annually, in drastic contrast to virtually nothing today. I point this out as a reminder that historically, and perhaps one day in the future, cash does not always yield zero. In fact, cash interest rates are often highest during bull markets when it’s most prudent to keep a higher cash balance as asset values increase.

For those who fear the performance drag from portfolio cash balances, or those who feel the pressure to “chase” yield in order to boost portfolio returns, this serves as a reminder that cash returns are not static throughout the course of a market cycle.

Hedging, Cash

At 10/31/97, value of “Market Hedges” was $2.0MM, or 1.4% of NAV. Hedges were also the source of his second largest loss that year, declining $2.1MM in value.

That’s a whole lot of premium bleed worth $2.0MM or ~1.5% of NAV! Interestingly, this is almost the exact gain from portfolio cash yields (see above). Coincidence?

If you believe that the phenomenon of the last 20 years will continue to hold – that interest rates will increase as the underlying economy recovers and equity markets move higher, then one can roughly use interest rates (and consequently portfolio cash yields) as a proxy to determine how much hedging premium to spend.

Theoretically, this should be a self-rebalancing process: higher cash yields in bull equity markets = more hedging premium to spend (when you need it most) vs. lower cash yields in bear equity markets = less hedging premium to spend (when you need it least).

Cash, Opportunity Cost

Klarman comments that cash provides protection in turbulent times and ammunition to take advantage of newly created opportunities, but the act of holding cash involves considerable opportunity cost in the form of foregoing attractive investments in the interim – but investors must keep in mind they cannot earn investment returns without actually investing.

After a temporary hiccup in the markets, Klarman discusses portfolio repositioning: adding to some positions while reducing or deleting others, to take advantage of the shifts in the market landscape.

It’s a delicate balance determining when to deploy capital, and when to hold it in the form of cash. You can’t run an investment management business holding cash forever – that would make you a checking account with extremely high fees.

The second point serves as an excellent reminder that the “opportunity cost” calculation involves not only the comparison between cash and a potential investment, but also between a potential investment and current portfolio holdings.

Derivatives, Leverage

Klarman held a wide variety of options and swaps in his portfolio, such as SK Telecom equity & swaps, Kookmin Bank equity and swaps, etc.

In Klarman’s writings, you’ll generally find warnings against using leverage, and equity swaps definitely constitute leverage. I wonder if the derivative swaps were a product of his interest in emerging markets. For example, perhaps Baupost was not able to trade directly in certain markets, and therefore utilized swaps to gain exposure through a counterparty authorized to trade in those countries.

When To Buy

In a market downturn, momentum investors cannot find momentum, growth investors worry about a slowdown, and technical analysts don’t like their charts.

In extreme market downside events, patterns & trends in liquidity, trading volume, sales growth, etc. – that may have existed for years – disintegrate. Therefore, investors who rely on those patterns and trends become disoriented, which then fuels and reinforces more market chaos. This is what we witnessed in 2008-2009, and the time for fundamental investors, and those with intuition and foresight, to shine.

Capital Preservation, Compounding,

Over time, by again and again avoiding loss, you have taken the first step toward achieving healthy gains.

Volatility

Toward the end of the December 1997 letter, Klarman praises his team of analysts and traders who, like himself, hate to lose money, even temporarily, for any reason at any time.

So let it be written! Klarman acknowledges that he doesn’t like to lose money, even temporarily in the form of volatility. 

A Little Bit of History Repeating

In 1977, Warren Buffett wrote an article for Fortune Magazine titled “How Inflation Swindles the Equity Investor.” In the article, Buffett outlines the parallels between equities and bonds, and the impact of interest rates & inflation movements on both asset classes.

Given the interest rate and inflation debate raging today, I thought it worthwhile to revisit and study what had transpired in the past.

Interestingly, if we applied the lessons of this 1977 article to today's environment, contrary to the article’s title, it actually bodes well for future equity prices (see bold below), especially those companies compounding and reinvesting earnings rather than paying dividends.

