The Buffett Series - Thinking about Bonds

The bond market has witnessed a truly spectacular rally over the last thirty five odd years. In recent times there have been trillions of dollars of bonds trading at negative yields - something that has never happened before. Over the years Mr Buffett has written about investing in bonds. Revisiting his 1984 letter, it's no wonder he wouldn't think of investing in bonds at current prices.

"Our approach to bond investment - treating it as an unusual sort of “business” with special advantages and disadvantages - may strike you as a bit quirky. However, we believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective. For example, in 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a “business” that earned about 1% on “book value” (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business.

If an investor had been business-minded enough to think in those terms - and that was the precise reality of the bargain struck - he would have laughed at the proposition and walked away. For, at the same time, businesses with excellent future prospects could have been bought at, or close to, book value while earning 10%, 12%, or 15% after tax on book. Probably no business in America changed hands in 1946 at book value that the buyer believed lacked the ability to earn more than 1% on book. But investors with bond-buying habits eagerly made economic commitments throughout the year on just that basis. Similar, although less extreme, conditions prevailed for the next two decades as bond investors happily signed up for twenty or thirty years on terms outrageously inadequate by business standards. (In what I think is by far the best book on investing ever written - “The Intelligent Investor”, by Ben Graham - the last section of the last chapter begins with, “Investment is most intelligent when it is most businesslike.” This section is called “A Final Word”, and it is appropriately titled.)"

In a recent CNBC interview Mr Buffett once again re-iterated the attractiveness of American companies return on tangible capital which allows many companies to reinvest capital in their businesses well above current interest rates. With regards to bonds he made the following remarks ...

“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. But that's been true for quite a while. And I've been talking about it the whole time. I said people were idiots in 2008 to put their money in cash. I mean, it was the one thing that wasn't going to go anyplace. And interest rates are enormously important over time. And that's – if bonds yield a whole lot more a year from now than they do now, stocks may well be lower.” 

“I think that when rates have been where they've been the last five or six years, or even a little longer, selling very long bonds makes sense for the same reason I think it's dumb to buy them. I wouldn't buy a 50-year bond, you know, in a million years at these rates. So if it's that dumb for me to buy it, it's probably pretty smart for the entity to sell them if I'm right. So I would say that the Treasury – I would've been – there's a lot of considerations they have. But I would be shoving out long bonds. And of course at Berkshire, you mentioned we had $80-some billion in very short stuff. I mean, everything we buy in the way of bonds is short.” 

“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. But the idea of committing your money, you know, at roughly 3 percent for 30 years-- now-- I think Austria sold some 50 year bond here, you know, at-- below 2 percent. I just don't understand the-- in Europe, there are certain inducements actually for the banks in terms of capital requirements to load up on governments. But it doesn't make any sense to me”.

Those investors buying bonds at the negative or very low yields now on offer are likely doing so because a) they're scared, b) their mandate makes them or c) they're speculating rates will go even lower.  It's unlikely they're buying them because d) they think they're good value.  

Understanding history can provide an edge in investing and Buffett brings up the 1946 bond market as an example in his 1984 letter above [I recommend reading the David Dynasty chapter 4 on the 1940's bond market titled "The Last Hurrah for Bonds"]. It's important to remember that the recent past is not necessarily a good guide to the future, that the unexpected can happen and the crowd is usually wrong.  

The bond market looks very much like a bubble. Howard Marks makes an insightful observation regarding bubbles … "The belief that some fundamental limiter is no longer valid - and thus historic notions of fair value no longer matter - is invariably at the core of every bubble and consequent crash."

The first breach of a fundamental limiter was real bond returns had to be positive. The final limiter breached was bond investors accepting negative rates. It's likely investors of the future will look back on this era and ask … "What were they thinking?"

The Buffett Series - Thinking about Competitive Advantage

This Series contains ten short essays on concepts that have featured in Mr Buffett's annual letters since the early 1980's. It's amazing how timeless and universal they are. This short essay looks at competitive advantage.  

A key requirement for a company to earn high returns on capital over a long period of time is to have a competitive advantage, commonly referred to as a 'moat'. Mr Buffett addresses the issue of competition in his 1993 letter where he talks about the Nebraska Furniture Mart, a businesses he acquired from Rose Blumkin [aka Mrs B.] in 1983. Under the motto, "sell cheap and tell the truth," she worked in the business until the ripe old age of 103.

Nebraska Furniture Mart is a pretty simple business, it sells furniture, flooring and home appliances. It's easy to understand and it's unlikely to be subject to a lot of change. In ten years time it will still be selling furniture.  

"One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business - one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners." Warren Buffett 1993

Nebraska Furniture Mart's competitive advantage is the lower prices it offers it customers and its large range. It's a virtuous circle. Lower prices lead to more sales which allows the business to secure better pricing and spread its fixed costs over a wider revenue base and then offer the savings back to the customers. It's a win-win situation. The massive scale advantage makes it almost impossible for a newcomer to set up shop and offer cheaper products. 

While Buffett wasn't thinking about the internet back in 1983, today the major competitive threat to a retailer is on-line competition. The furniture business is more immune to on-line competition given product size and a customers desire to try before they buy. As a furniture retailer I know recently told me "I won't sell anything that fits in a car!"

It's important to take the time to think about a company's competitive advantage. How easy would it be to re-create the business, are there barriers to entry? What makes the company so unique that allows it to maintain high returns. What could change that? A business with high margins and low barriers to entry is unlikely to be able to maintain those margins for long.  

“If you have an economic castle, people are going to come and want to take that castle away from you. You better have a strong a moat, and a  knight in that castle that knows what he’s doing.” Warren Buffett

"Frequently, you'll look at a business having fabulous results. And the question is, "How long can this continue?" Well, there's only one way I know to answer that. And that's to think about why the results are occurring now - and then to figure out the forces that could cause those results to stop occurring." Charlie Munger

The Buffett Series - What is Value Investing?

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr Buffett in his annual Berkshire letters. Over the years I've found there isn't a lot that Mr. Buffett and his partner Mr. Munger haven't worked out when it comes to investing. I am constantly discovering hidden investment gems, new ways of thinking about businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr Buffett's annual letters since the early 1980's. It's amazing how timeless and universal they are. The first essay looks at "What is Value Investing?".

".. we think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).

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 - 1992

Over the years Mr Buffett has shifted from buying fair companies at wonderful prices to buying wonderful companies at fair prices. Wonderful companies have the ability to compound earnings over time, unlike optically cheap companies which may provide a one off kicker.  

Some examples of such acquisitions by Mr. Buffett include buying See's Candy at 4X book, Scott Fetzer at 1.8X book and more recently Iscar at 5X book.  

"In GEICO, we paid 20 times earnings and a fairly sized multiple of book value." Warren Buffett, Berkshire 2013 Meeting.

Ultimately ‘Value’ is determined by what you get for what you give. While it is more difficult to ascertain the sustainability of high growth, it doesn't mean a high growth, high PE and high price to book value stock is not a ‘Value’ investment. At the same time, lots of stocks that trade on low PE's, low price to book values and high dividend yields have turned out to be terrible investments. They're generally referred to as "value traps". The key is to get back more in future returns than you give up at the time of acquisition. That's what investing is all about.

Daily Journal Meeting 2017

This Year's Daily Journal meeting contained lots of wit and wisdom from Charlie Munger, Warren Buffett's partner. He's got a cracking sense of humour at 93 years young.  

Some of the more interesting comments Mr Munger made where around the evolution of Warren Buffett as an investor. Buffett has recently purchased positions in airlines and Apple, two things he would never have done in the past given his dislike of the airline industry and his lack of understanding of tech.

Mr Munger also detailed the need for multi-disciplinary thinking, his thoughts on diversification and the need to rely on quality people.

Here are the key points from the meeting ..

On Picking Managers ..

“We are doing something that’s quite difficult. We are judging people because we don’t understand what the people do. And that’s what Andrew Carnegie did. He didn’t know anything about making steel, but he knew a lot about judging whether the people he was trusting making steel were any good at it. And of course that’s what Berkshire’s done, if you stop to think about it. We have a lot of businesses in Berkshire that neither Warren or I could tell you much about, but we’ve been pretty good at judging which people are capable of running those businesses.” 

On Capex …

“If it makes sense over the long term we just don’t give a damn what it looks like over the short term.”

On Wells Fargo ..

“They made a business judgement that was wrong. They got so caught up in cross-selling and so forth, they got incentive systems so aggressive that some people reacted badly and did things they shouldn’t. And then they used some misjudgement in reacting to the trouble they got in. I don’t think there is anything fundamentally wrong for the long haul with Wells Fargo. They made a mistake and it was an easy mistake to make”

“I don’t regard getting the incentives a little aggressive at Wells Fargo as the mistake , I think the mistake was when the bad news came they didn’t recognise it.” 

“I don’t think it impairs the future of Wells Fargo, in fact I think they’ll be better for it. One nice thing about doing something dumb is you probably won’t do it again.”

On choosing what to do in life ..

“In terms of picking what to do .. In my whole I life I’ve never succeeded much in what I wasn’t interested in. So I don’t think your going to succeed if what you’re doing all day doesn’t interest you. You’ve got to find something your interested in because it’s to much to expect from human nature that your going to be good as something you deeply dislike doing. That’s one big issue. And of course you have to play in a game where you’ve got some unusual talents. If your 5 foot one you do not want to play basket ball against a guy that’s 8 foot 3.”

About Amex/Payments Systems…

“If you think you understand exactly what’s going to happen to payments systems ten years out, your probably under some state of delusion. It’s very hard to know. They are doing the best they can, they have some huge advantages. It’s a reasonable bet, but nobody knows...  I don’t think those things are knowable, think about how fast they change.”

