Sit On Your Ass

Outperforming the market is hard. Over the last five years, it was easy. Easy if you owned just one stock. The world’s largest. You just had to buy Apple. And NOT sell it.

John Huber of Saber Capital touched on this in his annual letter:

“Over the past 5 years, with exceptions that you could probably count on two hands, Apple has outperformed the entire hedge fund industry, every one of the 10,000+ mutual funds, the passive funds at Vanguard and Blackrock, the most prestigious private equity funds, and the vast majority of venture capital funds in Silicon Valley. We’re talking about many trillions of dollars in all kinds of investment vehicles with all kinds of fees, managed by extremely smart people with unlimited research budgets and super smart employees, who all work extremely hard, and are all highly incentivized to produce great results. And Apple beat nearly every last one of them.”

When it comes to investing mistakes, most people think in terms of what’s been bought, not sold. Yet, selling a stock can be the biggest mistake there is.

“Of our most costly mistakes over the years, almost all have been sell decisions.” Chris Cerrone

“By far, the biggest mistakes I’ve made is selling stock early. As an example, we made a big investment in Tencent in 2003 and having sold that position early cost the fund twenty billion dollars.” Philippe Laffont

"The biggest mistake an investor can make is to sell a stock that goes on to rise ten-fold. It's not from owning something into bankruptcy. But that's what everyone thinks, at least judging by the questions we get from clients." Nick Sleep

"Over time, any honest investor and especially any honest value investor will tell you that their biggest mistakes were what they sold, not what they bought." Chris Davis

"The biggest mistake you can make is not failing to sell something you should have sold, it's selling something that you should have held on to.” Tom Slater

“If I’ve made one mistake in the course of managing investments it was selling really good companies too soon. Because generally, if you’ve made good investments, they will last for a long time.” Lou Simpson

“As the old saying goes: ‘it’s never wrong to take a profit’. But it is often not just wrong but the worst mistake that can be made.” James Anderson

“Selling early is the high blood pressure of the investment business. It’s a silent killer. And you know, people will always talk about the business they bought that went to zero, or the one that went down 50% or 75%. Yes, that’s bad. You want to avoid that but the business that you sold too early, that went on the compound tenfold, or 20-fold after that in my career, has been a real killer.” Peter Keefe

“Investor should be especially careful with their winners – selling too early is the most overlooked detractor from long-term outperformance.” Shad Rowe

Some of the best track records in investing have come from those investors who’ve identified great companies and ridden them. Whether it’s Li Lu, Terry Smith, Nick Train, Nick Sleep, Chuck Akre, Francois Rochon, Shad Rowe, Dan Davidowitz, Ted Weschler or Warren Buffett, they’ve chosen a different path to most investors. They view companies through a different lens and have delivered market crushing returns as a result.

Charlie Munger dubbed this approach, ‘Sit On Your Ass’ investing.

A few years ago I penned a piece titled, ‘When to Sell a Great Company?’ The conclusion was, almost never. I enjoyed a recent post by Chris Cerrone of Akre Capital titled ‘The Art of [Not] Selling’, aka ‘Sit on Your Ass’ investing. The article inspired me to finish a post which had been sitting dormant in my ‘drafts’ for the last year. I’ve woven elements of Chris’ article with investing insights from some of the eminent investors mentioned above.

While ‘Sitting On Your Ass’ sounds simple. In practice, it’s not. Ahead are some tips to help you remain seated when everyone else has decided to get out.

Let’s start with some of the attractions of ‘Sit on Your Ass’ Investing:

Availability

As much as I enjoy reading about Jim Simons, Ray Dalio, George Soros, Paul Singer, Stanley Druckenmiller and Howard Marks, their investment style is near impossible for Joe Average to replicate. That’s unless you’ve got a team of code cracking PhD’s, employ a hundred uncorrelated multi-asset strategies, have an intuitive leveraged global macro trading capability, a structurally hedged activist style or deep expertise in distressed assets.

The beauty of ‘Sit on Your Ass’ investing is that it’s available to everyone.

Lower Transaction Costs / Taxes

A benefit of not trading is avoiding short term capital gains tax, meaning less dollar leakage and a larger asset base to compound. Lower turnover also means less frictional costs like commissions and market impact.

“Sit on your ass investing. You’re paying less to brokers, you’re listening to less nonsense, and if it works, the tax system gives you an extra one, two, or three percentage points per annum.” Charlie Munger

“One of the key roles I’ve played at Peninsula on your behalf over the past 12 years is resisting the temptation to sell - doing nothing can run counter to a serious work ethic, but in the world of investing it can be a very effective strategy in that it: i) minimises transaction costs, ii) minimises taxes, and iii) respects the fact that as a practical manner, market timing is a fool’s errand.” Ted Weschler

“When you sell a stock you’ve got to be right twice. You gotta pay taxes and replace the investment. On a growth stock you just have to right once.” Shad Rowe

Fewer Decisions / Less Re-Investment Risk

A strategy of buying stocks cheaply to sell higher requires a constant supply of new ideas. Not only do you have to get the buy decisions right, but the sells too, and in perpetuity. ‘Sitting on Your Ass’ requires fewer decisions and allows more time to get acquainted with the companies you own.

“What we really like is buying good-sized to very large first-class businesses with first-class management and just sitting there. You don’t have go from flower to flower. You can just sit there and watch them produce more and more every year.” Charlie Munger

“If our firms can successfully grow, and we can resist the temptation to fiddle, then we can meaningfully reduce the reinvestment risk embedded in lots of share buying and selling.” Nick Sleep

Harness Compounding

The human brain is wired to think linearly not exponentially. Chris Cerrone reminds us that a penny doubled everyday for a month turns into $10,737,418.24! Of course, there’s no better investor to demonstrate the extraordinary power of compounding than Warren Buffett, who’s life has been the ‘product of compound interest’. The following table pretty much says it all.

The Power of Compounding - Warren Buffett vs The Market [Source: Visual Capitalist]

“A great company keeps working when you’re not. A great company will eventually earn more and more and more while you’re just sitting and doing nothing. And a mediocre company won’t do that. So you’re harnessing a long range force that will help you. It’s very important.” Charlie Munger

‘Sit on Your Ass’ investing leverages the growth in a business’ intrinsic value. Terry Smith, a dyed-in-the-wool ‘Sit on Your Ass’ investor, touched on this in his recent letter.

“Equities are the only asset in which a portion of your return is automatically reinvested for you. This retention of earnings which are reinvested in the business can be a powerful mechanism for compounding gains.”

Rare Quality Businesses

A multitude of factors impact stock prices in the short term; quarterly earnings, investor sentiment, macro developments, valuation re-ratings, analyst recommendations, etc. As the holding period lengthens, business performance exerts a greater influence on stock prices.

The best businesses for long term investment therefore are those with both ‘enduring’ high returns on capital and attractive reinvestment opportunities.

‘Enduring’ high returns require sustainable competitive advantages to protect the business from the vagaries of capitalism. These businesses are often referred to as ‘Compounding Machines’.

“We endeavour to look past the non-essential details. We want to identify the essence of each business’s competitive advantage.” Chris Cerrone

These businesses are few and far between. As such, businesses worthy of ‘Sit on Your Ass’ investors tend to represent sizable positions in their portfolios.

“Companies with truly unusual prospects for appreciation are quite hard to find for there are not too many of them.” Phil Fisher

“There's only a tiny number of exceptional companies.” Reece Duca

Long Runway

Growth is an essential element. Businesses that don’t grow are unlikely to be profitable long term investments.

“The real money is going to be made by being in growing businesses, and that’s where the focus should be.” Warren Buffett

“The runway ahead for our businesses may be very long indeed.” Nick Sleep

"In our office we often say, ‘How wide and how long is the runway’?" Chuck Akre

Macro Concerns

Macro issues often spook investors out of positions; trade wars, Fed policy, GDP growth, politics and geopolitical tensions are but a few. These short-lived facts and data points rarely have a bearing on a business’ long term value.

Businesses stress tested by previous economic cycles, with solid balance sheets, good management and sustainable competitive advantages survive.

“We try hard to tune out concerns about politics and the economy. We read the newspapers, and we work just down the road from Washington D.C. However, it has been our experience that we are at our worst as investors when we allow concerns about these issues, including elections, trade wars, and Fed policy, to influence our investment decisions.” Chris Cerrone

“Charlie and I spend essentially no time really thinking about macro factors.” Warren Buffett

Adopting the mindset of a business owner as opposed to a stock trader can help. Would a business owner sell their private company based on a tweet by Trump, a lower GDP print or a strategist forecast?

“Our business owner mentality.. allows us to virtually ignore the constant babble of short term macro noise." Allan Mecham

Destination Analysis

The myopic market focus on the short term provides opportunity for mis-priced opportunities in the long term. Wall Street analysts publish valuations and price targets with scant regard to where a business might be in five or ten years. Armed with a deep understanding of a business’ DNA, an investor can overlook short term operating results and reflect on how a business might be positioned five or ten years hence.

“We always focus on what the business will look like in the very long term.” Zhang Lei

“We patiently build up core expertise that allows us to evaluate the long term prospect of the businesses we are interested in.” Li Lu

“We’re trying to figure out what this businesses is going to look like five years from now and ten years from now, not what’s going to happen in the next quarter or the next year.” Dan Davidowitz

Focusing on the destination can also help an investor stick with a position, even after periods of significant outperformance. Nick Sleep articulated this point with regard to Amazon in his 2007 letter:

‘To those who argue Amazon is large already we ask two questions: What do you think e-commerce will be as a proportion of US retailing in ten years, and what do you think it was last year?

After doubling in the share price and the weighty resultant position in the Partnership it would be easy to claim victory, high five, and sell our shares in Amazon. However, the high weighting makes sense given our understanding of the destination of the business and the probability of reaching that destination. We have argued that the biggest error an investor can make is the sale of a Wal-Mart or a Microsoft in the early stages of a company’s growth. Mathematically this error is far greater than the equivalent sum invested in a firm that goes bankrupt. The industry tends to gloss over this fact, perhaps because opportunity costs go unrecorded in performance records. We wonder, would selling Amazon today be the equivalent mistake of selling Wal-Mart in 1980?”

Valuation

“To the surprise of many, neither valuation nor price targets play a role in our sell decisions.” Chris Cerrone

“Another question we often get from investors concerning valuation: Do you assign price targets for your companies? The answer is no. Price targets strike us as too precise and, as importantly, potentially limiting to total return if one feels compelled to sell once the stock reaches the price target.” Dan Davidowitz

“The opportunity to buy the shares of a great company at a fair price is rare. So, selling a great company because it surpasses an arbitrary price target after six, 12, or 18 months seems on its face to be counterproductive and tax-inefficient.” Shad Rowe

A high multiple doesn’t imply a stock is a poor investment. The power of compounding can render an ‘optically expensive stock’ cheap very quickly.

Valuations are inherently imprecise. Most analysts’ DCF models assume a company’s growth and returns mean revert in time. Businesses with enduring competitive advantages that can resist this reversion are likely to be worth significantly more than typical finance models suggest.

In addition, great management teams have a tendency to enhance value through time.

“The very best businesses tend to exceed expectations. What may seem like a high price today may be proven to be perfectly reasonable in hindsight.” Chris Cerrone

“I have noticed that the truly great companies and great managers generally get better over time.” Shad Rowe

This suggests valuation should carry less weight in the investment decision.

“We really have a great reluctance to sell businesses where we like both the business and the people. So I don’t think I’d count on seeing many sales. But if you ever attend a meeting here, and there are 60 or 70 times earnings, keep an eye on me.” Warren Buffett, 1996

“Selling great companies with large growth potential, even at seemingly rich valuations, is usually a mistake.” Allan Mecham

Position Sizes / Volatility

Not selling a stock that delivers exceptional returns can result in a quality problem; the stock becomes a large part of the portfolio. Ted Weschler’s position in W.R Grace & Co. was almost 50% of his fund before he closed Peninsular to join Berkshire Hathaway in 2011. When Nick Sleep closed Nomad Partners in 2014, Amazon had grown to represent more than thirty percent of assets. Chuck Akre’s position in Speedway had grown to c50% of his portfolio in 1993 despite trimming a third of the position over the previous two years. And when Li Lu delivered a 200%+ fund return in 2009 as BYD skyrocketed 400%, BYD constituted over 50% of his partnership.

When positions get large, future fund returns become increasingly influenced by such positions. Li Lu’s 2009 annual letter noted, “the extreme appreciation [of BYD] has made the stock constitute a very large portion of our portfolio. This will lead to more volatility going forward.”

A large position can also constrain decision making if it leads to commitment bias. Li Lu’s fund struggled in 2010 and 2011 as the BYD share price declined nearly 80% from its 2009 high. By the end of 2012, the position size still represented one third of the fund. By 2014, the position size had been substantially reduced [to c10%] as a result of new investments by limited partners and other portfolio gains. With the benefit of hindsight, Mr Lu questioned his decision regarding the proper sizing of BYD after the market gains became so large. In the end he felt commitment bias [via a prominent association with the company and loyalty to its top leadership] had constrained his decision making.

Aligned Investors

Investor alignment is paramount in light of the potential for outsized positions and volatile returns.

Educating investors and preparing them for an absence of portfolio activity is a sensible strategy.

“One common psychological trap that agents may fall into is that clients expect action, or to be more accurate, fund managers expect their clients to expect action! The investor Seth Klarman was once challenged on whether Buffett’s track record was statistically significant as he traded so little? To which Klarman answered that each day Buffett chose not to do anything was a decision too.” Nick Sleep

"If we were private business owners/investors, long spans of inactivity would raise no eyebrows. No reasonable person would expect a farmer to sell his farm in order to buy a different farm every decade, let alone every year or several times a year. As public -market investors, however, this ‘sitting on our hands’ behaviour is unusual." Clifford Sosin

“‘He really doesn’t Do anything. All he does is buy and hold. What I need are people who make money’ is a comment I occasionally hear from arithmetically challenged investors. I plead guilty. What we attempt to do is simple – identify great companies that fit within compelling long-term themes . . . companies that do something better, faster and cheaper FOR instead of TO their customers, with balance sheets big enough to go after huge opportunities. We attempt to buy shares at reasonable prices, and then hold on (hopefully forever).” Shad Rowe

Patience

Pascal observed, 'The hardest thing for a man to do is sit quietly in a room'. Charlie Munger and Warren Buffett have insurance and operating businesses to occupy them. Over the years I’ve noticed some investors, Warren Buffett included, have played around the edges in different investments while leaving their ‘quality’ companies well alone - a strategy worthy of consideration should it override a temptation to sell.

“It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait.” Charlie Munger

“Investing is a mind game. If you are in a rut as a concentrated investor, increase your chances of winning and add a couple positions. It also lets you breathe and your positions breathe a bit.” Ian Cassell

Pot Holes

Expect pot holes. Business performance, like stock returns, aren’t linear. Businesses have hiccups. Ensure they are temporary not structural.

“I don’t expect the best companies to show their excellence every quarter.” Li Lu

"Businesses do not meet expectations quarter after quarter and year after year. It just isn’t in the nature of running businesses." Warren Buffett

“It’s in the nature of things that the market is not going to do exactly what you want, when you want it.” Charlie Munger

Many of the great ‘Sit on Your Ass’ investors, Terry Smith, Li Lu, Warren Buffett, Francois Rochon, and Nick Sleep included, look to their companies operating results to judge progress, not stock prices.

“I introduced the concept of viewing our entire portfolio as a single ‘HCI Holding Company” based on the weighted average of our shares in each individual portfolio company. This is a very useful way to understand our activities since we view ourselves primarily as owners of businesses and hold our positions for a very long time with very low turnover.” Li Lu

When To Sell

Mr Cerrone sets out three criteria where Akre Capital may sell a stock; slowing growth, loss of competitive advantage or adverse new management. You’ll note they are all related to the operating characteristics of the business, not the soap opera of the market place or macro considerations.

“We sell really when we think we're re-evaluating the economic characteristics of the business. We probably had one view of the long-term competitive advantage of the company at the time we've bought it, and we may have modified that.” Warren Buffett

“When we become concerned about the strength of a company’s franchise, its competitive advantage, or its balance sheet we will sell immediately.” Dan Davidowitz

The major risk when adopting a ‘Sit on Your Ass’ investment approach is mis-analysis of the business. It’s all about the business and its future.

“What costs us money is when we mis-assess the fundamental economic characteristics of the business.” Warren Buffett

“In our opinion, the biggest risk in investing is the risk of mis-analysis.” Nick Train

Summary

If you’ve been a reader of my posts over the last few years, you will have no doubt noticed the commonality of the world’s best investors and their collective thinking regarding what constitutes a great business. And I have written about this for a reason. ALL of the best investors spend their time finding those outstanding businesses, so that when the urge to sell certain stocks overcomes the collective market and people are running for the hills, these Masters can sit comfortably in the knowledge that the deep understanding of those businesses that they own allows them a certain level of reassurance, and they can choose not to sell, or to Sit On Their Ass.

Selling, as explained above, costs more in the long run and requires an adeptness that most of us lack. When the world’s best state that their biggest mistakes were in selling, not buying, you have to take notice. Outperforming the market is almost impossible for the average investor, yet these Masters do it … ‘Sitting On Their Ass.’

Sources:
‘The Art of (Not) Selling’ - by Chris Cerrone. Akre Capital Management. 2019.
‘When to Sell a Great Company’ by Investment Masters Class. 2017.
‘Quality Companies, Compounders and Value Traps’ by Investment Masters Class. 2016.
‘Hold Discipline,’ Lawrence Burns, Baillie Gifford, 2021.

Follow us on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

Disclosing Positions

Not many investors have been likened to Warren Buffett in their investment career. Besides numerous other aspects, you would need to have an incredible track record for one, and most of the Investment Masters, despite having enviable track records themselves, have found it difficult to match Buffett and his long history of success.

UK based Neil Woodford has been likened to Buffett in the past, and for a while enjoyed both the financial success and the celebrity that came with it. Right up to the point where he didn’t. The recent demise of The Woodford Fund has been well-publicised and well-analysed, with a lot of reasons for its downfall.

‘The glittering career of Neil Russell Woodford, touted as the UK’s answer to legendary American investor Warren Buffett, lies in tatters. The UK financial regulator has turned on him, long-standing investors have collectively pulled billions of pounds from his funds, and a reputation built over four decades of front-line investment management has been ripped to shreds.” Barrons, June 2019

One factor that likely contributed to the downfall was Mr Woodford’s decision to publicly disclose all his positions. Now it has to be said that taken by itself, his disclosure would not have led to the downfall of the fund, but after the dust settled, it seems disclosure added to its woes.

“Woodford will publish only the top 10 holdings of his three funds while redemptions from the LF Woodford Equity Income Fund are halted, the firm said in a statement on Monday. The move is an abrupt shift from a longstanding commitment to provide transparency about investments; the fund previously disclosed all holdings at the end of each month.” Bloomberg, June 2019

Many managers release their letters publicly. While a letter’s purpose is to inform a fund’s investors, it can also be used to help clarify the manager’s own thinking. In many cases the letters are a marketing tool to help attract new funds. At times, managers use letters to explain how and why the fund’s performance differs from others. Some manager’s hope the information conveyed in their letters will encourage others into the investment, a catalyst to close the gap between an under-priced stock and its fair value.

Despite the many who do disclose, some choose not to publish letters, or if they do, they’re very hard to find. Others choose to disclose little about the positions that make up the fund.

Why is this so?

Front Run - Squeeze

Without doubt, The Woodford Fund’s woes were exacerbated by the market’s knowledge of the positions. For those unfamiliar with what transpired, the ‘star’ UK fund manager stopped redemptions after facing a multitude of problems; a cocktail of illiquid assets, poor performance, riskier assets and questionable management actions. This resulted in a mass exodus by investors. Market knowledge of the stock positions attracted predatory shorts which moved ahead of, or front-ran, the unwind of the fund. The UK’s FT noted:

“Mr Woodford’s ambition for full transparency on his holdings may have been enlightened, but recent weeks have shown the risks of such openness. Short sellers have been able to exploit his difficulties, driving down the prices of investments they know he will be under pressure to sell.”

It’s one reason managers can be reluctant to disclose positions.

“Our Fund is concentrated in relatively few large positions and greater disclosure than that required could make it more difficult to deal when we are building or divesting from positions in the Fund, and enable other market participants to “front run” our dealing activity to the detriment of the prices we can achieve.” Terry Smith

And size positions appropriately.

“Being too large in an activity enables the rest of the market to pick you off or ‘gun’ for you. We once did an option trade that was so compelling that we built much too large a position. We found that as market participants sensed the size of our positions, they ‘ganged up’ on us. The options that we bought at cheap prices just got cheaper and cheaper, people anticipated our ‘rolls’ from one option to another, and every trading action we took seemed to increase our losses. As soon as we unwound the position to stem the losses, prices rebounded to near normal levels. It was quite an expensive lesson for people who were used to trading quietly in the market, rather than being the focal point for attack.” Paul Singer

I suspect Bill Ackman knows that feeling all too well. In 2012, with much fanfare, he announced a $1 billion short position in Herbalife. Ackman opened the attack publicly with a three hour, 342-slide presentation at the New York Sohn Conference. Like a red rag to a bull, hedge funds, including Dan Loeb’s Thirdpoint, piled in on the long side, squeezing Ackman. Soon after, billionaire activist Carl Icahn whaled into a 25% stake, predicting at the time Ackman’s investment could produce the “mother of all short squeezes.” In 2017, when Ackman finally capitulated and closed the position, he’d dusted $500m.

Ackman survived the ordeal. But one of the most infamous funds that faced a ‘run on its positions’ and didn’t survive was Long-Term Capital Management. It almost took the US financial system down with it. Once highly secretive, as liquidity problems emerged, the fund was forced to seek capital, requiring a higher level of disclosure. Roger Lowenstein’s brilliant book, ‘When Genius Failed’, noted:

“As it scavenged for capital, Long-Term had been forced to reveal bits and pieces and even the general outline of its portfolio. Ironically, the secrecy-obsessed hedge fund had become an open book. Markets, as Vinny Mattone might say, conspire against the weak. And thanks to Meriwether’s letter, all Wall Street knew about Long-Term’s troubles. Rival firms began to sell in advance of what they feared would be an avalanche of liquidating by Long-Term. ‘When you bare your secrets, you’re left naked’.”

“Knowledge of Long-Term’s portfolio was, by now commonplace. Salomon was, and had been, pounding the fund’s positions for months. Deutsche Bank was bailing out of swap trades, and American International Group, which hadn’t shown any interest in equity volatility before, was suddenly bidding for it. Why this sudden interest, if not to exploit Long-Term’s distress? Morgan and UBS were buying volatility, too. Some of this activity was clearly predatory. The game, as old as Wall Street itself, was simple: if Long-Term could be made to feel enough pain - could be squeezed - the fund would cry and buy back its shorts. Then anyone who owned those positions would make a bundle.”

It’s little wonder many managers are careful about publicly disclosing positions, especially shorts.

“As you are aware, we are guarded in disclosing our shorts to anyone.” Andreas Halvorsen

"The danger is you get squeezed on that short. Bob Wilson, a very famous short seller, famously said that nobody ever gets rich publicising their shorts. You want to get rich quietly. I don't go on CNBC trying to talk a stock up." Leon Cooperman

Commitment Bias

Ackman’s nemeses in Herbalife weren’t confined to the hedge funds that squeezed him. The enemy was also within. The fact he was on the record in a big way [342 pages!] and had committed tens of millions in research and publicity costs meant he was all-in. While Ackman recognised the ‘commitment bias’ in Wall Street analysts he may have missed his own short comings.

“When one shares an investment thesis publicly, it can be more difficult to change one’s mind because the human mind has a tendency to ignore data that are inconsistent with a firmly held view, and particularly so, when that view is aired publicly. That is likely why Wall Street analysts continued to rate MBIA a buy until it nearly went bankrupt. And, I believe it is why analysts will likely keep their buy ratings until Herbalife is shut down by regulators or the company faces substantial distributor defections.” Bill Ackman

Many of the Investment Masters understand the risks of sharing positions, ideas and thoughts on the record. Talking up a big position can make it harder to change one’s view when contradictory evidence emerges.

“The more public you become with your positions the harder it is for your ego to let go of a position. You can’t let your ego slow you down when the facts change. Don’t talk openly about your positions until you are strong enough to change your mind in front of the crowd.” Ian Cassell

“When you pound out an idea as a good idea, you’re pounding it in.” Charlie Munger

“I avoid letting my trading opinions be influenced by comments I may have made on the record about a market.” Paul Tudor Jones

"I hated discussing ideas with investors - because I then become a Defender of the Idea, and that influences your thought process. Once you became an idea's defender, you had a harder time changing your mind about it.” Michael Burry

Competition

Great ideas are few and far between. Disclosing positions can lead to unwanted competition, meaning higher prices or potentially better performance by a competing fund. Funds management is a competitive industry and most funds are seeking to attract capital, not give their competitors a leg-up.

Despite Buffett’s openness with regards to his investment philosophy, business and industry insights, you won’t find him talking about the specific stocks he’s buying and selling.

“We cannot talk about our current investment operations. Such an “open mouth” policy could never improve our results and in some situations could seriously hurt us.  For this reason, should anyone, including partners, ask us whether we are interested in any security, we must plead the ‘5th Amendment’.” Warren Buffett, Partnership Letter 1964

"Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore, we normally will not talk about our investment ideas. This ban extends even to securities we have sold (because we may purchase them again) and to stocks we are incorrectly rumored to be buying. If we deny those reports but say “no comment” on other occasions, the no-comments become confirmation." Warren Buffett 1983

"If we decide to change our position, we will not inform shareholders until long after the change has been completed. (We may be buying or selling as you read this.) The buying and selling of securities is a competitive business, and even a modest amount of added competition on either side can cost us a great deal of money… For this reason, we will not comment about our activities in securities - neither to the press, nor shareholders, nor to anyone else - unless legally required to do so." Warren Buffett 1984

"Our never-comment-even-if-untrue policy in regard to investments may disappoint "piggy-backers" but will benefit owners: Your Berkshire shares would be worth less if we discussed what we are doing." Warren Buffett 1998

Buffett’s not alone in this regard.

