Howard Marks' Book: Chapter 19


This concludes our series on portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 19 “The Most Important Thing Is…Adding Value” Trackrecord, Compounding, Capital Preservation

“It means relatively little that a risk taker achieves a high return in a rising market, or that a conservative investors is able to minimize losses in a decline. The real question is how they do in the long run and in climates for which their style is ill suited…Without skill, aggressive investors move a lot in both directions, and defensive investors move little in either direction

Aggressive investors with skill do well in bull markets but don’t’ give it all back in corresponding bear markets, while defensive investors with skill lose relatively little in bear markets but participate reasonably in bull markets. Everything in investing is a two-edged sword and operates symmetrically, with the exception of superior skill.”

“The performance of investors who add value is asymmetrical. The percentage of the market’s gain they capture is higher than the percentage of loss they suffer…Only skill can be counted on to add more in propitious environments than it costs in hostile ones. This is the investment asymmetry we seek.”

“In good years in the market, it’s good enough to be average. Everyone makes money in the good years...There is a time, however, when we consider it essential to beat the market, and that’s in the bad years…it’s our goal to do as well as the market when it does well and better than the market when it does poorly. At first blush that may sound like a modest goal, but it’s really quite ambitious. In order to stay up with the market when it does well, a portfolio has to incorporate good measure of beta and correlation with the market. But if we’re aided by beta and correlation on the way up, shouldn’t they be expected to hurt us on the way down? If we’re consistently able to decline less when the market declines and also participate fully when the market rises, this can be attributable to only one thing: alpha, or skill…Asymmetry – better performance on the upside than on the downside relative to what our style alone would produce – should be every investor’s goal.”

For more on the topic of asymmetry, be sure to check out our article titled “Asymmetry Revisited


“A portfolio with a beta above 1 is expected to be more volatile than the reference market, and a beta below 1 means it’ll be less volatile. Multiply the market return by the beta and you’ll get the return that a given portfolio should be expected to achieve…If the market is up 15 percent, a portfolio with a beta of 1.2 should return 18 percent (plus or minus alpha).”

We often find common threads between different investors. For example, there is evidence that Buffett was thinking about expected beta as early as the 1950s and 1960s (back in the day when he did not have permanent capital) -- see our articles on Buffett Partnership Letters and Volatility.

Expected Return, Risk

“Although I dismiss the identity between risk and volatility, I insist on considering a portfolio’s return in the light of its overall riskiness…A manager who earned 18 percent with a risky portfolio isn’t necessarily superior to one who earned 15 percent with a lower-risk portfolio. Risk-adjusted return holds the key, even though – since risk other than volatility can’t be quantified – I feel it is best assessed judgmentally, not calculated scientifically.”

“‘beating the market’ and ‘superior investing’ can be far from synonymous…It’s not just your return that matters, but also what risk you took to get it…”

Opportunity Cost, Benchmark

“…all equity investors start not with a blank sheet of paper but rather with the possibility of simply emulating an index...investors can decide to deviates from the index in order to exploit their stock-picking ability…In doing so they will alter the exposure of their portfolio to…price movements that affect only certain stocks, not the index…their return will deviate as well."

We are all faced with this choice that, at a minimum, we can emulate an index. If we choose not to, it’s because we believe we can generate outperformance via higher returns and same risk, similar returns at lower risk, or higher returns at lower risk. If we cannot accomplish any of the above, then we have failed to do better than an index (and failed to add value as investors). But if we did not have an index or benchmark against which to measure progress, how would we know whether we have succeeded or failed?



Baupost Letters: 2000-2001


This concludes 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 those of you wishing to read the actual letters, they are available on the internet. We are not posting them here because we don’t want to tango with the Baupost legal machine.

Volatility, Psychology

Even giants are not immune to volatility. Klarman relays the story of how Julian Robertson’s Tiger Fund closed its doors largely as a result of losses attributed to its tech positions. As consolation, Klarman offers some advice on dealing with market volatility: investors should act on the assumption that any stock or bond can trade, for a time, at any price, and never enable Mr. Market’s mood swings to lead to forced selling. Since it is impossible to predict the timing, direction and degree of price swings, investors would do well to always brace themselves for mark to market losses.

