Soros’ Alchemy – Chapter 4

Seth Klarman of Baupost wrote in a 1996 Letter that one should always be cognizant of whether seemingly different investments are actually the same bet in order to avoid risk of concentrated exposures. In other words, the task of risk management involves identifying (and if necessary, neutralizing) common risks underlying different portfolio holdings. One such "common denominator" risk that comes to mind (in today's yield-hungry environment) is the availability of credit and its impact on asset and collateral values, which in turn greatly influences returns available to investors holding different securities across the capital structure. Below are some musing on the topic of credit reflexivity / boom and bust cycles from George Soros, derived from his book Alchemy of Finance – Chapter 4: The Credit and Regulatory Cycle.

Macro, Intrinsic Value, Psychology, Risk

“…special affinity between reflexivity and credit. That is hardly surprising: credit depends on expectations; expectations involve bias; hence credit is one of the main avenues that permit bias to play a causal role in the course of events…Credit seems to be associated with a particular kind of reflexive pattern that is known as boom and bust. The pattern is asymmetrical: the boom is drawn out and accelerates gradually; the bust is sudden and often catastrophic…

I believe the asymmetry arises out of a reflexive connection between loan and collateral. In this context I give collateral a very broad definition: it will denote whatever determines the creditworthiness of a debtor, whether it is actually pledged or not. It may mean a piece of property or an expected future stream of income; in either case, it is something on which the lender is willing to place a value. Valuation is supposed to be a passive relationship in which the value reflects the underlying asset; but in this case it involves a positive act: a loan is made. The act of lending may affect the collateral value: that is the connection that gives rise to a reflexive process.”

“The act of lending usually stimulates economic activity. It enables the borrower to consume more than he would otherwise, or to invest in productive assets...By the same token, debt service has a depressing impact. Resources that would otherwise be devoted to consumption or the creation of a future stream of income are withdrawn. As the total amount of debt outstanding accumulates, the portion that has to be utilized for debt service increases."

“In the early stages of a reflexive process of credit expansion the amount of credit involved is relatively small so that its impact on collateral values is negligible. That is why the expansionary phase is slow to start with and credit remains soundly based at first. But as the amount of debt accumulates, total lending increases in importance and begins to have an appreciable effect on collateral values. The process continues until a point is reached where total credit cannot increase fast enough to continue stimulating the economy. By that time, collateral values have become greatly dependent on the stimulative effect of new lending and, as new lending fails to accelerate, collateral values begin to decline. The erosion of collateral values has a depressing effect on economic activity, which in turn reinforces the erosion of collateral values. Since the collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans, which in turn may make the decline more precipitous. That is the anatomy of a typical boom and bust.

Booms and busts are not symmetrical because, at the inception of a boom, both the volume of credit and the value of the collateral are at a minimum; at the time of the bust, both are at a maximum. But there is another factor at play. The liquidation of loans takes time; the faster it has to be accomplished, the greater the effect on the value of the collateral. In a bust, the reflexive interaction between loans and collateral becomes compressed within a very short time frame and the consequences can be catastrophic. It is the sudden liquidation of accumulated positions that gives a bust such a different shape from the preceding boom.

It can be seen that the boom/bust sequence is a particular variant of reflexivity. Booms can arise whenever there is a two-way connection between values and the act of valuation. The act of valuation takes many forms. In the stock market, it is equity that is valued; in banking, it is collateral.”

“Busts can be very disruptive, especially if the liquidation of collateral causes a sudden compression of credit. The consequences are so unpleasant that strenuous efforts are made to avoid them. The institution of central banking has evolved in a continuing attempt to prevent sudden, catastrophic contractions in credit. Since a panic is hard to arrest once it has started, prevention is best practiced in the expansionary phase. That is why the role of central banks has gradually expanded to include the regulation of the money supply. That is also why organized financial markets regulate the ratio of collateral to credit.”