“The less definition offered, the less positions revealed, the less statistics applied – all the better for the portfolio that aims for these supra-normal returns. Hence, the fund’s individual positions may not be revealed except at the discretion of the manager.”  Michael Burry

“We will publicly discuss our transactions in marketable securities only when we believe such disclosure will be to your advantage. Good ideas are scarce, and the output of our research efforts is your exclusive property.” Frank Martin

“I follow Buffett’s perspective. He has said that specific investment ideas are rare and valuable and they’re like intellectual property and subject to being lifted. Therefore he only discloses them to the extent required by law. That’s pretty much what we follow.” Mohnish Pabrai

“One reason we don’t disclose our holdings is that we don’t want competition.  If the stock goes lower, which is quite possible, we’ll want to buy more.” Walter Schloss

“While I was at Graham-Newman, a man called up and said he’d like to speak to Mr. Graham. Because he was out of town that day, I asked if there was anything I could do in his stead. He said, “I just wanted to thank him. Every 6 months Graham-Newman publishes their portfolio holdings. And I’ve made so much money on the stocks that he had in his portfolio, I just wanted to come by and thank him. That was one of the reasons I decided never to publish our holdings. We work hard to find our stocks. We don’t want to just give them away. It’s not fair to our partners.” Walter Schloss

“I don’t want to disclose things pertaining to what positions we’re going into and why.” Ray Dalio

"I really don't like to give out ideas." Bruce Berkowitz

“We do not disclose information that would create a competitive disadvantage for the funds unless we are legally required to do so.” Bill Ackman

“We try not to talk very much about the companies in our portfolio and we certainly never talk about ones that are coming in and going out.” Chuck Akre

“If I figure out something really clever, I’m not going to go out and tell anyone, I’m not even going to tell my clients. I’m just going to do it in privacy and tell them later, “Hey, we made a bunch of money.” Maybe I’ll tell them what it was if the opportunity falls over.” David Abrams

“Given our larger AUM and the ease of disseminating our letters across the internet, we think it’s risky to detail our thesis about our scarce ideas. I’ll do my best to provide commentary without tipping our hand or revealing future intentions” Allan Mecham

“I think, as any businessman, you’d rather keep proprietary what you’d like to keep proprietary and only tell you what you have to or choose to. It’s one of the odd paradoxes why the money management industry has not fought back on the SEC’s disclosure rules for long investors who are not in an activist campaign or not in a corporate control campaign because there were all kinds of people that follow investors in their portfolios. And for investors who don’t turn their portfolios over a lot, they’re, in effect, giving away their intellectual property for free.” Jim Chanos

“We have discussed the dysfunctional of disclosing specific investment ideas. The problems are mainly psychological and include the locking in of an idea, the desire to seem consistent, the wish to seem prudent in other people’s eyes and so forth. There is then the effect of copy-cat investing, brokers trading against us and, as Walter Schloss found out, dealing with nervous-Nellies and so on.” Nicholas Sleep

‘Book Talking’

The process of talking up your investments is often referred to as ‘book talking’. Some managers see it as a way to attract interest in a name once it’s purchased, a catalyst to closing the gap between the stock’s trading price and ‘fair value’.

Unsurprisingly Buffett takes an unconventional view on this particular activity. While he doesn’t talk individual stocks, theoretically, he’d be more inclined to talk them down than up.

"We get asked questions about investments we own, and people think we want to talk them up. We have no interest in encouraging other people to buy the investments we own. We or the company are likely to be buying stock in the future. Why would we want the stock to go up if we’re going to be a buyer next year, and the year after, and the year after that?

But the whole mentality of Wall Street is that if you buy something — even if you’re going to buy more of it later on, or if the company is going to buy its own stock in — the people seem to think that they’re better off if it goes up the next day, or the next week, or the next month, and that’s why they talk about “talking your book.”

If we talked our book, from our standpoint, we would say pessimistic things about all four of the biggest holdings we have, because all four of them are repurchasing their shares, and, obviously, the cheaper they repurchase their shares, the better off we are. But people don’t seem to get that point.” Warren Buffett

Conclusion

Without the benefit of the many investor letters I’ve read over the years, I’d be less than half the investor I am today. Notwithstanding this benefit, there are risks that can arise from disclosing too much information. When you combine the market knowledge of a portfolio of illiquid or very large positions with redemption requests, things can quickly turn from manageable to disastrous. Just as telegraphing short positions can be asking for trouble.

It’s important to not let the public disclosure of positions blind you to evidence that you may be wrong. The courage to admit a mistake in the face of public disclosure is quite often difficult if not downright impossible for many investors.

Ultimately, like most things when investing, it really comes down to common sense. Remain open-minded and consider worse case scenarios.

Don’t let your disclosures get the better of you or your fund.

Join our Investing Community for daily insights on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

Thinking About P/E Ratios

When it comes to work, everyone likes a short-cut to success; in investing it’s no different. And the one short-cut investors use a lot of the time is the ‘Price to Earnings’ or ‘P/E’ ratio. Using this, you make an estimate of what the company’s earnings per share will be in the forthcoming year, and then divide that into the current share price. Hey presto, you’ve got a ratio you can compare against other companies and a tool for picking stocks. Great, huh?

It’s a nice way to think but in reality its not that simple.

Needless to say relying on the P/E ratio can be problematic. There are a few issues with it - here are some of the more obvious ones …

While the ‘Price’ component in the P/E ratio is pretty foolproof (assuming you can get volume there), relying on the ‘Earnings’ can cause some problems. Sometimes the earnings of a company don’t reflect the cash available to management and shareholders; lots of capex could be required or revenue is accrued rather than received in cash, etc.

Alternatively, a company’s earnings could be depressed by short term investments which will yield high returns in coming years, thus understating the current earnings power of the business.

“As a measure of undervaluation for me, P/E may not be terribly useful, as I may hope the company spends aggressively to exploit their nascent franchise advantages in markets and the spending may reduce current income. [For example] Berkshire has done a tremendous amount of investment that destroys current income so you can't really use P/E” Thomas Russo

Complicating matters further, the P/E ratio doesn’t take into account the capital structure; is a lot of debt required to produce the earnings? These are all considerations that need to be made.

But it’s also the level of the P/E ratio that can send the wrong signal.

When most people think of ‘value investing’, there’s a natural tendency for them to think of stocks on low P/E ratios. I certainly started out my investment career in that camp. I was always looking out for ‘cheap’ stocks; low multiple companies that could benefit from multiple expansion and an improved earnings outlook. I deemed high P/E stocks as the antithesis of value investing - far too dangerous.

Over time, my appreciation for what makes a value investment has dramatically changed. While investing in high P/E stocks can be dangerous, I now place far less emphasis on low P/E ratios, and more on the quality of the business and it’s ability to continue to grow. I’ve learnt from Buffett and Munger and many of the other Investment Masters about the true power of compounding and its ability to diminish the importance of the P/E ratio over time. I’ve also witnessed the capital destruction that sometimes results from chasing low P/E stocks.

This essay draws on some of those insights…

There Is No Single Metric

First things first, there is no single formula that leads to investment success.

"I don’t think price-earnings ratios, determine things. I don’t think price-book ratios, price-sales ratios — I don’t think any — there’s no single metric I can give you, or that anybody else can give you, in my view, that will tell you this is a great time to buy stocks or not to buy stocks or anything of the sort. It just isn’t that easy." Warren Buffett

“I wouldn’t look for a single metric like relative P/Es to determine what, or how to invest money.” Warren Buffett

‘Value Investing’ Is Not Buying Low P/E Stocks

Many investors confuse the term ‘Value Investing’ with buying stocks on low multiples. It’s not. Value Investing is buying a company for less than it’s intrinsic value. In layman’s terms it means you’re going to get back more than you outlaid. You’ll get an attractive return on your money and if your assumptions are out, you’ve still got a decent chance of doing okay because you allowed yourself a margin of safety.

“Whether appropriate or not, the term ‘value investing’ is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth, and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase." Warren Buffett

“The ‘value/growth dichotomy’ is false - at least, to a true value investor, whose aim is not to buy stocks which are ‘cheap’ on accounting measures (P/E, price to book, etc.) and to avoid those which are expensive on the same basis, but rather to look for investments trading at low prices relative to the investor’s estimate of their intrinsic value.” Marathon Asset Management

High P/E Stocks Can Be Value Stocks

Of course, everyone would like to buy high quality companies on low P/E ratios. Unfortunately that’s often not possible. History suggests that high quality companies that compound capital at high rates of return could have been purchased at very high multiples and still delivered attractive returns. Stocks that look ‘optically expensive’ on traditional ‘value metrics’ can still be great investments, provided they deliver earnings growth, even in the event of future P/E compression.

A recent Investment Insight note by Lindsell Train’s Nick Train, looked at the history of McDonald’s:

“.. by the start of 1990 McDonald’s was now trading at over $8 – an 8-bagger since 1980. Historic earnings were $0.48, for a P/E of 18x. I imagine in early 1990 there was prolonged discussion in institutional investment meetings about what the right P/E should be for McDonald’s and whether 18x wasn’t a bit rich – especially for a stock that had already done so well. Of course – with hindsight – we can now be sure that any debate about the valuation of McDonald’s in 1990 was more or less irrelevant. It could have been valued on over 50x and even at that rating it would still have performed in line with the S&P 500 through to today. (The S&P rose 7.5x between 1990 and 2018 and McDonald’s 22x – nearly 3x as much. Therefore McDonald’s could have been nearly 3x more expensive in 1990 and still performed in line.) And any quibbling about the valuation that actually encouraged a sale of the stock was downright ruinous.

Yet we all know that the credibility of the investment professional who argues that such and such stock is overvalued on 18x is often higher than that of the investor who counters along the following lines. “I don’t know what the right rating or price is for McDonald’s today, I just think the business has a lot of growth ahead of it and that we should hang on and just ignore the valuation, except in extremis.”

Terry Smith, in Fundsmith Equity Fund’s 2013 letter, looked back on the performance of Colgate and Coke;

“We examined the relative performance of Colgate-Palmolive and Coca-Cola over a 30 year time period from 1979-2009. Why 30 years? Because we thought it was long enough to simulate an investment lifetime in which individuals save for their retirement after which they seek to live on the income from their investment. Why 1979-2009? We wanted a recent period and in 1979 it so happens that Coca-Cola was on exactly the same Price Earnings Ratio (“PE”) as the market – 10x and Colgate was a little cheaper on 7x. The question we posed is what PE could you have paid for those shares in 1979 and still performed in line with the market, which we took as the S&P 500 Index, over the next 30 years?

We found the answer rather surprising - it was 36x in the case of Coke and 34x in the case of Colgate when the market was on 10x. Another way of looking at it is that you could therefore have paid a PE of 3.6x the market PE for Coke and 4.9x the market PE for Colgate in 1979 and still matched the market performance over the next 30 years. The reason is the differential rate of compound growth in the share prices (to a large extent driven by growth in the earnings) of those companies over the 30 years. They compounded at about 5% p.a. faster than the market. You may be surprised that this differential can have such a profound effect upon the outcome. It’s the magic of compounding.

.. Coke & Colgate’s total returns grew at about 5% p.a. faster than the market over the period 1979-2009, this 5% differential multiplied their share prices four times more than the market over that period. Of course, the next 30 years may be different to the 1979-2009 period.

It is also fair to point out that quality stocks may indeed not be too expensive relative to the rest of the market but that both will prove to be expensive, particularly when interest rates rise. But even so, I suggest you consider how you might have reacted if someone had suggested that you invest in Coke or Colgate at say twice the market PE in 1979. In rejecting that idea you would have missed the chance to make nearly twice as much money as an investment in the market indices over that period which included some periods of very high interest rates. Of course, capturing this opportunity would have required you to have the fortitude to sit on your hands during those periods of high interest rates and poor performance. As at 31st December 2013 they were trading at PE’s slightly above the market – our portfolio was on a PE of 20.6x versus 17.4x for the S&P 500, which doesn’t sound quite so expensive when you look at their historical performance and quality.”

And finally Polen Capital’s September 2018 Insights titled ‘Wonderful Companies at Fair Prices’ looked at the relationship between strong growth and P/E ratings and the implications of future P/E de-ratings …

“We spend far more of our time understanding the earnings potential of a business rather than trying to determine its fair value. Strong earnings growth is not only indicative to us of a potentially great business, but of a business that may be able to protect investor capital through a range of financial and economic circumstances. The charts in Figure 1 illustrate this point.

The chart on the left shows the effect of four different scenarios of earnings growth, P/E multiple compression and the resulting annual rate of return on a $100 investment in the same company. The first scenario (top line) is the most straightforward: assuming a company’s EPS grows 15% per year for five years (with no dividend payments) and its valuation doesn’t change, the investor’s annual rate of return over the five-year period will be 15%. In the second and third scenarios, the company’s EPS growth remains at 15% per year but the P/E of the company’s stock decreases by 10% and 20%, respectively, over the five-year period. In these two scenarios, though the valuation works against you, the investor still realizes annualized returns of 12.6% and 10%, respectively because the EPS growth remained strong. In the last scenario (bottom line), the company’s EPS growth is once again 15% but the valuation compression is more significant with a P/E ratio reduction of a full 50% over the five-year period, yielding a 0% annualized return for the investor. While not ideal, it is still worth pointing out the obvious: the investor didn’t lose money. Thus, even in the scenario where one arguably invested in an overvalued business, the underlying EPS growth provided a buffer and helped to prevent capital loss.

The chart on the right in Figure 1 presents the effects on the resulting annual rate of return for a $100 investment in the same company in a scenario where both the EPS growth of the business decelerates and the P/E ratio compresses. In this dynamic, over a five-year period the earnings growth could slow from 15% to 10% and the P/E multiple could contract by nearly 40% - yet the worst outcome would be flat returns. Put another way, EPS growth and valuation projections would need to be overestimated by more than 33% for an investor to lose money over the five-year time horizon.

This is how we approach valuation. It’s not overly complex nor is it meant to be. If, after thorough analysis, we have high confidence in a company’s ability to deliver attractive investment returns over a sustained period, then it becomes a business worth considering for our portfolios. projection Importantly, this return may very well assume that the stock’s P/E multiple compresses over our time horizon.”

The Polen article provided the examples of Visa and Alphabet where despite P/E contractions, the stocks delivered outstanding long run returns. In the case of Alphabet, the stock delivered 25% annualised returns, significantly outperforming the market, despite a near 60% PE compression.

“Perhaps the most notable thing about the Alphabet example is that the 25% annualized return was achieved despite the stock’s valuation compressing significantly. Alphabet’s forward P/E ratio was over 70x at one point in 2004 but then steadily declined to as low as 12.5x by 2012 (an 80% decline in valuation) before steadily recovering. Even with that recovery, Alphabet’s P/E declined by nearly 60% over the entire period and yet that significant P/E multiple compression did not prevent the investor from achieving outstanding long-term returns.”

The reason Alphabet could sustain such a significant PE compression was because earnings growth dwarfed the impact of the PE de-rating on the stock price. Finding companies with high earnings growth provides protection against a PE de-rating.

“If you have an asset that’s growing earnings at 20%, your money is doubling roughly every 3 ¼ years.  If you could have a five year time horizon and let’s say your money goes up 3 fold and you buy at a reasonable price, there is literally no way you lose money. If its cashflows grow 3 fold and you bought it at a reasonable price there is no scenario where you lose money. If the multiple gets cut in half or by 75% you still win assuming you bought it reasonably. I am not assuming you bought it at 500X or something like that. Having underlying growth of the cashflows solves so many problems so I always look for things that actually are generating some form of growth. I don’t know what the multiple will be in 2 years, but I know I underwrote it well.” Jason Karp

A recent excellent post by Morgan Housel summarised why over time a company’s earnings growth has a larger impact on a stock’s value than the multiple. It’s about compounded earnings.

“Valuation changes have a majority impact on your overall returns early on because company earnings are likely the same or marginally higher than when you made the investment. But as earnings compound over time, changes in any given year’s valuation multiples have less impact on the returns earned since you began investing.” Morgan Housel

Source: Collaborative Blog, Morgan Housel

Over time the impact of purchase multiples fade while earnings growth and ROE determine long term returns.

“While valuation multiples matter a lot in the short-term – they drive stock performance tremendously in years one through three – in years three and beyond, the impact of a change in multiples, unless extreme, fades when it comes to long-term capital compounding.” Yen Liow

Buffett and Munger have long recognised the benefit of buying wonderful companies at fair prices, as opposed to fair companies at wonderful prices.

“Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.” Warren Buffett

Over the years, they’ve shown a reluctance to part with high quality companies despite high multiples. They’ve even recognised the benefits of such companies buying back their own shares at high multiples, implying they believe intrinsic values are higher than those prices.

“The last bit of Coke Warren bought in 1990 was bought at 25X trailing earnings. So it wasn’t  cheap by traditional metrics, but on many fronts they considered it a no-brainer.” Mohnish Pabrai

"In GEICO, we paid 20 times earnings and a fairly sized multiple of book value." Warren Buffett

"If you’re right about the companies, you can hold them at pretty high values." Charlie Munger

"We really have a great reluctance to sell businesses where we like both the business and the people. So I don’t think I’d count on seeing many sales. But if you ever attend a meeting here, and there are [holdings at] 60 or 70 times earnings, keep an eye on me.... You can really hold them at extraordinary levels if you’ve got [wonderful businesses]." Warren Buffett 

"Looking back, when we’ve bought wonderful businesses that turned out to continue to be wonderful, we could’ve paid significantly more money, and they still would have been great business decisions. But you never know 100 percent for sure." Warren Buffett

“When we own stock in a wonderful business, we like the idea of repurchases, even at prices that may give you nose bleeds. It generally turns out to be a pretty good policy.” Warren Buffett

“The really great companies that buy [back stock] at high price-earnings, that can be wise.” Charlie Munger

Buffett makes the point above “you never know 100 percent for sure”. And therein lies the difficulty. The problem is, the future is never knowable. The key is to get comfortable such businesses have longevity and will continue to compound into the future. Ordinarily such businesses display a track record of performance, high and sustainable returns on equity, and excellent management. As few businesses can sustain high earnings growth over a period of ten to fifteen years most don’t deserve premium multiples. And when companies on high PE multiples stumble due to high earnings growth expectations that didn’t transpire, the results can be brutal; a double de-rating as earnings and the P/E ratio get marked lower. Paying high multiples for speculative stocks with limited track records is gambling not investing. It’s very, very dangerous.

“Most investors usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today's business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be. Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.” Warren Buffett

Focussing On Low P/E’s Can Lead You Into Value Traps

Screening for low P/E stocks, unsurprisingly, can lead you into low quality businesses. It’s one of the reasons that many of the Investment Masters focus on business quality first and valuation second.

“Many of our value competitors start the process of identifying likely investments by starting with price. Looking at a screen. We don’t believe in those screens. Cheap looking stocks will end up on screens. They will be either the lousiest competitors in an industry or operating in industries which are overly competitive. What makes us want to investigate a stock idea? - it’s not that it looks cheap - but if there seems to be something unique or superior about it. It may not optically look cheap.” Charles De Vaulx

"I’ve found that when valuation is the overriding driver of interest, I’m prone to get involved in challenging businesses or complicated ideas and liable to confuse a statistically cheap price with a margin of safety." Allan Mecham

"When you find a “cheap” stock, you can easily convince yourself that the long-term prospects of the company are great. That is why I try not to look at valuation at the beginning of the process. Cheap is not cheap when you hope for an increase of the P/E ratio in the short-run even though the long-term economics may be poor." Francois Rochon

“We try to avoid value traps by not making valuation the first, second, or third thing we look at. We never base our thesis on valuation alone. .. When you are analyzing your portfolio and opportunity costs, if the only thing your thesis rests on is ‘it's cheap,’ then it is time to move on.” Dan Davidowitz

“Too many investors focus on price first and business quality later, if at all. While every asset has a price, there are many we wouldn’t touch at any price, or with a ten-foot pole. Price is not value.” Chris Bloomstran

"I used to spend a lot of time screening the market according to typical value criteria such as price to book or P/E, but I now do this a lot less often. I find that these types of screen naturally direct you to cheap stocks, whereas what I am looking for are value stocks. The two things are not the same. I much prefer to make the first cut according to whether a company has a wide moat as the time is unlikely to be wasted." Robert Vinall

“We want to avoid value traps like the plague. That’s when you get down to the execution of value investing. Value investing works really well when it is well executed. But you can’t be superficial. You can’t just say it’s got a low PE, or a high dividend yield. Those are dangerous things.” CT Fitzpatrick

"Starting out I was a Graham and Dodd investor, focused on low price/ earnings ratios, good balance sheets and high dividend yields. The problem with that is you can get caught in too many value traps. I concluded I was better off focusing primarily on two key variables in weighing investment attractiveness: company valuation and business quality." David Herro

Summary

It should be clear that simply picking a stock based on the P/E level is a not sound investment strategy. Whilst some of the early indicators may suggest that a stock is a steal because of favourable ratios, it has been proven time and time again that it will more than likely end up being a value trap.

I’ll leave you with some final thoughts on this topic from some very wise people…

“In the evaluation of any business, we believe investors are best served by taking the time to fully understand the enterprise before giving appropriate consideration to its valuation.” Dan Davidowitz

“If you plan to hold a share for the long term, the rate of return on capital it generates and can reinvest at is far more important than the rating you buy or sell at.” Terry Smith

“We think, that the parameters that circumscribe “cheap” and “dear” in investors' minds are much too narrow. Investors are “anchored” to the top and bottom ends of a valuation range in a way that is not economically rational and is, therefore, inefficient. It can be hugely rewarding to buy a value-creating, strategically-advantaged company on 20.0x earnings and hugely damaging to your wealth to buy a supposedly “cheap” stock, in a value-destroying company on 10.0x.” Nick Train

“The idea that value investing means buying a company with a low p/e makes no sense. A company with a 20% incremental return on equity and is trading at 20X earnings, but can retain that return on equity for a long period of time because it has competitive advantages, is a way better value than a company trading at 10X earnings that has an 8% return on incremental capital. You can graph it out and over time those lines cross.” Chris Davis

“The funny thing with the investing business is that sometimes you can buy something at 20 times earnings and it can be cheap depending on the moat and the runway.”  Mohnish Pabrai

“On my time horizon, the calibre of a company is much more important than its value. You can be wrong about value in the short term, but still have a great investment over time. My worst errors have come from overestimating a company's business model, not overestimating the worth of a fine company.” Nick Train

Further Reading:
‘How growth became value and value didn’t,’ Terry Smith, Fundsmith.

Market Timing

There are many impossibilities in life.

And I’m sure you’ve heard of some of them - to live forever, to travel at the speed of light, or even to travel back in time. But one of the lesser known impossibilities is the belief that someone is able to consistently Time the Markets. And anyone telling you they know exactly when something is going to happen in those same markets is quite simply not telling you the truth.

If only it were possible.

Imagine being able to predict what the market was going to do at some point in time. To know exactly when it was going up, or down, or when it was time to get in or out. You’d be very wealthy and also very famous. But its not reality, despite many people acting like or believing that they can.

Market commentators and forecasters are always sprouting off on what the market is about to do. ‘Sell now, before it’s too late’. ‘Buy the dip.’. ‘A Market Crash is Imminent’. ‘Rotate into Cyclicals’. The unfortunate thing is that very few people have shown an ability to successfully navigate the ups and downs of the stock market, including the world’s best investors.

“There are only two types of people: those who can’t market time, and those who don’t know they can’t market time.” Terry Smith

Timing the Market is a very tricky thing to do. Despite knowing this, the most basic rules of investing almost suggest that we should be able to. Buy Low, Sell High - that is the simplest recipe for success in the stock market. When the market appears braced for a fall, move to the sidelines. After the decline, buy back those stocks cheaper.

If only it was that simple.

The good news is that the Investment Masters long term track records of success, stand in spite of this. You don’t have to be able to time the market, and in fact, Timing the market isn’t a pre-requisite to success at all.

Here’s what some of the world’s greatest investors had to say about market timing:

“I can’t time stocks.. I don’t know anybody else who can either.” Warren Buffett

“I don’t think we would want a manager who thought he could just go to cash based on macroeconomic notions and then hop back in when it was no longer advantageous to be in cash. Since we can’t do that ourselves.” Charlie Munger

“We wish we had perfect market timing (as well as the ability to fly). The reality is that no one does or ever will.” Seth Klarman

"Do not try to time the market." Chris Davis

“Active market timers usually fail.” David Swenson

"We don't try to time the market." Glenn Greenberg

"Our observation over 38 years is that no one can consistently predict either the stock market or the US economy." Bill Smead

“The odds of my adding value consistently by trying to time the market are very slim.” Lee Ainslie

“We think attempting to time markets (knowingly or unknowingly) is a fool’s errand.” Allan Mecham

“The real fool’s game remains, as it has throughout my career, attempting to time the stock market.” Shad Rowe

“In more than 35 years in the investment business, I have yet to find a short-term timing strategy that works.” Christopher Browne

“The character of the markets is continually changing, and there is no single timing system that will consistently, indefinitely work.” Barton Biggs

"After nearly 50 years in this business, I do not know of anybody who has [timed the market] successfully. I don't even know of anybody who knows anybody who has done it." Jack Bogle

"I don't believe all this nonsense about market timing. Just buy very good value and when the market is ready that value will be recognised." Henry Singleton

“Market timers consistently try to guess when to sell equities. To us, that’s a losing battle given the market had a positive return about three-quarters of the time.” Bill Nygren

“Market timing, rather than long-term investing, is ‘your first instinct’ as a money manager. But as I got older, I decided it's a fool's game." Roger Engemann

“We never try to ‘time’ the market.” Dan Davidowitz

“The greatest investors in history like John Templeton, Peter Lynch, Philip Fisher, Philip Carrett and Warren Buffett believe that it’s futile to attempt to predict the market in the short term. We share in their market agnosticism.” Francois Rochon

“We remain as market agnostic as ever. But, being market agnostic does not mean a lack of conviction. It just means that our convictions relate to the individual businesses we own and the valuations needed to generate the returns we aspire to.” Chuck Akre

“We do not look at the stock market or the individual price movements within the market to draw any inferences from, or any particular macro or micro information. In other words, we are totally stock market agnostic.” David Polen

"For the record, and in case there is any misunderstanding, we do not have the faintest idea what share prices will do in the short term - nor do we think it is important for the long-term investor." Nick Sleep

“Our data in our firm says most of the people in our firm are not very good market timers. They’re very good stock pickers but they’re not great market timers” Steve Cohen

“When we look at the US trading records for the long-term, we cannot find successful long-term investments that are based on short-term-oriented theories and strategies. The great long-term investments have all been made by value investors.” Li Lu

“While we may, from time to time, have views on where the stock market is headed, we generally do not make bets on its direction.” David Abrams

“As a practical matter, market timing is a fool’s errand.” Ted Weschler

“Seeking comfort has never been the basis of a winning strategy in the stock market. Neither has being a market timer.” Shad Rowe

“Has anyone ever consistently gauged turning points, timed markets? Sure, people can get it right once, twice. But then they’re dead the third time or the fourth time. I mean dead. I mean, buried.” Paul Singer

“I have no aptitude for market timing, and I think trying to be a long-term investor who actively times the market is a paradox poised for failure.” Scott Miller

“It’s in the nature of stock markets to go way down from time to time. There’s no system to avoid bad markets. You can’t do it unless you try to time the market, which is a seriously dumb thing to do.” Charlie Munger

“Our job to assemble portfolios that will perform well over the long run, and market timing is unlikely to add to the outcome unless it can be done well, which I’m not convinced is usually the case.” Howard Marks

“It is important to remember that timing the stock market is an impossible task even for seasoned professionals. Stay focused on your long-term goals and make sure you are comfortable with your asset allocation, so you can stomach the inevitable short-term volatility associated with investing.” Douglas Foreman

“Our directors will tell you that they’ve never been to a directors meeting where the subject of the direction of the stock market is — we are not in that business. We don’t know how to be in that business. Obviously, if we could guess successfully a high percentage of the time where the stock market was going to go, we would do nothing but play the S&P futures market. There wouldn’t be any reason to look at businesses and stocks. So it’s just not our game.” Warren Buffett

Markets are Complex Adaptive Systems

The reason it’s so hard to time the market is that markets are complex, adaptive systems. Some information is always unattainable and human reactions can be irrational and unpredictable. This often results in unexpected and non-linear outcomes.

