The Goal of Investing

The Investing Goal? What Is It?

If you quiz most people regarding their investment ambitions, the answer is likely to be ..  "grow my money", or thereabouts. Joe average isn’t striving to beat an index, and he’s certainly not trying to capture ‘attractive risk-adjusted returns’. Quite simply, most people want an adequate nest egg for retirement; which requires the protection and growth of their capital at an attractive rate considering the effects of inflation.

Inverting the question, ‘What is it you want to avoid?’. Common sense would suggest the answer: "not lose my money".

It raises some industry issues…

Relative Returns

The industry is fixated on relative returns. Nowadays, the majority of funds are trying [and mostly failing] to beat an index. The foundation of this strategy is: stock markets generally rise over time, if you make a little more in up periods and lose a little less in down periods [ie. better relative returns], you'll end up with a lot more money compared to investing in an index fund. Those few percentage points of annual outperformance mushroom into significant return differentials as the time horizon expands.

Unfortunately, markets don't always go up. Indices, even mainstream ones, can go for long periods with negative returns. Consider Japan's Nikkei index and America’s S&P500. Having peaked in 1989 at nearly 39,000, the Nikkei’s current level is just 16,700. The S&P500 has spent quite a few ten year periods, and more, without a positive return.

"Investors can lose sight of the fact that the market has gone through long periods when returns were minimal. During the 14 year period from the middle of 1968 to the middle of 1982 the S&P500 appreciated by less than 1% per year.” Lee Ainslie

"Say you were forty-eight years old in 1964 and put $100,000 into the Dow on the last day of 1964 with instructions that dividends be reinvested, confident that you would have a nice nest egg when you retired at age sixty-five. When the last day of 1981 rolled around, your money would be worth statistically less than your initial investment because of a moribund market and the depredations of inflation." Leon Levy
 
“There have been periods of longer than a decade for which investing in the stock market in expectation of a 7 percent real return turned out to be a devastating mistake. It took the market twenty-five years to regain its levels of 1929.” Andy Redleaf

An index fund or a relative return strategy might not be appropriate for an investor who can’t look ten years or beyond.

While index returns can remain stubbornly low or negative for long periods, most individual investors fail to capture the index return regardless of when they enter the market. Numerous studies highlight most individuals significantly under-perform the index. Downturns scare them out, only do they re-enter once momentum returns; sell low, buy high.

"In 2014, Dalbar released its 20th report QAIB (Quantitative Analysis of Investor Behaviour) and the results for the two decades are very instructive. From 1994 to 2013, the average return of investors in 14 equity funds was 5.02% compared to 9.22% for the S&P 500. Over 20 years, the total return to investors was 166% versus 484% for the S&P 500. This is an astronomical difference. And this shortfall is what might be called a "behavioral penalty." Francois Rochon

In contrast, an index has no emotion, it doesn't get scared out at the bottom. An index rides out the lows.

While relative returns are standard in markets, they may not be aligned to most customer demands. The majority of investors would probably rather a +15% return in a +20% market, than a -15% in a market -20%. Yet, a relative return manager would be deemed more skilful delivering the latter.

“We start with a deep truth, which is that if you were to ask the average portfolio manager, would you rather compound at 14 percent a year and have the market compound at 15 or would you rather compound at four and have the market compound at three? The vast majority might take the latter choice, because they would say, well, my firm will be enormous. We’re the opposite. We would use, A, all day.” Chris Davis

While relative outperformance in a market downturn maybe acceptable, many investors struggle with large losses. Large negative returns, even if they are good on a relative basis, are more likely to scare an investor out of a fund at the exact wrong time.

Asset Allocation

The investment industry derived the ‘Asset Allocation’ process to help individuals achieve their retirement goals. This process states younger investors should have higher exposure to equities, given their higher long term historic returns. As an investor ages, equities exposure should be reduced and replaced with less volatile bonds.

In principle, an increased equity exposure makes sense for younger investors provided funds are regularly added to the account. Remembering, whether you lose 10% in year 1, 10 or 20, if the capital doesn't change, you'll end up with the same amount regardless of when the loss occurred.

Most asset allocation models, while they might adjust for age, make no reference to the relative attractiveness of each asset class. The manager with say, 60% equities exposure, is usually mandated to be fully invested. While she's the resident expert on equities she can't go to cash if suitable investments aren’t available. Her best bet is to buy defensive stocks. Unfortunately in a bear market, even these may not be spared.

“The idea that you say, “I’ve got 60 percent in stocks and 40 percent in bonds,” and then have a big announcement, now we’re moving it to 65/35, as some strategists or whatever they call them in Wall Street do. I mean, that has to be pure nonsense. I mean, 60/40 or 65/30 — it just doesn’t make any sense.” Warren Buffett

The bond manager with a 40% slice of the money has a few options. She can move to shorter duration bonds to help protect the fund from rising rates. But if rates are very low, as they are now, it maybe difficult, or impossible to earn attractive [real &/or nominal] returns. Time has not always been kind to bond investors.

“An individual in a 50% bracket who put money into T-bills or government bonds after World War 2 and kept re-investing in these instruments to 1996, lost the major part of his or her capital” David Dreman

Over the last 30 odd years, the typical 40/60 portfolio has delivered. Bond yields trended lower and equities, though volatile, have trended higher. That’s the rear view mirror. Today’s bond yields are at or near record lows. Bond risk appears more asymmetric; bond yields have little room to fall. They could rise a lot. Low yields no longer provide an attractive income stream. It's return-free risk.

You shouldn’t expect a 40/60 portfolio to deliver returns over the next 10 years that mirror the last 30 years. It’s not likely to happen.

What do the Investment Masters do..

The Investment Masters, unlike most mutual funds, are FIRST trying to preserve capital. Making money comes next. The focus is on absolute, not relative returns; avoiding the permanent loss of capital is paramount.

Index agnosticism combined with an ability to hold cash when opportunities are scarce differentiate durable versus fragile portfolios.

While the Masters portfolios may appear unconventional, they’re often more conservative. Conventional investing doesn’t equate to conservatism. A portfolio's historic performance may provide some colour to it’s conservatism, it can’t fortell the future risk of permanent capital loss; the risk that matters.

The Investment Masters acknowledge the cost of outperforming in down markets will be accompanied by under-performance in bull markets. In the quest for higher long term returns this is a worthy price to pay.

"We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%." Warren Buffett

Profits and Losses are Not Symmetrical

Consider the following two investment funds:

Fund A .. loses 50% in year 1, makes 50% in year 2 and then makes 10% in year 3
Fund B.. loses 50% in year 1, gets back to break-even in year 2 and makes 0% in year 3

Which would you prefer?  

Fund B should be your preference. You get your money back. Fund A is still down 17.5% at the end of year 3. To get back to break-even, Fund A would have needed to deliver +81.8% in year 2 (not +50%) and then 10% in Year 3.  

Is you fund focused on preserving capital? Is your fund focused on outperforming down markets while accepting of some level of under-performance in strong markets?  

The Top 12 Investment Books

Over the years I've read a lot of books on investing, many of which are on the great investors. I've included a lot of my favourites in the further reading section here. I've read all of the books in that section and learnt something from everyone of them. I'm constantly revisiting these books as they provide a different context to investment environments, in addition to assisting me to better understand investing and human biases. The following books are my Top 12. They cover many of the great investors, the psychology of markets and they provide a glimpse into financial history. I have included a brief description of each below. It wasn't easy coming up with the Top 12 as there are plenty of other great books. As the Investment Masters advise .. keep reading!

1) The Intelligent Investor - Benjamin Graham

The world's greatest investor Warren Buffett wrote "By far the best book on investment ever written". This book belongs on every investors bookshelf. Ben Graham was recognised as the 'Dean of Value Investing'. Covers the key concepts of Margin of Safety and Mr Market. Mr. Buffett stated “Chapters 8 and 20 have been the bedrock of my investing activities for more than 60 years, I suggest that all investors read those chapters and reread them every time the market has been especially strong or weak.”