Does mentally preparing for bad outcomes help investors “do the right thing” when bad outcomes occur? 

When To Buy, When To Sell, Selectivity

Klarman outlines a few criteria that must be met in order for undervalued stocks to be of interest to him:

  • Undervaluation is substantial
  • There’s a catalyst to assist in the realization of that value
  • Business value is stable and growing, not eroding
  • Management is able and properly incentivized

Have you reviewed your selectivity standards lately? How do they compare with three years ago? For more on this topic, see our previous article on selectivity

Psychology, When To Buy, When To Sell

Because investing is a highly competitive activity, Klarman writes that it is not enough to simply buy securities that one considers undervalued – one must seek the reason for why something is undervalued, and why the seller is willing to part with a security/asset at a “bargain” price.

Here’s the rub: since we are human and prone to psychological biases (such as confirmation bias), we can conjure up any number of explanations for why we believe something is undervalued and convince ourselves that we have located the reason for undervaluation. It takes a great degree of cognitive discipline & self awareness to recognize and concede when you are (or could be) the patsy, and to walk away from those situations.

Risk, Expected Return, Cash

Klarman’s risk management process was not after-the-fact, it was woven into the security selection and portfolio construction process.

He sought to reduce risk on a situation by situation basis via

  • in-depth fundamental analysis
  • strict assessment of risk versus return
  • demand for margin of safety in each holding
  • event-driven focus
  • ongoing monitoring of positions to enable him to react to changing market conditions or fundamental developments
  • appropriate diversification by asset class, geography and security type, market hedges & out of the money put options
  • willingness to hold cash when there are no compelling opportunities.

Klarman also provides a nice explanation of why undervaluation is so crucial to successful investing, as it relates to risk & expected return: “…undervaluation creates a compelling imbalance between risk and return.”


The investment objective of this particular Baupost Fund was capital appreciation with income was a secondary goal. It sought to achieve its objective by profiting from market inefficiencies and focusing on generating good risk-adjusted investment results over time – not by keeping up with any particular market index or benchmark. Klarman writes, “The point of investing…is not to have a great story to tell; the point of investing is to make money with limited risk.”

Investors should consider their goal or objective for a variety of reasons. Warren Buffett in the early Partnership days dedicated a good portion of one letter to the “yardstick” discussion. Howard Marks has referenced the importance of having a goal because it provides “an idea of what’s enough.”

Cash, Turnover


Klarman presents his portfolio breakdown via “buckets” not individual securities. See our article on Klarman's 1999 letter for more on the importance of this nuance

The portfolio allocations changed drastically between April 1999 and April 2001. High turnover is not something that we generally associate with value-oriented or fundamental investors. In fact, turnover has quite a negative connotation. But is turnover truly such a bad thing?

Munger once said that “a majority of life’s errors are caused by forgetting what one is really trying to do.”

Yes, turnover can lead to higher transaction fees and realized tax consequences. On taxes, we defer to Buffett’s wonderfully crafted treatise on his investment tax philosophy from 1964, while the onset of electronic trading has significantly decreased transaction fees (specifically for equities) in recent days.

Which leads us back to our original question: is portfolio turnover truly such a bad thing? We don’t believe so. Turnover is merely the consequence of portfolio movements triggered by any number of reasons, good (such as correcting an investment mistake, or noticing a better opportunity elsewhere) and bad (purposeful churn of the portfolio without reason). We should judge the reason for turnover, not the act of turnover itself.

Hedging, Expected Return

The Fund’s returns in one period were reduced by hedging costs of approximately 2.4%. A portfolio’s expected return is equal to the % sizing weighted average expected return of the sum of its parts (holdings or allocations). Something to keep in mind as you incur the often negative carry cost of hedging, especially in today’s low rate environment.


Elementary Worldly Wisdom - Part 1


The following are portfolio management highlights extracted from a gem of a Munger speech given at USC 20 years ago in 1994. It’s long, but contains insights collected over many years by one of the world's greatest investment minds. Caustically humorous, purely Munger, it is absolutely worth 20 minutes of your day between browsing ESPN and TMZ. Creativity

“…the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form.”