On multi-disciplinary learning…

“You have to know the big ideas in all the disciplines to be safe if you have a life lived outside a cave.”

“Frequently the problem in front of you is solvable if you reach outside the discipline. The idea is just over the fence. But if you’re trained to stay within the fence you won’t find it. I’ve done that so much of my life, it’s almost embarrassing. It makes me seem arrogant because I will frequently reach into the other guys discipline and come up with an idea he misses.. I do not observe professional boundaries”

 On Buffett changing..

“If you’re in a game and your passionate about learning more all the time and getting better and honing your skills etc, of course you get better over time and some people are better at that than others. It’s amazing what Warren has done. Berkshire would be a very modest company now if Warren never learned anything... But what really happened was we went out into fields like buying whole businesses and bought into things like Iscar that Warren never would have bought. 

Ben Graham would never had bought Iscar. We paid 5X book for Iscar and it wasn’t in the Graham play. And Warren learned under Graham, he just learned better over time. And I’ve learned better. The nice thing about the game is you can keep learning. And were still doing that.

Imagine, we’re in the press now for all of sudden buying airline stocks. What had we said about the airline business. We thought it was a joke it was such a terrible business. Now if you put all those stocks together we own one minor airline. We did the same thing in railroads, we said railroads were no damn good. Too many of them and truck competition, and we were right for about 80 years. Finally they get down to four main railroads and it was a better business. And something similar is happening in the airline business.”

On Investing now and the need for change …

“It’s got harder and harder, now we get little edges when before we had golden cinches. We don’t make the same returns we made when we could pick this low hanging fruit.”

“Warren bought Exxon as a cash substitute. He would never have done that in the old days.  We have a lot of cash and we thought it was better than cash over the short term. That’s a different kind of thinking from the way Warren came up. He’s changed. He’s changed when he buys airlines and Apple. Think of the hooey we’ve done over the years over high tech as outside our competency and the worst business in the world is airlines. And we now appear in the press with Apple and a bunch of airlines. I don’t think we’ve gone crazy, I think we’re adapting reasonably to a business that has got a lot more difficult. I don’t think we have a cinch due to those positions, I think we have the odds a little bit in our favour. And if that’s the best advantage we can get we’ll have to live with it.”

On Indexing with a small index …

“When you have a small index and it gets popular it’s a self defeating situation. When the nifty fifty were all the rage, JP Morgan talked everybody into buying these 50 stocks. They didn’t care what price the stocks were they just bought those 50 stocks. In time they forced up the stocks to 60X where upon it broke down and everything went down by 2/3rds quite fast. If you get too much faddishness in one sector or one narrow index of course you can get catastrophic changes like they had with the nifty fifty era.”

On funds management and big decisions ..

“The prices for managing really big sums of money are going down down down - 20 basis points and so on. The people who rose in investment management didn’t do it getting paid 20 basis points. I would hate to manage a trillion dollars in big stocks and try and beat the indexes, I don’t think I could do it. In fact if you look at Berkshire and take out 100 decisions, which is two a year, the success of Berkshire came from two decisions a year for fifty years. We may have beaten the indexes but we didn’t do it by having big portfolios of securities and having subdivisions managing the drugs etc.”

On Books ..

“I just read this new book by Thorp, the guy who beat the dealer in Las Vegas.. then he did computer algorithmic trading.  I really liked the book, I recommend Thorp’s new book.”

Destroying old ideas …

"I’m very busy destroying bad ideas. I actually like it when I destroy a bad idea. I know so many people whose main problem in life is that old ideas displace the entry of new ideas that are better. That is the absolute standard outcome in life. There is an old German folksaying ‘we’re too soon old and too late smart.’ That’s everybody’s problem”

“It’s a very important habit getting rid of the dumb ideas. Everytime I get rid of a much beloved idea I pat myself on the back. The price we pay for being able to accept a new idea is awesomely large.”

Ideas …

“A few good ideas is all you need. And when you find the few of course you have to act aggressively. That’s the Munger system. You’re not going to find a million good ideas.”

On Valeant..

“Interesting thing is how many high grade people it took in. It was too good to be true. 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.”

On diversification..

“Am I comfortable with a non-diversified portfolio. I care about the Mungers. The Munger’s have three stocks. We have a block of Berkshire, a block of Costco, a block of LiLu’s fund and the rest is dribs and drabs… Am I comfortable? Am I securely rich? Your damn right I am… Is three stocks enough? What is the chances that CostCo is going to fail?, Berkshire is going to fail? What are the chances LiLu’s portfolio in China’s going to fail. Chances of any one is almost zero.”

“I’ve never for one moment believed this boulder-dash they teach about wide diversification. If you are a no-nothing investor of course you should own the average. If your capable of figuring out something that will work better you’re just hurting yourself looking for 50, when three will suffice, one will suffice if you do it right. Once cinch, what else do you need in life.. To think we are teaching these professors to teach this crap to our young.  People are getting paid for teaching boulder-dash.”

On Banks and the investment in Irish bank investment in 2008..

“That was a mistake we shouldn’t have made. Both Warren and I know you can’t really trust any of the numbers put out by the banking industry. People who run banks are subject to enormous temptations. It’s easy to make a bank report more earnings. Even if you are really good at something, you can drift into a dumb mistake.”

On India..

“India is grossly defective because they have taken the worst elements of our culture. They forged their own chains and put them on themselves. I do not like the prospects of India compared to the prospects of China.”

 On market declines..

“I regard it as a part of manhood. If you’re going to be in this game for the long haul which is the way to do it. You better be able to handle a 50% decline without fussing too much. Conduct your life so you can handle a 50% decline with aplomb and grace. Don’t try to avoid it. It will come. And if it doesn’t come I’d say your not being aggressive enough”. 

On China..

“What I like about China is they have some companies that are very strong and still selling at low prices. The Chinese are formidable workers and they make wonderful employees and there is a lot of strength in that system. The Chinese government helps its businesses, it does not behave like the government of India which doesn’t help its businesses at all. That’s what I like about China. I have to admire taking up a billion and a half people in poverty that fast,  that was never done in the history of the world. What they have done is just an incredible achievement. They have taken a poor nation and saved half their income when they are poor.  It was unbelievably admirable and effective.”

“Chinese people only have one problem, they believe in luck. That is stupid. Your want to believe in odds. Some reason in the culture too many people believe in luck and gamble. That’s a national defect”

On adversity..

“The idea that life is a series of adversities and each one is an opportunity to behave well instead of badly is a very very good idea.”

On Manager fees..

“If your advising other people you oughta be pretty rich pretty soon. Why would I take a lot of advice from somebody who couldn’t himself get pretty rich pretty soon. And if you’re pretty rich why shouldn’t you put your money alongside your investors and go up and down with them. And if it’s a bad stretch why should you scrape money of the top when they are going down a notch. I like the Buffett system.”

On being rational ..

“Rationality is a moral duty. If your capable of being reasonable it’s a moral failure to be unreasonable when you have the capacity to be reasonable”

 On Complex systems..

“If your dealing with a complex system, the rules of thumb that worked in the complex system in year one may not work in year 40.  The laws of physics you can count on, but the rules of thumb in a complex civilisation changes. Who would want to live in a state of sameness, you may as well be dead.”

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 Arbitrage Series - Part 3 : Time Arbitrage

Time Arbitrage is the term given to the process of seeking to profit from buying a security where the current market price does not reflect the expected value. The mispricing may result from a short term issue facing the company which is not expected to impact the long term intrinsic value of the company or the market misjudging the future economic performance of the company which will see its shares re-rated. In time, the share price is expected to converge with its value, hence the term 'Time Arbitrage'. 

“Value investing is a large-scale arbitrage between security prices and underlying business value.” Seth Klarman

The increasing short term focus of market participants often means investors place too much weight on short term factors impacting the company to the exclusion of the company's longer term potential. This can provide a structural edge. Many clients demand short term results and have little patience for short term underperformance, and this means fund managers risk losing both assets under management and their job if they don't focus on the next month, quarter, or maybe year at most. In addition, the increasing flow of money into passive and quant strategies and ETF's either chasing historical performance and/or on the basis of index composition can result in egregious mispricings of stocks.

“Time-arbitrage just means exploiting the fact that most investors - institutional, mutual funds or hedge funds - tend to have very short-term horizons, have rapid turnover or are trying to exploit very short term anomalies. So the market looks extremely efficient in the short run. In an environment with massive short-term data overload and with people concerned about minute-to-minute performance, the inefficiencies are likely to be looking out beyond, say, 12 months." Bill Miller

“The longer you can extend your time horizon the less competitive the game becomes, because most of the world is engaged over a very short time frame.” William Browne

"We are disinterested in short term results and thus have the luxury of focusing our research and purchases on the much less competitive universe of stocks that have less promise of near-term appreciation, but that have exciting longer term potential. This gives us a competitive edge." Ed Wachenheim

Focusing on the long term can also provide a ‘Behavioural Edge.' When a high quality stock is sold down due an earnings miss, a product issue, a management change, an industry or regulatory issue, a geopolitical event or some transitional business issue there's a decent chance investors have over-reacted to the negative news due to psychological biases. Peter Bevelin points out in his excellent book 'Seeking Wisdom - From Darwin to Munger' that "it is a natural tendency to act on impulse - to use emotion before reason.  The behaviours that were critical for survival and reproduction in our evolutionary history still apply today." The combination of fear, social proof [other investors are selling], loss aversion [we feel losses twice as much as gains] and recency bias [we overweigh what has happened recently and underweigh or ignore the long term evidence] counteract the average investors attempt to make a rational decision.  