2) Margin of safety - Seth Klarman

Mr Klarman runs Baupost Group, one of the world's most successful hedge funds. Timeless reading, Mr Klarman says "he wrote the book for the average person". While now out of print, this book provides great insights into the psychological aspects of investing, financial history, the inefficiency of markets and where to look for opportunities. Recommended by Warren Buffett, Bill Ackman, Joel Greenblatt, David Einhorn and Frank Martin.

3) The mind of wall street - Leon Levy

In my view one of the greatest minds of Wall Street, the late Leon Levy's book is his story of his life in the markets. Mr Levy was the founder of Oppenheimer Funds and started the hedge fund Odyssey Partners. With amazing insight Mr Levy's book written in 2002 forewarned of the coming financial crisis, the implications of the removal in 1999 of the Glass-Steagall Act of 1933 and the lessons of Hyman Minsky and 'Too big to Fail'. He outlined his prescient views on what would be the forthcoming troubles of the euro currency. The book mixes psychology with market intelligence.  On Bruce Berkowitz and Chris Mittleman's recommended reading list.  One of my favourite books.

4) The Essays of Warren Buffett

Warren Buffett is the greatest investor of the 20th century and he shares his wisdom through his annual Berkshire letters. This book collates the letters into various themes providing practical and sensible lessons for investors. The more investing books I have read the more I have come to realise that Mr. Buffett and Mr. Munger, together, really did work out the secrets to successful investing and business. Mr Buffet's ability to distil his thoughts and his generosity to share them is a gift to investors.  I am always revisiting this book for it's timeless wisdom. Recommended by Bruce Berkowitz, Tom Steyer, Seth Klarman and Mohnish Pabrai. A must read.

5) Poor Charlie's Almanack

Poor Charlie's Almanack provides a marvellous insight into the mind of one of the world's greatest investors. Covering the multitude of mental models used by Charlie Munger in his assessment of investments. More a coffee table book format this book contains endless wisdom that you will keep coming back to. Rated as the best book ever read by Mohnish Pabrai. On Bruce Berkowitz's recommended reading list.

6) the most important thing - Howard Marks

Howard Marks is the founder of the hugely successful Oaktree Capital Management. This book sets forth his investment philosophy with each chapter covering the various "important things" such as value, risk and investor psychology. Simple to read, this book will help formulate the mindset to be a successful investor. Recommended by Warren Buffett, Seth Klarman, Joel Greenblatt and Chris Davis.

7) The LITTLE BOOK OF VALUE INVESTING - CHRISTOPHER BROWNE

Christopher Browne started at his father's firm Tweedy Browne in 1969. This great little book is an easy read, laying out the basics of value investing in a simple and engaging manner. The book covers the topics of what to buy, where to look and how to analyse companies through Mr Browne's checklist. Recommended by Charles Royce, Marty Whitman and Bruce Greenwald. Another one of my favourite books.

8) The Outsiders - William Thorndike

The Ousiders is an exploration of 8 great American CEO's who built substantial value in their business such as John Malone, Henry Singleton and Katherine Graham. The book sets out the common characteristics of great leaders with particular emphasis on capital allocation. For the investor, the book provides a guide to identifying and finding company's that may be compounding machines. I've bought this book for numerous CEO's over the years. Outsiders was #1 on Warren Buffett's recommended reading list in 2012.

9) Fooled by Randomness - Nassim Nicholas Taleb

A great book on understanding the role of luck and skill in investing. Howard Marks of Oaktree cited 'Fooled by Randomness' as one of the most important books in shaping his thinking. This book will change the way you think about investing, probabilities, risk and the inherent uncertainty in the investing process. Like Taleb's other excellent books, Antifragile and Black Swan, not an easy read, but well worth the effort. 

10) The davis dynasty - John Rothchild

A fantastic book covering the history of one of Wall Street's greatest families, the Davis Family. Providing a vivid account of the financial markets in which they operated and the investment philosophy that enabled them to successfully traverse a multitude of market environments. This story of the Davis family enlightens readers to the trends, manias and follies through the last century and will better prepare them for a repeat of history.  Recommended by Mohnish Pabrai and Peter Bernstein.

11) A DECADE OF DELUSIONS - FRANK MARTIN

A Decade of Delusions contains the annual partner letters from Frank Martin of Martin Capital Management. The letters focus on the periods before and after the tech bubble in 2000 and before and after the Financial Crisis of 2008 and 2009. The comprehensive letters cover financial history, the psychology of investors and provide a real time commentary through two fascinating investment eras from the desktop of a great investor. Mr Martin set out the roadmap for what would become the tech crash and the greatest financial collapse since the great depression. A truly remarkable mind and a brilliant writer. This book is unequivocal evidence against the notion that no-one saw the Financial Crisis coming. Recommended by Warren Buffett and Seth Klarman.

12) Seeking Wisdom - From darwin to munger - Peter Bevelin

Seeking Wisdom from Darwin to Munger takes a tour of the evolution of man and wisdom.  The book focuses on how our thoughts are influenced, why we make misjudgements and tools to improve our thinking. The book covers biology, psychology, neuroscience, physics and mathematics and combines a collection of wisdom from Darwin, Einstein and Feynman to Munger and Buffett. The book will appeal to investors looking to broaden their knowledge and thinking when it comes to investing.  A Tour de Force.

The Evolution of a Value Investor

Over the years reading plenty of books on investing and studying many of the world's greatest investors I've come to recognise how truly insightful the combination of Warren Buffett and Charlie Munger really are.  

While Warren Buffett cites the book ‘The Intelligent Investor’ as "by far the best book on investing ever written" his style evolved over the years, in a large part influenced by Charlie Munger.  

"Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact Charlie had on me. It took a powerful force to move me on from Graham's limiting views. It was the power of Charlie's mind. He expanded my horizons" Warren Buffett

I think a lot of value investors evolve in a similar fashion. They start out on the hunt for cheap stocks and gradually they move towards the great businesses, the ‘compounding machines’, that can generate attractive returns over long periods of time. They transition from the search for low multiples for what are often poor businesses, to seeking truly great businesses at fair prices.

Here's a look at the evolution of Warren Buffett, as I see it.

The Buffett Partnership Years..

Warren ran the Buffett Partnership prior to undertaking his investment activities in Berkshire Hathaway where he employed a combination of value, event and activist investing styles. The portfolio was constructed to outperform in down markets and perform well [but likely under-perform] in very strong markets.  

Warren sought protection from weak markets by investing in uncorrelated strategies and focusing on bargain purchases. While the portfolio was unconventional when compared to the investment funds of then and now, Warren deemed it more conservative given its ability to protect capital in weak markets.

Many of the events Warren invested in are typical of the hedge fund strategies of today. These were split into three broad categories and their respective weighting were determined based on each categories level of attractiveness. Buffett named them the 'Generals', the 'Work-Outs', and the 'Controls'.

The 'Generals' consisted of generally undervalued securities where there was nothing to say about corporate policies and no timetable as to when the undervaluation would correct itself. They were bought primarily on quantitative factors [but with considerable attention to qualitative factors] with a margin of safety, a diversity of holdings and a 'bargain price' substantially below what careful analysis indicated value to a private owner to be. These securities would be sold at some level between what they were purchased at and what was regarded as fair value to a private owner. Warren sought good management, a decent industry and 'ferment' in a previously dormant management or stockholder group. While being most correlated with the stock market this portion of the portfolio was expected to achieve a satisfactory margin over the Dow over the years. Warren expected this category to be the star performer in a strongly advancing market.

The second category consisted of 'Work-Outs'. These strategies are typical of 'event' hedge funds today and include spin-offs, mergers, liquidations, sell-outs and re-organisation trades. These securities were purchased after company announcements. As the share prices depended on corporate action the timing of the return could be predicted. The attraction of this category was downside protection [most of the time] from falling markets, a big edge. The category was expected to be a drag on performance during bull markets. Despite the gross profits in each 'work-out' being quite small, the predictability coupled with a short holding period, produced quite decent annual rates of return with more steady absolute profits from year to year than the 'Generals'. Like modern hedge funds Warren used borrowed money to offset a portion of the 'work-out' portfolio. On a long term basis, Warren expected the 'work-outs' to achieve the same sort of margin over the Dow as attained by the 'generals'.  