“Financial history is best interpreted as a reflexive process in which there are two sets of participants instead of one: competitors and regulators…It is important to realize that the regulators are also participants. There is a natural tendency to regard them as superhuman beings who somehow stand outside and above the economic process and intervene only when the participants have made a mess of it. That is not the case. They also are human, all too human. They operate with imperfect understanding and their activities have unintended consequences.”

Soros’ Alchemy – Chapter 1, Part 3

Continuation in our series of portfolio management highlights from George Soros’ Alchemy of Finance – Chapter 1, Part 3: Soros introduces the theoretical foundations of reflexivity. Psychology, Intrinsic Value

“What makes the participants’ understanding imperfect is that their thinking affects the situation to which it relates…Although there is no reality independent of the participants' perception, there is a reality that is dependent on it. In other words, there is a sequence of events that actually occurs and that sequence reflects the participants' behavior. The actual course of events is likely to differ from the participants' expectations and the divergence can be taken as an indication of the participants' bias. Unfortunately, it can be taken only as an indication – not as the full measure of the bias because the actual course of events already incorporates the effects of the participants' thinking. Thus the participants' bias finds expression both in the divergence between outcome and expectations and in the actual course of events. A phenomenon that is partially observable and partially submerged in the course of events does not lend itself readily to scientific investigation. We can now appreciate why economists were so anxious to eliminate it from their theories. We shall make it the focal point of our investigation.”

“The connection between the participants' thinking and the situation in which they participate can be broken up into two functional relationships. I call the participants' efforts to understand the situation the cognitive or passive function and the impact of their thinking on the real world the participating or active function. In the cognitive function, the participants' perceptions depend on the situation; in the participating function, the situation is influenced by the participants' perceptions. It can be seen that the two functions work in opposite directions: in the cognitive function the independent variable is the situation; in the participating function it is the participants' thinking…

When both functions operate at the same time, they interfere with each other. Functions need an independent variable in order to produce a determinate result, but in this case the independent variable of one function is the dependent variable of the other. Instead of a determinate result, we have an interplay in which both the situation and the participants' views are dependent variables so that an initial change precipitates further changes both in the situation and in the participants' views. I call this interaction ‘reflexivity,’ using the word as the French do when they describe a verb whose subject and object are the same…

This is the theoretical foundation of my approach. The two recursive functions do not produce an equilibrium but a never-ending process of change…When a situation has thinking participants, the sequence of events does not lead directly from one set of facts to the next; rather, it connects facts to perceptions and perceptions to facts in a shoelace pattern. Thus, the concept of reflexivity yields a 'shoelace' theory of history.”

“Returning to economic theory, it can be argued that it is the participants' bias that renders the equilibrium position unattainable. The target toward which the adjustment process leads incorporates a bias, and the bias may shift in the process. When that happens, the process aims not at an equilibrium but at a moving target…

Equilibrium analysis eliminates historical change by assuming away the cognitive function. The supply and demand curves utilized by economic theory are expressions of the participating function only. The cognitive function is replaced by the assumption of perfect knowledge. If the cognitive function were operating, events in the marketplace could alter the shape of the demand and supply curves, and the equilibrium studied by economists need never be reached. How significant is the omission of the cognitive function? In other words, how significant is the distortion introduced by neglecting the participants' bias?

In microeconomic analysis, the distortion is negligible…When it comes to financial markets, the distortion is more serious. The participants' bias is an element in determining prices and no important market development leaves the participants' bias unaffected. The' search for an equilibrium price turns out to be a wild goose chase and theories about the equilibrium price can themselves become a fertile source of bias. To paraphrase J.P. Morgan, financial markets will continue to fluctuate. In trying to deal with macroeconomic developments, equilibrium analysis is totally inappropriate. Nothing could be further removed from reality than the assumption that participants base their decisions on perfect knowledge. People are groping to anticipate the future with the help of whatever guideposts they can establish. The outcome tends to diverge from expectations, leading to constantly changing expectations and constantly changing outcomes. The process is reflexive.”