Inflation, Duration, Compounding, Opportunity Cost

“It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment…When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner…For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities…

…I believe…that stocks, in economic substances, are really very similar to bonds. I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact no varied much at all…in the aggregate, the return on book value tends to keep coming back to a level around 12 percent. It shows no signs of exceeding that level significantly in inflationary years…

For the moment, let’s think of those companies, not as listed stocks, but as productive enterprises. Let’s also assume that the owners of those enterprises had acquired them at book value. In that case, their own return would have been around 12 percent too. And because the return has been so consistent, it seems reasonable to think of it as an ‘equity coupon’…

Of course, there are some important differences between the bond and stock forms. For openers, bonds eventually come due. It may require a long wait, but eventually the bond investor gets to renegotiate the terms of his contract. If current and prospective rates of inflation make his old coupon look inadequate, the can refuse to play further unless coupons currently being offered rekindle his interest…

Stocks on the other hand, are perpetual. They have a maturity date of infinity. Investors in stocks are stuck with whatever return corporate America happens to earn. If corporate America is destined to earn 12 percent, then that is the level investors must learn to live with. As a group, stock investors can neither opt out nor renegotiate…Individual companies can be sold or liquidated and corporations can repurchase their own shares; on the balance however, new equity flotations and retained earnings that the equity capital locked up in the corporate system will increase.

So, score one for the bond form. Bond coupons eventually will be renegotiated; equity ‘coupons’ won’t…

There is another major difference between the garden variety of bond and or new exotic 12 percent ‘equity bond’ that comes to the Wall Street costume ball dressed in a stock certificate.

In the usual case, a bond investor receives his entire coupon in cash and is left to reinvest it as best he can. Our stock investor’s equity coupon, in contrast, is partially retained by the company and is reinvested at whatever rates the company happens to be earning. In other words, going back to our corporate universe, part of the 12 percent earned annually is paid out in dividends and the balance is put right back into the universe to earn 12 percent also.”

Here is where things get interesting: 

“This characteristic of stocks – the reinvestment of part of the coupon – can be good or bad news, depending on the relative attractiveness of that 12 percent. The news was very good indeed in, the 1950’s and early 1960’s. With bonds yielding only 3 or 4 percent, the right to reinvest automatically a portion of the equity coupon at 12 percent was of enormous value. Note that investors could not just invest their own money and get that 12 percent return. Stock prices in this period raged far above book value…You can’t pay far above par for a 12 percent bond and earn 12 percent for yourself.

But on their retained earnings, investors could earn 12 percent. In effect, earnings retention allowed investors to buy at book value part of an enterprise that, in the economic environment then existing, was worth a great deal more than book value.

It was a situation that left very little to be said for cash dividends and a lot to be said for earnings retention. Indeed, the more money that investors thought likely to be reinvested at the 12 percent rate, the more valuable they considered their reinvestment privilege, and the more they were willing to pay for it…

If, during this period, a high-grade, noncallable, long-term bond with a 12 percent coupon had existed, it would have sold far above par. And if it were a bond with a further unusual characteristic – which was that most of the coupon payments could be automatically reinvested at par in similar bonds – the issue would have commanded an even greater premium. In essence, growth stocks retaining most of their earnings represented just such a security. When their reinvestment rate on the added equity capital was 12 percent while interest rates generally were around 4 percent, investors became very happy – and, of course, they paid happy prices.

Looking back, stock investors can think of themselves in the 1946-1956 period as having been ladled a truly bountiful triple dip. First, they were the beneficiaries of an underlying corporate return on equity that was far above prevailing interest rates. Second, a significant portion of that return was reinvested for them at rates that were otherwise unattainable. And third, they were afforded an escalating appraisal of underlying equity capital as the first two benefits became widely recognized. This third dip meant that, on top of the basic 12 percent or so earned by corporations on their equity capital, investors were receiving a bonus as the Dow Jones Industrials increased in price from 138 percent book value in 1946 to 220 percent in 1966…

This heaven-on-earth situation finally was ‘discovered’ in the mid-1960’s by many major investing institutions. But just as these financial elephants began trampling on one another in their rush to equities, we entered an era of accelerating inflation and higher interest rates. Quite logically, the marking-up process began to reverse itself. Rising interest rates ruthlessly reduced the value of all existing fixed coupon investments. And as long-term corporate bond rates began moving up (eventually reaching the 10 percent area), both the equity return of 12 percent and the reinvestment ‘privilege’ began to look different.