“The…basic approach…that Ben Graham used—much admired by Warren and me…this concept of value to a private owner...if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you've got a lot of edge going for you...

You had a huge margin of safety—as he put it—by having this big excess value going for you. But he was, by and large, operating when the world was in shell shock from the 1930s—which was the worst contraction in the English-speaking world in about 600 years...People were so shell-shocked for a long time thereafter that Ben Graham could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on… 

…the trouble with what I call the classic Ben Graham concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and it wouldn't click.

But such is the nature of people who have a hammer—to whom, as I mentioned, every problem looks like a nail that the Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they'd always done. And it still worked pretty well. So the Ben Graham intellectual system was a very good one…

However, if we'd stayed with classic Graham the way Ben Graham did it, we would never have had the record we have. And that's because Graham wasn't trying to do what we did…having started out as Grahamites which, by the way, worked fine—we gradually got what I would call better insights. And we realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other.

And once we'd gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses…Much of the first $200 or $300 million came from scrambling around with our Geiger counter. But the great bulk of the money has come from the great businesses.”

“…Berkshire Hathaway's system is adapting to the nature of the investment problem as it really is.”

So much of life consists of identifying problems and finding creative solutions. This is also true for the investment business. Yet, our industry sometimes focuses so much on complying with the rules, chasing that institutional $ allocation, that we fail to consider the rationale and why the rules came into existence in the first place. Conventionality does not equate the best approach. 

The content and knowledge featured on PM Jar is far more useful to Readers when digested and synthesized into your own mental latticeworks. Liberal interpretations are encouraged. Great and unique ideas are usually the craziest (at first).


“…the reason why we got into such idiocy in investment management is best illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, ‘My God, they're purple and green. Do fish really take these lures?’ And he said, ‘Mister, I don't sell to fish.’

Investment managers are in the position of that fishing tackle salesman. They're like the guy who was selling salt to the guy who already had too much salt. And as long as the guy will buy salt, why they'll sell salt. But that isn't what ordinarily works for the buyer of investment advice.

If you invested Berkshire Hathaway-style, it would be hard to get paid as an investment manager as well as they're currently paid—because you'd be holding a block of Wal-Mart and a block of Coca-Cola and a block of something else. You'd just sit there. And the client would be getting rich. And, after a while, the client would think, ‘Why am I paying this guy half a percent a year on my wonderful passive holdings?’

So what makes sense for the investor is different from what makes sense for the manager. And, as usual in human affairs, what determines the behavior are incentives for the decision maker.”

“Most investment managers are in a game where the clients expect them to know a lot about a lot of things. We didn't have any clients who could fire us at Berkshire Hathaway. So we didn't have to be governed by any such construct.”

Clients, Volatility, Trackrecord, Benchmark

“…if you're investing for 40 years in some pension fund, what difference does it make if the path from start to finish is a little more bumpy or a little different than everybody else's so long as it's all going to work out well in the end? So what if there's a little extra volatility.

In investment management today, everybody wants not only to win, but to have a yearly outcome path that never diverges very much from a standard path except on the upside. Well, that is a very artificial, crazy construct…It's the equivalent of what Nietzsche meant when he criticized the man who had a lame leg and was proud of it. That is really hobbling yourself. Now, investment managers would say, ‘We have to be that way. That's how we're measured.’ And they may be right in terms of the way the business is now constructed. But from the viewpoint of a rational consumer, the whole system's ‘bonkers’ and draws a lot of talented people into socially useless activity.”



PM Jar Exclusive Interview With Howard Marks - Part 1 of 5


“Investing is an art form. Take the hundred greatest painters, their paintings look nothing alike. The definition of great is not uniform.” When asked about the art on the walls, he answers he is not a collector, merely an admirer. There’s no corner office with custom or museum-quality furniture. There’s no glaring display of power or wealth. Yet the scent of importance and influence is most definitely present, only subtly so. Accepted and balanced, not flaunted.

Here is a thoughtful and reflective man who is acutely aware of himself and his environment. Here is a man who has been called ‘Guru to the Stars’ by Barron’s, whose admirers include Chris Davis, Warren Buffett, and Jeremy Grantham, and whose firm oversees nearly $80 billion in assets.