Soros’ Alchemy – Chapter 1, Part 1

Portfolio management highlights from George Soros’ Alchemy of Finance – Chapter 1: The Theory of Reflexivity. In part 1, Soros discusses the concept of price equilibrium, supply and demand, and why market prices fluctuate. Intrinsic Value

“The concept of an equilibrium is very useful. It allows us to focus on the final outcome rather than on the process that leads up to it. But the concept is also very deceptive…Equilibrium itself has rarely been observed in real life-market prices have a notorious habit of fluctuating. The process that can be observed is supposed to move toward an equilibrium. Why is it that the equilibrium is never reached? It is true that market participants adjust to market prices but they may be adjusting to a constantly moving target…

…modern economists resorted to an ingenious device: they insisted that the demand and supply curves should be taken as given…They argued that the task of economics is to study the relationship between supply and demand and not either by itself. Demand may be a suitable subject for psychologists, supply may be the province of engineers or management scientists; both are beyond the scope of economics. Therefore, both must be taken as given.

Yet, if we stop to ask what it means that the conditions of supply and demand are independently given, it is clear that an additional assumption has been introduced. Otherwise, where would those curves come from? We are dealing with an assumption disguised as a methodological device…

The shape of the supply and demand curves cannot be taken as independently given, because both of them incorporate the participants' expectations about events that are shaped by their own expectations.

Nowhere is the role of expectations more clearly visible than in financial markets. Buy and sell decisions are based on expectations about future prices, and future prices, in turn, are contingent on present buy and sell decisions. To speak of supply and demand as if they were determined by forces that are independent of the market participants' expectations is quite misleading.

The very idea that events in the marketplace may affect the shape of the demand and supply curves seems incongruous to those who have been reared on classical economics. The demand and supply curves are supposed to determine the market price. If they were themselves subject to market influences, prices would cease to be uniquely determined. Instead of equilibrium, we would be left with fluctuating prices. This would be a devastating state of affairs. All the conclusions of economic theory would lose their relevance to the real world.”

“Anyone who trades in markets where prices are continuously changing knows that participants are very much influenced by market developments. Rising prices often attract buyers and vice versa. How could self-reinforcing trends persist if supply and demand curves were independent of market prices?”

“The theory of perfect competition could be defended by arguing that the trends we can observe in commodity and financial markets are merely temporary aberrations which will be eliminated in the long run by the ‘fundamental’ forces of supply and demand…The trouble with the argument is that there can be no assurance that ‘fundamental’ forces will correct ‘speculative’ excesses. It is just as possible that speculation will alter the supposedly fundamental conditions of supply and demand.”

“If we want to understand the real world, we must divert our gaze from a hypothetical final outcome and concentrate our attention on the process of change that we can observe all around us. This will require a radical shift in our thinking. A process of change is much more difficult to understand than a static equilibrium. We shall have to revise many of our preconceived ideas about the kind of understanding that is attainable and satisfy ourselves with conclusions that are far less definite than those that economic theory sought to provide.”

Soros' Alchemy - Preface & Intro

Dear Readers, apologies for the length of time since our last article. It’s been a busy year – got married, growing the business, grappling with a large position ruining otherwise healthy year-to-date performance – you know, all the usual life items. We have all experienced situations when the fundamentals of a business are moving in an expected direction, yet the price does not respond in kind. Many moons ago, we highlighted an interview with Stanley Druckenmiller in which he stated:

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

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

Very interesting indeed, but also incredibly vague. Thankfully, Druckenmiller’s zen master George Soros has written multiple books. And that’s where we went searching for more detailed explanations on how to gauge supply and demand, the driving forces behind market liquidity and price movement. Without further ado, portfolio management highlights from George Soros’ Alchemy of Finance – Preface & Introduction:

Psychology, Catalyst, Liquidity, Intrinsic Value

“The phenomena studied by social sciences, which include the financial markets, have thinking participants and this complicates matters…the participants views are inherently bias. Instead of a direct line leading from one set of conditions to the next one, there is a constant criss-crossing between the objective, observable conditions and the participant’s observations and vice versa: participants base their decisions not on objective conditions but on their interpretation of those conditions. This is an important point and it has far-reaching consequences. It introduces an element of indeterminacy which renders the subject matter less amendable to…generalizations, predictions, and explanations…”