"When we find companies we consider undervalued, it's typically due to short-term worries we believe are temporary." Francois Rochon

“We’re very focussed on paying a cheap price, and that only comes about when there’s some short term challenge.” David Herro

"Our thesis often is based on the passage of time. What makes a negative story negative may just be that the next three to six months - the time space in which Wall Street analysts live - don't look so great." Robert Kleinschmidt

Effective 'Time Arbitrage’ requires an investor to ensure the problem facing the company is temporary and likely to be resolved. Asking questions such as 'does the company remains structurally sound?', 'has there been any structural change in the competitive landscape?' 'is the balance sheet still strong?' will help identify whether the share price dislocation is likely to be temporary or entirely warranted due to permanent issues. When answering these questions the investor must be open-minded, intellectually honest and test the investment thesis to avoid the behavioural biases that can blind an investor to negative information.   

"We rely on concentrated research to identify great businesses that are trading at highly discounted valuations because investors have over-reacted to negative macro or company specific events. That's the time-arbitrage part of the strategy, taking advantage when the market reacts to short-term factors that have little impact on long-term intrinsic values" Bill Ackman

Most investors spend their time thinking about the short term as it's much easier than contemplating the future. Investors also fall into the trap of extrapolating the recent past into the future. This provides the opportunity to profit by focusing on how a company might be performing in a few years' time and developing an alternate thesis that most investors have overlooked. Positive developments can include a consolidating industry, a new product to be launched, a major cost reduction program, the end to a major capital expenditure program, reversal of a bad inventory decision, positive management changes, a technological change which will drive sales, or corporate activity.

"Common situations that result in a mismatch between share price and share value .. may simply be time arbitrage, where we think the business performance looking out 18 to 24 months will be much better than the share price implies." Robert Alpert

"In my opinion, most individuals, including securities analysts, feel more comfortable projecting current fundamentals into the future than projecting changes what will occur in the future. Current fundamentals are based on known information. Future fundamentals are based on unknowns. Predicting the future from unknowns requires the efforts of thinking, assigning probabilities, and sticking one's neck out - all efforts that human beings too often prefer to avoid." Ed Wachenheim

To be successful the investor must have an insight into the future that is different to the consensus otherwise the positive news will already be reflected in the company's share price.

"In order to earn outsized returns, we need to hold opinions about the future that are different and more accurate than those of the majority of other investors. In fact, it can be said that successful investing is all about predicting the future more accurately than the majority of other investors." Ed Wachenheim

“One of the few sure ways to make money is to have a view that is off-consensus and have that view turn out to be right. To be contrarian is not enough. You have to be right.  Contrarian is a plus. To be contrarian and be right on you judgement is when you get the golden ring. It doesn’t happen that much but when it does happen you make extraordinary amounts of money.” Michael Steinhardt

"I'm often asking "What's the next guy's thesis?" Why is he going to buy it from us 18 months from now when the stock is up 50%?  It's not just going to be that it's worth 50% more. It's important to imagine the narrative that will make the next investor think it's a good investment then." Ricky Sandler

"All of the consensus is already baked into the price. In order to be correct in the markets, in order to make money in the markets, you have to see something that the consensus doesn't see. So you have to have an independent point of view." Ray Dalio

“The number one principle would be do not look at the world today, what’s happened in the past and happening currently, is in the price. Try and think how the world may look differently in 18-24 months from now and try and base your investments on that and not what’s true today. It’s amazing what that single little exercise can do.” Stanley Druckenmiller

While the time frame and price outcomes associated with 'Time Arbitrage' are more uncertain than most 'risk arbitrage' investments, the returns can be significant. Many of the Investment Masters happily acknowledge that their edge is from taking a longer term time frame. Like any investment activity, success requires hard work and independent analysis. 

"Time Horizon Arbitrage .... If there is a free lunch on Wall Street, we feel it is the time horizon perspective." Christopher Begg

“The single greatest edge an investor can have is a long-term orientation.” Seth Klarman

"I would say our edge is the willingness to take a longer view of a business." Glenn Greenberg

“You have to extend your time horizon if you want any chance of doing well. The competition in the space really thins out.  You have an opportunity to arbitrage time over others.” William Browne

Further Reading - 

The recent book 'Common Stocks & Common Sense' by Ed Wachenheim of Greenhaven gives an inside view into implementing 'time arbitrage' through case studies of 11 investments made since the fund was founded in 1987.  Greenhaven invests 'with a two to four year time horizon and cares little about the near term outlook for its holdings'.  Over the past 25 years, accounts managed by Greenhaven have achieved average annual returns of very close to 19 percent. Highly recommended reading.

Disclaimer

Learning from the Outsiders

Capital allocation can be defined as the process of deciding how to deploy a firm's resources to earn the best possible return for shareholders. Understanding and evaluating a company's capital allocation decisions, process and history is therefore critical to analysing potential investments.

One of my favourite books on capital allocation is The Outsiders. This book was written by William Thorndike who reflected that "Surprisingly, in business the best are not studied as closely as in other fields like medicine, the law, politics or sports," and "Despite its importance, there are no courses on capital allocation at the top business schools."

The book focusses on eight unconventional CEOs whose company's share prices massively outperformed the market. The list of CEO's include Henry Singleton from Teledyne, John Malone from Liberty Media, Katherine Graham from the Washington Post, Tom Murphy from Capital Cities Broadcasting and of course Warren Buffett of Berkshire Hathaway. In fact the book was the number one book on Mr Buffett's recommended reading list in 2012. Mr Thorndike noted these CEOs "thought more like investors than managers." It's no surprise many of the characteristics that define great company managers are common to the Investment Masters.

"Effective capital allocation .. requires a certain temperament. To be successful you have to think like an investor, dispassionately and probabilistically, with a certain coolness." Michael Maboussin

While each of the Outsider CEOs operated in different industries - some growing while others declining, with different capital intensities - there were many commonalities in how they managed their businesses. While it wasn't rocket science, the management style and initiatives these eight CEOs implemented, was unconventional for the time.

Some of the common characteristics included:

Acquisitions - while most of the CEOs were involved in acquisitions they were both opportunistic and patient. Acquisitions were only made when there was compelling discrepancies between value and price or when significant cost savings could be extracted. These CEOs either refrained from or were reluctant to issue scrip for acquisitions and only if the scrip was expensive and the 'Business Value' [ie intrinsic value] acquired was greater than the 'business value' given.

This latter point, in my view, is one of the most common mistakes CEOs and company boards make. They acquire expensive assets funded via either scrip mergers or capital raisings when their own share prices do not reflect their company's worth. While acquired assets may be high quality and accretive to earnings, these acquisitions can be hugely value destroying.

In his 1982 annual Berkshire letter, Warren Buffett provided an excellent overview of this common situation.

"Our share issuances follow a simple basic rule; we will not issue shares unless we receive as much intrinsic business value as we give. Such a policy might seem axiomatic. Why, you might ask, would anyone issue dollar bills in exchange for fifty-cent pieces? Unfortunately, many corporate managers have been willing to do just that."

"[In relation to] the acquirer who ends up using an undervalued (market value) currency to pay for a fully valued (negotiated value) property. In effect, the acquirer must give up $2 of value to receive $1 of value. Under such circumstances, a marvellous business purchased at a fair sales price becomes a terrible buy. For gold valued as gold cannot be purchased intelligently through the utilisation of gold - or even silver - valued as lead." Warren Buffett

Divestments - the Outsider CEOs were not in the business of growing for growth's sake. If another party wanted to pay an inflated price for an asset and the CEO no longer saw the growth potential of that asset they would not be afraid to shrink the business, sometimes substantially. If the market was undervaluing a part of the business the CEO would look to spin-off the division to realise that value. Should a business be underperforming with little prospect for a turnaround it was likely slated for sale or closed. The Outsider CEOs were not emotionally attached to any division and they cut their losing businesses. Capital investment was reserved only for those businesses with attractive returns on capital. The core focus was maximising long term value per share, not organisational size or growth.

Buy-backs - the CEOs were opportunistic acquirers of their own shares, BUT only when they deemed them to be trading below 'Business Value'. In many cases shares were repurchased in bear markets or when P/E's were at cyclical lows. Sometimes these buybacks were substantial. For example, in the case of Teledyne, over 90% of the shares on issue. All potential acquisitions were compared with the returns available from buybacks. Once again CEOs were not afraid to shrink their businesses.

Cash Flow - the CEOs focussed on cash flow per share not reported net income. The Outsider CEOs believed the "key to long-term value creation was to optimise free cash flow, and this emphasis on cash informed all aspects of how they ran their companies - from the way they paid for acquisitions and managed their balance sheets to their accounting policies and compensation systems."

Humility - the Outsider CEOs were humble, understated and analytical. The Outsider CEOs were distinctly "unpromotional". Mr Thorndike noted they "had familiarity with other companies and industries and disciplines, and this ranginess translated into new perspectives, which in turn helped them to develop new approaches that eventually translated into exceptional results."

Guidance/Dividends - none of the Outsider CEOs gave Wall Street guidance. Their focus was increasing the long term value per share. Taking a longer term view meant, at times, making investments or capital expenditures that may have detracted from short term earnings but added to long term value. The Outsider CEOs were frugal with regards dividends, realising the compounding benefits of reinvesting capital either in the business or in their own shares should their prices be depressed. 

Decentralisation - the CEOs ran decentralised organisations where significant autonomy was given to operating managers. This allowed managers at the coal face to respond quickly to a changing marketplace and for the CEOs to focus on capital allocation and strategic planning.