"Do not attempt to time the stock market. The near term direction of the stock market is determined by so many forces that it is difficult for anybody to identify all the relevant ones, let alone understand them and weigh them and then determine the extent that they are already discounted into the market. Furthermore, the forces are dynamic, leaving market timers at the mercy of future forces that are difficult (and many times impossible) to predict. For all these reasons, most market timers do not seem to enjoy acceptable batting averages." Ed Wachenheim

“It is worth reminding oneself from time to time that almost any description and every prediction about the U.S. stock market involves a gross oversimplification of an extraordinarily complex system, a system that adaptively incorporates the collective expectations of all its participants into the price of its securities.” Bill Miller

“The important turning points in markets are never identified with precision in advance by ‘experts’ and policymakers. This lack of foresight is not surprising, because markets and the course of the economy are not model-able scientific phenomena but rather are examples of mass human behavior, which are never predictable with anything like precision.” Paul Singer

“Markets are a so-called second-order system - to usefully employ your predictions you would not only have to make mostly correct predictions but you would also need to gauge what the markets expected to occur in order to predict how they would react. Good luck with that.” Terry Smith

Research suggests Market Timers Fail

Research shows the odds are against you if you try and time the market.

“Nobel Prize winner William Sharpe found that a market timer must be right a staggering 82 percent of the time to match a buy and hold return. That’s a lot of work to achieve what could be achieved by taking a nap.” Christopher Browne

“The persistent belief that superior returns can be generated through dancing in and out of stocks as the tune of the music changes, defies logic or empirical analysis but at least provides useful material for students of behavioural finance.” Marathon Asset Management

“The vast majority of us are terrible at so-called “market timing”, in which investors try to sell at or close to market peaks and buy at market lows. All the statistics about investor flows show that believing you can accomplish this feat is the triumph of hope over experience. The wisest investors who are most likely to get the best performance are those who have at least realised that they can’t do this successfully and so don’t try.” Terry Smith

Markets Timers Must Get Multiple Decisions Right

When attempting to time the market you need to get multiple decision right; the buying and the selling.

“In my experience, most people who are lucky enough to sell something before it goes down get so busy patting themselves on the back they forget to buy it back.” Howard Marks

“Are you really smart enough to not only a) predict a market fall but also; b) figure out how this translates into individual stock movements; c) get your timing sufficiently correct that you do not either forgo gains which far outweigh any losses you protect against or suffer some of the downturn; d) have sufficient mental agility and nerve to start buying when your prediction of a market fall has become reality; and e) get the timing roughly right on that side of the trade so that you don’t end up catching the proverbial falling knife or missing some or all of the recovery? If so, I doubt you will be reading this letter on your private island. But above all, I doubt you exist.” Terry Smith

Most Investors are driven by Emotion

Furthermore, human nature usually works against your chances of success. Most investors tend to be wired so they panic after markets decline and sell at or near the lows. Ordinarily they wait for the markets to stabilise before re-entering and miss the bottom.

“Being human, we are our own worst enemy. Everything that goes on in the world and the market conspires to make people buy when things are going well and prices are high and sell when things are going badly and prices are low.” Howard Marks

“Human nature - innate, deep rooted, permanent. People don't consciously choose to invest with emotion - they simply can't help it." Seth Klarman

Costs are a Drag on Performance

A market timing strategy also incurs additional costs in the form of trading commissions, spreads and taxes.

"If you buy, sell, buy, sell you’re gonna pay a lot of commissions and dealer spreads and lose your money." Shad Rowe

Markets have an Upward Bias

When you move to the sidelines there’s also an opportunity cost. Over time the markets have had a natural tendency to rise.

“Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor. (The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions. And don’t forget that shareholders received substantial dividends throughout the century as well.) Since the basic game is so favorable, Charlie and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of “experts,” or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.” Warren Buffett

“I think it’s dangerous to draw lines in the sand after which you’ll just sit it out. Once you do, the temptation is to spend all your time trying to defend why now is not the time to be invested. I wrote a piece last year on the 25th anniversary of Oakmark Fund. At the time the fund had returned something like 20x investors’ initial capital, while the S&P was up 10x. But when you look at the list of things investors had to deal with over that time – wars, hurricanes, global financial crisis, oil-price collapse, just to name a few – it’s amazing the market returned 10-fold.” Bill Nyrgen

“You want to spread the risk as far as the specific companies you’re in by owning a diversified group, and you diversify over time by buying this month, next month, the year after, the year after, the year after. But you are making a terrible mistake if you stay out of a game that you think is going to be very good over time because you think you can pick a better time to enter it.” Warren Buffett

The odds are high you’ll miss the best returns.

"We believe that the nature of financial markets do not favor timing investment strategies. In fact, historically, 90% of stock returns happened during 1.5% of trading days. Statistics are against those that think they can outsmart the market over a long period of time." Francois Rochon

The Best Long Term Performing Stocks Decline

“I don’t know how to time the market effectively, nor am I aware of any person or computer that has consistently done so. Inevitably, market timing leads to under-investment. Portions of the downside are often avoided, but so are the recoveries. Given the positive expected values of our investments over the long term, trying to predict the daily movements of the market is not likely to improve returns… Even the highest quality companies like Berkshire Hathaway and Nike have each had multiple 50%+ drawdowns during their decades of heroic returns. Only those able to endure the pain of such declines actually participated in the 100x+ returns that ultimately were realized by the holders.” Scott Miller

Timing May Interfere with the Investment Process

"You may have trouble believing this, but Charlie and I never have an opinion about the market because it wouldn’t be any good and it might interfere with the opinions we have that are good." Warren Buffett

So what can you do?

Rather than focus on what the market will do, focus on the things you can control; like your investment process.

“In my nearly fifty years of experience on Wall Street I’ve found that I know less about what the stock market is going to do but I know more about what investors ought to do; and that’s a pretty vital change in attitude.” Benjamin Graham

Position Properly / Follow a Game Plan

Portfolios need to be built so they can handle worst-case scenarios, which are often magnitudes greater than you expect. The ‘cardinal sin’ of investing is being stopped out at the bottom. This means having appropriate diversification, position sizes, liquidity, aligned clients and avoiding leverage.

“I never really have a strong outlook for what is going to happen in the coming year. I have never felt that you can really predict with any useful degree of precision what’s going to happen from one year to the next in terms of generalized market moves. So rather than waste any mental energy doing so, we just make sure that we are positioned properly so that no matter what happens, our clients are in good shape.” Chris Mittleman

“It’s always hard to know why the market does what it does. That’s part of the ever-interesting challenge we face in traversing the twists and turns of fluctuating prices and evolving fundamentals. On any given day, the sheer number of players, behaviours, economic factors, and business developments defy anyone’s ability to fully grasp what is going on and why. That’s why we develop and follow a game plan that does not purport to tell us what to do moment by moment, but rather is intended to help us successfully navigate the most challenging tumult. This is the essence of value investing.” Seth Klarman

“To survive markets that can be irrational for long periods of time requires not betting the farm, spreading risks, and seeking asymmetric opportunities where the upside is substantially higher than the downside.” Scott Miller

Don’t Try and Predict the Next Crash

The Investment Masters realise the folly in trying to predict the next stock market crash.

"Market forecasters will fill your ear but will never fill your wallet." Warren Buffett

“Trying to predict the timing of the next major market dislocation has always been a “fool’s errand.” Paul Singer

“Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.” Peter Lynch

“No one can predict market downturns with any useful level of reliability.” Terry Smith

“We believe that declines are unpredictable and those who attempt to predict the market are choosing a strategy which will serve them a loser’s hand over the long term.” Francois Rochon

Maintain a Long Term Perspective

As Buffett noted in the quote above, US equity markets have delivered attractive returns over the long term. That’s just as likely to be the case for the next century as well. That means if you have a long term investment horizon, you’ve got a natural tailwind behind you.

“Trust in time rather than timing.” Burton Malkiel

“It’s time in the market, not market timing that counts.” Christopher Browne

“History shows that time, not timing, is the key to investment success. Therefore the best time to buy stocks is when you have money.” Sir John Templeton

“We do not attempt to manage the percentage invested in equities in our portfolio to reflect any view of market levels, timing or developments. Getting market timing right is a skill we do not claim to possess. Studies clearly show that most successful fund managers avoid market timing decisions.” Terry Smith

“Let me underscore my belief that the short-term price movements are so inherently tricky to predict that I do not believe it is possible to play the in and out game and still make the enormous profits that have accrued again and again to the truly long-term holder of the right stocks.” Phil Fisher

In his recent 2018 annual letter, the Fundsmith Equity Fund’s Terry Smith looked back at the 1987 stock market crash, the largest percentage one-day stock market drop in history, and it’s impact on the long run returns of the US stock market. As is evident in the chart below and as Smith noted, ‘In the long term, it did not matter’.

Smith continued:

“However, this does not stop advisers and commentators predicting crashes and bear markets and suggesting you take preventative action, which ranges from reducing your equity holdings, buying or ‘rotating’ into lowly rated so-called ‘value’ stocks, through to selling everything and holding cash to safeguard the value of your assets or buying Bitcoin (down 80% in 2018).”

Source: Fundsmith 2018 Annual Report

Cash Should Reflect Opportunity-Set

The Investment Masters hold significant cash when they are unable to find attractive investments, not due to a market call.

“When bargains are lacking, we are comfortable holding cash.” Seth Klarman

"Because we are focused on absolute returns, we will hold cash in the absence of values and a margin of safety. We view cash as an opportunity fund." Arnold Van Den Berg

“It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.” Charlie Munger

"Our cash position is not a “market call,” it simply reflects an absence of ideas that we find attractive. We’ve never made hay by hoarding cash in anticipation of market corrections; a quick trip down memory lane serves as a reminder that we entered both bear markets (2002 & 2008) fully invested. We prefer partial ownership in businesses over snappy trades that require gazelle-like instincts to dart away from any hint of danger. We think attempting to time markets (knowingly or unknowingly) is a fool’s errand and agree with Peter Lynch: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Allan Mecham

"If we have cash, it’s because we haven’t found anything intelligent to do with it that day, in the way of buying into the kind of businesses we like. And when we can’t find anything for a while, the cash piles up. But that’s not through choice, that’s because we’re failing at what we essentially are trying to do, which is to find things to buy." Warren Buffett

“We tell our clients .. ‘we are fully invested all the time, we’re not market timers, we don’t know anything about the market’. If we can’t find anything we will buy a company that’s being taken over.” Mario Gabelli

Own Quality Companies

Owning quality companies is the best defence to endure economic downturns. They often come out the other side stronger.

"Generally speaking, trying to dance in and out of the companies you really love, on a long-term basis, has not been a good idea for most investors. And we’re quite content to sit with our best holdings. People have tried to do that with Berkshire over the years. And I’ve had some friends that thought it was getting a little ahead of itself from time to time. And they thought they’d sell and buy it back cheaper and everything. It’s pretty tough to do. You have to make two decisions right. You know, you have to buy — you have to sell it right first, and then you have to buy it right later on. And usually you have to pay some tax in-between. If you get into a wonderful business, best thing to do is usually is to stick with it." Warren Buffett

"A few words on the timing of purchases. Woody Allen said that 80% of success is showing up. That's one of the main reasons we always want to be invested in the stock market, because we believe that owning great companies, not trying to predict the stock market, is the key thing to be able to beat the index over the long run." Francois Rochon

Price, don’t Time

Focus on paying the right price for quality companies. If you can buy a good business at an attractive price, do so.

"It’s uncertain every single day. Take uncertainty as being involved in investment. But uncertainty can be your friend. When people are uncertain, we pay less for things. We try to price, we don’t try to time at all.” Warren Buffett

“We don’t have an opinion about where the stock market’s going to go tomorrow or next week or next month. So to sit around and not do something that’s sensible because you think there will be something even more attractive, that’s just not our approach to it. Anytime we get a chance to do something that makes sense, we do it... So picking bottoms is basically not our game. Pricing is our game. And that’s not so difficult. Picking bottoms, I think, is probably impossible. when you start getting a lot for your money, you buy it.." Warren Buffett

Be Guided by the Business, not Market Forecasts

“If we’re right about a business, if we think a business is attractive, it would be very foolish for us to not take action on that,because we thought something about what the market was going to do, or anything of that sort.” Warren Buffett

Expect Uncertainty, Volatility and Down Markets

Maintaining a disposition toward future uncertainty, volatility and down markets will better prepare you for when they inevitably come.

“The idea that you try to time purchases based on what you think businesses are going to do in the next year or two, I think that’s the greatest mistake investors make because it’s always uncertain. People say ‘well it’s a time of uncertainty’. It was uncertain on September 10, 2001, people just didn’t know it was uncertain. It’s uncertain every single day. Take uncertainty as being involved in investment. But uncertainty can be your friend. When people are uncertain, we pay less for things. We try to price, we don’t try to time at all.” Warren Buffett

“If I buy a farm near here and it turns out to be a terrible year, and pests come in, and there’s no rain and all that sort of thing, am I going to sell if for half the price that it was selling for a year earlier? When I know over the next 100 years, there are going to be 90 years that are pretty good and a few bad ones? It doesn’t make sense to try and time things that way.” Warren Buffett

Control Your Emotions

“We wish we had perfect market timing (as well as the ability to fly). The reality is that no one does or ever will. The key is to find a way to care about one’s investment results over time, but to not feel burdened by the daily fluctuations of Mr. Market. The only way to invest, after what you purchased has fallen in price, is to be that successful relief pitcher. Put yesterday’s outcome out of your mind, get back on the mound, and make the best decision you can today with all the information at hand.” Seth Klarman

Be Optimistic

“I feel that people should learn to be optimistic because life goes on, and sometimes favorable surprises come out of the blue, whether due to new policies or scientific breakthroughs.” Irving Kahn

“Bulls make more than bears, so if anything be an optimist about life and about things in general is a great attribute as an investor. You just can’t be starry eyed and naive.” Stanley Druckenmiller

“We have chosen optimism and the belief that our civilization is fundamentally progressing. While prudence frames our approach towards stock selection, we have so far been rewarded for maintaining a constructive attitude.” Francois Rochon

“I had to teach myself to be bullish. But I promise you, as soon as I started looking on the bright side, not only did my investment performance begin to improve, but I felt and looked younger, too. Let’s face it – bearishness is the natural province of crabby old people.  All the great investors – Buffett, Fisher, Munger, Templeton – stayed structural bulls and (have) reached grand old ages. Not only were they intellectually correct to be bullish – as history and their track records amply confirm – but they were emotionally smart, too.” Nick Train

Relax

"It’s very hard to move around successfully and beat, really, what can be done with a very relaxed philosophy." Warren Buffett

“Those investors who put the market on a time table not only become frustrated but end up making foolish moves. Instead, get on the train, sit back and enjoy the scenery.” Roger Engemann

Summary

So if you know someone who not only states they can predict the near term future, or this or that downturn or recession, but also the precise timing of those events, ask them what other things they’ve been able to predict. I guarantee there wont be much else. If it’s true, and I highly doubt that it is, it will have been no more than luck. Even a broken clock is right twice a day.

When the world’s greatest investors acknowledge they can’t time the market, what makes other people think they can? Seriously speaking, given the attractive long term returns generated by the world’s best investors without market timing, there is no logical reason that anyone should try to time the markets.

But if you do meet someone who wants to persist in this fool’s errand, borrow the very wise words of Terry Smith and say: “Good luck with that.”

Follow us on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

Further Reading:
“The Futility of Market Timing” - Drew Dickson, Albert Bridge Capital
“Even God Couldn’t Beat Dollar-Cost Averaging” - Nick Maggiulli
“The Stock Market Timing Game”

Thinking About Return on Capital

Return on capital. Its a simple thing. It’s defined as the amount of money the business earns on the capital that has been invested in the business. And its also one of the attributes the world’s most successful investors are after when they’re looking for quality companies.

There are other attributes that make up a great company, too. And every investor places a different level of importance on the characteristics they feel are important; strong management, consolidated industry, proven business model, high barriers to entry, attractive product, good culture, solid balance sheet, low obsolescence risk, etc. But among all these traits, one of the most common characteristics they seek is a high return on capital.

“What we really want to do is buy a business that’s a great business, which means that business is going to earn a high return on capital employed for a very long period of time, and where we think the management will treat us right.” Warren Buffett

The higher the return on capital, generally speaking, the better the business. It’s even better when such businesses can re-invest more capital at attractive rates of return. Not many businesses can do this.

“If you earn high enough returns on equity and you can keep employing more of that equity at the same rate — that’s also difficult to do — you know, the world compounds very fast.” Warren Buffett

“If you’re going to own a company for a long time, the earnings it generates today will be a small component of the eventual return.  Much more important will be how those earnings can be reinvested over time to build value.  When companies with positive compounding characteristics become available at really attractive prices, we’ll hope to take advantage.” Chris Davis

“It is not enough for companies to earn a high un-levered rate of return. Our definition of growth is that they must also be able to reinvest at least a portion of their excess cash flow back into the business to grow while generating a high return on the cash thus reinvested. Over time, this should compound shareholders’ wealth by generating more than a pound of stock market value for each pound reinvested.” Terry Smith

Such business are often referred to as ‘compounding machines’.

“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.” Warren Buffett

"A compounder is a competitively advantaged business that earns superior returns on invested capital. As cash earnings are reinvested back into the business, the value of the business grows year after year compounding our investment.” Christopher Begg

While stock prices often swing around erratically in the short term, over the long term, a company’s share price will reflect the business’ earnings. Over the long term, all you can get out of a business are the returns it produces.

“Bear in mind--this is a critical fact often ignored - that investors as a whole cannot get anything out of their businesses except what the businesses earn. Sure, you and I can sell each other stocks at higher and higher prices.” Warren Buffett

“Occasionally, people lose track of the fact that in the long run, shares can’t do much better than the companies that issue them.” Howard Marks

“The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.” Warren Buffett

And it’s the business’ return on capital and the re-investment rate that drive future earnings, making it the key driver of a stock’s long term performance.

“A stock return will eventually echo the increase in the per share intrinsic value of the underlying company (usually linked to the return on equity).” Francois Rochon

“Over the long run, it is a company’s return on capital, not changes in quarterly earnings, which primarily determines the direction of its share price. The return on capital of any company is largely subject to the state of competition within its industry.” Marathon Asset Management

“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.” Charlie Munger

“Over the longest period of time, if you do own [the company] through the ups and downs, your return roughly approximates basically the actual business return to actual capital invested in the business itself over the long term. The two tend to really converge pretty closely.” Li Lu

“The higher return a business can earn on its capital, the more cash it can produce, the more value is created. Over time, it is hard for investors to earn returns that are much higher than the underlying business’ return on invested capital.” Warren Buffett

It’s the reason Buffett and Munger steer well clear of businesses with low returns on capital.

“We like to think when we buy a stock we’re going to own it for a very long time, and therefore we have to stay away from businesses that have low returns on equity.” Warren Buffett

"If you have a business that’s earning 5 or 6 percent on equity and you hold it for a long time, you are not going to do well in investing. Even if you buy it cheap to start with." Warren Buffett

It’s also the reason Buffett and Munger et al think it’s worth paying more for businesses with high returns on capital. The high returns on capital combined with a high re-investment rate compound to drive extraordinary earnings and share price gains over time.

"Looking back, when we’ve bought wonderful businesses that turned out to continue to be wonderful, we could’ve paid significantly more money, and they still would have been great business decisions. But you never know 100 percent for sure. And so it isn’t as precise as you might think. Generally speaking, if you get a chance to buy a wonderful business — and by that, I would mean one that has economic characteristics that lead you to believe, with a high degree of certainty, that they will be earning unusual returns on capital over time — unusually high — and, better yet, if they get the chance to employ more capital at — again, at high rates of return — that’s the best of all businesses. And you probably should stretch a little." Warren Buffett

“Faced with the choice between investing in two companies with the same earnings growth, we are prepared to pay materially more (in P/E terms) for the business with high returns on equity and superior cash flow generation.” Marathon Asset Management

“If you invest for the long term in companies which can deliver high returns on capital, and which invest at least a significant portion of the cash flows they generate to earn similarly high returns, over time that has far more impact on the performance of the shares than the price you pay for them. Yet I have been asked far more frequently whether a share, a strategy or a fund is cheap or expensive than I am asked about what returns the companies involved deliver and whether they are good companies which create value or not.” Terry Smith

As high returns on capital attract competition, it’s important to get comfortable that the returns are sustainable.

“For most companies, high ROE’s and dividend growth rates will quickly be competed away.” James Bullock

“The problem with high ROE’s in capital intensive businesses is that it is hard to sustain the ROE’s. Here, high returns attract competition both from new entrants that come with new capital and existing competitors that try to see what the better performing competitor is doing to copy it. The new capital and the copycats often succeed in driving down the superior ROE’s. Really bad things happen to earnings when a 25% ROE turns into a 10% ROE.” David Einhorn

“Note that we are not just looking for a high rate of return. We are seeking a sustainably high rate of return.” Terry Smith

“Certainly, a long track record of high returns on invested capital seems like a quick and easy way to determine this. But the graveyards of capitalism are littered with companies that did, in fact, earn high ROICs for prolonged periods of time only to ultimately succumb to competition, either directly from a more astute rival or from a changing economic landscape.” Todd Combs

Notwithstanding, a long history of high returns on capital is a sensible starting place to look for potential investments.

“We think a long history of high returns is on average a strong indication of an exceptional, durable business model - a factor to which we don’t think other investors give a high enough weighting.” James Bullock

Ordinarily such businesses are protected by a ‘moat’.

“The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with ‘Roman Candles’, companies whose moats proved illusory and were soon crossed.” Warren Buffett

“A truly great business must have an enduring 'moat' that protects excellent returns on invested capital.” Warren Buffett

“Few businesses possess an ‘economic moat’ formed by enduring competitive advantages. Our experience reinforces the fact that it is these moats which enable the businesses to earn higher returns on capital than average." Chuck Akre

“There is a reasonably sound piece of economic theory called mean reversion which suggests that companies which generate high returns should attract competition, which will eventually reduce their returns to the average, or worse. The very small group of companies that manage to avoid this economic law of gravity have some kind of defence which enables them to fend off the competition. This is the oft quoted concept of the “moat” popularised by Mr Buffett.” Terry Smith

"Companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above-average profits." Joel Greenblatt

“Great businesses are the ones who really have above average returns on invested capital. But that kind of a business traditionally attract imitators, competitors, everybody wants to have above average returns on reinvested capital. And so truly good businesses are the ones who can fend off competitors, who can really have an enduring competitive advantage and have that higher than average return on invested capital and hopefully also have a long run-rate of continuous growth. Those are the businesses we’re looking for.” Li Lu

Identifying businesses with high sustainable returns on capital and sticking with them is a sure fire way to investment success. It’s a reason, once identified, why many of the Investment Masters are reluctant to sell great companies. Regardless of what their share prices do in the short term, the intrinsic value of the business grows. Time is on your side.

“Time is the enemy of the poor business, and it’s the friend of the great business. I mean if you have a business that’s earning 20 or 25 percent on equity, and it does that for a long time, time is your friend.” Warren Buffett

“A good company is one that regularly makes a high return in cash terms on capital employed, and can reinvest at least part of that cash flow in order to grow its business and compound the value of your investment. Bad companies do not do this. They make inadequate returns on the capital they employ. You may think you should invest in these poor companies as they are going to improve because the management will change, or they will be taken over, or their results will pick up with the economic or business cycle. But each day you wait for such events, these companies destroy a little bit more value. Good companies do the opposite. With a good company, time is on your side.” Terry Smith

Little wonder many of the Investment Masters focus on buying such businesses.

“Our  ideal investment  couples  high  returns  on  capital  with  shareholder-oriented  management, where  there  is  significant  opportunity  to  re-invest  excess  cash  flow.  We  buy these  companies  when  they  appear  to  us  to  be  undervalued.” Chuck Akre

“Very simply, we are trying to find businesses that exhibit three characteristics: predictable long-term growth, high returns on invested capital and well established, sustainable barriers to competition.” Brian Vollmer

“We also require companies to have extremely high returns on capital, which we define as 20% or more sustainably.” Daniel Davidowitz

“Return on Equity (ROE) furnishes the best single yardstick of what management has accomplished with money that belongs to shareholders.” John Neff

“It’s not P/E’s that matter, or profit margins on sales, but how much a business earns on the capital invested in it.” Christopher Bloomstran

“Return on capital is probably the single biggest measure that I feel one has to look at. Valuations comes a distant second or third.” Rajiv Jain

“Our primary research focus is on companies that can achieve sustainably high returns on capital.” Nick Train

“Return on capital at Nomad’s firms is over twice that of competing businesses.” Nicholas Sleep

“The metric we follow most closely is return on equity, which absent distributions and changes in multiples, is the return we as shareholders can expect to earn.” Brian Bares

"I think [estimating] return on incrementally invested capital is one of my most important jobs, i.e assessing how well the management teams and boards are keeping our portion of profits we are not receiving as dividends." Chris Bloomstran

“The single most important indicator of a good business is its return on capital. We believe that in almost every case in which a company earns a superior return on capital over a long period of time it is because it enjoys a unique proprietary position in its industry and/or has outstanding management. The ability to earn a high return on capital means that the earnings which are not paid out as dividends but rather retained in the business are likely to be re-invested at a high rate of return to provide for good future earnings and equity growth.” Bill Ruane

“How much a company earns on the capital invested in it is the best measure of how it is doing. From both financial and philosophical points of view, that's what counts.” Robert Pritzker

“At Berkshire, we particularly favor the rare enterprise that can deploy additional capital at high returns in the future. Owning only one of these companies – and simply sitting tight – can deliver wealth almost beyond measure. Even heirs to such a holding can – ugh! – sometimes live a lifetime of leisure.” Warren Buffett

As good as return on capital is as a measure of a superior business, it must be considered in the context of sustainability. Return on capital is a historic measure and so you must form a view as to whether the business is likely to be able to continue to earn those same attractive returns. This requires thinking qualitatively about the business and it’s competitive position; how is it performing today and how likely is it that it will continue to perform in the future? They’re both necessary questions.

Remember, the first rule of investing is ‘preserve capital’ which means ‘Return of Capital’. Buying businesses with high ‘Returns on Capital’ at fair prices are what have made the Investment Masters successful. How do your businesses look by comparison?

Further Reading:
Investment Master Class Tutorial: Capital Allocation
Berkshire Hathaway 1987 Letter

Follow us on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

Investment Stories vs. Facts

Who doesn’t love a story? Those tales of woe and drama, intrigue and suspense; and the better the storyteller the more we’re usually hooked.

Stories sell. We often believe them without thinking or questioning. And they can have an unjustified weight on our perceptions. Consequently, stories often impact markets and our investment decisions when they shouldn’t.

I’m sure you’ve seen a situation where an analyst or journalist writes a short story about a stock or sector? Then the market takes it as a given and the stock or sector plunges as a result. And I’m sure you can think of plenty of investment stories you’ve heard over the years. Just think about some of the more recent ones .. ‘bitcoin’s finite supply means it will be worth more’, ‘negative bond yields imply a global recession’, ‘the longest equity recovery in recent history portends a market crash’, or ‘value investing is dead’.

Why do we believe such stories? Why do we get hooked into these narratives that are neither factually correct or accurate? The answer is, we are wired that way; mankind actually hasn’t evolved much from the days we spent hunting and gathering. One of the key skills that allowed us to progress from these primitive beginnings and reach the top of the food chain was collaboration. And collaboration involved stories. Yuval Noah Harari made the point in his must-read book Sapiens.

"We are the only mammals that can cooperate with numerous strangers because only we can invent fictional stories, spread them around, and convince millions of others to believe in them." Yuval Noah Harari

In an essay titled ‘What Makes Us Human’, Lisa Mada notes “Humans around the world, from the very young to the very old, have been communicating and transmitting their ideas through stories for thousands of years, and storytelling remains integral to being human and to human culture.”