“It is only in certain…special circumstances that the indeterminacy becomes significant. It comes into play when expectations about the future have a bearing on present behavior – which is the case in financial markets. But even there, some mechanism must be triggered for the participants’ bias to affect not only market prices but the so-called fundamentals which are supposed to determine market prices…My point is that there are occasions when the bias affects not only market prices but also the so-called fundamentals. This is when reflexivity becomes important. It does not happen all the time but when it does, market prices follow a different pattern…they do not merely reflect the so-called fundamentals; they themselves become one of the fundamentals which shape the evolution of prices. This recursive relationship renders the evolution of prices indeterminate and the so-called equilibrium price irrelevant.”

“Natural science studies events that consist of a sequence of facts. When events have thinking participants, the subject matter is no longer confined to facts but also includes the participants' perceptions. The chain of causation does not lead directly from fact to fact but from fact to perception and from perception to fact.”

“Economic theory tries to sidestep the issue by introducing the assumption of rational behavior. People are assumed to act by choosing the best of the available alternatives, but somehow the distinction between perceived alternatives and facts is assumed away. The result is a theoretical construction of great elegance that resembles natural science but does not resemble reality…It has little relevance to the real world in which people act on the basis of imperfect understanding…”

“The generally accepted view is that markets are always right – that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite point of view. I believe that market prices are always wrong in the sense that they present a biased view of the future. But distortion works in both directions: not only do market participants operate with a bias, but their bias can also influence the course of events. This may create the impression that markets anticipate future developments accurately, but in fact it is not present expectations that correspond to future events but future events that are shaped by present expectations. The participants' perceptions are inherently flawed, and there is a two-way connection between flawed perceptions and the actual course of events, which results in a lack of correspondence between the two. I call this two-way connection ‘reflexivity.’”

“Making an investment decision is like formulating a scientific hypothesis and submitting it to a practical test. The main difference is that the hypothesis that underlies an investment decision is intended to make money and not to establish a universally valid generalization. Both activities involve significant risk, and success brings a corresponding reward-monetary in one case and scientific in the other. Taking this view, it is possible to see financial markets as a laboratory for testing hypotheses, albeit not strictly scientific ones. The truth is, successful investing is a kind of alchemy. Most market participants do not view markets in this light. That means that they do not know what hypotheses are being tested…”

“…I did not play the financial markets according to a particular set of rules; I was always more interested in understanding the changes that occur in the rules of the game. I started with hypotheses relating to individual companies; with the passage of time my interests veered increasingly toward macroeconomic themes. This was due partly to the growth of the fund and partly to the growing instability of the macroeconomic environment.”

“Most of what I know is in the book, at least in theoretical form. I have not kept anything deliberately hidden. But the chain of reasoning operates in the opposite direction: I am not trying to explain how to use my approach to make money; rather, I am using my experiences in the financial markets to develop an approach to the study of historical processes in general and the present historical moment…If I did not believe that my investment activities can serve that purpose, I would not want to write about them. As long as I am actively engaged in business, I would be better off to keep them a trade secret. But I would value it much more highly than any business success if I could contribute to an understanding of the world in which we live or, better yet, if I could help to preserve the economic and political system that has allowed me to flourish as a participant.”

Macro

“Monetary and real phenomena are connected in a reflexive fashion; that is, they influence each other mutually. The reflexive relationship manifests itself most clearly in the use and abuse of credit. Loans are based on the lender's estimation of the borrower's ability to service his debt. The valuation of the collateral is supposed to be independent of the act of lending; but in actual fact the act of lending can affect the value of the collateral. This is true of the individual case and of the economy as a whole. Credit expansion stimulates the economy and enhances collateral values; the repayment or contraction of credit has a depressing influence both on the economy and on the valuation of the collateral.”

“Periodic busts have been so devastating that strenuous efforts have been made to prevent them. These efforts have led to the evolution of central banking and of other mechanisms for controlling credit and regulating economic activity. To understand the role of the regulators it must be realized that they are also participants: their understanding is inherently imperfect and their actions have unintended consequences.”