Flexibility - the CEOs recognised the need to remain flexible as business conditions and markets were uncertain and constantly changing. At certain times it made sense to make acquisitions while other times favoured selling or spinning off assets. The Outsider CEOs did not have an ideology and were not bound by a strategy.

Mr Thorndike noted that, "although the outsider CEOs were an extraordinarily talented group, their advantage relative to their peers was one of temperament, not intellect." Great CEOs possess patience, independence, humility and a contrarian streak for success. It's the CEOs that get caught up in the emotional tides of the market, overpay for acquisitions, issue scrip at the wrong prices, focus on the short term and refuse to adapt to change that will destroy companies and your portfolio's returns.

Further Reading -
'Capital Allocation - Evidence, Analytical Methods, and Assessment Guidance' by Michael Maboussin (Credit Suisse)
'Phil Fisher on Mergers & Acquisitions' (Investment Masters Class)
'The Essays of Warren Buffett' - 'Mergers & Acquisitions'

The Arbitrage Series - Part 2

'Merger arbitrage', a form of 'risk' arbitrage, is the term given to buying stocks involved in a takeover situation to capture the spread between the market price and the takeover price. The target stock usually trades at a discount to the takeover price to reflect the risk the takeover fails as well as the time value of money until the deal completes.  

However, unlike 'classic arbitrage,’ there is a risk the deal won't happen. If a deal breaks, the target stock price generally falls back towards it's pre-deal level [the price can fall lower or retain some of the premium depending on the situation] leading to large losses. Thus the term 'risk arbitrage'.  

In a cash deal, the investor will buy the target's shares at a discount to the takeover price which are exchanged for cash at deal completion. In a scrip deal, the investor will buy the target's shares and short the acquirer's shares, in the appropriate ratio, to lock in the 'spread'. At completion the target's shares will be exchanged for the acquirer's shares which will be used to net off the short position.  

"Say you get a $50 offer from a company that was trading at $35 and it immediately jumps to $49. Now most investors don't want to stick around for the last dollar and risk losing $14 if the deal breaks. They made a good profit and want to take the property and go home. On the other hand, the arbitrageur steps in, and for that extra dollar, takes the $14 risk of deal completion. Now a dollar may not sound like a lot. But a dollar over $50 is roughly a two percent return. And let's say it's a tender offer and will close in 60 days. That means you can do the deal six times a year so six times two is a 12 percent rate of return. That can be an attractive rate of return for a relatively short term investment." John Paulson

The key attraction of merger arbitrage compared to investing in a company based on fundamentals is that you are less exposed to the broader influences of the stock market given the somewhat specific price and time outcome.

"The beauty of arbitrage is you can earn good returns that are non-correlated with the market." John Paulson

However, in stressed markets and/or economic environments, merger arbitrage returns tend to become more highly correlated with the broader market given financing can dry up, market-out and/or material adverse change clauses get triggered, and funds face redemptions.

Buffett has been actively involved in merger arbitrage in both the Buffett Partnership, and then, Berkshire Hathaway. Buffett only participated in ‘announced’ deals, unlike many investors who look to participate in pre-announced deals, where a deal maybe rumoured [rumourtrage], a company may disclose they are considering corporate actions/strategic alternatives or there is speculated to be further corporate action given significant merger activity in a sector.

"The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced. We do not trade on rumours or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities." Warren Buffett, 1988

Merger arbitrage is a specialised area requiring skills in valuation, portfolio/risk management, takeover laws/regulatory rules, industry dynamics, human psychology, tax rules etc.

"A legal education helps us in the analytical process. It instills discipline." Brian Stark

“One of the things you have to be good at in the risk arbitrage business is valuation: you need to be able to understand your downside.” John Phelan

"To be successful requires very specialised skills unique to the arbitrageur. One must be an expert in evaluating the financing, legal, regulatory, accounting, market and business issues that may affect a deal's outcome. To properly evaluate these risks, the arbitrageur must have expertise in analysing merger agreements, financing agreements, strategic issues and financial statements, as well as federal, state and local regulatory issues." John Paulson

Given the merger 'spread' is normally quite slim, the profits from merger arbitrage tends to be small relative to the loss you can incur if a deal fails. In the example above, an investor risked fourteen dollars to make one dollar. This asymmetry is why it is analogous to 'picking up nickels in front of a steamroller'.

“The strategy, while properly executed, can produce non-correlated, low-volatility returns, [however] any individual deal may carry substantial risk. This is because the upside in a transaction is very small compared to the potential downside. While the annualised return may be high, the absolute return is small, and the downside can be 10 times, 20 times or even 30 times the amount of potential gain.” John Paulson

“When things go wrong in merger arbitrage, they can go very wrong – often in an asymmetric way.” Joel Greenblatt

"Premiums, ranging generally from 10 percent to even 50 percent - exceptionally even 100 percent - maybe offered for acquisition targets. An arbitrageur, when he takes his long position, is thereby assuming a great part of this premium in the price he pays. Should the deal be sabotaged for some reason, the downside price slide can be rather large. So one must carefully calculate the downside risk." Guy Wyser-Pratte

To make money in merger arbitrage the investor needs the deal to complete. As a starting point it's worth considering a few basics. Prior to analysing a deal it's worth asking a few questions with regards to the jurisdiction of the deal. Roddy Campbell of Cross Asset Management poses the following three questions: Is there, 1) a level playing field? 2) a decent body of precedent of corporate law decisions? and 3) an ability to predict the behaviour of participants and comprehend their motives? If you answer NO on any of those, it's probably best to move on t0 the next opportunity.

It's worth establishing a checklist of key considerations to ensure items are not overlooked. Some considerations include:

Deal type - is the deal announced or rumoured? Announced deals carry significantly lower risk.
Type of Buyer - is the buyer a financial buyer [ie private equity] or a strategic buyer? If private equity, is management participating? what do they know? Sensible strategic acquisitions by larger corporates in the same industry tend to have a higher likelihood of success [in the absence of competition issues] than financial buyers.
Nature of Target - was the company being shopped for sale? A company being shopped means the company is 'in play' and the board is open to a transaction. Other buyers may emerge if the deal breaks. Conversely, the list of alternate buyers may already be exhausted. If the market was aware the company was being shopped the pre-deal price is likely to have some takeover premium in it which may disappear if the deal breaks.
Type of Bid - is the buyer paying cash or scrip, a combination of both, or some other form of payment? Is the deal a takeover, scheme of arrangement or other type of transaction? 
Borrow - if the deal is a scrip deal, is there ample borrow? What are the borrow costs?
Hostile or Friendly - has the seller agreed to the terms of the deal or is it a hostile takeover? Friendly deals have a much greater chance of proceeding.
Size of the deal - is the target company a small or large company relative to the buyer. Smaller deals relative to the size of the acquirer tend to be lower risk.
Funding of the Buyer - if a cash bid, does the bidder need/have financing in place and if not what is the appetite among lenders? Are the financial metrics acceptable, is the acquirer or the proposed combined entity too heavily geared? Will the financial metrics limit the acquirers ability to pay more?

"Among other things, it's offer was contingent upon obtaining 'satisfactory financing'. A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage." Warren Buffett, 1988

Value of the target - are the deal metrics comparable with other takeovers? Is the company valuation fair at the bid price? Could the bidder pay more for the company? A low valuation increases the chance of a contested bid and generally means less downside risk. A target or their shareholders, however, are more likely to reject a hostile bid at a low valuation.
Track record of Buyer - does the buyer have a track record of closing similar transactions?
Synergies of the deal - what is the upside from putting the companies together, how important is the deal to the acquirer? Could another party get more synergies?
Target Agreements - do the target's customers, financiers, suppliers etc have change of control clauses?
Shareholders of the target - will the target shareholders agree to the deal and is there any shareholder or group of shareholders who could block the deal? Are there any other corporates on the register who may bid?
Pre-bid stake - has the acquirer already built up a stake in the target? i.e. how committed are they? Is it sufficient to block alternative bids?
Break fees/No Shop clauses - is the acquirer/target liable for break fees? Will they put off another buyer? Is the target prevented from seeking a higher bid?
Post deal announcement price of the acquirer - has the market reacted favourably to the proposed acquisition? Are the acquirer's shareholders supportive of the transaction?  
Potential Counter bidders - is it likely another buyer for the company will emerge? The potential for a contested takeover can improve the asymmetry of returns.

"Generally, the characteristics that lead to a higher bid include: a low relative valuation, an attractive target, an industry experiencing consolidation, no lock-ups and the company not having been shopped prior to deal announcement." John Paulson

Acquirer bid - is there a chance another party could bid for the acquirer? Was the acquirer buying for defensive reasons? Will the deal break if an offer is made for the acquirer? This is a major risk to a trade, particularly if you have bought the target and short the acquirer. 
Fraud - Is the acquirer buying to mask an earnings hole/structural decline in their own business? Is the target likely to reject the acquirer's scrip? Are there question marks over the acquirers financials/cash flows/roll-up strategy?
Conditionality of bid - does the bid have few or a lot of conditions that need to be fulfilled for the deal to complete? How onerous are the conditions? The more conditions, the more chance of a deal break.
Market Out-clause - does the bidder have a market out-clause if stock markets or commodities etc fall or interest rates rise? Absence of out-clauses reduce the risk of a deal break.
Defence Options - what could the target company do to scuttle the deal, poison pills etc?
Anti-trust/Competition issues - are there any issues which may mean the deal is blocked by a competition regulator? Are there useful precedents?
Timing/Delays? - are there likely to be delays to the completion time? Competition /regulatory/ court rulings/ due diligence etc. Delays ordinarily reduce the returns unless the deal compensates for a delay in the timetable.
Regulatory Issues - are their regulatory issues outside competition? Are there national interest/sovereign issues? Is the deal in a country with a strong rule of law? Are there deal precedents?
Tax Issues - does the deal require a favourable tax ruling?
'Break' downside - where is the stock likely to trade if the deal breaks?  Does the bid highlight value not previously appreciated by the market, or is it likely to fall back to levels prior to the deal being announced or speculated? Is there a risk that new and disappointing information may come to light during the negotiation?
Company Performance - the underlying performance of both the target and acquirer can impact the probability of a deal closing. The more cyclical the industry the more risk either party's business may change significantly which may alter the deal outcome.