Stories are everywhere. In a recent article in the FT, Jon Authers, provided a few examples of ‘stories’ in today’s financial markets.

“What’s the story? US unemployment numbers are out, jobs are up, and wages are not growing as fast as they were. Does this mean we are back in “Goldilocks”, or should the narrative be “Making America Great Again”? And as for world markets, can we go back to the story that was looking so good until a surprisingly strong wage growth number brought it to a halt? That story was “Melt-Up”, after an extraordinary rally in stock markets.” Jon Authers

Mr Authers refers to the narrative fallacy, the tendency for humans to turn random or disparate data into stories.

“We think in stories. When applying the word “narrative” we often bump against the “narrative fallacy” — the human tendency to try to turn random or disparate data into a satisfying story. But that is how we make sense of the world. Any journalist will admit that to explain a complex story you must turn it into a narrative. Anyone selling you an investment similarly does so by telling a story.” Jon Authers

And our story instinct makes us vulnerable to believing narratives that just aren’t true. Joe Wiggins, of Behavioural Investment notes, “There are myriad behavioural pitfalls that blight value investing”, an obvious one is ‘Stories’. He provides us with an example in the context of value investing.

“We have an overwhelming desire to construct, and believe, coherent, simple narratives. Walter Fisher (1978) first posited the narrative paradigm theory, which argued for the pre-eminence of storytelling in human communication – compelling tales outweigh robust argumentation. Growth stocks often benefit from beguiling narratives, which we inextricably link to positive share price performance, whereas value stocks suffer from the reverse –‘cheap for a reason’ is the common slight aimed at undervalued stocks. As investors strive for consistency, it is hard to reconcile the typically negative narrative that accompanies a depressed value stock with the potential for strong future performance.” Joe Wiggins

Investing stories can be dangerous. It’s little wonder the world’s most successful investors are mindful of this.

"Most stock-picking stories, advice and recommendations are completely worthless." Ed Thorp

"Stories are more powerful than statistics because the most believable thing in the world is whatever takes the least amount of effort to contextualize your own life experiences." Morgan Housel

“Of all the dangers that investors face, perhaps none is more seductive than the siren song of stories. Stories essentially govern the way we think. We will abandon evidence in favour of a good story.” James Montier

“Humans are irrational. We’re not especially good at stock picking. We have a tendency to get caught by narratives and stories.” Raife Giovinazzo

“Stories sell stocks: the wonderful new product that will revolutionise everything, the monopoly that controls a product and sets prices, the politically connected and protected firm that gorges at the public trough, the fabulous mineral discovery, and so forth.” Ed Thorp

Stories appeal to our emotional side and they often blind us to the underlying facts. Stories are quick and easy. It’s human nature to respond to emotion before reason. That’s how we’ve evolved.

"Our brain is wired to perceive before it thinks - to use emotions before reason.” Peter Bevelin 

"Information presented in vivid and concrete detail often has unwarranted impact, and people tend to disregard abstract or statistical information that may have greater evidential value. Statistical data, in particular, lacks the rich and concrete detail to evoke images, and they are often overlooked, ignored or minimised." Richards Hueur

Stories are often formed from a single or limited number of observations transformed into a generalisation. Just the other day, the front page of a national financial newspaper I was reading carried the story about a man who had lost his job, whose wife had just had a baby, and could no longer afford his mortgage repayments. He sold his house and received less than he’d expected, which was also less than the amount an estate agent told him the house would sell for 3 months prior. The narrative was: people are being forced out of their homes as they can’t afford them, and house prices are falling. Therefore mortgage banks are in trouble. SELL BANKS. The market reacted accordingly despite a sample size of just one.

Relying on only a few anecdotes can lead investors to the wrong conclusions. The famous theoretical physicist, Richard Feynman, observed “The first principle is that you must not fool yourself and you are the easiest person to fool.”

Studied by many of the world’s greatest investors, Feynman understood the danger of relying on small sample sizes.

"You can't prove anything by one occurrence, or two occurrences, and so on. Everything has to be checked out very carefully. Otherwise you become one of these people who believe all kinds of crazy stuff and don't understand the world they're in. Nobody understands the world they're in, but some people are better off at it than others." Richard Feynman

"Many people believe things from anecdotes in which there is only one case instead of a large number of cases." Richard Feynman

Because stories often lack statistical rigour, they provide a false representation of reality. They can also suffer from wishful thinking, poor analysis, inappropriate analogies, or incorrect observations.

“The narratives investors use to explain the market or economy sometimes lack the statistical rigor required for a proper description. And as we have learned, if the description is faulty the explanation is likely wrong.” Robert Hagstrom

Overcoming the pull of stories requires keeping an open mind, collecting all the facts and testing investment ideas. Before acting on stories and narratives it’s important to test their validity. This can be done by collecting more information.

“One also needs to learn to fight certain human biases such as buying into stories. The thing that gets fundamental discretionary traders involved in trade is stories, because we can grasp onto them. But in general, it’s good to step away from the stories and take it back to the numbers.” Jim Leitner

“My point about narratives is that if you’re so caught up in the story and in finding evidence that supports the story, you might not adequately process data points that could raise important red flags,” Jake Rosser

When false narratives and stories are prevalent, stocks trade at the wrong prices; the stock price reflects the narrative, not the facts.

“Because of a financial-community appraisal that is at variance with the facts, a stock may sell for a considerable period for much more or much less than it is intrinsically worth.” Phil Fisher

It’s when a share price that’s been supported by a false narrative is subjected to reality, that investors who acted on that false information suffer.

“Investment fads and misinterpretations of facts may run for several months or several years. In the long run, however, realities not only terminate them, but frequently, cause the affected stocks to go to far in the opposite direction. The ability to see through some majority opinions to find what facts are really there is a trait that can bring rich rewards in the field of common stocks.” Phil Fisher

Such distortions in perception, or not seeing the world as it really is, can lead to serious investment mistakes. In fact, Charlie Munger considers seeing the world the way it really is, as the most important thing of all.

“I would argue rationality, which is seeing the world the way it is, instead of the way you hope it is, I’d say that’s the most important [thing]. If you don’t see the world the way it is, it’s like judging something through a distorted lens, you think the world is one way and it’s different. And of course, that leads to terrible mistakes. You want to think correctly.” Charlie Munger

“We should see the world the way it is, which is the same as seeking truth from facts.” Li Lu

So, before you jump into an investment or make a change to an existing investment, you need to ask yourself the following questions - “Do I have all the facts?” “Am I relying on an unsubstantiated story,” “Have I asked all the right questions?” and “What assumptions am I making?”

The Investment Masters don’t act without ensuring they have all the facts. They let the facts do the talking and don’t get caught up in stories and narratives.

“If you don’t know the facts don’t play.” Jim Rogers

“We’re not looking for opinions. We’re looking for facts.” Warren Buffett

“Opinions are a dime a dozen and nearly everyone will share theirs with you. Many will state them as if they are facts. Don’t mistake opinions for facts.” Ray Dalio

"Be obsessive in making sure your facts are right and that you haven't missed or misunderstood something." Barton Biggs

“I’m quite capable of selling a stock when it goes down. I am quite capable of buying a stock when it goes down. It all depends on the underlying facts.” Warren Buffett

“Most people do not look thoughtfully at the facts and draw their conclusions by objectively weighing the evidence… When you’re approaching a decision, ask yourself: Can you point to clear facts (i.e facts believable people wouldn’t dispute) leading to your view? If not, chances are you’re not being evidence based.” Ray Dalio

“When done well, investing involves learning how to process information in order to determine when the odds are in your favor; the goal is to make educated bets based on facts and not stories.” Todd Combs

“Both my failure in whiskey and my success in copper emphasized one thing – the importance of getting the facts of a situation free from tips, inside dope, or wishful thinking. In the search for facts I learned that one had to be as unimpassioned as a surgeon. And if one had the facts right, one could stand with confidence against the will or whims of those who were supposed to know best.” Bernard Baruch

“You have to come to your own conclusions, and you have to do it based on facts that are available. If you don’t have enough facts to reach a conclusion, you forget it. You go on to the next one. You have to also have the willingness to walk away from things that other people think are very simple.” Warren Buffett

“We must focus on facts – as Dragnet fans will recall, “Just the facts,” Stories usually have an emotional content, hence they appeal to the X-system – the quick and dirty way of thinking. If you want to use the more logical system of thought (the C-system), then you must focus on the facts. Generally, facts are emotionally cold, and thus will pass from the X-system to the C-system.” James Montier

“First you’ve got to get all the facts, and then you’ve got to face the facts. Not pipe dreams.” Paul Cabot

“Make your theories fit your facts, not your facts your theories.” Dickson G Watts

“Never act upon wishful thinking. Act without checking the facts, and chances are that you will be swept away along with the mob.” Jim Rogers

“In the 1950s, an early detective series on TV was Dragnet, starring the fictional Joe Friday. In the opening sequence to every show he would say: “My name is Friday. I’m a cop.” His other famous one-liner, usually delivered while trying to extract evidence from a hapless babbling witness, was: “Just the facts.” We would all do well to remember Joe’s witness interview technique when it comes to investing.” Terry Smith

Summary

The moral of this story is: be mindful of stories and get the facts. And only the facts. Just because one homeowner can’t pay his mortgage doesn’t mean house prices are going to crash and banks are going to be in trouble. Just because one person heard that so and so stock was going to tank doesn’t mean that it will.

Your task is to sift through the stories out there and find the kernels of truth, the facts that will determine if the story is correct. And while you’re doing it, don’t let other people’s emotional reactions or beliefs influence you to a different way of thinking. Don’t let urban myth dictate your investment activities. And whatever you do, look for evidence where stories are based on a sample size of one. Trust me when I say, they’re not hard to find, they’re just very hard to ignore.

Further Suggested Reading:
'Sapiens - A Brief History of Humankind’ - Yuval Noah Harari
‘Narrative Economics’ - Robert J. Shiller January 2017

 Keep learning on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

The Stock 'Business' Market

"That whole idea that you own a business, you know, is vital to the investment process." Warren Buffett

Between the ages of 11 and 19, Warren Buffett was a failed investor. Hard to believe, right?

And it wasn’t for lack of trying. By the age of ten, Buffett had read every investment book on the shelves of the Omaha library. He'd gorged on stock quotes and technical analysis, and whilst his education in investing could be said to have improved, quite simply he wasn't making any money.

But at the age of nineteen, Buffett picked up Ben Graham's 'Intelligent Investor' and everything changed for him. Within Chapter Eight of that book lay an alternative philosophy about investments. The author proposed that an investor was 'analogous to that of a silent partner in a private business' whose results would be 'entirely dependent on the profits of the enterprise'. Graham proffered that 'as long as the earnings power of [the] holdings remain satisfactory, [an investor] can give as little attention as he pleases to the vagaries of the stock market'.

It had been the 'vagaries of the market', the unexpected and inexplicable changes in stock prices that had obstructed Buffett from investment success. With this learning, a light went on in Buffett's mind. It was a seminal moment that would change his life. 

"From 11 to 19, I was reading Garfield Drew, and Edwards and Magee, and all kinds of — I mean, I read every book — Gerald M. Loeb — I mean, I read every book there was on investments, and I didn’t do well at all. And I had no real investment philosophy. I had a lot of things I tried. I was having a lot of fun. I wasn’t making any money. And I read Ben’s book in 1949 when I was at University of Nebraska, and that actually just changed my whole view of investing. And it really did, basically, told me to think about a stock as a part of a business." Warren Buffett

Like Buffett junior, the vast majority of market participants think of stocks as pieces of paper to be traded, not an entitlement or claim to the underlying earnings of a business.

"To many on Wall Street, both companies and stocks are seen only as raw materials for trades." Warren Buffett

These investors take their cues about their investment decisions and the company they’ve bought from short-term stock price movement rather than the performance and outlook of the underlying business.

"People buy a stock and they look at the price next morning and they decide to see if they are doing well or not doing well. It is crazy. They are buying a piece of the business.” Warren Buffett

As such, a stock price decline must imply the outlook is deteriorating, and vice versa. But stock prices move for all sorts of reasons, and many of them are unrelated to business fundamentals. And humans are emotional, they often over-react; psychological biases mean they often do the wrong thing at the wrong time. Consequently, stock prices can have little semblance to what a company is worth, be it too high or too low. Basically, stock prices are frequently irrational.

"The beauty of stocks is that they do sell at silly prices from time to time. That's how Charlie and I have gotten rich." Warren Buffett

This is the beauty and the real opportunity in public markets. These markets are brimming with emotional participants who don't know what they own, what their stocks are worth and who buy and sell at the wrong times. Emotions rather that facts drive their investment decisions. Sometimes it's not even people, but two algorithms programmed to sell at market prices, come what may. No price is the wrong price for an algorithm. 

“When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact market prices are frequently nonsensical.” Warren Buffett

In contrast, private market transactions are ordinarily set by astute, informed, rational sellers.

"In a negotiated purchase of a business, you’re almost always dealing with someone that has the option of either selling or not selling, and can sort of pick the time when they decide to sell, and all of that sort of thing. In stock markets, it’s an auction market. Crazy things can happen. You can have, you know, some technological blip that will cause a flash crash or something. And the world really hasn’t changed at all, but all kinds of selling mechanisms are tripped off, and that sort of thing. So you will see opportunities in the stock market that you’ll never really get in the business market." Warren Buffett

"The stock market will offer you opportunities for profit, percentage-wise, that you’ll never see, in terms of negotiated purchase of business." Warren Buffett

"An auction market, prevailing in the stock market, will offer up extraordinary bargains sometimes, because somebody will sell a half or one percent of a company at a price that may be a quarter of what it’s worth. Whereas in negotiated deals, you don’t get that." Warren Buffett

By acknowledging that stock prices could be nonsensical, Buffett overcame the powerful emotional impact that can derail an investors' decision making process. Buffett changed his perspective, he now looked to the business as his guidepost, not the share price.

"We don’t consider ourselves richer or poorer based on what the stock does. We do feel richer or poorer based on what the business does. So we look at the business as to how much we’re worth. And we do not look at the stock price, because the stock price doesn’t mean a thing to us." Warren Buffett

"You have to have an attitude that divorces you from being influenced by the market." Warren Buffett

“I think it’s almost impossible if you’re to do well in equities over a period of time if you go to bed every night thinking about the price of them. I mean, Charlie and I, we think about the value of them.” Warren Buffett

Taking a step further, Buffett framed his purchases under the guise of buying the whole enterprise which provoked a different analytical lens than for share purchases. 

"When we buy a stock, we always think in terms of buying the whole enterprise, because it enables us to think as businessmen, rather than as stock speculators." Warren Buffett

Buffett even considered stock purchases in the hypothetical context of a stock market that was indefinitely closed.

"No matter what the stock was selling for — it just doesn’t make any difference — because we do look at the businesses. We really look at it as if there wasn’t any quote on the stock. Because we don’t know what the stock is going to do. If the business gets worth more at a reasonable rate, the stock will follow, over time. But it won’t necessarily follow week by week, or month by month, or year by year... So we really measure all the time by the business. We think of it as a private business, basically, for which there’s a quotation. And if it’s handy to use that quotation, either in buying more stock or something of the sort, we may do it. But it does not govern our ideas of value." Warren Buffett

“We bought See’s Candy in 1972. We haven’t had a quote on it since. Does that make us wonder about how we’re doing with See’s Candy? No, we looked at the company results. So — there’s nothing wrong with focusing on company results. Focusing on the price of a stock is dynamite, because it really means that you think that the stock market knows more than you do. Now if the stock market may know more than you do, but then you shouldn’t be in stocks. I mean, you should have — the stock market is there to serve you and not to instruct you.” Warren Buffett

Buffett recognised that over the longer term a company's share price must reflect the value of the future earnings of that company. 

"Sooner or later, the amount of cash that a business can disgorge in the future governs the value it has — that the stock commands — in the market. But it can take a long time." Warren Buffett

"Wild swings in market prices far above and below business value do not change the final gains for owners in aggregate; in the end, investor gains must equal business gains." Warren Buffett

What a stock earns depends solely on the business that underlies that stock. It's little wonder Buffett considers himself, first and foremost, a business analyst.  

"When investing, we view ourselves as business analysts - not as market analysts, not as macroeconomic analysts, and not even as security analysts." Warren Buffett

"The only way we know how to make money is to try and evaluate businesses." Warren Buffett

And identifying good businesses that can grow their earnings is key. 

"People have been successful because they've stuck with successful companies. Sooner or later the market mirrors the business." Warren Buffett

Which means its important to think about what makes a good business. Focus on the ones you understand.

"I think most of the people in this room, if they just focused on what made a good business or didn’t make a good business and thought about it a little while, they could develop a set of filters that would let them, in five minutes, figure out pretty well what made sense or didn’t make sense." Warren Buffett, Berkshire AGM 1997

"The way you learn about businesses is by absorbing information about them, thinking, deciding what counts and what doesn’t count, relating one thing to another. And, you know, that’s the job. And you can’t get that by looking at a bunch of little numbers on a chart bobbing up and down about a — or reading, you know, market commentary and periodicals or anything of the sort. That just won’t do it. You’ve got to understand the businesses. That’s where it all begins and ends." Warren Buffett

"I would just read the Graham and the Phil Fisher books. And then read lots of annual reports, think about businesses, and try and think about which businesses you understand and which you don’t understand. And you don’t have to understand them all. Just forget about the ones that you don’t understand." Warren Buffett

"I think you ought to learn everything you can about industries and businesses that — where you think you have the ability to get your mind around them if you work at them. And with that arsenal, you’ll do very well, and if you’ve got the temperament for the business." Warren Buffett

Paying the right price for the future earnings is what value investing is all about.

"What you’re trying to do is look at all the cash a business will produce between now and judgment day, and discount it back at a rate that’s appropriate, and then buy it a lot cheaper than that." Warren Buffett

Not overpaying is important. Although, paying too much for a great business is more likely to lead to waiting longer for results rather than the permanent loss of capital.

"Stocks are part of a business. If the business does well, they’re [the investors] going to do all right as long as they don’t pay way too much to join into that business... [If] you pay too much for them, [the] risk is usually a risk of time rather than loss of principal, unless you get into a really extravagant situation." Warren Buffett

And if you get the business analysis right, the investment will be right. 

"We figure if we’re right about the business, we’re going to make a lot of money. And if we’re wrong about the business, we don’t have any hopes — we don’t expect to make money." Warren Buffett

"What costs us money is when we mis-assess the fundamental economic characteristics of the business." Warren Buffett

It also means not having to worry about the macro or political issues.

"I can’t remember any discussions Charlie and I have had, ever, going back to 1959, that where we would’ve come to the conclusion at the end of them that we would’ve passed on a great business opportunity — a business to buy — because of external conditions. Nor did we ever buy anything that we thought was mediocre simply because we thought the world was going to be wonderful." Warren Buffett

It shouldn't come as a surprise many of the Investment Masters think the same way as Buffett. While each Investment Master has their own style, a great majority consider themselves business owners rather than stockholders and consider stocks as 'pieces of a business'. 

“Forget the noise. Investing is about owning businesses!” Francois Rochon

"The number one idea is to view stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage." Charlie Munger

“You have to think of yourself as an owner of a business, rather than an owner of a piece of paper." Li Lu

“Think of securities as interests in companies, not trading cards.” Howard Marks

“Stock certificates are deeds of ownership in business enterprises and not betting slips.” J Paul Getty

“Stocks are ownership shares of businesses; they are not pieces of paper that bounce around on which you calculate Sharpe and Sortino ratios. They are ownership shares of businesses that we value, and either buy at a discount or short when they are overpriced.” Joel Greenblatt

Summary

I think one of the most important lessons from Buffett has to be this fundamental shift in his thinking. Prior to his discovery of Ben Graham’s book in 1949, he had been dabbling in the Stock Market and whilst having lots of fun, had not earned a cent. Once he had shifted his thinking towards Business Ownership as opposed to Stock Ownership, he began to make money.

And it’s a relatively simple lesson that is missed by the majority of the world’s investors. They live their lives based on what a stock price is doing rather than the future earnings potential of the businesses they own, and therefore often ‘create’ fluctuations in the prices of those stocks due to their emotions or thinking biases. Or even worse, the emotions and thinking biases of other people. AKA: the Herd.

So here’s some easy things to remember from all this:

1) Think about the stock as part of a business
2) Learn everything you can about businesses and industries
3) Identify good businesses with sustainable competitive advantages that are growing
4) Recognise that stock prices can be completely irrational and nonsensical
5) Apply Mental Tricks - consider you are buying the whole business and that the stock market will close indefinitely
6) Look to buy such businesses for less than they’re worth
7) Focus on the underlying performance of the business rather than its stock price
8) Provided the business does well over the long term, you will do well.

Sometimes the simple act of thinking about something in a different way can bring context to a situation.  Buffett's example is a case in point. It wasn't until he read Ben Graham’s book and changed his frame of reference to consider stocks as 'pieces of a business' that success came. And this approach has proven itself over time.

"I haven’t seen anything in the last 25 years, and I read — I glance through — most of the books. I’ve seen nothing to improve on Graham and Fisher in terms of the basic approach of going about investing, which is to think about stocks as businesses, and then think about what makes a good business." Warren Buffett

Further Reading:
‘Business Owner Mentally’ Investment Masters Class

 Keep learning on Twitter: @mastersinvest

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Out of Town

If there was one thing I learnt from my recent trip to Omaha, Nebraska (and let me tell you: I learnt a lot), it's that you don't have to be hunkered down in a glittering marble office in Wall Street to be a successful investor.

We all recognise Buffett and Munger as the Kings of the Game. Fifty years plus of successful investing has earned them the right to the crown. And they deserve it. Absolutely, without a doubt. And there they were, sitting comfortably and humbly before 20,000 adoring shareholders in one of the smaller towns in America's mid-west - Omaha, Nebraska. Which, if you don't know, is nowhere near Wall Street. In fact, Omaha is the polar opposite in many ways; a small population and very, very quiet. 

So why would the best investors in the world decide to grow roots in a place as divorced from Wall Street as you can get?

The answer is that the world's best investors are Independent Thinkers.

 “The consensus is often wrong, so I have to be an independent thinker. To make any money, you have to be right when they’re wrong.” Ray Dalio

"You can’t be a good value investor without being an independent thinker – you’re seeing valuations that the market is not appreciating." Joel Greenblatt

“Great investing requires an independent spirit, and the courage to acquire assets the crowd disdains.” Shelby Davis

Locating miles away from the noise of Wall Street allows Buffett to focus on what's important. Rather than obsess over geopolitical developments, analyst price targets, economist forecasts, interest rates, or the Fed's next move, instead Buffett focuses on the businesses as an owner would. He spends most of his day reading and thinking. Buffett only considers businesses he understands, scrutinising how sustainable their competitive advantages are, the quality of the management and their ability to deploy capital. He reads the raw financial statements, he talks to industry representatives and he collects the facts. Ultimately he's looking for wonderful businesses that can deliver more long-term value than the money that he puts in. It requires patience and discipline.

Like most great investors, Buffett is also somewhat of a contrarian. But not just for the sake of it; only when he has conviction. Basically speaking, if you do what everyone else does, you'll deliver average results. And remember, the average fund fails to beat the market over the long term.

Over the years I've noticed quite a lot of the world's best investors locate themselves away from the noise of Wall Street. I had the good fortune to speak with Chuck Akre while in Omaha and he reiterated his views on working well away from the distractions of Manhattan. Like Warren and Charlie, he prefers to do his thinking in a quieter place.

“The reason we are in a town with one traffic light and away from all the very bright and intellectually interesting people is that their stuff would be intellectually appealing to us and it would distract us from what it is we do well. And that’s a really important notion.” Chuck Akre

“If I was on Wall Street I’d probably be a lot poorer. You get overstimulated on Wall Street. You hear lots of things. You may shorten your focus and a short focus is not conducive to long profits. Here I can just focus on what businesses are worth. I don’t need to be in Washington to figure out what the Washington Post is worth, or be in New York to figure out what some other company is worth. Here I can just focus on what businesses are worth.” Warren Buffett

“We’ve found for the 22 years we’ve been away from Wall Street our performance has been better than the 22 years we managed from Radio City in New York. We went to the same meetings as the other analysts and the people who speak are so sensible that we can’t help but be influenced. It’s easier to be odd when your 1,000 miles away.” Sir John Templeton

"The advantage of being located in the foothills of the Blue Ridge Mountains is that we are outside of the fray. Removed from the noise, we are able to climb the mountain and survey the investment landscape with a rational, objective, long-term perspective." Chris Pavese

"It's a massive competitive advantage for us [being in Laguna Beach]. There's so much noise in New York and San Francisco and Chicago. The beauty of being in Laguna Beach is that you're not subject to the constant chatter that goes on, which really forces you to be short term in your orientation - to make decisions in 3 and 6 months periods of times versus five and seven year periods of times. We are able to be more thoughtful." Paul Black

“Seth Klarman, one of the most successful investors on the planet, works out of a decidedly unflashy office in Boston, far from the intoxications of Wall Street. If he wanted, he could easily rent the top floor of a gleaming skyscraper overlooking the Charles River.. And Buffett is tucked away in Omaha’s Kiewit Plaza – another building that is not exactly known for its razzamatazz. This strikes me as a significantly, yet largely unrecognized factor in the success of these investors. Small wonder, then, that I wanted to create my own version of Omaha.” Guy Spier

"Sufficiently removed from Wall Street's hullabaloo, Windsor applied our low P/E sometimes boring principles in consistent fashion. We weren't fancy just prudent and consistent. We always took note of prevailing opinion, but we never let it sway our investment decisions" John Neff

"There’s just so much buzz and craziness in finance in a place like Manhattan that I think it was actually an advantage for Warren to be brought up in a place out of Omaha." Charlie Munger

"You can think here. You can think better about the market; you don't hear so many stories, and you can just sit and look at the stock on the desk in front of you. You can think about a lot of things" Warren Buffett

“Boca Raton is far from New York, but we believe being disconnected is a good thing. We have a unique investment philosophy and process, which is built upon independent fundamental research. We are not concerned with what anyone else thinks of the companies we own. In that way, we think it is actually an advantage to be on an island of sorts.” Damon Ficklin

“It helps us not being in the midtown Manhattan rate race. I’m not comparing our firm’s AUM numbers or profitability with anyone else. I don’t care about that stuff. We can think and do our own thing.” Brian Bares

“Being in Edinburgh, having a bit of distance and perspective on what’s happening in financial markets may provide that ability to be patient in this most impatient of industries. We think that’s more likely to add value for our clients over time.” Tom Slater

“I worked in New York for a couple of years. And people kept whispering to me on street corners. And I kept listening, which was even worse. So I got back to Omaha where there’s less chance you’ll go way off the track. It’s one of the advantages of being in Omaha, frankly.” Warren Buffett

“I’ve realised that successful investors all live far from financial centres. For example, Buffett lives in Omaha and I live in Seattle. Places like Beijing, Shanghai, New York City or Hong Kong are not necessarily the best. All those highfalutin’ people are just noise. Why is it called noise? Because it ultimately produces next to nothing.” Li Lu

“Our journey in investment as a firm began in Edinburgh and it continues there. Our location puts us far from the madding crowd but our perspective on the world is wide open.” Baillie Gifford

“The by-product of removing yourself from the hustle and bustle of this industry - because it's a fire hose of data - when I got to Italy, by myself, in the quiet of my room, I could think about our companies in a way I couldn't do if I was in my office.” Reece Duca

In today's day and age, given the access to almost unlimited information on companies online, you don't need to be located on Wall Street to be successful. Many of the world's best sit in offices that are significantly divorced from the glitter and hype of that place and have sustained incredible track records because of it. So where are you? If you look around you and see a little less glitter and noise, don’t be discouraged, in fact it might be an edge you didn't know you had!