Stocks are quite properly though of as riskier than bonds…they come equipped with infinite maturities. (Even your friendly broker wouldn’t have the nerve to peddle a 100-year bond, if he had any available, as ‘safe.’) Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return – and 12 percent on equity versus, say 10 percent on bonds issued by the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.”

As Mark Twain said, “history does not repeat itself, but it does rhyme.” Food for thought. 

36South: Profiting from the Tails

Many have read about Cornwall Capital (I wrote about them awhile back), a firm that successfully profited from shorting subprime CDS. Those who enjoyed the Cornwall Capital piece are in for a treat. Below are highlights extracted from an Eurekahedge interview with Richard Hollington of 36South, a hedge fund that also specializes in profiting from volatility and tail risk. This piece is a little longer than our usual articles. There is a lot of good commentary below on how to source, execute, size, and manage portfolio hedges. However, reading this article does not a hedging expert make. In other words, I don’t recommend trying this at home.

Hedging, Derivatives, Fat Tail, Barbell, Sizing, Expected Return, Volatility

“The underlying philosophy is that markets are rational most of the time but 5% of the time rationality gets thrown out of the window, whether because people have made money too easily and become complacent or have lost money too quickly and are so distressed that they are off-loading assets below their intrinsic worth. The emphasis of this approach is market psychology. We search for fear, greed, hysteria and mania. We sell into a bubble about to burst and buy into a post-crash recovery. Bubbles as we know, can take time to play themselves out over an extended period of time and their turning points are normally associated with high volatility. This makes the method of investing in an opportunity critical. Normally it is better to wait until the bubble is bursting as the markets tend to go a lot higher or lower than one thinks. The downside to this is that the move might be over in a short period of time.”

“Our investment methodology is to BUY ONLY long dated “out-of-the-money” options. This methodology has some excellent features…these options can return multiples of the original investment. We look for options that have the potential to return between 5 and 10 times the original investment. Because of their high reward characteristics, only 10-20% of the fund need be invested in these options to achieve our target returns of 15-25%. Our worst case loss is thus known, being the amount invested in options…Our rationale here is that one can never get killed jumping out of a basement window!”

“We zero in on…situations by using our in-house developed ‘Quadrivium’ Methodology. Quadrivium literally means where four rivers meet and a strategy which conforms to criteria required in each of the four circles in our approach will be selected to form a portion of our risk portfolio. The four criteria are used in conjunction with each other in order to ‘ensure that one reality respects all other realities’ as Charlie Munger put it so well. These criteria are:

• Volatility has already been covered. We ensure the option (using volatility as a proxy) is cheap enough to provide the leverage we require for the level of risk.
• The next criterion is to look at the technical picture of the market to seek confirmation that there is potential for market movement to the extent and in the direction that we require to attain a multiple return on the option price.
• The next criterion is fundamentals in that market/asset/option to corroborate our view. We have developed a framework of economic indicators that we monitor in each of the markets we have selected to trade. We are specifically looking for flaws in the structure of markets which are caused by government policy and supply demand imbalances.
• The next step in the process is based on the sentiment prevailing in the market that we wish to trade. Sentiment often becomes deeply entrenched at market tops and bottoms to the extent that supporters of the status quo can become aggressive in defense of their beliefs. In order to gauge the prevailing sentiment in the market we use Internet searches for key words and couple this with feedback obtained from diverse media coverage. These media opinions can reflect ‘irrational exuberance’ or deep-seated pessimism on a particular stock, index, commodity or currency. These quotations from seasoned professionals in the financial markets encapsulate the essence of this driver of our trading philosophy.”

“Since we know exactly what the current option portfolio is worth we can safely say that this is the absolute worst-case meltdown in the fund based on market risk. This would be an extremely unlikely scenario because long dated options always have some time value and it would mean all positions have moved against us in all asset markets and volatilities have collapsed at the same time. We manage each option on a stop-loss methodology. The stop-loss is based on the number of times the initial option premium multiplies. The first stop is instituted when the option premium has increased three fold. At this level a 60% stop on the option price is registered. As it moves to four times, the stop is tightened to 50% and so on until a maximum of eight times when the stop will be 10%. At this point in time the option has earned the right to discretionary stop-loss status as long as it does not hit the 10% in place. A profit target is then calculated which is based on a three standard deviation move above the 200-day moving average. We will also sell options which have only a year to run if they have not achieved the minimum 3-fold increase and are still worth something.”