The investor must consider the above issues at a minimum to determine whether to participate in a deal. Every transaction is different.  

Often investors will work out a probability weighted outcome based on different scenarios [ie 15% chance of deal break which will see stock fall to 5% below undisturbed price [ie price stock trading before deal], 60% chance of deal complete at stated time, 25% chance of competing bidder paying 20% more for target]. The investor will calculate the annualised return the current spread provides. The difficulty is in weighing up the factors and estimating the probabilities.

"It's very easy to compute what the returns are from a spread. But what's not easy to compute is what the risks of the deal breaking apart are." John Paulson

The investor is unlikely to have concrete answers to all the necessary questions and will need to make informed judgements.   

"In arbitrage you have to be able to pull the trigger, even when your information is imperfect and your questions can’t all be answered. You have to make a decision: should I make this investment or not? You begin with probing questions and end up having to accept that some of them will be imperfectly answered – or not answered at all." Robert Rubin

"One of the things I do very well in investing is I gather a lot of information, but I never know the whole picture. I have a lot of inputs, but never everything. And I have to make a decision on incomplete information. And I feel very comfortable doing it." James Dinan

"Investing isn't black or white. It's different shades of grey, and what was common to all of us [in Goldman's risk arbitrage team] was that we could see the different shades of grey and handicap them. There were very few second chances. The process had to be good." Richard Perry

The investor must constantly monitor the takeover's progress as well as general market and industry conditions to manage risk and optimise returns.  

"The odds of a merger reaching closure changed constantly over time, as risks emerged and receded and share price fluctuated. We had to stay on top of the situation, recalculating the odds and deciding whether to commit more, reduce our position, or even liquidate it entirely." Robert Rubin

"Merger arbitrage is not a one decision investment. It is an ongoing process: prices fluctuate, the economy changes, government actions are taken, stock is always being bought and sold. Merger arbitrage is not a part-time activity. It required constant vigilance." Ivan Boesky

Ultimately, an investor must be comfortable with the worse case outcome and the effect on their overall portfolio. I've seen plenty of situations where a deal break results in a share price trading significantly below the pre-bid trading price. For example when a takeover premium was already in the price and the register has become dominated by non-natural holders who need to sell, an acquirer walks due to any one of a number of possible reasons, or the target fails to act in the shareholder's best interests.   

“Risk arbitrage sometimes involved taking large losses, but if you did your analysis properly and didn’t get swept up into the psychology of the herd, you could be successful. Intermittent losses – sometimes greatly in excess of your worst case expectations – were part of the business.” Robert Rubin

Pure merger arbitrage funds limit position sizes and look to participate in many transactions to spread risk and minimise the loss from a single deal breaking.     

"Of course, an arbitrageur would be involved in many deals at any one time. You had to do a lot of them, because arbitrage is an actuarial business, like insurance. You expect to lose money in some cases but to make money over the long run thanks to the law of averages.” Robert Rubin

"A common approach to managing a merger arbitrage portfolio is to diversify a portfolio across a broad range of small positions. By minimising position sizes, the manager can protect himself from significant drawdowns [loss] in the event of an adverse deal outcome. This broadly diversified approach, however, should lead to no better than average returns." John Paulson

“Of course, some investment strategies for instance, our efforts in arbitrage over the years require wide diversification. If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. Thus, you may consciously purchase a risky investment - one that indeed has a significant possibility of causing loss or injury - if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favoured by probabilities, but refuse to accept a single, huge bet.“ Warren Buffett

While Warren Buffett recognized the benefits of a diversified approach he tended to concentrate in a small number of attractive deals. The merger activity was part of a broader portfolio of investment styles that could absorb any large loss.

"Our relatively heavy concentration in just a few situations per year (some of the large arbitrage houses may become involved in fifty or more workouts per annum) gives more variation in yearly results than an across-the-board approach. I feel the average profitability will be good with our policy." Warren Buffett, Buffett Partnership Letter

"Because we diversify so little, one particularly profitable or unprofitable transaction will affect our yearly result from arbitrage far more than it will the typical arbitrage operation. So far Berkshire has not had a really bad experience. But we will - and when it happens we'll report the gory details to you." Warren Buffett, Berkshire Letter

“We do not do a lot of arbitrage, but participate in extreme opportunities.” David Einhorn

Like many investment strategies, when there has been a history of returns money flows into the strategy which lowers its returns. Similarly, in the absence of deals, too much money chasing too few opportunities affects returns.

Easy credit and a bull market leads to increasing deal activity and the potential for contested deals. The merger boom leading into the Financial Crisis was a case in point. Deals regularly traded at premiums to the takeover prices as a credit bubble fueled a private equity buying binge resulting in a flurry of contested deals. Sell-side research analysts spent their days running LBO screens over company financials to identify the next potential target. All was well until the credit markets closed.

“When an area of investment such as risk arbitrage or bankruptcy investing becomes popular, more money flows to specialists in the area. The increased buying bids up prices, increasing the short-term returns of investors and to some extent creating a self-fulfilling prophecy. This attracts still more investors, bidding prices up further. While the influx of funds helps to generate strong investment results for the earliest investors, the resultant higher prices serve to reduce future returns.” Seth Klarman

"The strategy has its cycles based on the overall level of deal activity as well as the supply of capital." John Paulson

Buffett succinctly outlined the requirements for successful merger arbitrage in his 1998 letter..

“To evaluate arbitrage situations you must answer four questions 1) How likely is it that the promised event will indeed occur? How long will your money be tied up? 3) What chance is there that something still better will transpire – a competing takeover bid, for example? And 4) what will happen if the event does not take place because of anti-trust action, financing glitches etc?” Warren Buffett

The key to successfully employing merger arbitrage is to avoid deal breaks.  

"Risk arbitrage is not about making money, it's about not losing money." John Paulson

"The common characteristics of deals that break are poor earnings, an inability to consummate financing and/or regulatory obstacles. By eliminating deals that exhibit these characteristics, one can reduce the insistence of deal breakage." John Paulson

John Paulson, of Paulson Partners outlines his strategy for success..

"Our particular strategy to manage the portfolio for outperformance is comprised of five basic principles: 1) avoid deals that may break, 2) optimise returns from the spread portfolio, 3) weight the portfolio to possible competitive bid situations 4) focus on deals with unique structures that offer high returns; and 5) selectively short the weaker transactions." John Paulson

While merger arbitrage is unlikely to offer the same opportunity for returns as finding compounding machines, at times it can be a useful complement to value investing. Over the years, the best merger arbitrage opportunities I've witnessed are deals with very low conditionality that provide optionality for a bidding war. In these situations the return profile can move from negative to positive asymmetry. It's interesting, that despite John Paulsen's history in merger arbitrage it was buying sub-prime CDS's with massive positive asymmetry that made him billions. He risked a small amount for a massive pay-off.

Further reading - 

The Arbitrage Series - Part 1

“Because my mother isn’t here tonight, I’ll even confess to you that I have been an arbitrageur.” Warren Buffett

Arbitrage can be defined as 'the simultaneous or near simultaneous purchase and sale of the same securities or commodities in different markets to make a profit on the (often small) differences in price'.

This essay will take a brief look at 'classic arbitrage' and 'risk arbitrage'. Part two of the series will cover 'merger arbitrage', part three will cover 'time arbitrage.'

'Classic Arbitrage' refers to, for example, a trader noting a price differential between New York and London gold prices and then buying gold in the cheaper market to quickly on sell in the more expensive market to capture the 'spread' [ie profit] with almost no risk. Gold prices in London were kept in line with New York, as arbitrageurs like this trader exploited any pricing anomalies.    

"A century ago, when you bought the same security in New York and London, there was just a little variation in price from one city to the other. The professional bought the identical security in one city and sold it in another for a very small, but almost sure, profit." Roy Neuberger

With the rapid advancement of high-speed communications and computer technology, the traditional landscape of classic arbitrage has undergone a profound transformation. A contemporary illustration of this shift is embodied in the practices of high-frequency traders, who exploit pricing differentials across various stock exchanges within each market. These traders leverage sophisticated algorithms capable of intercepting trade data at lightning speed, executing market orders within nanoseconds to capitalize on pricing inefficiencies.

In this dynamic environment, computers are strategically positioned at exchanges, incurring premium rents for co-location, to gain an early advantage in accessing market data. Employing cutting-edge technology, such as microwave communication and state-of-the-art computer chips and low-latency order routing. Their objective is often to identify potential orders en route to other exchanges and execute ahead of them ["dirty poker?"]

The ascendance of these automated systems marks the demise of the era of 'classic arbitrage' for human participants. The rise of the machines signifies a paradigm shift, relegating traditional arbitrage strategies to obsolescence in the face of technologically-driven market dynamics.

The key idea in classic arbitrage is taking advantage of a pricing inefficiency with the absence of risk.