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The Investment Masters on bonds...

If we were asked to come up with 5 or 10 names of the world's greatest stock market investors, most of us could do it easily and many of us would probably include one or more of the following - Buffett, Munger, Graham, Templeton, Lynch, Fisher, Steinhardt et, al. But picking bond market gurus is a much more difficult task, however. Bill Gross and Jeff Gundlach are two names that come to mind for me, and to be honest, I can't think of many others.

Gross and Gundlach's ability to unravel the economic landscape has allowed their portfolios to beat their bond market benchmarks time and time again, and fund inflows have followed. But relative to the great stock market investors, their returns have been rather pedestrian. That's in no way to say they're inferior investors, they're just fishing in a different pond. 

Most of those people we consider the investment greats have made their money, not in bonds or 60:40 stock/bond allocations, but through owning stocks. If anything, they've shunned bonds.

"On the whole we are allergic to bonds.” Walter Schloss

"Gentlemen who prefer bonds don't know what they're missing." Peter Lynch

In recent years, I can't recall one Investment Master recommending government bonds as an investment. It's fair to say that most have been outright dismissive....

"If I had a choice between holding a US Treasury bond or a hot burning coal in my hand, I would choose the coal. At least that way I would only lose my hand." Paul Tudor Jones

“With interest rates being historically low right now I would not want to invest in bonds. Also a bond is a contract and you can’t do anything with that.” Ted Weschler

“I believe the risk lies in the risk-free rate.” Sir Michael Hintze

“It absolutely baffles me who buys a 30 year bond. I just don't understand it. And, they sell a lot of them so clearly, there's somebody out there buying them." Warren Buffett

"It is very strange situation to have the Fed say our goal is 2% inflation and people buy Treasury bills at 1.5% and have to pay tax on it. The government has announced to you it doesn’t pay to save. You will have nothing in the way of purchasing power.  To me it has just been absurd to see pension funds [in 2013 and future years] saying we ought to have 30% in bonds.” Charlie Munger

"Anyone betting on much lower interest rates in the next five years is making a big mistake." Steven Einhorn

“Almost anybody who trades risk assets has felt the impact of low rate policies. If there is a bubble, it is probably in the price of sovereign debt globally.” Jon Pollock

"Switzerland raised 50-year money at negative interest rates. A guy who owns a home in Denmark will get a check every month because he has a negative interest rate on his mortgage. It’s crazy, right? It makes no sense." Leon Cooperman

"Long-term government bonds are ridiculous at current yields. They are not safe havens. Investors who have experienced the price run-up in the bond market but who have not marked down their forward expected portfolio rate of return are making, in our view, a possibly fatal mistake.” Paul Singer

There are a few good reasons that the Investment Masters haven't been advocating bonds; they're expensive, the return profile is asymmetric, there's no upside participation, prices have been manipulated, and a bout of unexpected inflation would mean some seriously permanent capital losses. Furthermore, over the long term bond returns have significantly lagged equities, and that's not likely to change in the future. 

Let's consider some of those..

Bonds are Expensive

Buffett advocates a common sense approach to buying bonds; that is, viewing bond investments with a businessman’s perspective. What does the return profile look like? What is an equivalent PE ratio? How long would it take to double your money? On this basis, and relative to equities, bonds have looked horribly expensive.

“The ten-year bond is selling at 40 times earnings. And it's not going to grow. And if you can buy some business that earns high returns on equity and has even got mild growth prospects, you know, at much lower multiple earnings, you are going to do better than buying ten-year bonds at 2.30 or 30-year bonds at three, or something of the sort." Warren Buffett

“A bond that pays you 2% is selling at 50X earnings and the earnings can’t go up. And the Government has told you we would like to take that 2% away from you by decreasing the value of money. That is to absurd to own something like that. To make that a voluntary choice in the last ten years against owning assets has struck me as absolutely foolish." Warren Buffett

No Upside Participation

When you hold a bond you get paid a coupon and hopefully receive your face value at maturity. You don't get more coupons if the government or the company issuing the bond does well. Unlike owning a stock, there is no upside optionality. That's why it's called 'fixed' income. The coupon, maturity date and repayment of par are all fixed.

“Bonds offer no growth in intrinsic-worth opportunities comparable to equity securities. A bond indenture makes two primary promises: to make generally fixed semi-annual interest payments and to redeem the bond at par value on maturity date. If there is no upside, it makes no sense to us whatsoever to expose our clients to risk on the downside.” Frank Martin

"Whereas companies routinely reward their shareholders with higher dividends, no company in the history of finance, going back as far as the Medicis, has rewarded its bondholders by raising the interest rate on a bond." Peter Lynch

“In fixed income.. returns are limited and the manager's greatest contribution comes through the avoidance of loss. Because the upside is truly "fixed," the only variability is on the downside, and avoiding it holds the key. Thus, distinguishing yourself as a bond investor isn’t a matter of which paying bonds you hold, but largely of whether you're able to exclude bonds that don't pay. According to Graham and Dodd, this emphasis on exclusion makes fixed income investing a 'negative art.'" Howard Marks

"In stocks you've got the company's growth on your side. You're a partner in a prosperous and expanding business. In bonds, your nothing more than the nearest source of spare change. When you lend money to someone, the best you can hope for is to get it back, plus interest." Peter Lynch

Asymmetry of Bond Yields

When interest rates on bonds are plumbing record lows, close to zero or in some cases negative, it's difficult to imagine them falling much further. However, should yields rise to a level more consistent with history and economic theory [eg Taylor rule], bond prices could fall a lot. The lower the coupon the more downside there is from interest rates rises. If you have to sell before maturity, you could be wearing a large loss. This is the exact opposite type of asymmetry the Investment Masters seek; limited upside, big downside.

“When the [Treasury] yield is below 2.50%, it doesn't take much of either an inflation scare or something else—but it would most likely be an inflation scare—to make rates rise. And as they rise from such low levels, the mathematics are just brutal, and you can get your clock cleaned by going long Treasuries or high-grade bonds.” Michael Lewitt

“How in the world could we be talking about rates never going up when in fact rates have bottomed?…In the investment world when you hear ‘never,’ as in rates are ‘never’ going up, it’s probably about to happen.” Jeff Gundlach

"It would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash." Ray Dalio

"An investor in fixed income today is beginning a compounding stream with the curve at the mid-1% level on cash to under 3% at 30 years. A rising interest environment will penalise the owner of long-dated debt with price declines, the longer the maturity the more severe the decline. A sustained increase in rates will help by allowing for re-investment at higher yields, but an expectation of returns much above initial yields would be asking for a lot." Christopher Bloomstran

"The Federal Reserve was founded in 1913. This is the first time in 102 years that the central bank bought bonds, and that we've had zero interest rates, and we've had them for five or six years. So do you think this is the worst economic period looking at these numbers we've been in in the last 102 years? To me it's incredible." Stanley Druckenmiller

US10yr Bond Yield Vs S&P500 Earnings Yield  [Source Bloomberg]

Permanent Capital Loss

Successful investing requires avoiding the permanent loss of capital. This means not only avoiding absolute capital losses but also the loss of purchasing power inflicted by inflation.

“I define risk as the chance of permanent capital loss adjusted for inflation." Bruce Berkowitz

"What we care about is avoiding the permanent loss of capital and, increasingly relevant today, the permanent loss of purchasing power.” David Iben

“The goal of investing is to protect and increase your portfolio in inflation-adjusted dollars over time.” David Dreman

"There is no real safety without preserving purchasing power.”  Sir John Templeton

"The riskiness of an investment is .. measured by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period." Warren Buffett

Ordinarily, one hundred dollars today will buy you more than $100 in ten years as inflation raises the cost of goods over time. Historically bonds have compensated investors for inflation, providing a real return of a few percent [see chart below]. In recent years, real returns have shrunk and in some instances turned negative.

“In our opinion, the only thing that is guaranteed with a bond that has a lower interest rate than the rate of inflation is impoverishment. Generating negative real returns goes against the very concept of investment. With each passing year, the holders of this asset class have their capital slowly crumble. From our perspective, the certainty of capital loss in purchasing power is the very definition of risk.” Francois Rochon

For the first time in history, some government and corporate bond yields have ventured below zero. Holding these bonds to maturity guarantees a permanent loss of capital even before inflation. Little wonder, the Investment Masters have steered well clear of buying bonds. 

US10Year Yield less Inflation [Source Bloomberg]

Inflation Risks

As we know, investors are prone to focus on the rear-view mirror. Prominent in most investor's rear view mirror has been the financial crisis, where the collapse in aggregate demand raised the prospects of deflation. The subsequent recovery has been characterised by low inflation which has conditioned investors to expect more of the same; extrapolating the last 10 years. But the future could be very different.

In a post last year titled 'The Buffett Series - Thinking About Bonds' I recommended reading the chapter 'The Last Hurrah for Bonds' in the excellent book, 'The Davis Dynasty'. Investment Master, Shelby Davis was an outspoken critic of bond investments in the 1940's. Here's an extract ... 

"[Shelby Davis] became an anti-bond maverick. The recent past had told people bonds were attractive and safe, but the present was telling Davis they were ugly and dangerous. Interest rates were fast approaching what economist John Maynard Keynes called the "balm and sweet simplicity of no percent." Keynes was exaggerating, but not by much - the yield on long-term Treasuries hit bottom-2.03 percent in April 1946. Buyers would have to wait 25 years to double their money, and, to Davis, this was pathetic compounding. He saw the threat in the "sea of money on which the U.S. Treasury has floated this costliest of wars." With the government deep in hock and forced to borrow another $70 billion to cover its latest shortfall, he was certain lenders soon would demand higher rates, not lower.  The most reliable inflation gauge, the consumer price index, rose sharply in 1946."

What followed was a 34-year bear market in bonds that lasted from the Truman era to the Reagan years. The 2 to 3 percent bond yields in the late 1940's expanded to 15 percent in the early 1980's and, as yields rose, bond prices fell and bond investors lost money. The same government bond that sold for $101 in 1946 was worth only $17 in 1981! After three decades, loyal bondholders who had held their bonds lost 83 cents on every dollar they'd invested. Ignoring the scene in the rear-view mirror, Davis focused his attention on navigating the future. 

The biggest dupes in the triple swindle were fat cats and institutions (pension funds, insurance companies, and their ilk). These sophisticated types who could afford bonds might have seen the folly in owning government paper in the late 1940's, but most didn't. Fanciful arguments tranquilized the bond bulls. They believed that because bonds were profitable in the past decade, they’d be profitable in the next. They convinced themselves that the Fed could keep interest rates from rising, indefinitely.  A government that controlled the price of pork chops, it was widely assumed, could also control the price of money."

And Davis was right ...

“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

Sound familiar? Since the Financial Crisis, investors have allocated significantly more funds into bonds than stocks. Only now are investors awakening to the risks of rising inflation. 

"What is the worst investment against inflation? Bonds. The objective of governments who are overly indebted will be to devalue bonds so that their burden can be reduced. Yet, what are investors doing these days? They are aggressively buying bonds and moving away from equities. They rant against debt but continue to buy government notes or leave cash in the bank at 1% interest. 

What is the best hedge against inflation? Owning companies with unique products that have high pricing power. If I were a German investor in 1945, I would have wanted to own Porsche, Beck’s, Hugo Boss, Bayer, Braun, and Nivea. The value of the German currency could have gone to zero, but if the brands were solid, you still could have realized a profit in any currency. Our job is to select solid companies that can withstand inflation and other economic risks." Francois Rochon, 2010

Prices are being Manipulated

The global central banks have become the price setter in the bond market. Having taken short rates to zero, for the first time in history, the global central banks sought to lower the long end of the curve by buying bonds. The endgame was to force investors into riskier assets, [e.g. junk bonds, equities, real estate], create a wealth effect, and stimulate the economy. This may very well be the biggest 'peg' in financial history. 

"While we are aware that debt markets can persist at zero or even modestly negative rates for a period of time, we believe it is best to make capital allocation decisions on the basis that fixed income securities will eventually trade where a fixed income investor would own them rather than where governments and fixed income traders will push them." Larry Robbins

Historic Underperformance

Earlier this century, only bonds were deemed a safe investment; equities were considered too speculative. As a result, bond yields were lower than the yields on common stocks.

"After the great market decline of 1929 to 1932, all common stocks were widely regarded as speculative by nature. A leading authority stated flatly that only bonds could be bought for investment." Benjamin Graham

This changed after the 1930's when it dawned on investors that stocks offered more upside than bonds, as the retained earnings after dividend payments could compound within the company... 

"To report what Edgar Lawrence Smith discovered, I will quote a legendary thinker - John Maynard Keynes, who in 1925 reviewed the book, thereby putting it on the map. In his review, Keynes described 'perhaps Mr. Smith's most important point ... and certainly his most novel point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back in the business. Thus there is an element of compound interest (Keynes' italics) operating in favor of a sound industrial investment.

"It was that simple. It wasn't even news. People certainly knew that companies were not paying out 100% of their earnings. But investors hadn't thought through the implications of the point. Here, though, was this guy Smith saying, "Why do stocks typically outperform bonds? A major reason is that businesses retain earnings, with these going on to generate still more earnings--and dividends, too." Warren Buffett

“In the 1920s, a brilliant and important book by Edgar Smith, Common Stocks for Long-Term Investment, became a prime market influence. It was still popular in the fall of 1929, but most people read it too late. Mr. Smith advocated the benefit to corporate growth of the application of retained earnings and depreciation. Thus capital appreciates. The book may have been influential in changing accepted multiples of 10 x earnings to higher multiples of 20 to 30 x earnings."  Roy Neuberger

And outperform they did. Analysis by Professor Siegel of the Wharton School of Business highlights returns on several major classes of financial assets, including stocks and bonds, in the US during the past two hundred years. The figures are staggering. Long term bonds significantly under-performed stocks.

Source: Li Lu's Lecture 'The Prospect of Value Investing in China'

"Here is the result: 1 US dollar in stocks, after discounting for inflation, experienced an appreciation of 1 million times the original value over the past 200 years! Its value today would be 1.03MN US dollars. Even the remainder of this number is bigger than the return on every other class of assets. What are the reasons behind such an astonishing performance? The answer lies in the power of compounding. The average annualized rate of return for stocks, discounting inflation, is only 6.7%. No wonder Einstein called compound interest the eighth wonder of the world." Li Lu

David Dreman's excellent book 'Contrarian Investment Strategies' contains a chapter titled 'An Investment for All Seasons' which states; "I will make clear, the crucial but little known fact that stocks are not a risky investment, if you hold them for a number of years... stocks also keep their value better than almost any other investment through hyperinflation and most other crises."

Source:Masterinvestor

Dreman noted .. "Stocks outperformed T-bills 73% of the time for all five year periods between 1802 and 1996, 81% for ten year periods, 95% and 97% respectively for 20- and 30- year periods. The results after the war are better yet. For any five year period stocks outdistanced T-bills 82% of the time, and for any 20-year or 30-year period 100% of the time. The comparison with long bonds are nearly identical."

Source: Masterinvestor

Mr Dreman concludes.. "the probability that the investor holding stocks will double her capital every 10 years after inflation, quadruple every 20, combined with 100% odd that she will outperform T-bills or government bonds in 20 years, can hardly be called risky. Conversely, the supposedly 'risk-free' assets actually display a large and increasing element of risk over time."

Mr Dreman is not alone. The Investment Masters recognise this ... 

"The S&P outperformed inflation, Treasury bills, and corporate bonds in every decade except the ‘70’s, and it outperformed Treasury bonds – supposedly the safest of all investments – in all four decades.”  Sir John Templeton

"Stocks outperformed bonds, as Edgar Lawrence Smith, Irving Fisher, and John Maynard Keynes noted as far back as the twenties." David Dreman

"Practical experience demonstrates that stocks provide superior returns over reasonably long holding periods." David Swenson

"Not every time in my life, but probably 90 percent of the time in my life, it’s made more sense [owning equities] than owning fixed-dollar investments." Warren Buffett

"In spite of crashes, depressions, wars, recessions, ten different presidential administrations, and numerous changes in skirt lengths [for 60 years until 1987], stocks in general have paid off fifteen times as well as corporate bonds, and well over thirty times better than Treasury bills." Peter Lynch

"In the very long term, equities represent the best investment class." Francois Rochon

"Stocks have historically outperformed over moderate to longer periods by a significant amount." Ed Thorp

“History has shown that equities are the best way to build long-term wealth.” Shelby Davis

And that's likely to continue in the future.. 

"In the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money-market account. In the long run, a portfolio of poorly chosen stocks won't outperform the money left under the mattress." Peter Lynch

"The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century." Warren Buffett

Notwithstanding, there may be occasions where it makes sense to invest in bonds.  

"... though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable:  When bonds are calculated to be the more attractive investment, they should be bought." Warren Buffett

The last time was back in the 1980's when bond yields peaked at 15% plus.

“We remember vividly 35 years ago staring at long-term impeccable bonds trading at 15% to 17% yields, thinking; “Why bother trading, hedging and knocking ourselves out? Why not just liquidate the whole portfolio and own these things and go on vacation for 10 years?” Paul Singer

“Anyone with a sense of contrarian mentality had to look at interest rates in the early 1980’s as presenting a potentially great opportunity. You knew the Fed would have to ease as soon as business started to run into trouble. In addition, we had already seen an important topping in the rate of inflation.” Michael Steinhardt

"In 1981 the public should have seen Volcker's jacking up of short-term rates to 21 percent as a very positive move, which would bring down long-term inflation and push up bond and stock prices." Stanley Druckenmiller

"When I purchased long-term zero-coupon bonds in the early 1980's at market yields in excess of 13%, I welcomed the prospect of outsized volatility because I felt it would eventually work in my favour." Frank Martin

That's not the case today..

“It is possible that there could be a time where a wise investor could be all in treasuries. It is virtually impossible for me to see when. I guess I could imagine it, but I haven’t seen it. Long-term treasuries are a losing battle over the long pull.” Charlie Munger, 2018

Warren Buffett once again espoused his thoughts in his most recent letter ...

"I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.

It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment “risk” by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk."

So let's wrap it up.. over the very long term, stocks have outperformed bonds by a significant margin. As an investor's holding period lengthens, the chances of a portfolio of quality businesses [low debt, good management, pricing power, etc.] purchased at reasonable prices outperforming a bond portfolio rises. Notwithstanding, if you require funds in the short term, or you can't stomach a large decline in the quoted prices of your portfolio of stocks, you probably shouldn't be investing in the stock market. With rates as close to zero as they've been in decades, today's bond market looks like a bubble to me. It's little wonder the world's greatest investors continue to favour quality businesses over bonds. Wouldn't you?

Further Reading:

David Dreman, 'Contrarian Investment Strategies' - Chapter 13/14 'An Investment for All Seasons'/'What is Risk?'

Peter Lynch, 'One up on Wall Street' - Chapter 3 'Is this Gambling or What'

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Learning from Benoit Mandelbrot

If you've been reading some of my recent posts, you will have noted my, and the Investment Masters belief, that many of the investment theories taught in most business schools are flawed. And they can be dangerous too, the recent Financial Crisis is evidence of as much. One man who, prior to the Financial Crisis, issued a challenge to regulators including the Federal Reserve Chairman Alan Greenspan, to recognise these flaws and develop more realistic risk models was Benoit Mandelbrot.

Over the years I've read a lot of investment books, and the name Benoit Mandelbrot comes up from time to time. I recently finished his book 'The (Mis)Behaviour of Markets - A Fractal View of Risk, Ruin and Reward'. 

So who was Benoit Mandelbrot, why is he famous, and what can we learn from him?

Benoit Mandelbrot was a Polish-born mathematician and polymath, a Sterling Professor of Mathematical Sciences at Yale University and IBM Fellow Emeritus (Physics) who developed a new branch of mathematics known as 'Fractal' geometry.  This geometry recognises the hidden order in the seemingly disordered, the plan in the unplanned, the regular pattern in the irregularity and roughness of nature. It has been successfully applied to the natural sciences helping model weather, study river flows, analyse brainwaves and seismic tremors. 

A 'fractal' is defined as a rough or fragmented shape that can be split into parts, each of which is at least a close approximation of its original-self. In nature, think of clouds, mountains, trees, ferns, river networks, broccoli, or cauliflower. Nassim Nicholas Taleb, who dedicated his best-selling book, 'Black Swan' to Mandelbrot, explains "This character of self-affinity implies that one deceptively short and simple rule of iteration can be used, whether by a computer or, more randomly, by Mother Nature, to build shapes of seemingly great complexity." 

When it comes to the stock market and fractals, think of hourly, daily, weekly, monthly or yearly stock price moves. Remove the x-axis labelled 'time', and they all looks pretty much alike. 

Source: J SHEI

Mandelbrot found that the underlying power law that was evident in random patterns in nature also applies to the positive and negative price movements of many financial instruments. The movement of stock prices followed a power law rather than a 'Bell', 'Gaussian' curve or 'Normal Distribution'.

"In the 1960's a maverick mathematician named Benoit Mandelbrot argued the tails of the distribution might be fatter than the normal bell curve assumed; and Eugene Fama, the father of efficient-market theory who got to know Mandelbrot at the time, conducted tests on stock prices changes that confirmed Mandelbrot's assertion. If price changes had been normally distributed, jumps greater than five standard deviations should have shown up in a daily price data about once every seven thousand years. Instead, they cropped up about once every three to four years." Sebastian Mallaby, 'More Money than God.'

While Mandelbrot's theory won't help us predict where a stock or commodity price is going or help us value a company, it can help us extract an element of order from the randomness of markets. It can also help us better understand and recognise risk - a prerequisite for successful investing. 

"The value of the great Benoit Mandelbrot's work lies more in telling us that there is a 'wild' type of randomness of which we will never know much (owing to their unstable properties.)" Nassim Nicholas Taleb

“The essence of investment management is the management of risks, not the management of returns. Well-managed portfolios start with this precept.”  Benjamin Graham

"A thoughtful investment approach focuses at least as much on risk as on return. But in the moment-by-moment frenzy of the markets, all the pressure is on generating returns, risk be damned." Seth Klarman

"Above all, we think vigilance towards risk is central to solid investment returns" Allan Mecham

Today, the Investment Masters recognise the traditional model, a core component of business school curricula, is flawed.  It has the propensity to significantly underestimate the probability of extreme volatility, known as tail events, that can lead to the permanent loss of capital.

"Things like Gaussian curves and Value at Risk (VAR) were some of the dumbest ideas ever put forward." Charlie Munger

"The idea that you have a bell-shaped curve is false. You have outlying phenomena that you can't anticipate on the basis of previous experience." George Soros

"It’s so much easier to work with that [Gaussian] curve, because everybody knows the properties of that curve, and can make calculations to eight decimal places using that curve. But the only problem is that curve is not applicable to behavior in markets, and people find that out periodically." Warren Buffett

"I think we pay more respect to the tails of the bell curve than most funds do: we tend to be at the tighter end of the spectrum." Israel Englander

 "The devil is in the residuals, as all of us have discovered to our sorrow." Howard Marks

"Extreme events are where ruin is found. It's also true that these extreme changes in securities prices may be much greater than you would expect from the Gaussian or normal statistics commonly used." Ed Thorp

"I discovered along the way that the economists and social scientists were almost always applying the wrong maths to the problems, what became later the theme of the Black Swan. Their statistical tools were not just wrong, they were outrageously wrong - they still are. Their methods underestimated "tail events," those rare but consequential jumps. They were too arrogant to accept it.  This discovery allowed me to achieve financial independence in my twenties, after the crash of 1987."  Nassim Nicholas Taleb

Source: Paul D Kaplan, 'Beyond the Bell Curve'

While I've long recognised the flaws in the 'bell curve' and witnessed them on an almost daily basis, I found the book a useful construct to help think about volatility and market risk. Benoit's book decimates the notion of a normal distribution of stock price changes and all of the models that rely on it: the efficient-market hypothesis, CAPM, Value at Risk [VAR] etc. 

Below I've included some of my favourite quotes from the book ..

"I am not a Luther fomenting schism in the Church. I am an Erasmus who, through study, reason, and good humour, tries to talk some sense. My aim; to change the way people think, so that reform may go forward." 

"My life's work has been to develop a new mathematical tool to add to man's small survival kit."

"Since my youth I have been shamelessly disrespectful of received wisdom."

"My understanding of economics comes not from abstract theory, but from observation."

"Keep it simple is the catchphrase of good models."

"Contrary to orthodoxy, price changes are very far from following the bell curve."

"Examine price records more closely, and you typically find a different kind of distribution than the bell curve. The tails do not become imperceptible but follow a 'power law.'"

"If price changes scale, the overhang can be catastrophic. Once you are riding out on the far ends of a scaling probability curve, the journey gets very rough."

"Periods of big price changes groups together, interspersed by intervals of more sedate variation - the tell tale marks of long memory and persistence. It shows scaling."

"The very heart of finance is fractal."

"The market is very risky - far more risky than if you blithely assume that prices meander around a polite Gaussian average."

"Market turbulence tends to cluster. This is no surprise to an experienced trader. They also know that is in those wildest moments - the rare but recurring crisis of the financial world - where the biggest fortunes of Wall Street are made and lost. They need no economists to tell them this. But their intuition is entirely validated by the multi-fractal model."

"Large price changes tend to be followed by more large price changes, positive or negative. Small changes tend to be followed by more small changes. Volatility clusters."

"That cotton prices should vary the way income does [ie. to a power law]; that income variations should look like Swedish fire insurance claims, that these, in turn, are in the same mathematical family as formulae describing the way we speak, or how earthquakes happen - this is, truly, the greatest mystery of all."

"Greater knowledge of danger permits greater safety. For centuries, shipbuilders have put care into the design of their hulls and sails. They know that, in most cases, the sea is moderate. But they also know that typhoons arise and hurricanes happen. They design not just for the 95% of sailing days when the weather is clement, but also for the other 5%, when storms blow and their skill is tested. The financiers and investors of the world are, at the moment, like mariners who heed no weather warnings. This book is such a warning."

"Why does the old order continue? Habit and convenience. The math is, at bottom is easy and can be made to look impressive, inscrutable to all but the rocket scientist Business schools around the world who keep teaching it."

"Real markets are wild. Their price fluctuations can be hair-raising - far greater and more damaging than the mild variations of orthodox finance. That means that individual stocks and currencies are riskier than normally assumed. It means that stock portfolios are being put together incorrectly; far from managing risk, they may be magnifying it. It means that some trading strategies are misguided, and options mis-priced. Anywhere the bell curve assumption enters the financial calculations, an error can come out."

"Markets are turbulent, deceptive, prone to bubbles, infested by false trends. It may well be that you cannot forecast prices. But evaluating risk is another matter entirely."

"Most financial models say little with much. They input endless data, require many parameters, take long calculation. When they fail, by losing money, they are seldom thrown away as a bad start. Rather, they are 'fixed'. They are amended, qualified, particularised, expanded and complicated. Bit by bit, from a bad seed a big but sickly tree is built, with glue, nails, screws and scaffolding. That people still lose money on these models should come as no great surprise."