The final category were 'Control' situations where Warren either controlled the company or took a very large position and attempted to influence policies of the company. This is akin to today's activist/private equity investors. Positions tended to develop from the 'generals' purchases unless a sizeable block of stock was purchased. Warren preferred to be passive unless an active role was considered necessary to optimise the employment of capital. This may have involved strengthening management, re-directing the utilisation of capital or effecting a sale or merger. When building stakes in 'control' situations the prices tended to be correlated with the stock market but once a position was built they tended to act more like the 'work-out' portfolio. Once control was achieved the value of the investment was determined by the value of the enterprise, not the market. The asset value was far less volatile than the stock market which provided downside protection in weak markets.  

In the early days, Warren remained focused on avoiding the permanent loss of capital and sticking with businesses he knew that could be bought at a significant discount to what a private owner may pay for the whole business. The 'Control' situations and 'Work-outs' provided the means to insulate the portfolio against market sell-offs. 

In 1969 Buffett announced his retirement from the partnership and returned funds and proportional interests in Berkshire Hathaway to the investment partners. The partnership had delivered an astonishing annual compounded return of 31.6%pa between 1957 and 1968 versus +9.1%pa for the Dow.

onto Berkshire Hathaway...

Berkshire Hathaway then became Warren's investment vehicle. Buffett met Munger in 1959 and they swapped investment ideas before Munger officially joined Berkshire as Chairman in 1968. While Buffett still engaged in activities such as merger arbitrage at Berkshire there was an increasing focus on 'Controls' and in particular, quality companies.

It was the acquisition of See's Candy that enlightened Munger and Buffett to realise they had under-estimated the value of quality.

“If we’d stayed with the classic Graham, the way Ben Graham did it, we would never have had the record we have,” Munger said. “And that’s because Graham wasn’t trying to do what we did.”

"See’s Candy did teach us both a wonderful lesson. And it’ll teach you a lesson if I tell you the full story. If See’s Candy had asked $100,000 more, Warren and I would’ve walked. That’s how dumb we were at that time. And one of the reasons we didn’t walk is while we were making this wonderful decision we weren’t going to pay a dime more, Ira Marshall said to us, “You guys are crazy. There are some things you should pay up for,” quality of business — quality, and so forth. “You’re underestimating quality.” Well, Warren and I instead of behaving the way they do in a lot of places, we listened to the criticism. We changed our mind." Charlie Munger

At See's Candy, Munger and Buffett recognised the enormous value of pricing power. Munger convinced Buffett it was better to pay a higher price for a great business than a cheap price for an average or poor business. Buffett expanded on his evolution at the 2003 Berkshire meeting:

"There was not a strong, bright red line of demarcation where we went from cigar butts to wonderful companies. But we moved in that direction, occasionally moved back, because there is money made in cigar butts. But overall, we’ve kept moving in the direction of better and better companies, and now we’ve got a collection of wonderful companies." Warren Buffett

At Berkshire, Munger and Buffett honed their investment skills. Peter Kaufman, in his excellent book 'Poor Charlie's Almanac' notes ‘Charlie's approach to investing is quite different from the more rudimentary systems used by most investors. Instead of making a superficial stand alone assessment of a company's financial information, Charlie conducts a comprehensive analysis of both the internal workings of the investment candidate as well as the larger, integrated "ecosystem" in which it operates. He calls the tools he uses to conduct this review 'Multiple Mental Models'. They borrow from and neatly stitch together the analytical tools, methods, and formulas from such traditional disciplines as history, psychology, physiology, mathematics, engineering, biology, physics, chemistry, statistics, economics and so on’.

Munger and Buffett sought businesses where a combination of factors could lead to extraordinary results, or as Munger called them, ‘Lollapalooza Effects’.  

The investment in Coke is a great example. Buffett paid a c25X price-earnings multiple for the last piece of Coke he bought. But Buffett and Munger recognised the enormous potential in the business. They started to focus more on a company's moat to protect the businesses economics, a company's ability to raises prices without hurting sales, the ability to re-invest incremental capital at very high rates of return, the huge operating leverage in the business, the large runway for global sales, the economies of scale from a massive distribution business and customer footprint [ie advertising] and the psychological factors that influence a company's customers decision to purchase and how these can be strengthened and reinforced. They also focused on the skill of management in deploying capital. This was the ultimate type of business.  

As Berkshire grew, it's range of investment opportunities like Coke became more limited. At Berkshire’s AGM in 2016 Munger noted they had to revert to Plan B.

More recently Berkshire has acquired far more capital intensive business like the railway business, Burlington Northern Santa Fe. While still a monopoly type of asset, the asset is far more capital intensive than a typical Buffett investment. Buffett has also invested in more mature businesses like Heinz with Brazilian investor 3G who has a reputation for streamlining businesses and getting them re-focused on growth.

It's no doubt Munger and Buffett would love to be able to outlay large licks of capital in attractive businesses like Coke was at the time of acquisition. Given their distaste for technology they have avoided the likes of Google, Ebay and Facebook. Outside of the technology angle these latter businesses would have ticked off a lot of the mental models that Munger loves .. winner-takes-all, first-mover-advantage, network effects, strong and growing moats, high return on incremental capital and economies of scale.

The greatest investing duo of the last century have evolved through the decades. They still focus on value yet their analysis of that value has evolved and improved. They have profressed their skills to better capture the power of compounding. And they are still evolving.

For further reading I highly recommend reading Buffett's Partnership letters, The Berkshire Hathaway annual letters and Poor Charlie's Almanac.  The recent lecture at UCA by Mohnish Pabrai on Berkshire's See's Candy/Coke investment is also excellent.

The Seven Deadly Sins of Portfolio Management

"Seven deadly sins, seven ways to die"

I read a great quote by Zeke Ashton of Centaur Capital on how funds blow up: 

“In almost every case of catastrophic failure that we’ve observed, we believe the root cause can ultimately be boiled down to one or a combination of just five factors. The five factors are 1) leverage 2) excessive concentration 3) excessive correlation 4) illiquidity and 5) capital flight.” Zeke Ashton

Most investors start the investment process by looking up. The objective: make money. Identify those stocks which can go up a lot and fill the portfolio with them. They focus on the upside. Very few investors start out by looking down. Instead they should be asking, “What could go wrong? What downside protection do the stocks provide? What happens if the expected scenarios fail to materialise? Are there existential risks?”

Charlie Munger has long advised "inverting" problems. As a portfolio manager, instead of first asking, "How can I make money?", ask, "How can I avoid that which loses money?" By ensuring individual stocks in the portfolio and the portfolio of stocks together minimise the risk of permanent capital impairment [aka the real risk of investing], you’ll be well on your way to investment success.

Below, I’ve outlined my observations of the key factors that blow-up funds, the ‘Seven Deadly Sins of Portfolio Management’ [I've added two more of my own]. Ordinarily it's a combination of these factors that get fund managers into trouble.

Sin 1 - Excessive Leverage

Remember leverage gives someone else the right to say when the game is over. Too much leverage at the portfolio level and/or in the companies that you own can lead to the permanent loss of capital. Within a long/short portfolio, high gross exposure [even when net exposure is low] can impair capital quickly if prices diverge the wrong way. For these reasons, the Investment Masters limit leverage and avoid companies with excessive corporate debt.

Leverage can also come in the form of derivative exposure or shorts. Both can provide unlimited downside, effectively wrong-way asymmetric bets. A telling example were the hedge funds that shorted Volkswagen in 2008. They learnt the hard way the asymmetrical danger of shorting. For a moment Volkswagen became the world’s most valuable company and a new term entered the investment lexicon, ‘getting Volkwagened’. Esoteric strategies using derivative structures can create unintended risks when unexpected circumstances arise. The normal distribution curves assumed in investment models can be upended by tail events.

‘Volkwagened’ Source: Bloomberg

Sin 2 - Excessive Concentration

Mistakes in investing are inevitable given the magnitude of variables involved and imperfect information. Having too much exposure to one stock or sector can be costly. Large positions can become illiquid and if they become publicly known, may attract predatory activity. The Investment Masters tend to limit their position sizes [even more so for shorts] to minimise this risk.