Wisdom From James Montier

I have a confession to make: I have a huge crush on James Montier. I think the feeling might be mutual (see picture below, from a signed copy of his book Value Investing: Tools and Techniques for Intelligent Investment.) Jokes aside, below are some fantastic bits from his recent essay titled “No Silver Bullets.”

Risk, Correlation

“…private equity looks very much like public equity plus leverage minus a shed load of costs…hedge funds as an ‘asset class’ look like they are doing little more than put selling! In fact, I’d even go as far as to say if you can’t work that out, you probably shouldn’t be investing; you are a danger to yourself and to others!

The trick to understanding risk factors is to realize they are nothing more than a transformation of assets. For instance, what is the ‘equity risk?’ It is defined as long equities/short cash. The ‘value’ risk factor is defined as long cheap stocks/short expensive stocks. Similarly, the ‘momentum’ risk factor is defined as long stocks that have gone up, and short stocks that have done badly. ‘Carry’ is simply long high interest rate currencies/short low rate currencies. Hopefully you have spotted the pattern here: they are all long/short combinations.”

Proper investing requires an understanding of the exact bet(s) that you are making, and correct anticipation of the inherent risks and correlated interactivity of your holdings. This means going beyond the usual asset class categorizations, and historical correlations. For example, is a public REIT investment real estate, equity, or interest rate exposure?

For further reading on this, check out this article by Andy Redleaf of Whitebox in which he discusses the importance of isolating bets so that one does not end up owning stupid things on accident. (Ironic fact: Redleaf and Montier have butted heads in the recent past on the future direction of corporate margins.)

Leverage

“…when dealing with risk factors you are implicitly letting leverage into your investment process (i.e., the long/short nature of the risk factor). This is one of the dangers of modern portfolio theory – in the classic unconstrained mean variance optimisation, leverage is seen as costless (both in implementation and in its impact upon investors)…

…leverage is far from costless from an investor’s point of view. Leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one by transforming the temporary impairment of capital (price volatility) into the permanent impairment of capital by forcing you to sell at just the wrong time. Effectively, the most dangerous feature of leverage is that it introduces path dependency into your portfolio.

Ben Graham used to talk about two different approaches to investing: the way of pricing and the way of timing. ‘By pricing we mean the endeavour to buy stocks when they are quoted below their fair value and to sell them when they rise above such value… By timing we mean the endeavour to anticipate the action of the stock market…to sell…when the course is downward.’

Of course, when following a long-only approach with a long time horizon you have to worry only about the way of pricing. That is to say, if you buy a cheap asset and it gets cheaper, assuming you have spare capital you can always buy more, and if you don’t have more capital you can simply hold the asset. However, when you start using leverage you have to worry about the way of pricing and the way of timing. You are forced to say something about the path returns will take over time, i.e., can you survive a long/short portfolio that goes against you?”

Volatility, Leverage

“As usual, Keynes was right when he noted ‘An investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money.’”

Expected Return, Intrinsic Value

“...the golden rule of investing holds: ‘no asset (or strategy) is so good that it can it be purchased irrespective of the price paid.’”

“Proponents of risk parity often say one of the benefits of their approach is to be indifferent to expected returns, as if this was something to be proud of…From our perspective, nothing could be more irresponsible for an investor to say he knows nothing about expected returns. This is akin to meeting a neurosurgeon who confesses he knows nothing about the way the brain works. Actually, I’m wrong. There is something more irresponsible than not paying attention to expected returns, and that is not paying attention to expected returns and using leverage!”

Hedging, Expected Return

“…whenever you consider insurance I’ve argued you need to ask yourself the five questions below:

1. What risk are you trying to hedge?
2. Why are you hedging?
3. How will you hedge?
• Which instruments will work?
• How much will it cost?
4. From whom will you hedge?
5. How much will you hedge?”

“This is a point I have made before with respect to insurance – it is as much a value proposition as anything else you do in investment. You want insurance when it is cheap, and you don’t want it when it is expensive.”