"Whether guide or master, modern portfolio theory bases everything on the conventional market assumptions that prices vary mildly, independently, and smoothly from one moment to the next. If those assumptions are wrong, everything falls apart; rather than a carefully tuned profit engine, your portfolio may actually be a dangerous, careening rattletrap."

"The same false assumptions that underestimates stock-market risk, mis-price options, build bad portfolios, and generally misconstrue the financial world are also built into the standard risk software used by many of the world's banks. The method is called Value at Risk."

"Finance today is in the primitive state of natural history three centuries ago. Its concepts and tools are limited, and so it frequently confounds species."

"I am not yet finished; nor do I believe we are ever to have a perfect understanding of so complex a system as the global money machine. In economics, there can never be a "theory of everything." But I believe each attempt comes closer to a proper understanding of how markets behave."

Within Mandelbrot's book lies many truisms of the market, with one of the most recurring themes being that traditional business school financial models are quite simply, wrong. Mr Market does not play ball the way we would all like, nor does it conventionally follow the gentle line of a Gaussian Curve. Mandelbrot's genius lies in the fact that he has observed the markets over a long time, and using similar thought patterns to other Investment Masters, has been able to see what others haven't or wouldn't. What he teaches is to look beyond the obvious and the common; from chaos one can find order and from order one can find chaos. How visual complexity can be created from simple rules and that it is dangerous to blindly follow false assumptions. Mandelbrot is a genius and his learning is another gift to us all.

Further Reading:
Investment Masters Class Tutorial 'Efficient Market Hypothesis'
Investment Masters Class Tutorial 'Value at Risk'

Fingers of Instability Re-visited

No doubt you will have noticed that in the last week or so we've experienced a significant spike in market volatility. There's a common saying that markets go 'up the escalator, and down the elevator,' and that has certainly been evident of late. During the period of volatility we've witnessed stock markets being sold and bond prices falling, and through it all we've also watched investors all over the world react. 

Historic correlations have also become unhinged, as the market's participants start to question the implications of global central banks normalizing interest rates. Whether this volatility will continue and the markets will decline further, no-one actually knows. But what is evident is that the market moves were largely unexpected.  

The recent blog post titled 'Fingers of Instability' highlighted the more recent changes in market structure that has created fragility in the system. As more assets are held by people with zero comprehension of what they actually own, it's no surprise volatility spiked when the unexpected happens. These investors have no idea of the underlying worth of their investments and therefore no price to anchor to. No price is too high or low for an index fund to sell or buy. And when there is fear they all try to run out the gate at the same time. Throw in HFT and momentum strategies and in the end you've got a recipe for absolute disaster. But while its a disaster for uninformed investors, its also a potential opportunity for unemotional investors who have done the hard work and can take advantage of indiscriminate selling.

So, given what has occurred in the markets of late, I thought it would be a good idea to revisit a few of the important lessons that emanate from all of this. 

Common Sense - good investing requires common sense. Buying something that's expensive in the hope someone will pay more for it, is speculating, it's not investing. I can't see any rational reason why someone would think buying bonds as an investment makes any sense given ultra-low or negative yields . Historically bonds have provided a real return, but since the Financial Crisis bonds have moved from NOT providing a real return to in some cases giving a negative return. If you're holding to maturity you're going to be losing money after inflation in the first instance, and losing money full-stop in the second. That's an asymmetric bet the wrong way around.

Rear-View Mirror - Investors have a tendency to chase performance. One example of this is the bitcoin frenzy we've been witnessing lately. From time to time, I put a few things up on my Linkedin account, but if you follow it you'll note that I haven't written a lot about bitcoin as I don't see it as a legitimate investment. Its speculation, not an investment. I certainly have a view on the topic, but I'll also take note of the likes of Buffett, Munger, and Druckenmiller; they've been around the block a few times and their collective opinions are valuable to me. Despite my reticence to write about bitcoin, what's interesting is the number of my acquaintances who've asked me whether they should invest in it. And why do they care? Because it's gone up a lot, and they're wanting to chase performance. My Linkedin post on Bitcoin included a chart with a Warren Buffett quote on bubbles. It got 10,000+ hits.. that's an attention bubble right there!

Understand - if you don't understand something don't invest. Some investors learnt some tough lessons last week when the Inverse Volatility [XIV] ETF blew up. I'd say most investors in the fund were chasing performance. Selling volatility is a dangerous strategy if you don't know what you're doing and even more so when you don't know how the fund you're investing in works.

Expect the Unexpected - Don't set your portfolio up for that perfect outcome. Winning in the investment game is not losing. In a bull market all you need is an index fund. The difficult part is timing your exit. And no one knows when a market turns; they can and will turn on a dime. Don't be disappointed in lagging a bull market, it's often the price to pay for admission to long-term market-beating results. It's the outperformance in down markets which drive long term gains. You can't run a portfolio optimized for a bull market that will perform well in a down market. It's important to stress test your portfolio. How will the different assets perform under alternative investment scenarios?

I can't tell you with 100% conviction where the markets are going and neither can you. But you can give yourself the best chance of attractive long term returns by using common sense, understanding what you own and not chasing performance, and then building a portfolio of quality companies that are likely to continue growing over the next five or ten years. If you remain unemotional, focus on the intrinsic worth of your companies rather than market gyrations, the renewed increase in volatility is an opportunity, not a threat.

The Sandpile and Fingers of Instability

The markets are complex systems; they can turn on a dime. While things might be travelling along nicely, it doesn't take much for sentiment to take an aggressive turn, the market to become pre-occupied with the negatives and all of a sudden the market is a lot lower. While the market's participants will look back and point to 'this reason' or 'that reason' as the event blamed for the sell-off,  in reality the situation is no more alarming than the negative news snippets that the market would ordinarily take in its stride.

I find a useful 'mental model' for explaining this phenomenon in the markets is the sandpile analogy; where a pile of sand develops from dropping individual grains from above. The sandpile continues to grow until a critical state is reached from which a single grain, no bigger than any of the previous grains, can bring about a collapse in the structure. As I've said before, it only takes one stone to start an avalanche. The real difficulty in this of course is that no one can predict which grain will be the one that triggers that avalanche.

One of the best books I've read on the concept of critical states is 'Ubiquity - Why Catastrophes Happen' by Mark Buchanan. I picked this book up from Bruce Berkowitz's recommended reading list. Mr. Buchanan delves into the unpredictability of complex natural and human cataclysms created by dynamic critical states.  His theory on the 'fingers of instability' that run through sandpiles is a useful construct to work with when thinking about financial markets.

"After the sandpile evolves to its critical state, many grains rest just on the verge of tumbling, and these grains link up into "fingers of instability" of all possible lengths.  While many are short, others slice through the pile from one end to the other. So the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability. The power law simply reflects this situation, and points to the riddling instability that underlies the sandpile's workings. In this simplified setting of the sandpile, the power law also points to something else; the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche, large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organisation of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size" Mark Buchanan

Like sandpiles, as financial asset prices rise, markets have a tendency to reach a critical state, balanced uneasily from whence anything can happen. An indistinct piece of information or an individual market order can create an unexpected abnormal and exceptional, non-linear reaction.

“As George Soros has pointed out, the proximate cause of a panic is never the real cause any more than the last straw actually breaks the camel’s back” Andy Redleaf

“It’s always hard to know when you are in a bubble, and if you are in a bubble, when it is going to pop. It’s a lot like the chaos theory image of dripping sand onto a little pile that’s shaped like a cone on the beach. The pile gets higher and higher and finally suddenly there will be a little avalanche.” Ed Thorp

“When catastrophes occur, we naturally seek to identify the principal cause so we can avoid another disaster or at least derive some comfort from knowing what happened. We like it best when we can point to one specific, easily identifiable cause, but that is not always possible. Many scientists believe that large scale events in biology, geology, and economics are not necessarily the result of a single large event but rather of the unfolding of many smaller events that create an avalanche—like-effect. Per Bak, a Danish theoretical physicist developed a holistic theory of how systems behave called 'self-organised criticality'. To illustrate the concept of self-criticality, Bak often used the metaphor of a sandpile” Robert Hagstrom

Throughout history, each subsequent stock market correction has been characterised by an innovation which has been unique to that period; either it was new, or its adoption was at a level of unprecedented proportion. In the crash of 1929 the blame for the collapse was laid at the foot of 'margin debt'. In the 1987 stock market crash it was 'portfolio risk management tools'. The tech crash was characterised by 'new era valuation methodologies', while the Global Financial Crisis saw exponential growth in 'dis-intermediated opaque structured products'.

Unfortunately, on Wall Street, innovations typically come with unintended consequences. 

"When Wall Street gets innovative, watch out!" Warren Buffett

"In reflecting on the societal impact of various areas of innovation, complexity and connectivity, it is easy to recount examples with mostly positive or mixed consequences. But in the realm of finance, as much as we traders appreciate the opportunity to unpack and trade complexity in securities, structures and markets, we wonder if the overall impact of financial innovation, including derivatives, structured products, high-frequency trading and communication advances, is a net negative, albeit with a possibly long delay before the drawbacks become visible" Paul Singer

Turning to the sandpile as the metaphor for markets, these innovations represent the 'long fingers of instability'. Crazy valuations, cheer-leading brokers, unethical salespeople, conflicted ratings agencies, illiquidity, and opaqueness are a few of what I consider the 'shorter' or 'intermediate fingers of instability'. Combined, they resulted in a brittle foundation for asset prices, vulnerable to the next piece of negative news or price action.

So what are the 'fingers of instability' that run through today's markets?

The biggest risk to market structure today is the increasing dominance of 'Passive Investing' [ETF's & Index Funds], High Frequency Trading and Volatility targeting. These strategies are price indiscriminate [ie they have no regard to the underlying fundamental values of the companies] and when combined with increasing Connectivity and Illiquidity pose material risks to markets. I'll cover off on each of these..

High-Frequency Trading [HFT] and Market Illiquidity

HFT has been sold to the regulators and the masses as 'market-makers' or liquidity providers. HFT certainly adds to the volume traded, but volume is not liquidity. Most HFT firms end the day with no net position - whatever they've sold, they've bought, and vice versa. An easy way to understand the difference between liquidity and volume is to imagine the market had only two participants, both HFT firms. Each firm traded 1,000 shares back and forth between themselves 100 times a day. To an outsider, the volume would appear as 100,000 shares of daily volume. Imagine now, a third entrant, a genuine buyer, enters the market to buy 10,000 shares. After they've bought their first 1,000 shares there is no liquidity.

Furthermore, HFT firms access trading flow data with lower latency, meaning they get trading information quicker than other participants. A genuine buyer sends an order into multiple exchanges [as markets are now far more fragmented], and the HFT firm co-locates their own servers within each exchange to interpret and react to that flow data before its onward journey to the next exchange. The original purpose of the exchange, to match genuine buyers and sellers of stocks and promote price discovery for the efficient allocation of capital, no longer holds true. 

“HFT is essentially removing liquidity from the market because it knows what you are doing and can do it before you.”  John Burbank

"Seeing someone's order to sell, the High Frequency Trader sells first, causing the stock to fall, and then buys it back at the lower price. How is this different from the crime of front-running?" Ed Thorp

“.. the systemic risk in these High-Frequency Trading systems. We saw this in the flash crash of 2010. The market just fell apart because some computers couldn’t handle the volatility. Technological risk is high, and that’s a problem, a real problem. The cancellation of orders is a real problem. The lack of public information and the lack of transparency are big problems."  John Bogle

"[HFT is] not a liquidity provider. It may create more volume but that's not the same as being a liquidity provider. To the extent that it is front running, I think society has generally been against front running for good reasons... Here they've gained an advantage by figuring out how the system worked and getting there first and that adds nothing" to economic activity." Warren Buffett

When volatility increases, HFT has a tendency to widen spreads or become inactive. The traditional market-makers, the specialists on the NYSE, and proprietary trading desks, have all but vanished. Following the Global Financial Crisis, regulators banned proprietary trading by Investment Banks in an attempt to prevent large losses and mitigate government bailouts. The unintended consequence of that action is less liquidity provision.

"[HFT] Trading creates the appearance of liquidity and depth, but this can and does, vanish with no notice in a millionth of a second. Traditional structures have disappeared, including: specialists who actually made orderly markets, standing ready to buy and sell to keep markets flowing; the big financial firms as partnerships, where executives' net worth was tied to the stability as well as profitability of the firm." Paul Singer

Passive Investing [ETF's and Index Funds]

An increasing number of investors have moved to 'passive' products [albeit the term is a misnomer - investing in an index is an active decision, and which index anyway??] for their ease of access and low cost. The majority of these investors rely on just 'price' as their investment signpost. As passive investing takes a larger share of the investing universe, new money flows to the biggest index components regardless of price. 

"Owners of Index Products have no real interest in the business performance of the underlying portfolio companies, and little or no knowledge or appreciation for what those companies actually do for a living, or how well they do or could do it.  

Nobody knows what this pattern means, and nobody has seen anything like it. It is not capitalism. It is not communism. It does not resemble anything that people have contemplated when thinking about markets, the virtues of private ownership of the means of production, and the prospects of growth and prosperity for masses of citizens.

Moreover, nobody knows how the passive style of investing will play out and evolve. There is a real likelihood that it, and its apparent stability, is unsustainable and brittle. But markets can be "wrong" for a very long time before they decide to change direction." Paul Singer

It is when market participants have no knowledge of the underlying companies they own that risk rises. There is no price point they can tether to in deciding whether to buy, hold or sell. No price is too high for an index fund to buy and no price is too low to sell. 

“It is not liquidity or perfect price discovery that ensures good pricing but it is knowledge of value. It is when we lack this knowledge that we demand liquidity and price discovery as poor substitutes.”  Andy Redleaf

Likewise, investors in ETF's more often than not have no idea what their ETF's own and thus are worth. ETF's are typically constructed to be 'marketed and sold' without regard to their investment merit.

"The inclusion criteria [for index related products] are certainly not what in the past was quaintly referred to as "investment criteria." Paul Singer

“ETF’s are very efficient, very easy and very simple. There is no question about that. Therein lies part of the problem. It makes it easy for someone to say I want to buy Germany but doesn’t even look to see what’s in the German ETF or if it’s a good ETF to own.  It could be a terrible ETF but nobody looks anymore.  There are excesses developing in the ETF business. When we have the next bear market a lot of people are going to find out they collapsed and went down more than everything else because that’s what everybody owns.” Jim Rogers

If and when prices decline, it is the price action that becomes the news. Selling begets more selling as no-one knows the right price. It becomes a circular reference; people ask, "why do I own this biotech ETF? I've got no idea what it owns or what it's worth .. get me out!"

“People who buy for non-value reasons are likely to sell for non-value reasons.  Their presence in the picture will accentuate erratic price swings unrelated to underlying business developments.”  Warren Buffett

“Investors with no knowledge of (or concern for profits, dividends, valuation or the conduct of business simply cannot possess the resolve needed to do the right thing at the right time. With everyone around them buying and making money, they can't know when a stock is too high and therefore resist joining in. And with a market in free fall, they can't possibly have the confidence needed to hold or buy at severely reduced prices.”  Howard Marks

“The more investors invest by asset class rather than by picking individual companies, the more the market will tend to move as one, intensifying herd behaviour and the likelihood of panics, making hundred year floods even more likely.” Andy Redleaf

“I also think share prices are increasingly distorted by the collective buying and selling of ETFs. As more and more trading happens without any thought about valuation, price discovery has to be  somewhat less efficient... I have no idea when, but a reckoning will come and people will run away in blind panic.” Peter Keefe

But getting out isn't always that easy. Often the constituent components are far less liquid than the actual ETF. While things go smoothly no-one cares. Like a movie theatre, the exits work fine until someone screams 'fire'.

“With all technology, and all these ETF’s and quantitative systems introduced I do have concern technology has outpaced markets ability to handle it.. and when get into next bear market could be a messy affair. Unravelling of structured issues. Quant trading are momentum based not value based. “A body of motion tends to stay in motion”.Quantitative trading worries me. There is risk of some outsized outcome.” Leon Cooperman

Quant Trading

As active managers have struggled to keep up with the market indices, more and more investors have moved to index products and quant-based strategies. More money is now being managed by computer systems, many of which base their investing decisions on momentum or trend-following systems. This strategy focuses on buying stocks which have outperformed, again with no regard for underlying values. The strategy works until it doesn't. The buying on the way up is incremental. When the market turns down however, the volume of selling increases significantly, as not only the current flow needs to be sold, but all the accumulated stock on the way up as well.

"Quants and their computer models primarily extrapolate the patterns that have held true in past markets. They can’t predict changes in those patterns; they can’t anticipate aberrant periods; and thus they generally overestimate the reliability of past norms. They know all about how things will work if times are normal, but their analysis is of no help when events occur that reside in the far-off, improbable tails of the probability distribution" Howard Marks

Volatility Targeting

Volatility targeting is a strategy that rebalances between risky assets and cash in order to target a constant level of risk [or volatility] over time. Many institutional investors and hedge and mutual funds managers have embraced the strategy in an attempt to improve portfolio returns.

These strategies have introduced unknown risks and may lead to breakdowns where volatility rises, causing such managers to sell shares, which further drives up volatility, requiring the manager to sell even more shares - a circular reference. 

The October 2017 stability report from the IMF note "during volatility spikes, these [volatility targeting] strategies can lead to significant asset sales to pare back leverage. Such an episode took place in August 2015, when a representative volatility-targeting investment strategy cut its global equity exposure drastically. The size of US equity holdings held by volatility-targeting investment strategies may be larger than $0.5 trillion today. Although this is less than 2.5 percent of the market capitalization of all US publicly traded equities, the trading volume related to deleveraging from these trading strategies could be much larger, particularly at times of equity market stress."

Richard Bookstaber recently touched on risks of volatility targeting strategies on Wealthtrack: 

"A lot of asset managers do what's called volatility targeting, they tell their investors they will manage investments so they have on average a volatility of say 12%. Which means in a typical year, you may see your investments go up or down 5% or 10% or maybe 12%, but you are not going to see 20% moves unless something strange happens.  If volatility now for equities is 12% and you have a billion dollar portfolio you can hold 100% equities. Let's say volatility shoots up to 24%, if you are targeting 12% volatility, now you have to sell half your assets. Suddenly half a billion dollars of equities is going into the market and you're not the only one doing it. There are a lot of strategies like this where as volatility goes up people have to de-risk and reduce exposure. So rising volatility leads to a drop in the market, which add further to volatility and a further drop in the market. You get this cycle between rising volatility and a reduction in prices and returns. The big concern are these strategies that are rule based and have positive feedback, they accentuate moves." Richard Bookstaber

Connectivity

The increasing inter-connectivity of the markets and the speed at which algorithms interpret trade data and execute orders means the safeguard of human common sense is rendered obsolete. Risk management models that draw on historical data can't intuitively make sense of a crisis situation. This can lead to 'flash crashes', where stock prices collapse in a matter of seconds. 

"The stock exchanges have converted from "open outcry" where wild traders face each other, yelling and screaming as in a souk, then go drink together. Traders were replaced by computers, for very small visible benefits and massively large risks. While errors made by small traders are confined and distributed, those made by computerized systems go wild - in August 2010, a computer error made the entire market crash the "flash crash"; in August 2012..  the Knight Capital Group had its computer system go wild and cause $10 million dollars of losses a minute, losing $480 million." Nicholas Nassim Taleb

Summary

Today's markets have become increasingly dominated by passive investing, quant trading and volatility targeting strategies, where orders are executed without regard to price. Liquidity is being compromised by disappearing and front-running HFT and the absense of specialists and proprietary traders. This new market structure features trading speeds beyond human comprehension which together with fewer and fewer fundamental active managers [they've lost the money to index funds!] increases the potential for disorder.

If you understand the value of the businesses you own and like you can take advantage of the sell-offs triggered by the 'fingers of instability'. Ultimately, the more participants there are who invest without regard to underlying values the better for long term investors - prices and values do ultimately converge! Recognising the causes of technical corrections helps keep emotions intact while others are panicked and, or paralyzed.

Paul Singer's profound understanding of markets and risk has allowed Elliott Associates to compound capital successfully over 40 years with only two small down years.  He opines that when you witness episodes such as the 'flash crashes' of recent years, it is highly probable you are observing the future. He understands the risks in modern innovations and how they combine to make markets prone to disorder.

"All the innovations and complexity in the modern world of finance combine in different ingredients at different times with different catalysts and triggers, to create fragility, not stability."

Clearly the way the market operates has changed over time, as has the very market itself. Human intervention has been minimalized to make way for so-called technological advancements. Computers now run the show, yet they lack the capability to recognise underlying value. And while continued change in this regard is inevitable, new innovations can have far reaching negative impacts on the market, leading to further avalanches, collapses or crashes. So knowing what your investment portfolio contains and its worth is fundamental to success, as is a working knowledge of the 'fingers' that can destabilise entire markets. Because who knows? Your next trade could be that single grain of sand...

When to Sell a Great Company?

Let's face it, it's hard to find great companies. It's the veritable needle in a haystack conundrum; there are hundreds of thousands of businesses out there but only very few can be called 'great.' 

Great companies are those that will be worth a lot more many years from now; those with solid balance sheets and cashflow, great management, high returns on capital, pricing power,  excellent cultures, and with strong competitive advantages that keep competition at bay with minimal risk of disruption or obsolescence.

I'm sure you've noticed that most of the Investment Masters have a preference for buying high quality businesses. These businesses are typically capital light organisations which can reinvest their cashflows at high rates of return. They are often referred to as 'compounding machines'.

Like many investors, Buffett started out looking for cheap stocks. Over time, with the insights from his See's Candies acquisition and of course a little help from Charlie Munger, he realised the best returns were to be found in owning the great businesses. 

The questions at hand are should you sell a great business? And, if so, when?

The answer for a long-term investor may actually be never ...  

“Selling great companies with large growth potential, even at seemingly rich valuations, is usually a mistake.” Allan Mecham

"Our favorite holding period is forever." Warren Buffett

“If the job has been correctly done when a common stock is purchased, the time to sell it is almost never." Phil Fisher

“I have also learnt that selling a stake in a good company is almost always a mistake... Selling good companies is rarely a good move. The good news is that we don’t do it very often.” Terry Smith

“The question about selling a really great business is never. Because to sell off something that is a really wonderful business because the price looks a little high or something like that is almost always a mistake. It took me a lot of time to learn that. I haven’t fully learned it yet. It’s rare it makes sense. If you believe the long term economics of the business are terrific, it’s rarely makes any sense to sell it.” Warren Buffett

“Some of our biggest mistakes have been in selling down positions in great businesses when we thought they were fairly valued, or even a bit overvalued. In our experience, compounders tend to keep compounding, so we’re slow to sell unless something in the business or company has fundamentally changed or if the valuation has just become extreme." Peter Keefe

“The reason I wanted to include my adventures with Ferrari in this letter was to try to reinforce in my brain the importance of just sitting on your ass when you own great businesses run by great managers. It is not a good idea to sell them unless they are egregiously overvalued.” Mohnish Pabrai

"We continue to think that it is usually foolish to part with an interest in a business that is both understandable and durably wonderful.  Business interests of that kind are simply too hard to replace." Warren Buffett

“If we have identified a great business, a compounding machine that we’ve purchased well, we want not to interrupt that compounding unnecessarily by curtailing it with a sell target. We want these businesses to continue to compound and we want to own that as long as they continue to be exceptional. So no sell targets, only buy targets.” John Neff, Akre

“If you own a business that really is a true genuine compounder where you have a ramp to grow and particularly for re-investment at high rates of return, don’t sell it, and definitely don’t sell it all. I get cute with a lot of other things that aren’t your classic compounders but any time I’ve sold shares in one of the handful of businesses that I think we can own forever it has proven to be a mistake.” Chris Bloomstran

“The key thing is when you find an outstanding company not only do you have to buy it but also learn to hold it. And that’s the hard part because you have some inclination of wanting to manage the risk when it becomes a little expensive or ends up occupying a larger weight in your portfolio. That can be a mistake.” Francois Rochon

"If I’ve made one mistake in the course of managing investments it was selling really good companies too soon. Because generally, if you’ve made good investments, they will last for a long time." Lou Simpson

“When you find a truly wonderful business, stick with it. Patience pays, and one wonderful business can offset the many mediocre decisions that are inevitable.” Warren Buffett

"The only good reason to sell shares in a successful common stock of high quality is if its share price gets “maniacal” or if it no longer meets our eight criteria for stock selection." Bill Smead

“Selling fabulous businesses is something we should be wary of doing on a regular basis. Or as Philip Fisher wrote the time to sell is ‘almost never.’” James Anderson

"The real thing to do with a great business is just hang on for dear life." Warren Buffett

“Finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market [has] proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear.” Phil Fisher

Even when great companies trade at an expensive multiple, it doesn't necessarily mean they won't deliver attractive returns.

"If a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result." Charlie Munger

Many an investor has made the mistake of selling a great business at a high price in anticipation of buying it back cheaper. Getting the timing right is problematic and great companies are hard to find. 

"If we believe the business model is going to continue to compound our capital at high rates, and we recognise that number will go up and down for normal business experiences, we want to hang on to the business, because the really great ones are, A, too hard to find, and B, too hard to replace. Every now and again we fool around with taking a little bit of something off of the table because we think it’s gotten too rich. My sort of life experience is that if I sell a stock at $30 because it’s too rich, and I set in my mind that I’m going to buy it back at $23, inevitably, it trades to $23 and an eighth, or $23 and one, or whatever it is. Oh yeah, whereas if it trades at $22.98, you know it trades 300 shares there, or something like that, and I never get it back. And then the next time I look, instead of being $30, it’s $300. And I messed it up." Chuck Akre

“The short-term investor is intensely focused on the present. But this focus puts one at extreme risk of missing out on the future. If a short-term manager’s best holding is 10% overvalued on a given day, he sells it. For good reason: it might underperform next quarter. But since the best companies deliver the nicest surprises over time, that business may never be undervalued again. In fact, the manager who loves to trade around his positions might be right more often than he’s wrong; but the ones he trims that never come back to him cause more damage than all the smallscale trading successes. If your performance is driven by home runs, why bunt?” David Poppe

It can be psychologically difficult to buy back in at a higher price if you're wrong. Even Buffett acknowledges this bias impacts him.. 

“It’s a little hard when you looked at something at X and it sells at 10X to buy it. It shouldn’t be, but I can just tell you psychologically it’s harder - if you looked at it in the first place and passed at X to buy at 10X.  It’s cost people a lot of money. It cost people in Berkshire. People saw it at a lower price and they say 'if it gets back there I’ll buy it,' but that’s a terrible way to think.” Warren Buffett

“I think it’s usually a bad mistake to sell your interest in wonderful businesses. I don’t think people find them that often. And I think they get hung up, if they’ve sold them at X that they want to buy them back at 90 percent of X, or 85 percent of X, so they’ll never go back in at 105 percent of X. I think, on balance, if you are in a business that you understand and you think it’s a really outstanding business, that the presumption should be that you just hold it and don’t worry. And if it goes down 25 percent in price or 30 percent in price, if you have more money available, buy more. And if you don’t, you know, so what? Just look at the business and judge how it’s doing.” Warren Buffett

To highlight this point, in his 1995 annual letter, Buffett referenced his experience with Disney shares...