Sin 3 - Excessive Correlation

On occasion, stocks may become correlated and move in the same direction, offsetting the benefits of diversification. Correlations can "go to 1" in difficult market conditions. Things you expect to be uncorrelated may become correlated due to crowding, index implications, money flows, economic factors or geographic/geopolitical events. There is little protection in a bear market outside of short positions and cash. Investment Masters tend to seek diversification, limit sector exposure, hold cash and constantly consider and manage the potential correlation risks in the portfolio.  

Sin 4 - Illiquidity

Illiquidity hurts when an investment thesis changes and/or the portfolio manager needs cash and wishes to exit a position. At times, there may be no market to sell into. If investors can remove capital from a fund at any time this can create a liquidity crunch and a portfolio manager may need to sell assets that are ‘saleable,’ as opposed to those they would prefer to sell. This can lead to further portfolio concentration, further losses, and capital flight. The Investment Masters monitor portfolio liquidity and manage position sizes according to stock liquidity, overall portfolio liquidity and their mandate’s redemption criteria.

Sin 5 - Capital Flight

Capital flight occurs when investors demand their money back at the same time, ordinarily coinciding with weak markets and lower stock prices. Selling a stock at the lows results in the permanent loss of capital. Howard Marks often says ‘the cardinal sin of investing is selling the lows.’ It's even more risky when positions are illiquid. A negative feedback loop can develop where selling stocks to fund redemptions creates further losses and subsequent redemptions. The Investment Masters tend to seek like-minded investors who understand the investment process, have longer time horizons and/or seek more permanent sources of capital.

Sin 6 - High Flyers

When expensive stocks de-rate or a stock market bubble bursts, the result tends to be a permanent impairment of capital. For example, a portfolio loaded with tech stocks at the height of the Nasdaq boom in 2000 or in the ‘Nifty-Fifty’ stocks in the late 1960's ended in significant losses for investors when each bubble burst. The Investment Masters tend to adopt conservative forecasts and avoid paying excessive multiples for stocks unsupported by intrinsic value.

Sin 7  - Fraud

Fraudulent acts by investment managers or a company can be disastrous, a’la Bernie Madoff’s ponzi scheme and Enron’s accounting scandal. Ensuring you really understand how the businesses or funds you own operate and by analysing the long term track record of management will go a long way to avoid these problems. The fact the Investment Masters "eat their own cooking" helps align a managers interest with co-investors.

Summary

Thinking about how a portfolio is structured with regard to the ‘Seven Sins’ is a useful starting point. Almost every fund that has blown-up, and will blow-up in the future, will have one or more of these attributes.  

Portfolio management is a skill that requires a broader skillset than picking a bunch of stocks you like. It requires considered thinking. Each and every stock and it's respective size, valuation, riskiness, liquidity, cross-correlation, complexity etc must be considered in the context of the whole portfolio. Furthermore, having like-minded investors who understand your investment process and the nature and volatility of the likely return profile is also critical.

And choosing passive products is no panacea to avoiding these sins. Many index funds and ETF’s have excessive exposure to certain sectors and/or expensive stocks; they won’t be immune to capital flight and illiquidity in weak markets. You don't avoid these risks by being a passive investor. 

Remember, successful investing starts by not losing. Indulge in the ‘Seven Sins’ at your peril.

COMPOUNDING SHORT STORIES - A KING, COLUMBUS and INDIANS

Compounding really is the magic of investing. To be a successful investor you only have to do two things .. don't lose money and compound capital at a reasonable rate of return.

The Investment Masters understand that losing money inhibits the power of compounding and that is why they focus on avoiding the permanent loss of capital as opposed to beating an index.

Below are some of my favourite excerpts on the power of compounding. The story of the 'Peasant and the King' comes from the book 'Classics - An Investors Anthology' while the story of Columbus, the Mona Lisa and the Manhattan Indians come from Warren Buffett's early partnership letters. The final short extract comes from a 2011 letter from Jeremy Grantham.

The Peasant and the King ['Classics - An Investors Anthology']

And then there was the king who held a chess tournament among the peasants- I may have this story a little wrong, but the point holds- and asked the winner what he wanted as his prize. The peasant, in apparent humility, asked only that a single kernel of wheat be placed for him on the first square of his chessboard, two kernels on the second, four on the third-and so forth. The king fell for it and had to import grain from Argentina for the next 700 years. Eighteen and a half million trillion kernels [18,500,000,000,000,000,000] or enough, if each kernel is a quarter inch long, to stretch to the sun and back 391,320 times That was nothing more than one kernel's compounding at 100 percent per square for 64 squares. 

[This story really does highlight the absurdity of achieving 100% returns a year. Assume a 20 year old lives to 84 years [equivalent to 64 chess board squares of investing years] and starts with $1. Doubling his stake every year the old man would end up with $18,500,000,000,000,000,000]

Columbus's Journey - The Joys of Compounding [Buffett Partnership Letter 1962]

I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter's rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that's $2 trillion for those of you who are not government statisticians) by 1962. Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living a long time, or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point.

The following table indicates the compounded value of $100,000 at 5%, 10% and 15% for 10, 20 and 30 years. It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.

Mona Lisa - Joys of Compounding - Part II [Buffett Partnership Letter 1963]

Now to the pulse-quickening portion of our essay. Last year, in order to drive home the point on compounding, I took a pot shot at Queen Isabella and her financial advisors. You will remember they were euchred into such an obviously low-compound situation as the discovery of a new hemisphere.

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

If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000.00. That's $1 quadrillion or over 3,000 times the present national debt, all from 6%. I trust this will end all discussion in our household about any purchase or paintings qualifying as an investment.

However, as I pointed out last year, there are other morals to be drawn here. One is the wisdom of living a long time. The other impressive factor is the swing produced by relatively small changes in the rate of compound. Below are shown the gains from $100,000 compounded at various rates:

It is obvious that a variation of merely a few percentage points has an enormous effect on the success of a compounding (investment) program. It is also obvious that this effect mushrooms as the period lengthens. If, over a meaningful period of time, Buffett Partnership can achieve an edge of even a modest number of percentage points over the major investment media, its function will be fulfilled.

Some of you may be downcast because I have not included in the above table the rate of 22.3% mentioned on page 3. This rate, of course, is before income taxes which are paid directly by you --not the Partnership. Even excluding this factor, such a calculation would only prove the absurdity of the idea of compounding at very high rates -- even with initially modest sums. My opinion is that the Dow is quite unlikely to compound for any important length of time at the rate it has during the past seven years and, as mentioned earlier, I believe our margin over the Dow cannot be maintained at its level to date. The product of these assumptions would be a materially lower average rate of compound for BPL in the future than the rate achieved to date. Injecting a minus 30% year (which is going to happen from time to time) into our tabulation of actual results to date, with, say, a corresponding minus 40% for the Dow brings both the figures on the Dow and BPL more in line with longer range possibilities. As the compounding table above suggests, such a lowered rate can still provide highly satisfactory long term investment results.

Manhattan Indians - The Joys of Compounding Part III [Buffet Partnership 1964]

Readers of our early annual letters registered discontent at a mere recital of contemporary investment experience, but instead hungered for the intellectual stimulation that only could be provided by a depth study of investment strategy spanning the centuries. Hence, this section.

Our last two excursions into the mythology of financial expertise have revealed that purportedly shrewd investments by Isabella (backing the voyage of Columbus) and Francis I (original purchase of Mona Lisa) bordered on fiscal lunacy. Apologists for these parties have presented an array of sentimental trivia. Through it all, our compounding tables have not been dented by attack.

Nevertheless, one criticism has stung a bit. The charge has been made that this column has acquired a negative tone with only the financial incompetents of history receiving comment. We have been challenged to record on these pages a story of financial perspicacity which will be a bench mark of brilliance down through the ages.

One story stands out. This, of course, is the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12 1/2 billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6 1/2% return (The tribal mutual fund representative would have promised them this.) to obtain the last laugh on Minuit. At 6 1/2%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion.