Trackrecord, Compounding

“…one of the myths perpetuated by our industry is that there are lots of ways to generate good long-run real returns, but we believe there is really only one: buying cheap assets.”

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).

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. 

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.”

An Interview with Bruce Berkowitz - Part 2

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

AUM, Compounding, Subscription, Redemptions

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

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

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

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

AUM, Sourcing

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

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

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

Diversification, Correlation, Risk

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

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

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

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

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

Making Mistakes, Sizing

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

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

Creativity, Team Management, Time Management

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

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

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

When To Sell, Expected Return, Intrinsic Value, Exposure

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

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

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

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

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

UPDATE:

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

Cash, Redemptions, Liquidity, When To Sell

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

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

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

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

Buffett Partnership Letters: 1966 Part 1

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

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

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

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

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

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

Sizing, AUM

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

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

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

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

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

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

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

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

Sizing, Diversification

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

Hochschild, Kohn = 10% NAV

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

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

An Interview with Bruce Berkowitz - Part 1

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

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

Cash, Liquidity, Redemptions, Expected Return

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

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

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

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

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

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

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

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

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

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

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

The first part is self-explanatory.

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

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

Howard Marks' Book: Chapter 6 - Part 1

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

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

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

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

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

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

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

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

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

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

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

Howard Marks' Book: Chapter 5 - Part 4

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

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

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

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

Risk

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

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

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

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

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

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

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

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

Risk, Fat Tail

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

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

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

Wisdom from Steve Romick: Part 2

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

Capital Preservation, Conservatism

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

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

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

Exposure, Intrinsic Value

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

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

For example:

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

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

What would you do?

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

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

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

Risk, Hedging

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

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

Howard Marks' Book: Chapter 3

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

Intrinsic Value

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

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

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

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

Making Mistakes, When To Buy, When To Sell

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

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

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

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

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

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

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

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

When To Sell

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

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

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

Sizing

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

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

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

Buffett Partnership Letters: 1961 Part 3

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

Sizing

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

“…and probably 40 or so securities.”

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

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

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

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

Catalyst, Diversification, Expected Return

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

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

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

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

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

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

Leverage

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

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

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

Intrinsic Value, When to Sell

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

Don’t be too greedy.

Klarman-Zweig Banter: Part 1

Seth Klarman of Baupost is a great investor. Jason Zweig is a great writer. When combined, we get a great Klarman-Zweig Interview published Fall 2010 in the Financial Analyst Journal (Volume 66 Number 5) by the CFA Institute. Here is Part 1 of tidbits from that conversation. Part 2 is available here.

Volatility

Graham and Dodd’s works help Klarman “think about volatility in marks as being in your favor rather than as a problem.” Volatility is a good thing because it creates opportunities and bargains.

Intrinsic Value, Exposure

“A tremendous disservice is perpetrated by the idea that stocks are for the long run” because most people don’t have enough staying power or a long time horizon to actually implement this belief. “The prevailing view has been that the market will earn a high rate of return if the holding period is long enough, but entry point is what really matters.”

“If we buy a bond at 50 and think it’s worth par in three years but it goes to 90 the year we bought it, we will sell it because the upside/downside has totally changed. The remaining return is not attractive compared with the risk of continuing to hold.”

Shorting

Baupost does not sell short because the “market is biased upward over time…the street is biased toward the bullish side.” But this also means that there are more “low-hanging fruit on the short side.”

Leverage

“We do not borrow money. We don’t use margin.” However, it should be pointed out that Baupost has substantial private real estate investments, many of which would employ leverage or financing. Perhaps it’s the non-recourse nature of real estate financing that distinguishes whether Klarman is willing to employ leverage. In addition, Baupost does engage in derivative transactions (such as interest rate options) that are quasi forms of leverage (e.g., premiums in return for large notional exposure).

Cash

The “inability to hold cash and the pressure to be fully invested at all times meant that when the plug was pulled out of the tub, all boats dropped as the water rushed down the drain.”