"One more bit of history: I first became interested in Disney in 1966, when its market valuation was less than $90 million, even though the company had earned around $21 million pre-tax in 1965 and was sitting with more cash than debt. At Disneyland, the $17 million Pirates of the Caribbean ride would soon open. Imagine my excitement - a company selling at only five times rides!" 

Impressed with his findings, the Buffett Partnership bought a large amount of Disney stock at a split adjusted price of 31 cents per share. If you look back on this, you may think this was an outstanding move, given that the stock now sells for more than $90 per share. In his 1995 letter however, Buffett acknowledged he 'nullified' the brilliant buying decision in 1967 when he sold out for 48 cents per share!

Sometimes it might feel like the right thing to do is to sell on bad news. Provided the investment thesis remains intact and the longer term business outlook hasn't changed, it's probably best to hold on. 

“Selling fine businesses on “scary” news is usually a bad decision.” Warren Buffett

That's not to suggest the share prices of great businesses will be immune to a stock market correction. They more than likely will.  Unfortunately, Mr Market won't necessarily distinguish between the good and bad businesses - even the great businesses can expect to have their prices knocked down.

“When the market falls sharply, it doesn’t distinguish between the good girls and the bad girls.”  Peter Cundill

“Unfortunately, an emotionally inspired selling wave snowballs and carries with it the prices of all issues, even those that should be going up rather than down.” J Paul Getty

“I used to hold Berkshire stock as a proxy for cash and that was a mistake. During times of distress, everything will go down, including Berkshire.” Mohnish Pabrai

“In the crashes that follow most bubbles, enormous interim markdowns can befall good companies as well as bad, requiring sharp analysis to differentiate between them, and high conviction and an iron stomach to hold on.” Howard Marks

“You're deluding youself if you believe your stocks, however cheap they are, won't temporarily go down when Mr Market decides to correct." Charles de Vaulx

“For most people, the most dangerous self-delusion is that even a falling market will not affect their stocks, which they bought out of a canny understanding of value.” Leon Levy

Don't let a market correction scare you out of holding a great business for the long term. Remember, 'quoted' prices can and often do reflect the emotions of the crowd, not the true underlying value of the business.  

“When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact market prices are frequently nonsensical.” Warren Buffett

Many of the Investment Masters adopt the mindset of a business owner as opposed to a share market trader to help filter out the noise of stock market fluctuations.

"In our view, what makes sense in business also makes sense in stocks: An investor should ordinarily hold onto a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business." Warren Buffett

In light of the above, you have to make sure you can survive the short term fluctuations to achieve high long-term returns. This requires patience, a solid understanding of the underlying business to give you the conviction to hold, the recognition that values and prices can get out of kilter, and an absence of leverage.  As Charlie Munger advises, if you're not willing to experience a 50% decline in a stock you probably shouldn't be in the stock market.

"This is the third time that Warren and I have seen our holdings in Berkshire Hathaway go down, top tick to bottom tick, by 50%. I think it's in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact, you can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations." Charlie Munger 2009

You'll note Charlie Munger said that Berkshire shares had dropped in value by 50% for the third time. Had an investor sold out of Berkshire Hathaway during any one of those declines they would have done themselves a major disservice. 

The share prices of great businesses also tend to recover from downturns faster as they often emerge in a stronger position - weaker competitors either fail or lose market share through measures taken to survive the downturn.

"From 1932 to nearly the present, the studies confirm that when bad things happen to good companies, they recover - and usually quite nicely in a reasonable amount of time." Chris Browne

"At the end of the day, in order to build wealth, there is a simple approach which we have followed for 17 years at Giverny Capital: investing for the long term in high-quality companies purchased at attractive valuations—investing in companies that will survive the crises of our civilization and the short-term irrationally of our economic system." Francois Rochon

"People don't believe business quality is a hedge, but if your valuation discipline holds and you get the quality of the business right, you can take a 50 year flood, which is what 2008 was, and live to take advantage of it." Jeffrey Ubben

"We think a rigorous discipline of buying quality companies, when priced right and run by honest, intelligent management teams, offers the best defence against challenging macro conditions." Allan Mecham

“It was our companies that protected us [in the downturns]. It was not because we were clever at buying and selling stocks during the day time.” Chuck Akre

Clearly the Investment Masters understand the value of holding ownership in great businesses for the long term. Selling at the wrong time can mean forgoing the gains from share prices that recover to levels that dwarf their prior peaks. Those that continue to provide great returns and weather the unpredictable periodic storms that Mr Market tends to throw at us are worth holding, and the idea of selling ownership in a 'great' company is usually a mistake. 

Are You Checking the Portfolio Too Often?

Warren Buffett doesn't have a computer on his desk. He buys stocks for the long run and he doesn't let short term stock prices impact his investing decisions. He advises investors "Don't watch the market closely" highlighting that when investors are "trying to buy and sell stocks, and worry when they go down a little bit - and think they should maybe sell them when they go up - they're not going to have very good results".  

While it's important to keep abreast of developments at a company, it's important not to let a company's short term stock price move unduly influence investment decision-making. In many cases, short term stock moves are purely random phenomena.

"Some investors attach great importance to the daily or even hourly ups and downs, while others, like the undersigned, pay them no heed except when they present us with mouth-watering opportunity to do something." Frank Martin

As humans have evolved to feel losses significantly more than gains an investor who experiences a stock price decline maybe liable to make sub-optimal investment decisions.

“When directly compared or weighted against each other, losses look larger than gains.  This asymmetry between the power of positive and negative expectations or experiences has an evolutionary history. Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.” Daniel Kahneman

“When an investor focuses on short-term increments, he or she is observing the variability of the portfolio, not the returns – in short, being “fooled by randomness”. Our emotions are not designed to understand this key point, but as investors, we need to come to grip with our emotional liabilities.” Barton Biggs

Nicholas Taleb, in his profound book, 'Fooled by Randomness', talks about the difference between noise and meaning. He uses the example of the happily retired dentist who builds himself a nice trading desk in his attic, aiming to spend every business day watching the market while sipping decaffeinated coffee. He watches his inventory of stocks via a spreadsheet with live price updates. 

Taleb notes ..

"A 15% return with a 10% volatility (or uncertainty) per annum translates into a 93% probability of success in any given year. But seen at a narrow time scale, this translates into a mere 50.02% probability of success over any given second as shown in the table.  Over the very narrow time increment, the observation will reveal close to nothing. Yet the dentist's heart will not tell him that. Being emotional, he feels a pang with every loss, as it shows in red on his screen. He feels some pleasure when the performance is positive, but not in equivalent amount as the pain when the performance is negative"

"Viewing it from another angle, if we take the ratio of noise to what we call non-noise (ie left column/right column), which we have the privilege of examining quantitatively, then we have the following. Over one month, we observe roughly 2.32 parts noise for every one part performance. Over one hour, 30 parts noise for every one part performance, and over a second 1,796 parts noise for every one part performance."

"Over a short time increment, one observes the variability of the portfolio, not the returns."

Allan Mecham of Arlington Value Capital [AVM] addressed the issue in his 2011 annual letter where he cited the historical odds of their fund outperforming the S&P500 in any given month over the preceding five years ...

"The data confirmed our suspicions: AVM performed 55% of the time - nearly a coin flip. This offers an interesting takeaway when combined with investors' inert psychology; had we reported monthly results, investors would have had the bizarre experience of disliking their exposure to top-notch gains (AVM's five year annualised return of 18.7% net of fees, versus -0.4% for the S&P500 would rank second out of 6,000 US equity funds tracked by Morningstar."

Many of the Investment Masters recognize the adverse psychological effects constant monitoring of a stock portfolio can have on investment returns.

“Almost all investors experience more pain and anguish from losses than they do pleasure from gains. The agony is greater than the ecstasy. I don’t know why this is true, but it is. Maybe it’s because the investment business breeds insecurity. But to the extent that the investor is focused on daily or even minute-by-minute performance of his or her portfolio, the time of pain is inadvertently increased and the time of pleasure reduced. The problem is that the investment pain leads to anxiety, which in turn can cause investors to make bad decisions. In other words continual performance monitoring is not good for your mental health or for your portfolio’s well-being, even though contemporary portfolio management systems and their suppliers, strenuously promote it.” Barton Biggs

“Well-worn studies confirm the financial utility of long-term viewpoints; however, behavioural psychologists augment the case by showing investors dislike losses two to three times more than they like gains. If short-term gains/losses carry 50/50 odds, then the disdain for losses implies that infrequent monitoring and long-term horizons aide both mental health and financial wealth. In short, Winston Churchill's quip on revenge may aptly apply to myopic investment habits: "Nothing costs more and yields less." Allan Mecham

"To be sure, the future is very abstract and provides little in the form of near-term emotional rewards. I've spent 40 years surrounded by people who watch the prices of the stocks they own as they fluctuate on a daily, or heaven forbid, hourly basis. Speeding through time on an emotional roller-coaster that ends where it starts is like envy: nothing good comes from the expenditure of enormous energy." Frank Martin

“Dick Thaler’s got a phrase, instead of watching CNBC, you should be watching ESPN. The idea being that tracking how you’re doing every day is going to cause tremendous unhappiness and it’s going to lead to more biases. Actually, we worked with one of our academic advisors, Professor Joey Engelberg who’s a UCSD and he’s done research that when the market goes down, there’s more admittances for heart attacks at the hospitals around the country.” Dr Raife Giovinazzo

“I try not to actually log in to the account unless I know I want to do something. I don’t want the daily blow-by-blow on prices. It’s bad for the investing psyche; it makes you impatient and lose perspective.” Chris Mayer

“When people can check their returns 30 times a minute on the internet, time horizons shrink, investors are impatient and sell at any sign of underperformance, so they fail to participate in periods of overperformance.” Joel Greenblatt

“The frequency with which an investor checks his investments plays a significant part in his or her level of risk aversion. As stocks go down on nearly as many days as they go up according to De Bondt and Thaler, stocks can be highly unattractive if they are observed on a daily basis. Other behavioralists have estimated that if an investor’s time horizon was 20 years, the equity premium would fall to 1.5% from 6% as there is very little chance an investor would experience a loss after so many years, and stocks would be a much more appealing investment.” Christopher Browne

To counter this psychological bias, some of the Investment Masters, like Buffett, try to keep away from quote screens during the day.

"If I have a Bloomberg on, I find I am looking what the market is doing. I am looking at every news story. I really like to be the one who is parsing the information, rather than having a lot of irrelevant information thrown at me." Lou Simpson

"I don't have my computer or Bloomberg monitor set up to show me the price of all my holdings on one screen; if I need to check the price of a stock, I do it individually so that I won't see the price of all my other stocks at the same time. I don't want to see these other prices unnecessarily and to subject myself to this barrage of calls to action. It's worth thinking a little more about the effect of all this gratuitous noise on my poor brain. Checking the stock price too frequently uses up my limited willpower since it requires me to expend unnecessary mental energy simply resisting these calls to action. Given that my mental energy is a scarce resource, I want to direct it in more constructive ways. We also know from behavioural finance research by Daniel Kahneman and Amos Tversky that investors feel the pain of loss twice as acutely as the pleasure of gain. So I need to protect my brain from the emotional storm that occurs when I see that my stocks or the market are down. If there's average volatility, the market is typically up in most years over a 20-year period. But if I check it frequently, there's a much higher probability that it will be down at that particular moment. (Nassim Taleb explains this in detail in his superb book Fooled by Randomness.) Why, then, put myself in a position where I may have a negative emotional reaction to this short-term drop, which sends all the wrong signals to my brain?" Guy Spier

“If you don’t like what’s happening to your shares, switch off the screen. The price of the shares you buy may vary for reasons which have nothing to do with the fundamentals of the business. So movements in share prices are not necessarily a guide to whether your investment is good or bad. If you have chosen shares in good companies or a fund at reasonable prices, and you find gyrations in their prices unsettling, then simply stop looking at the share price.” Terry Smith

“None of us have a Bloomberg terminal. We have an outsourced trader, in Vancouver. We don’t generally trade the same day we make decisions.” Yen Liow

By avoiding the impact of seeing short term losses an investor is more likely to be able to take a longer term perspective - a key edge in investing.

“Kahneman and Tversky were able to prove mathematically that individuals regret losses more than they welcome gains of the exact same size – two to two and one-half times more. It was a stunning revelation … If you don’t check your portfolio every day, you will be spared the angst of watching daily price gyrations; the longer you hold off, the less you will be confronted with volatility and therefore the more attractive your choices seem. Put differently, the two factors that contribute to an investor’s unwillingness to bear the risks of holding stocks are loss aversion and a frequent evaluation period. Using the medical word for short-sightedness, Thaler and Bernartzi coined the term myopic loss aversion to reflect a combination of loss aversion and the frequency with which an investment is measured… In my opinion, the single greatest obstacle that prevents investors from doing well in the stock market is myopic loss aversion.” Robert Hagstrom

“The more often people look at their portfolios, the less willing they will be to take on risk, because if you look more often, you will see more losses.” Richard Thaler

"You know, I think people’s investment would be more intelligent, you know, if stocks were quoted about once a year." Warren Buffett

With regards the trading dentist, Taleb concluded ..

"Now that you know that the high-frequency dentist has more exposure to both stress and positive pangs, and that these do not cancel out, consider that people in lab coats have examined some scary properties of this type of negative pangs on the neural system (the usual expected effect: high blood pressure; the less expected: chronic stress leads to memory loss, lessening of brain plasticity, and brain damage). To my knowledge there are no studies investigating the exact properties of trader's burnout, but a daily exposure to such high degrees of randomness without much control will have physiological effects on humans (nobody studied the effect of such exposure on the risk of cancer). What economists did not understand for a long time about positive and negative kicks is that both their biology and their intensity are different. Consider that they are mediated in different parts of the brain that the degree of rationality in decisions made subsequent to a gain is extremely different from the one after a loss."

Is it time to move that Bloomberg terminal?

The Value of Cash

The typical equities investment mandate and most mutual funds are required to be fully invested in stocks. The mindset being that the asset allocation decision is a separate function from stock selection. So for instance in the case of a balanced fund, the asset allocator determines the percentage of total assets allocated to each asset class - cash, fixed income, bonds, alternatives etc. The equity manager gets the equities allocation and must remain fully invested in equities regardless of whether or not he or she can find quality assets at attractive prices.

In such an approach, the individual tasked with the stock picking is prohibited from holding cash even at times when they perceive valuations as unattractive or macro risks as elevated. It's not whether an investment makes or loses money that is important (ie absolute returns), their concern is the investment's performance relative to the stock market.

Many prominent top-down asset allocation models predominantly emphasize an investor's risk profile as the primary factor in establishing suitable asset exposures. Typically, this assessment is based on age, where a younger age corresponds to higher risk tolerance and, consequently, a higher allocation to equities and a lower allocation to bonds. However, these models often overlook the consideration of the relative attractiveness of each asset class at the time of allocation. This oversight was starkly evident during the global financial crisis.

In practice, adhering strictly to age-based allocation without weighing the current market conditions can lead to significant drawbacks. The flaw becomes apparent, particularly during broad market sell-offs, making it challenging for equity managers to generate attractive returns when compelled to remain fully invested.

“For most people, the most dangerous self-delusion is that even a falling market will not affect their stocks, which they bought out of a canny understanding of value.” Leon Levy

“Unfortunately, an emotionally inspired selling wave snowballs and carries with it the prices of all issues, even those that should be going up rather than down.” J Paul Getty

“I used to hold Berkshire stock as a proxy for cash and that was a mistake. During times of distress, everything will go down, including Berkshire.” Mohnish Pabrai

“When the market falls sharply, it doesn’t distinguish between the good girls and the bad girls.” Peter Cundill

“You're deluding yourself if you believe your stocks, however cheap they are, won't temporarily go down when Mr Market decides to correct." Charles de Vaulx

The person responsible for selecting stocks lacks the authority to determine their attractiveness. Moreover, accountability for suboptimal outcomes seldom falls on the asset allocator, who often shelters behind historical asset class returns. When a balanced fund experiences losses in equities, the equity manager deflects blame, asserting, "I had to remain fully invested." Simultaneously, the asset allocator points to age-based guidelines, stating, "The ultimate fund investor is 20 years old, justifying the prescribed percentage in equities." It becomes a game of passing the buck.

In contrast, the Investment Masters acknowledge that the ideal allocation to equities at any given moment hinges on the relative price levels prevailing then, recognizing that these relative prices are in a perpetual state of flux.

In contrast to the aforementioned strategy, the Investment Masters adopt a flexible approach to investing. They are willing to retain cash if appealing opportunities are scarce, steadfastly refusing to compromise on their pricing criteria. Operating with flexible mandates that don't necessitate full investment, they acknowledge the advantages of maintaining financial firepower. This reserve allows them to seize opportunities and acquire assets when the right moments present themselves.

Despite Warren Buffett advocating index funds to Joe Public his largest current holding is cash. In a recent CNBC interview Buffett stated ..

"Now unfortunately right now the largest 'business' we own-- we've got about $95 billion in and it's selling at a 100 times earnings. And the earnings can't go up, which sounds like a pretty dumb investment and it is. But that's what we get on treasury bills basically and-- we literally have-- it's not all in bills. But we have $95b in cash including mostly bills and we are paying a 100 times earnings for something like I say whose earnings can't go up. You get 1% and that does not make me happy. And I like to buy businesses. We will buy businesses. But it makes it much tougher-- when there's 1% money around and the people who-- many of the people who buy businesses use as much borrowed money as they can. And when they get that-- at rates that are based off that very low rate of 1%-- they can pay a lot more money than we can - using what-- pretty much all equity money 'cause that's the way we look at money. So-- we have not—made significant acquisition now for 15 months or thereabouts"

Although Buffett asserts that he doesn't base his investment decisions on the macro environment or the specific level of the stock market, he emphasizes the importance of only investing when he can discern attractively priced opportunities. It makes sense that there are less attractively priced opportunities when markets are elevated rather than weak.

“It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.” Charlie Munger

The lesson from the Investment Masters is not to be afraid of holding cash. Cash is an asset which allows you to take advantage of opportunities when asset prices are subdued.

“Cash combined with courage in a time of crisis is priceless.” Warren Buffett

"In many different ways, cash gives you options.  It offers wonderful downside protection and upside optionality"  Mohnish Pabrai

"Because we are focussed on absolute returns, we will hold cash in the absence of values and a margin of safety. We view cash as an opportunity fund" Arnold Van Den Berg

The ability to hold cash provides investors with the flexibility to avoid buying unattractive assets. It is better to receive little or no returns from cash than exposing the fund to the risk of permanent loss of capital. 

“Holding cash is uncomfortable, but not as uncomfortable as doing something stupid” Warren Buffett

"Thinking outside the box about the optionality of cash gives quiet but resolute credence to the contention that this seemingly benign asset is in reality a double edged sword, defending against loss on one hand and arming for gain on the other." Frank Martin

Further Reading: Tutorial - Investment Masters 'The Value of Cash'
Frank Martin: 'An Enterprising Thought - Cash as an Option'
John Neff [Akre]: ‘How We Think About Cash - by John Neff’

Analysing Investment Performance - Short and Long Term

The Investment Management industry is fixated on short term performance. 

Oaktree's Howard Marks has said "short term performance is an imposter - "The investment business is full of people who got famous for being right once in a row.” 

Unlike most professions, a rookie investor can do better than a professional over the short term. You'd never expect an amateur to beat Roger Federer in a tennis match but plenty of amateur's portfolios will outperform Warren Buffet over the short to medium term. It's only over the longer term that you can ascertain the skill of each investor.

"In the short term, there will always be winners and losers. But in the long term, there are very few winners." Li Lu

The majority of investment managers, asset consultants and investors obsess over short term performance. As many individuals cannot access their pension funds until retirement it would make more sense to analyze a style of investing or an asset class that outperforms over the long term.

“If you know one style does best in the long run, maybe you shouldn’t care about short term performance comparisons.” Chris Browne

Investment Managers that underperform the market over short periods are vulnerable to having their funds taken away. 

"Many mainstream portfolio managers, judged as they are on short-term performance, feel they must be swinging all the time. They must focus on the present, on survival. If they don't meet the relentless present demands, they'll have no corner office from which to build a great long-term track record." Frank Martin

"Most of our competitors feel intense pressure from their clients to generate short term performance and have trouble maintaining a truly long-term perspective, whether in bad or good markets." Seth Klarman

“It’s still true that the biggest players in the public markets – particularly mutual funds and hedge funds – are not good at taking short-term pain for long-term gain. The money’s very quick to move if performance falls off over short periods of time." Jeffrey Ubben

Having permanent capital or investors with a long-term mindset allows investment managers to focus their attention on longer term opportunities or 'time arbitrage' which tend to be less crowded.

“That is the secret sauce: permanent capital. That is essential. I think that’s the reason Buffett gave up his partnership. You need it, because when push comes to shove, people run." Bruce Berkowitz

No investment style can guarantee outperformance all the time. Even the Investment Masters, who are renowned for their long term investment performance, have short to medium term periods where they have underperformed or lost money.

“I’m 76 years of age. I've been through a number of down periods. If you live a long time, you’re going to be out of investment fashion some of the time” Charlie Munger

“To capture superior long-term results you have to be willing to endure short-term underperformance.” CT Fitzpatrick

“We expect to have negative years on occasion (and our record makes that point clear!). Those who take a longer term perspective – and their shorter term fluctuations in stride – tend to be amply rewarded in the long run (our record makes that clear as well.)” Frank Martin

"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

Francois Rochon has beaten the index by 6.1%pa since 1993 (Remember a few extra percentage points compounded over a long period leads to significant outperformance). Yet Francois historically has, and expects to, underperform the index on average every three years.

"Over the 22 years of its track record, our US portfolio has underperformed the S&P 500 on six occasions (or 27% of the time). This is in line with our "Rule of Three" which stipulates that we accept to underperform the index one year out of three on average. This average, if we can maintain it, would be far superior to the overall performance of portfolio managers. It is a difficult task to maintain outperforming the S&P 500 but it is our mission. We must accept the fact that we will sometimes underperform the index over the short term when our investment style or specific companies are out of favor with mainstream thinking. And we try to welcome rewarding periods of portfolio outperformance with humility." Francois Rochon

"To be aware of this fact ['Rule of Three'] is vital so we can be psychologically prepared for the inevitable periods when we will have results that are worse than average. We have to accept from the start that it is impossible to be always the best in that field even if one is competent and loaded with motivation and efforts." Francois Rochon

The key is to ensure any negative returns reflect short term volatility rather than the permanent loss of capital due to deteriorating underlying business fundamentals.

"In my view, the biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital." Li Lu

When evaluating an investment manager it is important to analyze long term performance to ensure it wasn't a result of luck.

“Short term results often benefit from luck and have no connection with skill. For example, take a short period, not even one or two years long. At any time, even one or two weeks, there will always be some rock stars." Li Lu

"Since a multitude of variables move stock prices around, particularly in the short run, it is virtually impossible to distinguish skill from luck without a large sample size, i.e., a long record." Tweedy Browne & Co

"In a bad year, defensive investors lose less than aggressive investors. Did they add value? Not necessarily. In a good year, aggressive investors make more than defensive investors. Did they do a better job? Few people would say yes without further investigation. A single year says almost nothing about skill, especially when the results would be expected on the basis of the investor's style." Howard Marks

Short term outperformance doesn't imply a well constructed and low risk portfolio.

“Any asset class or strategy can have its moment in the sun, yet as time passes we learn what risks were employed to achieve those periods of outperformance” Christopher Begg

Investment consultants and investors have a tendency to place excessive emphasis on past results. More often than not, short term out performance is followed by a period of subpar performance. 

“Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages subpar performance from here on out.” Howard Marks

So funds can have good performance for the long run yet still be a dangerous investment. A brilliant long term track record of returns will turn to nothing if the portfolio suffers a zero or significant loss.

“And never forget that anything times zero is zero. No matter how many winners you’ve got, if you either leverage too much or do anything that gives you the chance of having a zero in there, it’ll all turn to pumpkins and mice.” Warren Buffett

"In business and also investment, success is measured through the compounding of a series of returns. Mathematically, the biggest risk to a compounded series of returns is large negative numbers or even a single negative number, if large enough. Take however many spectacular annual outcomes and multiply them by just one zero and the answer is of course, zero." Marathon Asset Management

A classic example of this was the hedge fund Long Term Capital Management. The fund, managed by legendary traders, a former vice chairman of the Federal Reserve and two Nobel prize winning economists, delivered exceptionally stable positive returns with low volatility until it all came crashing down. 

Source: Wikipedia

LTCM's performance is analogous to the 'Thanksgiving Turkey' in Nicholas Taleb's book 'Fooled by Randomness.'

"A turkey is fed for a thousand days by a butcher, every day confirms to its staff of analysts that butchers love turkeys "with increased statistical confidence". That is until Thanksgiving. It is mistaking absence of evidence (of harm) for evidence of absence."

Similarly, the absence of volatility and losses in Madoff's Ponzi scheme was not evidence the strategy was a sound investment. LTCM and Madoff highlight that an impressive long track records does not shelter you from the risk of terminal destruction. It's paramount to understand the risks behind the returns.

As Buffett has long said he would not take any risk of permanent loss of capital.

“We will never play financial Russian roulette with the funds you’ve entrusted to us, even if the metaphorical gun has 100 chambers and only one bullet. In our view, it is madness to risk losing what you need in pursuing what you simply desire.”

The Investment Masters acknowledge the folly of being focused on short term performance. 

“We think fixating on short-term results is bound to harm investment managers and investors alike. High scores are rarely shot while being critiqued mid-swing on each and every hole.” Allan Mecham

“We place no weight on short-term results, good or bad, and neither should you. In fact, we have and will continue to willingly make decisions that negatively impact short-term performance when we think we can lower risk and improve our long-term returns.” CT Fitzpatrick

"While it’s not always easy, we try to remain unaffected by short term results, both good and bad." Francois Rochon

"We never take the one-year figure very seriously. After all, why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off? Instead, we recommend not less than a five year test as a rough yardstick of economic performance." Warren Buffett

Instead of focusing on short term performance the Investment Masters tend to focus on the underlying performance of the companies they own.

"The best way to track the development [of the fund] is through the development of the earnings of the underlying businesses. Share prices can do pretty crazy things from time to time. The earnings by contrast provide a reliable indication of progress after taking into account the overall economic picture." Robert Vinali

"We do not evaluate the quality of an investment by the short term fluctuations in its stock price. Our wiring is such that we consider ourselves owners of the companies in which we invest. Consequently, we study the growth in earnings of our companies and their long term outlook." Francois Rochon

Don't forget successful investing is hard work and Long term outperformance is difficult.