So much for that.

Some of you may view your investment policies on a shorter term basis. For your convenience, we include our usual table indicating the gains from compounding $100,000 at various rates:

This table indicates the financial advantages of:

(1) A long life (in the erudite vocabulary of the financial sophisticate this is referred to as the Methusalah Technique)

(2) A high compound rate

(3) A combination of both (especially recommended by this author)

To be observed are the enormous benefits produced by relatively small gains in the annual earnings rate. This explains our attitude which while hopeful of achieving a striking margin of superiority over average investment results, nevertheless, regards every percentage point of investment return above average as having real meaning.

Finally, an extract from Jeremy Grantham's 2011 Letter..

I briefly referred to our lack of numeracy as a species, and I would like to look at one aspect of this in greater detail: our inability to understand and internalize the effects of compound growth.

This incapacity has played a large role in our willingness to ignore the effects of our compounding growth in demand on limited resources. Four years ago I was talking to a group of super quants, mostly PhDs in mathematics, about finance and the environment. I used the growth rate of the global economy back then – 4.5% for two years, back to back – and I argued that it was the growth rate to which we now aspired. To point to the ludicrous unsustainability of this compound growth I suggested that we imagine the Ancient Egyptians whose gods, pharaohs, language, and general culture lasted for well over 3,000 years. Starting with only a cubic meter of physical possessions (to make calculations easy), I asked how much physical wealth they would have had 3,000 years later at 4.5% compounded growth.

Now, these were trained mathematicians, so I teased them: “Come on, make a guess. Internalize the general idea. You know it’s a very big number.” And the answers came back: “Miles deep around the planet,” “No, it’s much bigger than that, from here to the moon.” Big quantities to be sure, but no one came close. In fact, not one of these potential experts came within one billionth of 1% of the actual number, which is approximately 10^57, a number so vast that it could not be squeezed into a billion of our Solar Systems. Go on, check it. If trained mathematicians get it so wrong, how can an ordinary specimen of Homo Sapiens have a clue?

Well, he doesn’t. So, I then went on. “Let’s try 1% compound growth in either their wealth or their population,” (for comparison, 1% since Malthus’ time is less than the population growth in England). In 3,000 years the original population of Egypt – let’s say 3 million – would have been multiplied 9 trillion times! There would be nowhere to park the people, let alone the wealth. Even at a lowly 0.1% compound growth, their population or wealth would have multiplied by 20 times, or about 10 times more than actually happened. And this 0.1% rate is probably the highest compound growth that could be maintained for a few thousand years, and even that rate would sometimes break the system.

The bottom line really, though, is that no compound growth can be sustainable. Yet, how far this reality is from the way we live today, with our unrealistic levels of expectations and, above all, the optimistic outcomes that are simply assumed by our leaders. Now no one, in round numbers, wants to buy into the implication that we must rescale our collective growth ambitions.

STUDY HISTORY

"History never repeats itself but it rhymes." Mark Twain

Studying history can provide an enormous edge in investing. While history never exactly repeats itself I have witnessed plenty of examples over the last twenty plus years that leave me convinced that a lot of what happens we've seen before. Hopefully this post will highlight that there is never much new in investing.

One of the most memorable examples for me was just ahead of the Financial Crisis when the credit markets had slammed shut in late 2007 after the initial Bear Stearns hedge fund liquidity problems in June was followed by a run on the UK lender Northern Rock in September. Northern Rock was subsequently bailed out by the UK government. I was in charge of the Hedge Fund advisory business at a global investment bank which had just IPO'd a 'shadow banking' home lender whose funding relied on the wholesale credit markets. While the credit markets were effectively closed, the equity market did not peak for another month [See chart below]. At the time I was reading about Jessie Livermore. This paragraph about Jessie Livermore stood out to me at the time..

"While his tape-reading skills were still important, they were not as important as studying the fundamentals of each company and the credit conditions of the stock market and the economy. His first successful “raid” on the stock market based on his sound, fundamental studies occurred during the Panic of 1907. As credit conditions tightened and as a number of businesses and Wall Street brokerages went bankrupt during the summer, Livermore could sense that something was wrong – despite the hopes of the public evident in the still-rising stock market. Sooner or later, Livermore concluded, there will be a huge break of epic proportions. Livermore continued to establish his short positions, and by October, the decline of the stock market started accelerating with the collapse of the Knickerbocker Trust in New York City and Westinghouse Electric. J.P. Morgan eventually stepped in to avert the collapse of the banking system and the New York Stock Exchange, but only after Livermore managed to make more than one million dollars by shorting the most popular stocks (and covering on a plea from J.P. Morgan himself) in the stock market."

Keen to learn more about this era, I picked up the book 'The House of Morgan' by Ron Chenow which chronicled the history of J.P Morgan. A few chapters provided an excellent summary of the booming stock market of the late 1920's ahead of the ensuing crash and great depression.

During the 2009 Financial Crisis I wrote a note to my clients titled, ‘How Will We Look Back on This Crisis’. The note was a compilation of quotes from this 1990 book and while they referred to the 1920's and 1930's they were just as apt to the modern times. Consider the following ...

"Prophets of the age espoused an ideology of endless prosperity and talked of a new economic era."

The Fed's Greenspan and others, ahead of the Financial Crisis, were espousing the 'Great Moderation.' Greenspan presided over nearly two decades of prosperity and the lavish praise on the economy reflected the belief that Greenspan's deft changes in interest rates and crisis interventions had stabilised the economy without rekindling inflation.

In his book 'The Most Important Thing,' Howard Marks noted, "On November 15, 1996 The Wall Street Journal reported on a growing consensus, ‘From boardrooms to living rooms and from government offices to trading floors, a new consensus is emerging; The big, bad business cycle has been tamed.’"

"For many pundits, the sheer abundance of cash precluded any crash."

"There is a vast amount of money awaiting investment. Thousands of traders have been waiting for an opportunity to buy stocks on just such a break as has occurred over the last several weeks. The excess cash was viewed as a sign of wealth, not an omen of dwindling opportunities for productive investment."

Greenspan cut interest rates after the tech crash and left rates low which fuelled a rally in asset prices.

"Riding this cash boom, the American financial services industry grew explosively."

The American financial system also grew explosively ahead of the Financial Crisis. During the peak of the housing boom, in October 2007, the S&P Financials sector reached 20.1% of the S&P 500. Not even two years later in March 2009, that weighting had collapsed to 8.9% - the same level of twenty year’s prior. In tandem, the shadow banking market had expanded rapidly.

"There was a fad for foreign bonds, especially from Latin America, with small investors assured of their safety. The pitfalls were not exposed until later on, when it became known that Wall Street banks had taken their bad Latin American debt and packaged it in bonds that were sold through their securities affiliates."

Let's rephrase that … "There was a fad for mortgage backed bonds, especially from sub-prime borrowers with global investors assured of their safety. The pitfalls were not exposed until later on, when it became known that Wall Street banks had taken their bad mortgage debt and packaged it in bonds that were sold through their securities affiliates."

"The 1920s were also a time of manic deal making. As Otto Kahn recalled, there was a perfect mania of everybody trying to buy everybody else's property .. new organisations sprung up. Money was so easy to get. The public was so eager to buy equities and pieces of paper that money was .. pressed upon domestic corporations as upon foreign governments."

Let's rephrase that … "The years leading into the Financial Crisis were also a time of manic deal making. There was a perfect mania of everybody trying to buy everybody else's property .. new organisations sprung up. Money was so easy to get. The private equity funds were so eager to buy equities and pieces of paper that money was .. pressed upon domestic corporations as upon foreign governments."

"Wall Street was being swept by new forms of leveraging… many brokerage houses, including Goldman Sachs, introduced leveraged mutual funds, called "investment trusts". A second favourite device was the holding company. Holding companies would take over many small operating companies and use their dividends to pay off their bond holders, who had financed the takeovers in the first place. This permitted an infinite chain of acquisitions."