Ever gracious and generous with his time, Howard Marks, the co-founder and chairman of Oaktree Capital Management, sat down with PM Jar to discuss his approach to the art of investing: transforming symmetrical inputs into asymmetric returns. What follows are excerpts from that conversation.

Part 1: An Idea of What Is Enough

“I think that having an idea of a goal is something to work for, but it's also important to have an idea of what is enough.”

Marks: The goal of investing is to have your capital be productive. It's to make money on your money. Certain investment organizations – pension funds, insurance companies, endowments – have specific goals and requirements to make a certain amount of money that will permit them to accomplish their objectives. Everybody has a goal, and some are different from others. Some people don’t have a specific goal – they just want to make money.

In 2007, people said: “I need 8%. It would be nice to make 10%. It would terrific to make 12%. It would be wonderful to make 15%. It would be absolutely fabulous to make 18%. 20% would be fantastic.” Whereas they should have said: “I need 8%. If I get 10%, that would be great. 12% would be wonderful. I’m not going to try for 15% because to try for 15%, I’d have to take risks that I don’t want to take.” I think that having an idea of a goal is something to work for, but it’s also important to have an idea of what is enough.

PM Jar: In your book, The Most Important Thing, you wrote that it’s difficult to find returns if they’re not available, and chasing returns is one of the dumbest things that an investor can do. Does an investor’s return goal change with the market cycle or where the pendulum is located?

Marks: You should be cognizant of where you are buying because where you buy says a lot about the return which is implied in your investment. Every time we organize a fund, we talk about the return we can make, which is informed by where we expect to buy things. Consequently, sometimes we think we will get very high returns because we have the opportunity to buy stuff cheap. Sometimes we think we’ll get lower returns because we can’t buy that much stuff cheap. So clearly, different points in time and different positions of the pendulum imply different kinds of returns – not with any certainty, but you should have a concept of whether you are getting great bargains, so-so bargains, or paying excessive prices (in which case, you should be a seller not a buyer).

But we’re dangerously close to confusing two topics. A return goal is what you want, what you need to be successful, or what you aspire to. An expected return is what you think you can make on the things you can buy today – sometimes you should be able to make 5% and sometimes you should be able to make 15% – which may have nothing to do with your desired return or required return. 

Continue Reading -- Part 2 of 5: Real World Considerations  

Baupost Letters: 1998


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.

Hedging, Opportunity Cost, Correlation

Mid-fiscal year through 4/30/98, Klarman substantially increased exposure to disaster insurance (mainly out of the money U.S. equity put options + hedges against rising interest rates and currency fluctuations) because of his fear of a severe market correction and economic weakness. To maintain these hedges, Klarman stated he was willing to give up a portion of portfolio upside in return for protection against downside exposure. For fiscal year ended 10/31/98, these hedges accounted for a -2.8% performance drag.

The performance drag and mistake occurred as a result of expensive & imperfect hedges:

  • cheapest areas of the market (small-cap) became cheaper (Baupost’s portfolio long positions were mainly small cap)
  • most expensive areas of the market (large-cap) went to the moon (Baupost’s portfolio hedges were mostly large cap)

In assessing the performance results, Klarman stated that he did not believe he was wrong to hedge market exposures, his mistake was to use imperfect hedges, which resulted in him losing money on both his long positions and his hedges at the same time. Going forward, he would be searching for more closely correlated hedges.

In many instances, hedging is a return detractor. The trick is determining how much return you are willing to forego (premium spent and opportunity cost of that capital) in order to maintain the hedge, and how well that hedge will actually protect (or provide uncorrelated performance) when you expect it to work.

The only thing worse than foregoing return via premium spent and opportunity cost, is finding out in times of need that your hedges don’t work due to incorrect anticipation of correlation between your hedges and the exposure you are trying to hedge. That’s exactly what happened to Baupost in 1998.

Catalyst, Volatility, Expected Return, Duration

Attempting to reduce Baupost’s dependence on the equity market for future results, and the impact of equity market movement on Baupost’s results, Klarman discusses the increase of catalyst/event-driven positions (liquidations, reorganizations) within the portfolio, which are usually less dependent on the vicissitudes of the stock market for return realization.