"Risk arbitrage" strategically exploits pricing inefficiencies arising from trading imbalances or information uncertainty triggered by various corporate events. These events encompass mergers, tender offers, liquidations, spin-offs, stub trades, and corporate reorganizations, among others.

The arbitrageur's primary goal is to seize the spread between the current trading price and the genuine value of the security. This spread encapsulates both the time value of money until the event concludes and a risk premium associated with the potential non-completion of the deal, hence the epithet 'risk' arbitrage.

Fundamentally, the arbitrageur endeavors to pinpoint mispriced risks within the market. Several factors contribute to this mispricing, such as a stock's exit from an equity index, a lack of Wall Street coverage for a spun-off company, the stigma surrounding a bankruptcy reorganization, heightened risk aversion due to uncertainties about a deal's success, involvement in cross-border transactions outside existing shareholder mandates, or the intricacies and lack of understanding regarding the nuances of the event.

"Since World War 1 the definition of arbitrage - or 'risk arbitrage', as it is now sometimes called - has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganisation, liquidation, self-tender etc." Warren Buffett

“Risk arbitrage investments, which offer returns that generally are unrelated to the performance of the overall market, are incompatible with the goals of relative-performance-oriented investors. Since the great majority of investors avoid risk-arbitrage investing, there is a significant likelihood that attractive returns will be attainable for the handful who are able and willing to persevere.” Seth Klarman

The strength of 'risk arbitrage' lies in its low correlation with the broader stock market, attributed to the defined timeline associated with the event that is anticipated to rectify the pricing anomaly. This inherent characteristic serves as a safeguard for the portfolio during market downturns. Such investments are commonly denoted as 'special situations' or 'event investing.'

"The risk pertains not primarily to general market behaviour (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialise." Warren Buffett 1963

“In the first place, with respect to a special situation as it is known in Wall Street. That is a security which upon study is believed to have a probability of increasing in value for reasons not related to the movement in stock prices in general, but related to some development in the company’s affairs. That would be particularly a matter such as recapitalization and re-organisation, merger and so forth.” Ben Graham

"The unique aspect of the strategy is its ability to earn attractive returns that are not dependent on the market's direction." John Paulson

"Our goal is to make money independent of the direction of the market.. We always do this through arbitrage." Brian Stark

"Risk arbitrage differs from the purchase of typical securities in that gain or loss depends much more on the successful completion of a business transaction than on fundamental developments at the underlying company. The principal determinant of investors' return is the spread between the price paid by the investor and the amount to be received if the transaction is successfully completed. The downside risk if the transaction fails to be completed is usually that the security will return to its previous trading level, which is typically well below the takeover price.” Seth Klarman

Warren Buffett referred to these types of investments as 'work-outs' and employed the strategies at both the Buffett Partnership and then Berkshire Hathaway.

"Starting in 1956, I applied Ben Graham's arbitrage principles, first at Buffett Partnership and then Berkshire. Though I've not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%." Warren Buffett, 1988

Buffett recognised the benefits risk arbitrage positions would add to the overall portfolio. In down markets, arbitrage positions tend to outperform. While they are likely to be a drag on performance in strong bull markets, it's outperformance in down markets which is the key to high long term returns.

"I continue to attempt to invest in situations at least partially insulated from the behaviour of the general market." Warren Buffett, 1960

"This category produces more steady absolute profits from year to year than the generals [fundamental value investments] do. In years of market decline, it piles up a big edge for us; during bull markets it is a drag on performance. On a long term basis, I expect to achieve the same sort of margin over the Dow attained by generals." Warren Buffett, 1963

Although risk arbitrage returns typically demonstrate a lack of correlation with the overall market, it's essential to acknowledge that during periods of market stress, correlations often elevate. This occurs as mergers and tender offers are more likely to fail as acquirers re-assess the prices they are prepared to pay, deteriorating business conditions may trigger material adverse change conditions, market-out-clauses come into effect, financing dries up or spin-offs trade poorly. Spreads can also widen if dedicated arbitrage funds experience increasing redemptions.  

"The greatest risk in arbitrage is if capital leaves at the wrong time. You are attempting to exploit temporary mis-pricings between one security and another. Most of your success comes when the correct relationship between those securities is restored. When the relationship is out of whack and your capital leaves is when you get hurt." Brian Stark

As the arbitrageur is collecting the time value of money until deal completion, plus the risk premium for the risk of deal failure, the return can be computed as an annualised rate of return. This return can then be compared to current interest rates. When interest rates are low, annualised returns from risk arbitrage also tend to be low. Some mutual funds use arbitrage as a proxy for cash when they are nervous about markets but mandated to remain fully invested. Warren Buffett uses arbitrage as a proxy for cash, but only when returns are attractive. 

"Arbitrage positions are a substitute for short-term cash equivalents, and during the year we held relatively low levels of cash. In the rest of the year we had a fairly good-sized cash position and even so chose not to engage in arbitrage. The main reason was corporate transactions that made no economic sense to us; arbitraging such deals comes to close to playing the greater fool game (As Wall Streeter Ray DeVoe says: 'Fools rush in where angels fear to trade)." Warren Buffett, 1989

While risk arbitrage can serve as a viable alternative to cash, it comes with a notable caveat—when deals fall through, the resulting returns bear little resemblance to cash returns. In instances like merger arbitrage and tender offers, the losses incurred can be disproportionately higher, often ranging from 10 to 20 times the anticipated return from the successful completion of the deal. This inherent asymmetry is likened to the metaphor of 'picking up nickels in front of a steamroller,' emphasizing the perilous nature of the strategy.

Recognizing this risk, many investors adopt a strategy of diversification and impose limits on position sizes to effectively mitigate the potential downsides inherent in risk arbitrage. This cautious approach aims to strike a balance between the pursuit of returns and the prudence required to navigate the inherent uncertainties associated with these investment endeavors.

"The gross profits in many 'work-outs' appear quite small. A friend refers to this as getting the last nickel after the other fellow has made the first ninety-five cents. However, the predictability coupled with a short holding period produces quite decent annual rates of return." Warren Buffett

Many specialist investors use leverage which enhances the annualised returns, but may significantly increase the risk profile. While there is no optimal level of debt, an investor must consider the impact on the portfolio in stressed market conditions or when there are multiple deal breaks.  

"I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behaviour. My self imposed limit regarding borrowing is 25% of partnership net worth. Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs." Warren Buffett

"We believe that reasonably leveraged and well-hedge arbitrage portfolios are considerably less risky than unhedged, outright equity portfolios." Brian Stark

Successful risk arbitrage requires identifying the attractive potential investments where the probability of success is high.  

“We will engage in arbitrage from time to time – sometimes on a large scale – but only when we like the odds.” Warren Buffett

 "For every arbitrage opportunity we seized in the 63 year period, many more were foregone because they seemed properly priced." Warren Buffett

The strategy tends to be cyclical and like all forms of investing, this style will not guarantee success. At times when interest rates are low, there is a surge in M&A activity or an excess of capital pursuing too few available deals, returns maybe unattractive. 

"Arbitrage has looked easy recently. But this is not a form of investing that guarantees profits of 20% a year, or for that matter, profits of any kind. As noted, the market is reasonably efficient much of the time: for every arbitrage opportunity we seized in the 63 year period, many more were foregone because they seemed properly priced. An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline. Investing in arbitrage situations, per se, is no better strategy than selecting a portfolio by throwing darts.” Warren Buffett, 1988

"We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders. In our activities, we will heed the wisdom of Herb Stein: "If something can’t go on forever, it will end." Warren Buffett, 1988

Even the best arbitrageurs can have bad luck. The key is to ensure the portfolio can handle the downside should the worst case scenario happen.

"Our experience in workouts this year has been atrocious - during this period I have felt like the bird that inadvertently flew into the middle of a badminton game." Warren Buffett, 1969

Engaging in risk arbitrage has the potential to enhance portfolio returns, but it's certainly not a pursuit for the faint-hearted. This highly specialized strategy demands a diverse skill set for effective execution. Just like any form of investing, success hinges on having a distinct edge, operating within one's circle of competence, and meticulously assessing each investment within the broader context of the entire portfolio.

"Corporations will forever be buying, selling and restructuring their way into better businesses, creating fodder for event-driven investors for years to come." Jason Huemer

Further suggested reading:

"The hedge fund manager's edge: an overview of event investing" Chapter 8 - Jason Huemer.  Evaluating and Implementing Hedge Fund Strategies" - Third Edition
 

Value - Market, Intrinsic and Private

There's lots of ways to think about value. When I studied property valuation at university we were taught that value was, ‘the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion.’

Unfortunately, in the stock market there is no one-size-fits-all definition of value. It's worth focusing on market value, intrinsic value and private  value.  

Intrinsic value, also referred to as underlying or business value, reflects a company's worth and is probably most closely aligned with the definition of value in the opening paragraph. A company is worth the discounted value of the future cash flows an owner will receive. The Investment Masters focus on the free cash flows coming out of the business rather than earnings.

"In reality, earnings can be as pliable as putty when a charlatan heads the company reporting them" Warren Buffett

"Cash flow, not reported earnings, is what determines long-term value" William Thorndike

An investor forgoes capital today to achieve higher returns in the future. While a company's shares can theoretically trade at any price, a company is not worth more than the value of those discounted cash flows.