Wall Street was awash with new forms of leveraging before the Financial Crisis. RMBS', CDO's, CDS, SIV's, PIK loans and many other types of credit derivatives were growing exponentially. In April 2007, The Economist noted "According to the Bank for International Settlements, the nominal amount of credit-default swaps had reached $20 trillion by June last year. With volumes almost doubling every year since 2000, some reckon the CDS market will soon be worth more than $30 trillion. The investment banks and private equity firms were up to their eyeballs in debt fuelled acquisitions.”

"As masters of leverage, the Van Sweringens used each new purchase as collateral for the next. Their holding companies took control of other holding companies in an endless hall of mirrors, all supported by little cash but powerful Morgan connections. By 1929, the Van Sweringen railroads ruled America's fifth largest railroad system atop a forty story Cleveland tower and controlled trackage equal in length to all Britains railroads."

This was close to home for me. It sounded very much like Babcock & Brown [which ultimately went bust], not to mention the investment banks and private equity firms.

"Leffingwell subscribed to the cheap-money theory of the crash, that is he blamed excessively low interest rates for the speculation in stock. In 1927, Monty Norman had visited New York and asked Ben Strong [Governor of Federal Reserve] for lower interest rates to take pressure off the pound. Strong obliged by lowering the discount rate. Leffingwell believed this had triggered the stock market boom. In early March 1929, when Leffingwell heard reports that Monty was getting 'panicky' about frothy condition on Wall Street he impatiently told Lamont "Monty and Ben have sowed the wind. I expect we shall have to reap the whirlwind .. I think we are going to have a world credit crisis"

Many observers also blamed The Fed's Greenspan for keeping rates artificially low after the tech bubble for inflating the housing bubble and booming stock market. It too ended in a world credit crisis.

"Were the increasing number of stock mergers grounds for concern? And should the federal government take action to stop speculation on Wall Street."

Mergers and acquisitions surged in the year before the Financial Crisis, all funded with cheap debt and lax lending covenants. Ahead of the crisis, the Fed's Greenspan was confident the stability and structure of the financial markets had improved and it was not the Fed's job to address asset bubbles.

"Both the market and public faith in bankers were collapsing."

The public at large and the publics faith in bankers collapsed after Bear Stearns was bailed out, Lehman went bust and the Fed had to bail out the banking system at large.

"Harrison [took over the Fed in 1928 after Strong's death] lowered interest rates and pumped in billions of dollars in credit to buoy banks with heavy loans to brokers."

Ben Bernanke, Harrison's equivalent, also aggressively lowered interest rates and the US Treasury pumped more than a trillion dollars into the financial companies via TARP, swap lines and other measures in an attempt to stabilise the system. 

"He bought up to $100 million in government bonds per day and made sure Wall Street banks had adequate reserves with which to deal with the emergency. In scale and sophistication, his post crash actions made Pierpont's in 1907 look antediluvian in comparison, for he expanded credit as needed. Harrison confirmed the principle of government responsibility in financial panics."

Bernanke also expanded the Fed's balance sheet and provided credit to financial institutions. He expanded the collateral accepted and his actions were on an unprecedented scale. On numerous occasions in 2008 and 2009, the Federal Reserve Board invoked emergency authority to authorise new broad-based programs and financial assistance to individual institutions to stabilise financial markets. Loans outstanding for the emergency programs peaked at more than $1 trillion in late 2008.

"The stereotype of bankers as conservative, careful, prudent individuals was shattered in 1929."

Certainly bankers reputations were decimated following the Financial Crisis.

"The consequences of such an economic debauch are inevitable," said the Philadelphia Fed Governor. "Can they be corrected and removed by cheap money? We do not believe they can." .. That fall Hoover complained to Lamont about bear raids, short selling and other unpatriotic assaults against national pride. The following year would be the worst in stock market history."

The Fed also attempted to resolve the crisis with cheap money. In 2008 the US's SEC banned short selling of financial companies to ‘protect the integrity and quality of the securities market and strengthen investor confidence.’ The U.K. FSA took similar action.

"The House of Morgan arranged a $10m line of credit. Under Whitney's tutelage, the old Kidder, Peabody was folded."

On Friday March 14, 2008, Bear Stearns secured a 28-day loan from JPMorgan and thought it would receive access to the New York Federal Reserve’s discount window for additional funding. Those hopes were dashed before the weekend was out though, and by that Sunday the firm had been sold to JPMorgan for $2, a price ultimately raised to $10 two weeks later.

"A proposed rescue plan for the Bank of the United States got a cool reception on Wall Street, even after Leutenant Governor Herbert H. Lehman, the state banking authorities, and the new York Fed all pleaded for it. The regulators wanted to merge the Bank of the United States with three other banks, backed by a $30 million loan from Wall Street Banks."

"At an emotional meeting, Joseph A Broderick, the state banking chief warned that if the bankers rejected the rescue plan, it might drag down ten other banks… As the Wall Street bankers sat stony-faced Broderick reminded them how they had just rescued Kidder, Peabody and how they had banded together years before to save Guarantee Trust."

"But they refused to save the Jewish bank, pulling out of their $30 million commitment at the last minute. "I asked if their decision to drop the plan was final", Broderick recalled. "They told me it was. Then I warned them they were making a colossal mistake in the banking history of New York." The biggest bank failure in American history, the Bank of the United States bankruptcy fed a psychology of fear that already gripped depositors across the country."

Let's rephrase that … "A proposed rescue plan for Lehman Brothers got a cool reception on Wall Street, even after Henry Paulsen, the US Treasury Secretary , and the New York Fed all pleaded for it. The regulators wanted to merge Lehman Brothers with Barclays Bank or Bank of America."

"At an emotional meeting, Timothy Geithner, the NY Fed chief warned that if the bankers rejected the rescue plan, it might drag down ten other banks… As the Wall Street bankers sat stony-faced Geithner reminded them how they had just rescued Bear Stearns and how they had banded together years before to save Long Term Capital Management."

"But the UK regulator refused to approve the deal with Barclays and save the bank at the last minute. ‘I asked if their decision to drop the plan was final,’ Geithner recalled. ‘They told me it was. Then I warned them they were making a colossal mistake in the banking history of New York.’ The biggest bank failure in American history, Lehman Brothers bankruptcy fed a psychology of fear that already gripped depositors across the country."

".. The banks failure shook confidence across America, It was a failure that could have been easily avoided by the proposed merger."

The failure of Lehman Brothers shook confidence across America.

"The Morgan-Hoover feud over debt was mild compared with their debate over short selling on Wall Street.. Hoover now shared the average American's view of Wall Street as a giant casino rigged by professionals."

"Now the crisis shifted to London, as investors traced financial ties between Germany and England. During the summer of 1931, investors dumped sterling in massive amounts."

"Prime Minister Ramsay MacDonald and Philip Snowden knew the pound couldn't be defended without a foreign loan."

"Foreign bankers insisted that he close the budget gap as the pre-condition for a loan. But any such austerity talk bought outcries from Labour ministers, who saw it as a betrayal of their followers to appease rich bankers".

Similarly, the crisis in the US travelled to Europe where the Euro came under pressure as a result of the PIGS [Portugal, Italy, Greece and Spain] economic turmoil and their inability to pay off their debts. The German government demanded austerity measures as a condition of a bail-out.

The Global Financial Crisis and the early 1920's and 1930's had strikingly similar conditions. Many of the issues that arose had been experienced before. Most of what occurred was not new. The packaging of sub-prime loans ahead of the crisis was a replay of banks activities in the late 1920's. Once again, from the 'House of Morgan'..

"Pecora also studied the operations of the National City Company whose 1900 salesmen had unloaded risky Latin American bonds on the masses. It emerged that in touting bonds from Brazil, Peru, Chile and Cuba to investors, the bank hushed up internal reports on problems in these countries. After bank examiners criticised sugar loans made by the parent bank, the securities affiliates sold them as bonds to investors.”

In the Financial Crisis the Investment Banks were also charged with unloading poor quality loans on unsuspecting buyers. The rating agencies aided and abetted this process by placing AAA ratings on some of the sub-prime loan tranches. That too had happened before in the junk bond crisis of the 1980's. In Seth Klarman's 1991 book, 'Margin of Safety' he notes..