“Preserving private capital for long periods of time is the exception, not the rule, in history.” Paul Singer

 

Great Investors Sleep Well

The Investment Masters recognise the need to be well rested which means correctly structuring a portfolio and not taking on too much risk…

"Lack of sleep.. causes stress.  The more stress we experience, the more we tend to make decisions that are short term.” Peter Bevelin

“The financial calculus that Charlie and I employ would never permit our trading a good night’s sleep for a shot at a few extra percentage points of return.” Warren Buffett

"Conservative investors sleep well.” Phil Fisher

"If you want to sleep well at night, do your own homework. Don't be hasty.” John Neff

“When it comes to investing, my suggestion is to first understand your strengths and weaknesses, and then devise a simple strategy so that you can sleep at night!" Walter Schloss

“It is important for a portfolio manager to sleep well at night.” Ed Wachenheim

“In my younger days I heard someone, I forgot who, remark “sell to the sleeping point”. This is a gem of wisdom of the purest ray serene. When we are worried it is because our subconscious mind is trying to telegraph us some message of warning. The wisest course is to sell to the point where one stops worrying.” Bernard Baruch

“Wealth management, the markets in their own perverse way occasionally remind us, is not just about eating well, it’s also about sleeping well.” Frank Martin

“Investors should always keep in mind that the most important metric is not the returns achieved, but the returns weighed against the risks incurred. Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.” Seth Klarman

“We are fundamental investors and we tend to worry more than most. As a result, are willing to trade some upside during good times for the ability to sleep better at night. Holding cash in the absence of compelling opportunities helps us sleep. At the right price, and under certain conditions, hegding a portion of our risk through the purchase of put options helps us sleep even better.” Christopher Parvese

"We sleep better at night knowing that we are focused on investing in true bargains." Bruce Berkowitz

“Our ‘sleep-at-night test’ is a critical risk management tool.” Bill Ackman

“Successful investing goes hand in hand with productive worrying. Worried that a stock you hold might fall sharply? Reduce your holdings or buy some puts. Concerned that interest rates may rise or the dollar fall? Establish an appropriate hedge. Worried that the stock you bought on a tip might be a bad idea? Sell it and move on. Worry enough during the day and you can, in fact, sleep justifiably well at night.” Seth Klarman

“I think it may have been JP Morgan that someone asked this question -  they said ‘I’m worried about how high things are, should I sell? The advice he gave was ‘sell down to the sleeping point.” Ed Thorp

“Our approach to risk management at Pershing Square relies in part on what I have deemed the 'Sleep at Night Test.” Bill Ackman

“I want to sleep well at night. Focusing on underlying values and allowing the power of time and compounding to work for me was appealing when I was in my teens, and it’s even more appealing now.” Christopher Tsai

“I set my own VAR. My value at risk limit is can I sleep at night.” David Tepper

Sleeping well at night requires constructing a portfolio that can tolerate unexpected adverse events and isn't going to result in the permanent loss of capital. It requires deep thought as opposed to relying on a risk model.

Avoiding the '7 Deadly Sins of Portfolio Management' will go a long way to ensuring a portfolio's longevity.  

"We try to ‘reverse engineer’ our future at Berkshire, bearing in mind Charlie's dictum: "All I want to know is where I'm going to die so I'll never go there" Warren Buffett

"If we can't tolerate a possible consequence, remote though it may be, we steer clear of planting it's seeds" Warren Buffett

Make sure you can sleep well at night!

Lessons from Valeant

Pershing Square's 2016 Annual report was released recently. While Bill Ackman's long term track record is impressive, he lost a substantial amount of money in Valeant. He wasn't alone, a few other high profile investors such as ValueAct and Sequoia also took significant losses. Like all good investors, Mr.Ackman acknowledged his mistakes and highlighted the lessons he learnt.

The Investment Masters recognise the importance of analyzing past mistakes, so as not to repeat them. In most cases we can learn more from our mistakes than our successes. We can also learn from the mistakes of other.

“When we make mistakes, we always try to do post-mortems.” Lou Simpson

"The big difference between those who are successful and those who are not is that successful people learn from their mistakes and the mistakes of others." Sir John Templeton

Mr. Ackman recently exited the Valeant position. While he acknowledged he may have sold at a price that may look cheap, he detailed his rationale for selling. Valeant had plunged more than 90% from it's peak; a permanent loss of capital.

At the time of sale, Valeant represented just 3% of the Pershing’s portfolio. Ackman surmised that even if the share price increased substantially, the impact on the overall portfolio would be modest and wouldn't compensate for the human resources and significant mind-share the investment would consume.

Ackman stated, "Clearly, our investment in Valeant was a huge mistake. The highly acquisitive nature of Valeant's business required flawless capital allocation and operational execution, and therefore, a larger than normal degree of reliance on management. In retrospect, we misjudged the prior management team and this contributed to our loss."

Ackman noted the many lessons from the investment and raised some important considerations for investors:

• Management’s historic ability to deploy capital in acquisitions and earn high rates of return is not a sufficiently durable asset that one can assign material value to when assessing the intrinsic value of a business

• Intrinsic value can be dramatically affected by changes in regulations, politics, or other extrinsic factors we cannot control and the existence of these factors is a highly important consideration in position sizing

• A management team with a superb long-term investment record is still capable of making significant mistakes

• A large stock price decline can destroy substantial amounts of intrinsic value due to its effects on morale, retention and recruitment, and the perception and reputation of a company

I recall reading Ackman's 110-page presentation on Valeant titled "The Outsider" where his detailed thesis explained why it was such a compelling opportunity. Ackman paralleled the similarities between Valeant and the highly successful companies profiled in William Thorndike's book, 'The Outsider CEO's'.  It was a pretty compelling sales pitch. 

Notwithstanding the benefit of hindsight, I've outlined some red flags that may assist in avoiding the next Valeant disaster.

Highly Acquisitive Company

Valeant was a highly acquisitive company, effectively a 'roll-up'.  Such companies always carry more risks. Ackman has acknowledged past performance in acquisitions is not a durable asset. In the "Outsiders" presentation Ackman noted, "Management has completed 100+ acquisitions and licenses, investing $19b+ since 2008" .. "Acquisitions have been highly accretive" .. "Valeant management expects the majority of the company's future free cash flow will be allocated to its value-creating acquisition strategy." It’s worth taking heed of the risks in acquisition driven companies, as stated by Phil Fisher some six decades ago!

"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 1960

High Guidance

Valeant had a track record of providing aggressive guidance. Guidance in 2012 was 40-45% EPS growth. In 2013 it was c35%. In 2014 it was c40% and in 2015 guidance was c21-25%.

“Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no surprise environment, and earnings simply don't advance smoothly (except, of course, in the offering books of investment bankers). Charlie and I not only don't know today what our businesses will earn next year we don't even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future and we become downright incredulous if they consistently reach their declared targets, Managers that always promise to "make the numbers will at some point be tempted to make up the numbers.” Warren Buffett

“Having a person running a company to please Wall Street can really be problematic.” Jim Chanos

“Rejecting guidance is rare among public companies, though it’s a practice we applaud. We worry that providing quarterly guidance may tempt companies to publish aggressive growth targets to appease Wall Street. Our concern is not that the aggressive forecasts won’t be met, but rather that they will, at any cost! Earnings growth should be a consequence of sound strategy, not the object of it." Allan Mecham

Win/Lose

Valeant business model in part comprised buying pharmaceutical companies, stripping R&D costs out and aggressively raising prices on older drugs. Valeant certainly wasn't a win-win proposition for consumers, government budgets or the community at large.

"There was a lot wrong with Valeant. It was so aggressive and it was drugs people needed…  I don’t think capitalism requires you to make all the money you can. I think there times when you should be satisfied with less. Valeant looked at it like a game of chess, they didn’t think of any human consequences. They just stepped way over the line and in the end of course they were cheating” Charlie Munger

"We want our operations and the businesses we invest in to pass the “Win-Win Test” with all six counterparties: customers, employees, suppliers, stewards, shareholders, and the community. Win-Win is the only system that is sustainable over the long-term – any fatal flaw with any counterparty will inevitably self-correct. We believe by striving to eliminate Win-Lose, Lose-Win, and Lose-Lose situations we can go far in removing many of the blind spots that those unsustainable relationships nurture." Christopher Begg

Corporate Debt

Valeant's acquisition spree was funded via a massive increase in corporate debt. Fortune magazine noted, "Its debt-to-equity ratio, a measure of a company's financial leverage, is nearly eight times that of other big pharma companies like Pfizer, Novartis and Merck."

"I turn down many otherwise down attractive investments because of their weak balance sheets, and I believe that this discipline is a material reason for our success over the years." Ed Wachenheim

"Staying away from excessive leverage cures a lot of ills." Thomas Gayner

Position Size

Ackman reflected that given the risks facing Valeant that were outside of his control, the position size was too large. In Pershing Square's 2015 Interim Report, Ackman disclosed that Valeant was at odds with his usual principles of investment; Valeant required continued access to capital markets to achieve accelerated growth. With lower conviction and higher risk position sizes must be structured accordingly.

"Our lack of strong convictions about these businesses [Salomon, USAir Group, Champion International], however, means that we must structure our investments in them differently from what we do when we invest in a business appearing to have splendid economic characteristics." Warren Buffett 1989

“Make your position size more a function of not how much you can make, but really how much you can lose. So manage your position based on your downward loss perspective not your upward potential.” James Dinan

Consistency / Commitment Bias

With the benefit of hindsight, it's easy to suggest Ackman should have cut his position earlier.  Ackman's close proximity to the company may have blinded him to the problems starting to surface. The "Outsiders" presentation noted a confidentiality agreement between Pershing Square and Valeant in 2014 allowed them to conduct "substantial due diligence". This included in-person meetings with the board, extensive management interviews, review of the R&D pipeline, selective local due diligence at the country level and review of bear thesis. Ackman was all-in.

"One of the most difficult intellectual confessions is to admit you are wrong.  Behaviourally we know we are subject to confirmation bias. Eagerly we wrap our minds around anything and everything than concurs with our statement. Too often, we misjudge stubbornness for conviction. We are willing to risk the appearance of being wrong long before a willingness to personally confess our own errors." Robert Hagstrom

Falling In Love

When investors make a large commitment to a stock and then publicly promote it, it can be psychologically challenging to change tack. It's paramount to stay open minded and not fall in love with a position or management. As Ackman acknowledged, even a management team with a superb track record can make a mistake.

“If we only confirm our beliefs, we will never discover if we’re wrong. Be self-critical and unlearn your best-loved ideas. Search for evidence that dis-confirms ideas and assumptions. Consider alternative outcomes, viewpoints and answers.” Peter Bevelin

"One thing my father taught me at a young age was not to fall in love with companies or the people running them." Lloyd Khaner

Get Out

Valeant had collapsed dramatically before Ackman finally sold. Sometimes when investing, the best option can be to sell. Running concentrated positions in a multi-billion dollar portfolio reduces flexibility. Ultimately, Ackman acknowledged the position was taking an emotional toll on the firm and it was in the best interest to move on. The small position size following the stocks collapse meant it's contribution to future returns was going to be marginal. Profits and losses are not symmetrical. If you lose 80% of your money you need to earn 400% to get back to break even. Better to cut your losses and focus your energies elsewhere.

"Large permanent losses can dampen the confidence of an investor - and I sternly believe that a good investor needs to be highly confident about his ability to make decisions, because investment decisions seldom are clear and usually are muddled with uncertainties and unknowns." Ed Wachenheim

"Even the most conservative investors can be paralysed by large losses, whether due to mistakes, premature judgements, or the effects of leverage.  If losses impair your future decision making, then the cost of a mistake is not just the loss from that investment alone, but the impact that loss may have on the future chain of events.  If a loss freezes you from taking full advantage of a great opportunity, or pressures you to make it a smaller position than it should or would otherwise be, then the cost may be far greater than the initial loss itself." Seth Klarman

All investors make mistakes, even the great ones. The key is to address them early and take action. Then learn from the mistake.

“In every great stock market disaster or fraud, there is always one or two great investors invested in the thing all the way down. Enron, dot-com, banks, always ‘smart guys’ involved all the way down.” Jim Chanos

“Quickly identify mistakes and take action.” Charlie Munger

"If you feel you have made a mistake, get out fast" Roy Neuberger

“Whatever the outcome, we will heed a prime rule of investing; you don’t have to make it back the way you lost it.” Warren Buffett

Ultimately an investor is only as good as his or her next investment. Being on the lookout for red flags can help an investor from taking undue risks and impairing capital. It's important to remain open minded and continually test a thesis to ensure the outlook hasn't changed.

Remember the first rule of investing is don't lose money. And rule number 2 …. don't forget rule number one.

Portfolio Construction - Where is the risk?

A recent post by John Hempton of Bronte Capital on a fairly well known value investor's portfolio back in March 2008 posed the challenge of 'risk-assessing' the portfolio.  I don't know Mr Hempton personally but I enjoy reading his posts, he's an independent thinker.  

The post, titled "A puzzle for the risk manager", detailed the investment manager's stock portfolio which performed very poorly over the next 12 months.   Managing assets requires continued learning and you can learn a lot by studying not only your own mistakes but the mistakes of others.  

"The big difference between those who are successful and those who are not is that successful people learn from their mistakes and the mistakes of others" Sir John Templeton

This case study provides a great opportunity to think about the process of portfolio construction, human psychology and history. 

Here is the portfolio:

I'll run through some of my thoughts on the portfolio and the issue of portfolio construction.

The key to managing risk is to think.  There is no substitute for thinking about the portfolio and how it may perform in adverse conditions.  Using screens and computer models of loss expectancy are a poor substitute for common sense and many fund managers who relied on such models learnt an expensive lesson in the financial crisis.

“The best way to minimize risk is to think” Warren Buffett

"In life as in investing, what kills you is what you don't know about and what you're not thinking about" Bruce Berkowitz

The number one risk a portfolio manager must avoid is the permanent loss of capital.   So the question becomes, does this portfolio pose the risk of the permanent loss of capital?  

Building an investment portfolio involves a lot more than just picking cheap stocks.  It requires consideration of position sizes, industry concentration, liquidity and how the overall portfolio will perform under different scenarios including those which may not have happened before.  The portfolio manager must be alert and aware of changes in the markets, economy, politics, and society at large.  Changing circumstances may warrant portfolio changes. 

In many cases, portfolio failure results from poor portfolio construction, a failure to recognise changing circumstances and/or the failure of imagination about what the future may portend. 
A portfolio must be constructed to withstand the unexpected.

"A fiduciary should think more about the safety of an entire portfolio than about any individual holding"  Seth Klarman

In assessing any portfolio, I like to think of the seven common causes of catastrophic failure   - excessive concentration, excessive correlation, illiquidity, excessive leverage, fraud, capital flight and valuation risk.

Let's assess the subject portfolio on each:

Concentration: The subject portfolio has 48% of its assets exposed to the financial sector. To me this is the biggest risk as financial stocks inherent leverage make them susceptible to failure.

While Warren Buffett has invested in financials he also acknowledged the significant risks.  His 1990 letter referenced his Wells Fargo investment that year...

"The banking business is no favourite of ours.  When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portfolio of assets can destroy a major portion of equity.  And mistakes have been the rule rather than the exception at many major banks."  

Mr Buffett thought broadly about the possible worst case scenarios facing both the banking sector and Wells Fargo.  Only after concluding such a worst case outcome would not 'distress him' did he invest.

"Of course, ownership of a bank - or about any other business - is far from riskless.  California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run.  Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.  None of these eventualities can be ruled out."

Buffett noted at the time..

"Buying into the banking business is unusual for us.. but opportunities that interest us and that are also large enough to have a worthwhile impact on Berkshire's results are rare.   Therefore, we will look at any category of investment, so long as we understand the business we're buying into and believe that price and value may differ significantly."

The key point Mr Buffett makes here is "understand".  The issue confronting investors prior to the financial crisis was that the banking industry had become increasing complex and opaque.   Innovation in capital markets had seen credit markets grow feverishly as banks securitised significant quantities of assets, increasingly relied on wholesale funding markets as opposed to deposits, played in credit derivatives and placed excessive trust in ratings agencies.  The global banking industry had become far more entwined and far more susceptible to fickle credit markets. 

“Complex systems are full of interdependencies—hard to detect—and non-linear responses.  In such an environment, simple causal associations are misplaced; it is hard to see how things work by looking at single parts. Man-made complex systems tend to develop cascades and runaway chains of reactions that decrease, even eliminate, predictability and cause outsized events. So the modern world may be increasing in technological knowledge, but, paradoxically, it is making things a lot more unpredictable.” Nassim Taleb

"The condensation of credit cycles and the increasing incidence of credit dislocations is a consequence of the globalisation of the world economy, technological advancements in the electronic transmission of information, and financial innovations such as derivatives and securitisation that blur the distinctions among markets and asset classes.  The confluence of these developments has perversely made the markets more informed but less informative.  Information and capital rocket around the world at unprecedented velocities and volumes, leaving investors to process market data before reacting.  Today, a pin dropping in Argentina can cause simultaneous ripples (or waves, or in rare cases tsunamis) as far away as Japan.  By the time the pin drops, it may already be too late for investors to protect their capital.  In a financial world dominated by innovation and new products that blur the traditional distinctions between debt and equity, disruptions in the credit markets are certain to affect all hedge fund strategies in all asset classes.  The increasing frequency and severity of extreme credit events points to the heightened risk of contagion among markets and asset classes. "  Michael Lewitt, 2003

It's hard to see how an investor could have had a reasonable understanding of the risks sitting on the books of many of the global banks.  Increasing reliance on credit markets posed risks, even for those banks with large deposit bases.  An investor with a generalist mindset and an appreciation of credit markets would be mindful of the potential for capital destruction in the sector.

"The analysis of credit cycles involves an understanding of monetary policy, financial and industry innovation, and regulatory change.  The ability to identify in advance those moments when credit cycles veer into crisis also requires imagination, an appreciation of human folly and a willingness to imagine worst case scenarios.  In order to identify times of maximum risk, understanding human psychology is at least as important as understanding economics.  Credit cycles involve a combination of historical, sociological, political, economic and psychological factors that are both unique to each specific cycle and common to all cycles.  Hard and soft data must be examined.  The unhappy truth is that markets don't learn their lessons very well.  Financial history tends to repeat itself.  The only questions are when and to what degree.  Hedge fund managers charged with preserving capital and producing positive returns in both good and bad markets must pay particular attention to the etiology of credit cycles and particularly those extreme turning points that lead to financial crisis that can consume years of returns in the blink of an eye"  Michael Lewitt 2003

The world's best investors take account of the fact that some things cannot be known.  Forecasts are often wrong.  Investors make mistakes.  Portfolios must be constructed to account for these limitations.

"We adhere to policies that will allow us to achieve acceptable long-term results under extraordinarily adverse conditions, rather than optimal results under a normal range of conditions"  Warren Buffett

"A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns"  Warren Buffett

"We should all be humble enough to realize that once every 20 or 30 or 40 years, values go to real extremes. Any investment program must take into account the impossibility of knowing when and to what extent such extremes might occur." Paul Singer

While most successful investors run reasonably concentrated portfolios they diversify across industries in an attempt to limit downside risk, no matter how favourable one particular sector may look.

"We have had periods in which one or more areas looked absolutely fabulous, but it is part of our discipline to continue to invest in a number of areas in order to limit pain if we are wrong about any one"   Paul Singer

The subject portfolio had 26% of investments exposed to the tech sector [technology/semiconductor], 20% in beer investments and 15% in media assets. Industry exposure limits must be set relative to the potential risk, however a 20% limit is common amongst successful investors.

Correlation - It's not hard to see the significant risks a US recession/credit dislocation would pose on this portfolio given the increasing systemic risk in the global banking industry.

A global recession would also place pressure on consumer spending and business capex.  In times of turmoil correlations have a tendency to go to one.  So without hedges or cash, portfolios can be at risk of significant loss.  The key is ensuring they are not permanent. 

"If every position in the portfolio could be uncorrelated with every other position and also uncorrelated with the markets, we would be happy indeed.  However, as the world does not work that way, we approach diversification and seek uncorrelation in an incremental fashion." Paul Singer

"Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem.  Correlation is often underestimated, especially because of the degree to which it increases in crisis.  A portfolio may appear to be diversified as to asset class, industry and geography, but in tough times, non-fundamental factors such as margin calls, frozen markets and a general rise in risk aversion can become dominant, effecting everything similarly." Howard Marks

Establishing a checklist of risk factors that may negatively impact a portfolio and then calculating the percentage exposure can assist in identifying fault lines and downside risk in the portfolio.  Risk factors such as sector/industry exposure, market cap, liquidity, inflation, high gearing, interest rates, currency, housing market exposure, recession, market leverage/beta, consumer exposure, business capex, high PE, business quality, yield, credit market, index type, investor crowding, disruption, cyclical/defensive, growth/value, sovereign/geographic exposure etc are a good starting point. 

Building protection through cash holdings or hedges can limit portfolio risk.  The cost of such hedges maybe under-performance in a bull market.  This is a cost successful investors are prepared to accept.

Liquidity - Liquidity is important as it allows the manager to exit in case of a faulty or changed investment thesis or in the event of redemptions [capital flight].  Illiquidity and redemptions can be a deadly combination.  It would appear the subject portfolio was liquid enough to allow the manager to reduce losses before they became catastrophic.

Capital Flight - Any fund manager that experiences significant losses or relative under-performance is at risk of redemptions depending on the nature of the end client.  A portfolio may experience significant mark to market losses even while the intrinsic value of the stocks are little changed.  While volatility is ordinarily the friend of the value manager, in time of market chaos the manager may not get the opportunity to ride out the market decline should significant redemptions arise.  The issue for the subject portfolio is that the mark to market losses reflected permanent loss of capital which impeded a recovery.

"I may not care about volatility but the reality of having temporary capital is the volatility matters" Mohnish Pabrai

Leverage - This subject portfolio had debt at two levels, the stock level and the portfolio level.  The risk inherent in the financials positions was discussed above. 

The subject portfolio had long exposure of 127% and a short position of 11% providing a net exposure of 111%.  This means that for every $1 invested by a fund unitholders, the manager had $1.11 exposed to the market.  While not ridiculously aggressive, I personally don't understand why managers run net exposures over 100%.  Many long only fund managers mandates limit cash holdings which poses the question "who is making the call on whether the market is attractive?".  It appears this manager had the ability to run lower net and chose not to.  If you are going to run a short book I think it makes sense to use it to minimise portfolio risk not increase it.  The subject portfolio is no different to a geared long fund [absence any commentary on the shorts? ie high beta?].   

Valuation Risk - Mr Hempton noted the "PE ratios mostly looked reasonable".  On a "screening process" the portfolio probably looked attractive relative to the market.  At the time, the market was elevated and a M&A frenzy was driving stock multiples higher.  A 'value screen' at the time would take no account of the fact bank earnings were about to collapse [with the benefit of hindsight] and a low PE was no protection from a credit dislocation.  The banks were 'value traps'.

Fraud - while there is unlikely to be a case of fraud by the manager there was certainly fraud going on at the US housing level.

Ultimately the subject portfolio failed as it wasn't constructed to handle a credit crisis.  The portfolio's financial investments did not recover like the broader market due to bank recapitalisations, bankruptcies or nationalisations.  There was permanent loss of capital.

Other value managers faced severe drawdowns through the crisis but provided they had more permanent capital and/or liquid positions and their portfolio's intrinsic value wasn't impaired they could hold on for the market price to better reflect the underlying value of the stocks.  Owning, high quality businesses, with good cash flow and solid balance sheets allowed many investment managers to recover quickly from the market sell-off of 2008/2009.

"People don't believe business quality is a hedge, but if your valuation discipline holds and you get the quality of the business right, you can take a 50 year flood, which is what 2008 was, and live to take advantage of it"  Jeffrey Ubben

The chart below shows a portfolio containing an equal weighting of the subject portfolio's stocks which is a reasonable proxy for the subject portfolio [in white].  It highlights the subject portfolio's performance mirrored the S&P500 and FTSE Banks indices [a good reason sector ETF's aren't safe! but that's another topic].  These indices experienced significant permanent losses and never recovered like the broader market.

Some additional thoughts ..

History - the 2008/2009 global financial crisis wasn't the first time the banking industry had suffered serious losses.  Had the manager considered previous credit crisis it's unlikely he/she would have had such an aggressive exposure to banks.   There were plenty of warning signs a crisis may be coming.

Macro - the portfolio manager appears to have picked the portfolio on the basis of cheap stocks with little consideration of the macro risks.  Plenty of value managers who considered themselves 'stock pickers' paid dearly for ignoring the macro environment in 2008/2009.

Humility - there is every possibility the manager had a track record of success in the bank sector before which blinded him/her to the potential dangers. 

"There’s this balancing act between being stoic and an investor who’s maybe too ashamed to admit they’re wrong or in denial about being wrong. It’s a risk. If you’re so used to being right in the end, and if you’re used to your investment thesis working out “Sometimes the difference between success and failure was not just about our understanding and steadfast belief in the value of a holding, but how long we were willing to wait to achieve that result. In the long term, you can always lull yourself into a sense of complacency that everything will work out and that if you seem wrong today, you just wait a little while and you’ll be proven right. It can be a problem to trick yourself into believing too much in your own capabilities, if you are overly patient without being as discerning about whether it’s justified or not." Chris Mittleman

Social Proof - Mr Hempton noted "all of these positions could be found in quantity in the portfolios of other good investors."   The portfolio manager may have taken comfort from this.  While it can be useful to look at other investors holdings it doesn't abdicate the requirement for independent thought and analysis.  Other investors portfolios may have been constructed with less risk or hedged.  Other 'good' investors may be wrong.

"You are neither right nor wrong because the crowd agrees or disagrees with you. You are right because your data and reasoning are right." Warren Buffett

“In every great stock market disaster or fraud, there is always one or two great investors invested in the thing all the way down. Enron, dot-com, banks, always ‘smart guys’ involved all the way down.” Jim Chanos

Losses - while the portfolio was under pressure I'd argue the manager had the opportunity to significantly reduce risk to minimise losses.  The chart below shows the portfolio was down c20% at the time the UK lender Northern Rock collapsed after the European credit markets closed shut.   Given the exposure to European Financials this should have flashed a warning sign.  The manager had liquid positions and the ability to cut losses.

A Portfolio manager's judgement can be impaired by losses and it can be difficult to implement hedges/risk reduction in a crisis. It's important to constantly review the portfolio, test your investment ideas, remain intellectually honest and address mistakes.

“The price of managing risk in the middle of a crisis is much too high so we try position the portfolio to thrive in a variety of market environments” Jake Rosser

"Large losses, though initially only on paper, often derail an otherwise rational investor. An illogical fear of loss insidiously exerts an undue influence on portfolio decision making. (Rationally, the lower prices go, ceteris paribus, the less the likelihood of further loss—a truism that falls on deaf ears when fear has the upper hand.)" Frank Martin

While this portfolio manager may have had a track record of success prior to 2008 the permanent loss of capital was significant.   As they say in this business, you're only as good as your next trade.  Unfortunately, a solid track record of success can be eliminated by the permanent loss of capital.  Never forget, any number times zero, is zero!

"In business and also investment, success is measured through the compounding of a series of returns.  Mathematically, the biggest risk to a compounded series of returns is large negative numbers or even a single negative number, if large enough.  Take however many spectacular annual outcomes and multiply them by just one zero and the answer is of course, zero"   Marathon Asset Management
 

Further Recommended Reading-
One of the best articles on risk management is 'Risk Control & Risk Management' by Paul Singer of Elliott Associates, whose 35 year-plus track record of consistent returns with only two small down years is astounding.  The article is featured in the book 'Evaluating and Implementing Hedge Fund Strategies', 3rd edition.

Michael Lewitt's essay "Understanding credit cycles and hedge fund strategies" forewarned of the risks in credit markets.  The essay is also featured in the book 'Evaluating and Implementing Hedge Fund Strategies' 3rd Edition.

The excellent book 'Capital Returns' by Marathon Asset Management contains their prescient forewarnings of the risks building in the global banking system before it's collapse in 2008 and 2009.

The book 'Ubiquity - Why Catastrophes Happen' by Mark Buchanan delves into complex systems and how catastrophes can happen.

The Tutorials in the Investment Masters Class cover many topics relevant to the analysis and the links have been provided above. 

DISCLAIMER

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.