“Intrinsic value, is in its simplest form the discounted present value of future cash flows” Frank Martin

"Intrinsic value is the number, that if you were all knowing about the future and you could predict all the cash a business would give you between now and judgement day, discounted at the proper discount rate, that number is what the intrinsic value of the business is. In other words, the only reason for making an investment and laying out money now is to get back more money later on. That's what investing is all about. When you look at a bond it's very easy to tell what you get back, it says it right on the bond, it says when you get the interest payments and the principal. The cashflows are printed on the bond, the cash flows aren't printed on the stock certificate. That's the job of the analyst, to change that stock certificate, to change that into a bond. To say that's what I think it will pay out in the future." Warren Buffett

“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

Those cash flows will be received in the future and the future is unknown. Some company's cash flows are simpler to estimate like a REIT with contracted lease payments while other company's cash flows are much harder to forecast such as a new technology venture. As future cash flows are uncertain it's impossible to ascertain a precise value for what a company is worth. Therefore an estimate of a company's worth is a range and not a single figure. In cases such as technology it may not be possible to estimate future cash flows which significantly raises the risk of investment.

"It is important to understand that intrinsic value is not an exact figure, but a range that is based on your assumptions" Jean-Marie Eveillard

“Calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong. The more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base.” Warren Buffett

A company's intrinsic value is subject to changes in earnings expectations and changes in investor return requirements but really shouldn't fluctuate that much. The more certain the cash flows the more stable the company's intrinsic value. Intrinsic value tends to be far less volatile than a company's market value.

"Value to some extent is in the eye of the beholder. It is very hard to pin down what the value of a future set of cash flows from a business, be it a cable TV or biotechnology, is going to be. Some are easier to predict than others. But it is very hard to predict what those future cash flows are going to be. And it is very hard to ascertain the correct discount rate to bring them back to the present with." Seth Klarman

As cash flows are inherently unpredictable, its makes sense to be conservative when making estimates. The more conservative the estimates, the greater the margin of safety.

“Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners.” Warren Buffett

"When we look at value, we tend to look at it on a very conservative basis - not making optimistic forecasts many years into the future, not assuming growth, not assuming favourable cost savings, not assuming anything like that. Rather looking at where it is right now, looking backward and saying, is that the kind of thing the company has been able to do repeatedly? Or is this a uniquely good year and is it unlikely to be repeated?" Seth Klarman

Market value is the value of the company at any one point in time as reflected in it's share price. The value of the whole company is the last share price multiplied by the number of shares on issue plus the company's debt, also known as enterprise value.

In reality, market value can be, and often is, significantly different from both intrinsic value and private value. Just because a stock trades at a certain price does not mean the company is worth that amount. If you have a small parcel of shares you may be able to achieve that price. If you own a large stake in the company it may not be possible to sell them all at that price.

"The underlying value of a security is distinguishable from its daily market price, which is set by the whim of buyers and sellers, as are the prices of rare art and other collectibles” Seth Klarman

Market value can be significantly above intrinsic value. Plenty of people pay more for companies than they are really worth. This may occur when they expect someone else to pay even more [ie they are speculating], they have unrealistic growth expectations, they have an investment mandate that means they have to buy, they are focused on the short term outlook, they are too optimistic, their buying decisions are quant driven [eg momentum], or they believe the share price looks cheap relative to other companies etc. 

Conversely, a company's market value can be significantly below intrinsic value - the future maybe uncertain, macro factors maybe overwhelming fundamentals, investors maybe focused on the short term outlook, investors may be acting irrationally, or investors may have a mandate requiring them to sell the shares etc.

“Mr. Market gives you opportunities to buy above and below intrinsic value.” Mario Gabelli

"Growth in corporate intrinsic value is often obfuscated by stock price movement, which does not appropriately track the accretion in business value. That’s good for all of us who are appraisers of businesses, because it means you get more mispricing and better opportunity to get a franchise at a cheap price." Mason Hawkins

Market value is influenced by the same factors that affect intrinsic value but even more so by the human emotions of fear and greed. Lots of investors buy and sell shares without respect to intrinsic value. As a result, market value tends to be far more volatile than intrinsic value. It's this volatility that provides the opportunity to buy businesses below their intrinsic worth.

"Prices fluctuate more than values - so therein lies opportunity" Joel Greenblatt

"Market price is the price the stock is currently trading at. It is determined by supply and demand of sellers at a point in time and may have no relationship with private market or intrinsic value." Li Lu

"The stock market is dominated by participants that perceive stocks almost as casino chips. With that knowledge, we can then buy great businesses sometimes well below their intrinsic value" Francois Rochon

Finally, private value is the value of the company based on a price another company or private investor may pay for the whole company. Private value is influenced by the same factors as intrinsic value and is often higher than intrinsic value. This is because another company who buys the whole company has access to all of the cash flows (not just the dividends), can determine capital allocation, may get tax benefits and, or maybe able to remove duplicate costs to achieve synergy benefits to increase earnings.

It is possible for another company or private investor to pay too much above intrinsic value for the same reasons an investor pays too much - emotional factors like greed, cheap financing or a private equity buyer flush with cash, over-estimating future earnings, relying on multiples of other companies or transaction multiples etc. 

"The ultimate irony is that private market value, being defined as what business people would pay was, in fact a moot point [in the mid to late 1980's]. There were no business people doing deals because the Wall Street leverage artists had prices way above what prudent business people would pay. We always attempted to define private market value as what we would pay to own a business." Seth Klarman

So how do you take advantage of the three different types of values?

Value investors like to buy shares in companies when the market value is significantly below intrinsic and private value. Share prices, while they may move significantly from intrinsic value in the short term, have a tendency to reflect intrinsic value long term. Over time underlying business fundamentals tend to determine share prices rather than short term factors. 

"The price of any particular security can be pictured as something resembling a captive balloon attached, not to the ground but to a wide line traveling through space. That line represents "intrinsic" value. As time goes on, if a company's earning power and true prospects improve, the line climbs higher and higher. If these or other basic ingredients of intrinsic value get worse, the line declines correspondingly. At any one time, the psychological influences (i.e., how the financial community is appraising these more fundamental matters of intrinsic value) will cause the price of the particular stock to be anywhere from well above this line to well below it. However, while momentary mass enthusiasm or unwarranted pessimism will cause the stock price to be far above or well below intrinsic value, it, like our captive balloon, can never get completely away from the line of true value and will always be pulled back toward that line sooner or later." Phil Fisher

The Investment Masters often refer to buying stocks well below intrinsic value as buying dollars for fifty cents or so.

“If a business is worth a dollar and I can buy it for 40 cents, something good may happen” Water Schloss

Buying shares with respect to longer term intrinsic value is a common investment strategy of many of the Investment Masters and is commonly referred to as 'time arbitrage'. 

"We rely on concentrated research to identify great businesses that are trading at highly discounted valuations because investors have over-reacted to negative macro or company specific events. That's the time-arbitrage part of the strategy, taking advantage when the market reacts to short-term factors that have little impact on long-term intrinsic values" Bill Ackman

Investors who buy at a discount to intrinsic value are buying with a 'margin of safety'. If a company trades at a wide enough discount to its intrinsic value it's likely to attract other investors, other companies or private equity to take advantage of the under valuation.

"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

“I never want to pay above intrinsic value for stock – with very rare exceptions where someone like Warren Buffett is in charge." Charlie Munger

"The concept of a margin of safety is that an investor should purchase a security at a price sufficiently below his estimate of its intrinsic value that he will have protection against permanent loss even if his estimate proves somewhat optimistic. An analogy is an investor standing on the 10th floor of a building, waiting for an elevator to carry him to the lobby. The elevator door opens. The investor notices that the elevator is rated for 600 pounds. There already are two relatively obese men in the elevator. The investor estimates their weights at about 200 pounds each. The investor knows that he weighs 175 pounds. The investor should not enter the elevator. There is an inadequate margin of safety. Maybe he underestimated the weights of the two obese men. Maybe the elevator company overestimated the strength of the elevator’s cable. The investor waits for the next elevator. The door opens. There is one skinny old lady in the elevator. The investor says hello to the lady and enters the elevator. On his ride to the lobby, he will enjoy a large margin of safety." Ed Wachenheim

Many value investors look to the prices paid in mergers and acquisitions of similar companies to determine the potential private value of a company. When a company trades at a wide discount to that value it can provide an investment opportunity.

“Look at the prices paid in corporate mergers and acquisitions to find stocks that are selling at a significant discount to what they are actually worth to a knowledgeable buyer” Christopher Browne

The beauty of listed shares is that they are heavily influenced by human emotions. Investors are subject to tendencies and biases like groupthink, herd behaviour and basing investment decisions on recent performance. Intrinsic value and private value tend to be less influenced by human emotions.

“The big difference between private acquisitions and public equities is a negotiated transaction versus the non-negotiated transaction. When I buy stocks in the public markets, I am dealing with unintelligent sellers for the most part, or sometimes sellers that are very influenced by psychology on market nuances.” Mohnish Pabrai

This is one of the reasons many investment masters are cautious with new IPO's. The price tends to be set by rational individual[s] who look for the optimal time to maximise the sale price of the company.

“An intelligent investor in common stocks will do better in the secondary market than he will doing buying new issues. The reason has to do with the way prices are set in each instance.  The secondary market, which is periodically ruled by mass folly, is constantly setting a 'clearing price'. No matter how foolish that price may be, it's what counts for the holder of a stock or bond who needs or wishes to sell, of whom there are always going to be a few at any moment. In many instances, shares worth x in business value have sold in the market for 1/2 x or less. The new issue market, on the other hand is ruled by controlling stockholders and corporations, who can usually select the timing of offerings or, if the market looks unfavourable, can avoid an offering altogether. Understandably, these sellers are not going to offer any bargains, either by way of a public offering or in a negotiated transaction. It's rare you'll find x for 1/2 x here.” Warren Buffett

Finally, many Investment Masters look for a catalyst that will close the gap between market value and intrinsic or private value. This may include things like asset sales, spin-offs, new management, buy-backs, insider buying, fixing balance sheets, closing unprofitable divisions etc. The quicker the gap can be closed the less the share price is exposed to general movements in the share market.