"One of the last junk-bond-market innovations was the collateralised bond obligation [CBO]."

"What attracted underwriters as well as investors to junk-bond CBO's was that the ratings agencies, in a very accommodating decision, gave the senior tranche, usually about 75 percent of the total issue, an investment grade rating."

"The existence of CBO's was predicated on the receipt of the investment-grade credit rating on the senior tranche. Greedy institutional buyers of the senior tranche earned a handful of extra basis points above the yield on other investment-grade securities.”

"The rating agencies performed studies showing the investment-grade rating was warranted. Predictably these studies used historical default-rate analysis and neglected to consider the implications of either a prolonged economic downturn or a credit crunch that might virtually eliminate re-financings. Under such circumstances, a great many junk bonds would default; even the senior tranche of a CBO could experience significant capital losses. In other words, a pile of junk is still junk no matter how you stack it."

History repeats, it's deja vu all over again. Spending the time to understand the history of financial markets will help you avoid some of the pitfalls investors often fall into. Some of my favourite books that touch on the history of the markets include The Davis Dynasty [1930's onwards], A Decade of Delusions [Tech Crash and Financial Crisis], Too Big to Fail [Financial Crisis] and the House of Morgan [great chapters on the 1920's and 1930's]. 

Edward Chancellor in 'Capital Returns' noted, ‘It's not true, however, to say nobody in the financial world saw it [the Financial Crisis] coming. On the contrary, in the years prior to 2008 many serious investors and strategists were alert to the dangers posed by strong credit growth, dubious financial innovation and the appearance of various housing bubbles around the world.’ Seth Klarman noted in 2008, ‘People say that what has happened recently was completely unpredictable and god knows how many sigma event, but that's just not right. This was completely predictable and I could cite eight or ten people who in one way or another predicted it.’ I concur. In the Baupost’s 2005 Annual Letter, Klarman noted..

"Finally, as Northern Trust’s Paul Kasriel recently highlighted in the New York Times, household borrowing is out of control, and this debt is clearly propping up the U.S. economy. By way of example, in the third quarter of 2005, households spent a record annual rate of $531 billion more than their after-tax earnings. Historically, consumers regularly earned more than they spent; the recent binge in borrowing for consumption is truly unprecedented. It has (thus far) resulted in consumer spending at a record high 76% share of GDP.

"Consumers are using their increasingly valuable homes as quasi-ATMs, extracting $280 billion of cash through home equity borrowings in the second quarter of 2005 alone. This is a surprisingly new phenomenon; in the last three decades of the 1900s, there was virtually no net home equity extraction by consumers. While we cannot predict how these excesses will play out, it seems clear that such trends cannot continue indefinitely, and that a restoration of fiscal sanity will bring with it wrenching, largely unexpected, and painful adjustments.

The world could well be setting up for considerable upheaval and with it an avalanche of opportunity. As we have said, nearly every investment professional is fully invested, and many are leveraged. With massive trade imbalances and huge U.S. government budget deficits, tremendous leverage everywhere you look, massive and unanalysable exposures to untested products like credit derivatives, still low interest rates, rising inflation, a housing bubble that is starting to burst, and record and unprecedentedly low quality junk bond issuance, there appears to be little, if any, margin of safety in the global financial system."

If you remain in doubt I suggest you read Frank Martin's excellent book. ‘A Decade of Delusions’ which contain his annual letters from before and during the crisis. He laid out a prescient roadmap of the carnage that was to become the Global Financial Crisis. The 2005 and 2006 annual letters include the following headers “The Perfect Storm?,” “The Blossoming of the Financial Economy: The Cataclysm in the Creation of Credit,” “Bubbles Are Indigenous to the Financial Economy,” and “If Housing Prices Roll Over.” Chapter 10 (2007 MCM annual report excerpts) included a draft letter to clients in 2007 proposing a strategy to buy put options on selected investment banks, as well as subtitles that included, “Edging toward the Precipice” and “Credit-Default Swap Alchemy: Transmuting Junk into Gold.”

ROLL UP ROLL UP - CIRCUS TRICKS

A roll-up is effectively an arbitrage play.  An acquisitive listed company buys another company [usually unlisted, but not necessarily] on a lower multiple which ordinarily is accretive to the acquirers earnings.  The market/analyst community rewards the acquisitive company with high future earnings forecasts and a higher multiple to reflect this higher growth. 

The acquisitive company is often consolidating a fragmented industry and the stock market puts a premium multiple on the company which allows the acquisitive company to raise equity or debt to continue to buy other assets [ie roll-up the industry] and drive earnings.  It becomes a circular function.  It all works well in theory until it doesn't.

Over the years I've seen a lot of roll-ups blow up and usually there are a number of common factors involved.  

David Einhorn described the process in his book 'Fooling Some of the People All of the Time' when discussing his short position in 'Century Business Services (CBIZ), a 'roll-up' of accounting service firms with lousy accounting itself'  ...

"In a roll-up, a consolidator typically buys small, private companies at a lower multiple than the consolidator receives in public markets.  Every acquisition is accretive to earnings, which drives the stock price higher and enables the consolidator to use its currency to do more acquisitions of private companies in a never ending virtuous circle."

The discussion on roll-ups is well explained by George Soros's REFLEXIVITY theory in his book the Alchemy of Finance [see The Case for Mortgage Trusts - pg61]. In discussing the roll-up trend in mortgage trusts Soros notes..

"The conventional method of security analysis is to try and predict the future course of earnings and then to estimate the price investors may be willing to pay for those earnings.  This method is inappropriate to the analysis of mortgage trusts because the price investors are willing to pay for shares is an important factor in determining the future course of earnings."

The key difference between a roll-up and a normal corporate is that the roll-up requires an ongoing premium market multiple to continue to drive growth and maintain that premium multiple. Plenty of analysts overlook this FACT.   

Most companies earnings are not reliant on the whim of the stock market [financials/highly geared companies can be an exception]. Seth Klarman explains this with reference to George Soros's REFLEXIVITY theory in his book Margin of Safety..

"Stock price[s] can at times significantly influence the value of a businesses.  Investors must not lose sight of this possibility.  Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital.  When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability and bankruptcy."

Common Problems

Poor acquisitions - M&A is not easy and most transactions fail.  In the case of selling businesses, the vendors are in a position of power. They know the business better than the buyer.

"We have all the difficulties in perceiving the future that other acquisition minded companies do.  Like they also, we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale - a time when the business is likely to be walking 'just fine.'" Warren Buffett

Lack of Organic Growth - the roll-ups typically need acquisitions to fuel growth as pedestrian underlying growth alone will not justify the high multiple placed on the company.   When management is largely focused on acquisitions often their existing business are mis-managed and promised acquisition synergies may not materialise.

Accounting Issues - There can be questionable practices in regards to accounting of the acquired companies to boost EPS growth. While accounting earnings may look good often cash flow does not.

Law of Large Numbers - In the early days, a roll-ups acquisitions tend to represent a larger percentage of the underlying asset base so can be highly accretive. Over time, larger and larger acquisitions are required to move the dial on EPS growth as the asset base expands.  As the industry consolidates, often imitators enter the market increasing competition and the prices to be paid for further business acquisitions. Larger acquisitions tend to increase the risk profile of the company and may require bridging finance.

Debt - Roll-ups often utilise debt as an interim measure to fund acquisitions prior to equity raising. As debt levels rise risk also rises. When combined with accounting issues [ie earnings higher than cash flow] this can be a deadly combination. 

Marathon Asset Management remind us..

"When debt propels growth rates and equity returns higher, enthusiastic investors may too easily forget the dangers inherent in financial leverage."

"When conditions change, very quickly (and more often than not, very unexpectedly) debt, hitherto unnoticed takes centre stage.  Those who comfortably applauded the results of leverage in the good times then find themselves caught in a negative spiral as the process reverses."  

Fraud/Over Promotion - when management need to keep promising growth via acquisitions there can be a temptation to try and paper over underlying business issues to meet market expectations.