“We are never fully invested if there is nothing great to do…we always have cash available to take advantage of bargains – we now have about 30 percent cash across our partnerships – and so if clients ever feel uncomfortable with our approach, they can just take their cash back.”

AUM

“…probably number one in my mind most of the time – how to think about firm size and assets under management. Throughout my entire career, I have always thought size was a negative. Large size means small ideas can’t move the needle as much…As we entered the chaotic period of 2008…for the first time in eight years, we went to our wait list...We got a lot of interesting phone calls from people who needed to move merchandise in a hurry – some of it highly illiquid…So, to have a greater amount of capital available proved to be a good move.”

Returning Capital

“…I think returning cash is probably one of the keys to our future success in that it lets us calibrate our firm size so that we are managing the right amount of money, which isn’t necessarily the current amount of money.”

Redemptions

“Not only are actual redemptions a problem, but also the fear of redemptions, because the money manager’s behavior is the same in both situations.” In preparation for, or the mere threat of possible redemptions, may prompt a manager to start selling positions at exactly the wrong time in an effort to make the portfolio more liquid.

Clients

“Having great clients is the real key to investment success. It is probably more important than any other factor…We have emphasized establishing a client base of highly knowledgeable families and sophisticated institutions…”

Ideal clients have two characteristics:

1. “…when we think we’ve had a good year, they will agree.”
2. “…when we call to say there is an unprecedented opportunity set, we would like to know that they will at least consider adding capital rather than redeeming.”

“Having clients with that attitude allowed us to actively buy securities through the fall of 2008, when other money managers had redemptions and, in a sense, were forced not only to not buy but also to sell their favorite ideas when they knew they should be adding to them.”

Buffett Partnership Letters: 1958 Part 2

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. Selectivity, Hurdle Rate, Risk

“The higher level of the market, the fewer the undervalued securities and I am finding some difficulty in securing an adequate number of attractive investments. I would prefer to increase the percentage of our assets in work-outs, but these are very difficult to find on the right terms.”

All investors practice some degree of selectivity, since not all ideas/securities/assets we examine makes it into our portfolios. Selectivity implies that, for each of us, there exists some form of selection criteria (e.g., hurdle rate, risk measurement, good management, social responsibility, etc.).

In 1958, Buffett talks about finding it difficult to locate “attractive investments” on the “right terms” as the market got more expensive. Perhaps it’s a comfort to know that Buffett grappled with problems just like the rest of us mere mortals!

Jokes aside, as markets rise, what happens to our standards of selectivity? Do we change our usual parameters (whether consciously or subconsciously) – such as changing the hurdle rate or risk standards?

It’s a dynamic and difficult reality faced by all investors at some point in our careers, made more relevant today as markets continue to rally. I believe how each of us copes and adapts in the face of rising asset prices (and whether we change our selectivity criteria) separates the women from the girls.

Intrinsic Value, Exposure, Opportunity Cost

“Unfortunately we did run into some competition on buying, which railed the price to about $65 where we were neither buyer nor seller.”

“Late in the year we were successful in finding a special situation where we could become the largest holder at an attractive price, so we sold our block of Commonwealth obtaining $80 per share…It is obvious that we could still be sitting with $50 stock patiently buying in dribs and drags, and I would be quite happy with such a program…I might mention that the buyer of the stock at $80 can expect to do quite well over the years. However, the relative undervaluation at $80 with an intrinsic value of $135 is quite different from a price $50 with an intrinsic value of $125, and it seemed to me that our capital could better be employed in the situation which replaced it.”

Once a security has been purchased, the risk-reward shifts with each price movement. Any degree of appreciation naturally makes it a larger % of NAV, alters portfolio exposures, and changes the theoretical amount of opportunity cost (to Buffett’s point of his “capital could better be employed” in another situation).

So what actions does a portfolio manager take, if any, when a security appreciates but has not reached the target price, to a place where it’s neither too cheap nor too expensive, where we are “neither buyer nor seller”?

Unfortunately, Buffett offers no solutions in the 1958 letter. Any thoughts and suggestions from our Readers?