Catalysts are a way to control volatility and better predict the expected return of portfolio holdings. Catalysts also create duration for the equity investor, such that once the catalyst occurs and returns are achieved, investors generally must find another place to redeploy the capital (or sit in cash).


Klarman called cash balances in rising markets “cement overshoes.” At mid-year 4/30/98, Baupost held ~17% of the portfolio in cash because Klarman remained confident that cash becomes more valuable as fewer and fewer investors choose to hold cash. By mid-December 1998, Baupost’s cash balance swelled to ~35% of NAV.

Risk, Opportunity Cost, Clients, Benchmark

In the face a strong bull market, Klarman cites the phenomenon of formerly risk-averse fund managers adopting the Massachusetts State Lottery slogan (“You gotta play to win”) for their investment guidelines because the biggest risk is now client firing the manager, instead of potential loss of capital.

Klarman observes the psychological reason behind this behavior: “Very few professional investors are willing to give up the joy ride of a roaring U.S. bull market to stand virtually alone against the crowd…the comfort of consensus serving as the ultimate life preserver for anyone inclined to worry about the downside. As small comfort as it may be, the fact that almost everyone will get clobbered in a market reversal makes remaining fully invested an easy relative performance decision.”

The moral of the story here: it’s not easy to stand alone against waves of public sentiment. For more on this, see Bob Rodriguez experience on the consequences of contrarian actions & behavior.

When the world is soaring, to hold large amounts of cash and spending performance units on hedges could lead to serious client-rebellion and business risk. I do not mean to imply that it’s wrong to hold cash or hedge the portfolio, merely that fund managers should be aware of possible consequences, and makes decisions accordingly.

Expected Return, Intrinsic Value

Klarman discusses how given today’s high equity market levels, future long-term returns will likely be disappointing because future returns have been accelerated into the present and recent past.

Future returns are a function of asset price vs. intrinsic value. The higher prices rise (even if you already own the asset), the lower future returns will be (assuming price is rising faster than asset intrinsic value growth). For a far more eloquent explanation, see Howard Mark’s discussion of this concept



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.


“…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?

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.



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.


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?



Wisdom from Steve Romick: Part 3


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

Creativity, Team Management

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

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

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

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

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


Benchmark, Hurdle Rate

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

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



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

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


Foreign Exchange

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



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

Buffett Partnership Letters: 1963 Part 2


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

Benchmark, Hurdle Rate

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

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

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

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

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

But a question continues to tickle my brain:

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


Expected Return, Volatility

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

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

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

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

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


Team Management

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

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

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


Baupost Letters: 1995


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


When To Buy, Risk

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

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

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


Benchmark, Conservatism, Clients

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

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

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


Selectivity, Cash

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

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

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


Catalyst, Volatility, Special Situations

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

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



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

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

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

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

Buffett Partnership Letters: 1962 Part 1


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

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

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



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

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


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

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



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

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


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

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


Clients, Time Management

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

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

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

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

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


Buffett Partnership Letters: 1961 Part 4


This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. For those interested in Warren Buffett’s portfolio management style, I highly recommend the reading of the second 1961 letter in its entirety, and to check out our previous posts on 1961.



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

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

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

Conservatism ≠ Buying “Conservative” Securities

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

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

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


Clients, Benchmark

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

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

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

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


“With over 90 partners…”

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


Trackrecord, Mark To Market, Liquidity

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

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

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

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


Howard Marks' Book: Chapter 1


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

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

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

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


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

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

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

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

Definition of Investing, Benchmark

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

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

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

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

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

What's Benchmark Got To Do With It


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

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

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

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

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

James Montier on Tail Risk Hedging


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

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

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

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

Klarman-Zweig Banter: Part 2


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

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

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

Team Management

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

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

Michael Price, Creativity

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

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

Risk, Creativity

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

Capital Preservation, Conservatism

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

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

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

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

Foreign Exchange, Benchmark, Inflation

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

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

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

Buffett Partnership Letters: 1959 & 1960


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

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

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

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

Separate Accounts, Time Management

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

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


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

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