Overconfidence/Groupthink  - when a management team has made a string of successful acquisitions they can become overconfident. Without a thorough unbiased review of the business, a board may overlook risks involved in the acquisition process.

"Of one thing, however be certain: If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisers will come up with whatever projections are needed to justify his stance. Only in fairytales are emperors told they are naked." Warren Buffett

The end result is ordinarily an equity market de-rating of the stock.   When expectations of strong growth slow the stock price can get decimated as analysts cut their earnings forecast and investors no longer are willing to pay such a high premium. A double whammy - earnings and PE de-rate. When equity prices sink below the price of previous capital raising investors often lose support for the stock. Stocks can enter a death spiral.

Both Warren Buffett and George Soros have discussed the conglomerate roll-ups in the 1960's.  In the Alchemy of Finance, Soros noted ..

"The key to the conglomerate boom was a prevailing misconceptions among investors. Investors had come to value growth in per-share earnings and failed to discriminate about the way earnings growth was accomplished." 

Warren Buffett's 2014 Annual Letter also touched on the subject.

“In the late 1960s, I attended a meeting at which an acquisitive CEO bragged of his “bold, imaginative accounting.” Most of the analysts listening responded with approving nods, seeing themselves as having found a manager whose forecasts were certain to be met, whatever the business results might be.

 Eventually, however, the clock struck twelve, and everything turned to pumpkins and mice. Once again, it became evident that business models based on the serial issuances of overpriced shares – just like chain-letter models – most assuredly redistribute wealth, but in no way create it. Both phenomena, nevertheless, periodically blossom in our country – they are every promoter’s dream – though often they appear in a carefully-crafted disguise. The ending is always the same: Money flows from the gullible to the fraudster. And with stocks, unlike chain letters, the sums hijacked can be staggering.

At both BPL and Berkshire, we have never invested in companies that are hell-bent on issuing shares. That behaviour is one of the surest indicators of a promotion-minded management, weak accounting, a stock that is overpriced and – all too often – outright dishonesty.” 

Valeant Corporation is a more recent example of a roll-up that has been decimated.

Omega's Leon Cooperman described the issues on CNBC recently ..

“I’ve seen this movie before. The company grew as a result of a roll-up strategy.  They took a high priced stock, bought a lot of businesses, used a lot of debt.  They lost their multiple which meant their equity was not a currency for acquisition and they’ve exercised their debt option so they couldn’t put more debt on the balance sheet and do acquisitions. So the market is striving to figure out what the internal level of recurring earnings is and this companies faux pas is statements or restatement that don’t engender any confidence.”

Wally Weitz of Weitz Investment Management stated on Wealthtrack that when he asked the Valeant CEO how he managed a far-flung business the CEO responded "we tell managers 'make your numbers or we will get someone who will.'" Mr Weitz noted "When there is pressure from the top to make numbers, sometimes people succumb to that and bad things happen. Management is so important," “The Philidor deal made us wonder what other arrangements they might have."

As Warren Buffett has reminded us ..

“Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers.” 

And Marathon Asset Management note..

“An obsession with growth, combined with over-promotion, is likely to end in tears.” 

And it's not a new phenomena. Phil Fisher recognised the risks of an acquisition focused company in 1960 .. 

"There may be quite a high degree of investment risk in a company that as a matter of basic investment policy is constantly and aggressively trying to grow by acquisition.. it is my own belief that this investment risk is significantly still further increased when one of two conditions exist in a company's organisational make-up. One is when the top executive officer regularly spends a sizeable amount of his time on mergers and acquisitions. The other is when a company assigns one of its top officer group to making such matters one of his principal duties. In either event powerful figures within a company usually soon acquire a sort of psychological vested interest in completing enough mergers or acquisitions to justify the time they are spending." Phil Fisher

In a recent interview with the FT famed short seller Jim Chanos talked how he liked to find short positions in roll-ups and what he saw at Valeant ..

"We're just drawn like moths to the flame, I guess, to companies in crummy businesses that decide to tell the Street that they're actually growth companies by virtue of playing acquisition accounting games in terms of valuing the assets and/or spring-loading by having the target companies hold off business in the interim period between announcement of the deal and the closing of the deal so they look better once you fold them in. And so we love those kinds of stories, the roll-ups, or as they been deemed, the 'platform companies.’”

"Valeant is a good example. The first time I looked at this company, before we handed it to our very able pharmaceutical analyst, I immediately at a research meeting said : "this looks like Tyco." In terms of not the business itself but the frantic nature of the acquisitions, and a CEO who was just hell bent on buying companies and making them fit no matter what."

".. and again that was a gut check kind of reaction, but it was also pattern recognition, having seen these sort of things before. And having a person running a company to please Wall Street can be really problematic, and even on the first pass though you would see that with a company like Valeant, and that's why it was so exciting and why I then insisted that we spend a lot of time on it, because it just seemed to.. for a couple of us on the team who are a little bit older than the others, we saw parallels to some of the great roll-ups of the late 90s and early 2000s. So I think that was helpful for us."

"So Valeant within confines of a few different opinions at our shop looked like Tyco, Enron and WorldCom.  You're probably on the right track if you're a short seller if it reminds you of not only one of those, but three of those."

Chanos's first problem was it's way of doing business.  Cutting R&D spend at the acquired companies and raising drug prices of the newly acquired drugs to boost earnings.  Chanos believed earnings were overstated as there was no R&D spend to support future earnings as drugs don't last forever.

"So he [the Valent CEO] got Wall Street for a very short period of time to have its cake and eat it too by how he had them evaluate the company, and now I think people are beginning to see through that, of course. So a lot of these rollups, they truly have to get Wall Street to believe that two plus two equals five, for a short period of time. When in fact the way they do deals, two plus two is often 3.5."

Not everyone avoided losing money on Valeant including famed investors Bill Ackman and Sequoia Funds.  Ackman made an exception for Valeant .. From the Interim 2015 Pershing Square Holdings Report...

"We select investments in companies that meet our extremely high standards for business quality. We primarily invest in businesses that are simple, predictable, and free-cash-flow-generative with substantial barriers to competition and strong pricing power due to brands, unique assets, long-term contracts, and/or dominant market position. We vastly prefer businesses that have limited exposure to macroeconomic factors by generally avoiding companies that are highly exposed to commodity prices, material changes in interest rates, and other extrinsic factors we cannot control. We focus on large capitalization, North-American-domiciled businesses that earn the substantial majority of their profits in North America. We often hedge large non-U.S. currency exposures in the portfolio. We seek investments that trade at a discount to intrinsic value as is, and an even wider spread as optimized.

The result of this approach is a portfolio comprised of the highest quality collection of businesses that we have ever owned, managed by the strongest management teams that we have worked with, all trading at substantial discounts to intrinsic values. These businesses are generally conservatively financed, often investment grade or soon to be, generate substantial amounts of recurring free cash flow, typically don’t need access to equity capital to survive or thrive, and often return capital to shareholders through buybacks or dividends. As a result of these characteristics, the intrinsic value of the businesses we own is not particularly correlated with equity or credit market volatility.

We may make occasional exceptions to the above principles if we believe the additional risks are compensated for by greater potential profitability. For example, we own a number of highly acquisitive businesses, namely – Valeant, Platform Specialty Products and Nomad – for whom access to capital is necessary to achieve accelerated growth. Even in these cases, however, if the capital markets were to shut, their growth would slow from their current extremely high levels, but their businesses would remain profitable and cash generative. In each case, the current valuations reflect no value for these companies’ ability to make economically attractive acquisitions."

Even the world's best investors make mistakes.  So what are the lessons for investors.  Some traders [eg Soros] have profited from identifying roll-ups in the early stages of their growth/industry consolidation phase given their growth prospects and reflexivity. 

However, being on the wrong side of a roll-up can lead to the permanent loss of capital.  If you are going to buy a company reliant on acquisitions for growth watch out for the pitfalls outlined above. I'll let Buffett conclude...

"I think if you had to look at one of the primary indicators of what sort of species you’re viewing, you would see whether somebody’s issuing — if they’re issuing stock continuously, one way or another, they’ve probably got a chain letter game going on. And that does come to a bad end." Warren Buffett