“One of the approaches I take is to look for a stock in the public market that is selling at a significant discount to private market value where I can identify catalysts for potential change” Leon Cooperman

"Investors should pay attention not only to whether but also to why current holdings are undervalued. Look for investments with catalysts that may assist directly in the realization of underlying value." Seth Klarman

The stock market coupled with the emotions of participants provide the opportunities for investors to buy companies below what they are worth. Provided market prices are determined by human nature that's unlikely to change.

Quality Companies, Compounders and Value Traps

Many of the world’s greatest investors have evolved to focus on high quality companies. In the post 'Evolution of a Value Manager' I outlined how Buffett, with help from Charlie Munger and the insights from the acquisition of See's Candy, transitioned from seeking cheap companies [ie low PE/, price/book etc] to searching for high quality companies at reasonable prices. Li Lu, C.T Fitzpatrick and Mohnish Pabrai are three Buffett disciples who have made a similar transition.  

"See's Candies - it was acquired at a premium over book [value] and it worked. Hochschild, Kohn, the department store chain was bought at a discount from book and liquidating value. It didn't work. Those two things together helped shift our thinking to the idea of paying higher prices for better businesses." Charlie Munger

The key to understanding the value of high quality companies is compounding. There is no universal definition of what high quality is but I think it's fair to say a high quality company is one which is understandable, dominant in it's industry, enjoys high barriers to entry, has attractive profit margins and a sustainable rate of return which is above average. Other attributes include strong free-cash-flow, a capital light business model, a good runway for sales growth, high quality management and a rock solid balance sheet. The highest quality companies have the ability to re-invest free-cashflow back into the business at high rates of return. These 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

In the case of See's Candies, it was a very high quality company but it didn't offer the same potential re-investment opportunity of a Coke or Gillette as it didn't have the global sales runway of these universal brands. For Buffett though, this didn't matter, he could send the profits back to Berkshire headquarters for redeployment into other attractive investments.

"We've tried 50 different ways to put money into See's. If we knew a way to put additional money into See's and produce a quarter of what we're getting out of the existing business, we would do it in a second. We love it. We play around with different ideas, but we don't know how to do it." Warren Buffett

"If we hadn't bought See's, we wouldn't have bought Coke. So thank See's for the $12 billion.  We had the luck to buy the whole business and that taught us a lot." Warren Buffett

So how do you identify high quality? It's important to consider common stocks as businesses and not just pieces of paper. This helps remove some of the emotional influences and human biases an investor faces and guides an investor to the key factors that will drive future earnings. Earnings are the lifeblood of the company and a company's worth is the discounted value of the earnings it can deliver over it's lifetime. While in the short term, a stock price may vary significantly from the underlying value of the business, in the long term, share prices and value converge.  

To identify high quality businesses you need to think about the characteristics of the business that  will determine its success over time. It's important to understand the basics of the businesses. What does the business sell? Is it a necessity, a commodity, a fad, a royalty stream? Is it subject to technological obsolescence? Why do the customers buy the product from the company and not someone else? Do they buy based on price, quality, convenience, subscription, referral etc? What demand is the product fulfilling? Is the product a small part of a much larger purchase? Is the company a win-win for all stake-holders? Does the business have some unique aspect that makes it hard for others to compete with it [ie network effects, 'winner takes all', geographic advantage, scale advantage, government licence, patent, cost advantage, strong brand,  high switching costs etc]. Does the business operate in  a competitive industry?  Are competitors entering or exiting the industry? Does the business have lots of competitors, suppliers and customers, or few? Will technology impact the business in a positive or negative way? Can the business put up prices without impacting sales? Does the business have a long runway for sales growth? What is the market penetration? Is the business facing the law of large numbers? Does the business need a lot of capital to grow? Does the business have a structural tailwind or headwind? Is the business subject to regulatory change? Is the business improving or declining? How is the business impacted by inflation?

While investment checklists aren't a panacea for thinking they can help an investor avoid common mental short-cuts and investment pitfalls.

A business with a history of profitability through different economic environments is a lower risk proposition than a start up. It's been stress-tested by economic cycles. Some high quality businesses are boring, they don't attract competition. Some high quality businesses maybe on the cusp of a technological development that will escalate future growth. A good example was Disney, which Munger recognised owned a valuable film library, which could suddenly be monetised with the invention of the DVD.  

High quality businesses have superior management who can adapt to change, are aligned with their shareholders and have a track record of deploying capital skillfully. High quality businesses also have solid balance sheets and high levels of free cash flow.

Once you've identified a high quality business the question is what to pay? Buffett paid three times book value for See's Candy and a P/E multiple above twenty for his last purchases of Coke. So if you can find a compounding machine it can be worth paying up for.  

"Is Costco worth 25 times earnings? I think: Yes.  Am I ready to sell any Costco? No. Would I buy more Costco at 25X earnings? I’m probably wrong, but I’d certainly rather buy Costco at 25X earnings than 90% of the other stocks." Charlie Munger

The difficulty is in identifying the few businesses that will grow into their multiple and beyond as most won't. Allan Mecham of Arlington Capital noted ‘Home Depot which in 1984 traded for 48 times earnings and even from such a lofty valuation went on to compound at 20% over the following 29 years’ .. but, ‘Home Depots are extremely rare.’ Paying too much for a business can result in poor returns.

Conversely, value traps tend to have characteristics at the other end of the spectrum of high quality companies. They are optically cheap, hence the name value trap. These businesses are commonly referred to as 'melting ice cubes' as the intrinsic value of the business melts away.  

“If you’re in a lousy business for a long time, you’re going to get a lousy result even if you buy it cheap.” Warren Buffett

A good example of value traps over the last ten or so years are businesses which have been subject to technological obsolescence. These businesses in many cases were high quality compounding machines in an earlier life but who have since seen their barriers to entry destroyed by some innovation. Kodak is a good example. Kodak dominated the market for film and photographic paper prior to the invention of the digital camera. In the beginning digital camera images were seen as inferior low resolution. Then at a sudden tipping point, when digital camera prices plummeted and quality improved, Kodak's earnings and stock price was decimated.  

A similar thematic played out with newspapers. The newspapers had few competitors, huge scale advantages, and a monopoly on advertising and news. Slowly at first, classified websites offering better search functions and lower costs started to gain a following. A tipping point was reached and many newspapers went bankrupt.

Cable TV operators are facing a similar threat from high speed internet because now you no longer need a cable network for distribution. The cable network was once the barrier to entry. Netflix doesn't need a cable monopoly or a local TV licence to deliver content to its customers. Anyone in the world with high-speed internet in now a potential customer. The more customers Netflix can sell to, the more it can pay for programming, the more customers it can attract. It's a virtuous circle.  

The internet has decimated traditional businesses and provided the means for the early adopters to move to a 'winner takes all' position which wasn't previously possible.  

The common characteristics of value traps are declining businesses. While the impact at first tends to be slow, it escalates rapidly when adoption hits a tipping point.

Value traps can also arise where management is misaligned with investors and/or makes poor capital allocation decisions. Even in high quality businesses management who deploy capital poorly can destroy value. Seeking businesses where management is aligned through stock ownership or appropriate incentives helps avoid these problems. Vetting management’s track record should be part of the due diligence process.  

In declining businesses it is common for management to try and buy their way out of trouble by making acquisitions in unrelated fields to dilute or cover-up the core business performance. This almost always ends badly.

The best way to avoid value traps is to think deeply about the business and the forces that could harm its earnings potential and focus on high quality companies. Don’t let a low valuation metric lure you into poor quality investments.

Further reading:
Tutorials - Quality Companies, Compounding Machines, Value Traps
Other - Fear of paying a high multiple (Valuation heuristics) - RV Capital
Don't Confuse Cheap with Value - Broyhill Asset Management

The Ten Commandments of Business Failure

“I like to study failure… we want to see what has caused businesses to go bad." Warren Buffett

"If I were ordaining rules for running boards of directors, I'd require that three hours be spent examining stupid blunders." Charlie Munger

Most business schools spend time studying the ingredients for business success. Many of the Investment Masters acknowledge the benefits of inverting a concept, looking at an investment question or problem in another way. Instead of searching for the ingredients that make for a successful business, trying to identify the common factors that will kill a business, can both help you avoid potential loss and help you identify businesses worth pursuing.

A great starting place is Don Keough’s book, "The Ten Commandments for Business Failure." Don Keough, a philosophy major, is a former CEO of the Coca-Cola Company and Berkshire Board Member. The book is introduced by his good friend, Warren Buffett.

Mr Keough notes, "A company doesn't fail to do anything. Individuals do, and when you probe a bit you usually find that failure lies not in a litany of strategic mistakes - though they all may be present in one form or another - but the real fault lies, as Shakespeare noted, in ourselves, the leaders of the business."

"Businesses are the products and extension of the personal characteristics of its leaders - the lengthened shadows of the men and women who run them. They are the main actors on the business stage and when, through one of more personal failings, they take a business in the wrong direction, then the business is headed for failure".  

Mr Keough recognises the commandments aren't startling breakthroughs in management thinking. They just make 'common sense.’ Mr Keough challenges the reader, ‘Show me a failed business, even one based on the latest wikinomics, and I will bet you with considerable assurance that their leaders have violated more than one of these commandments. One step towards failure unchecked, leads to another.’

I've outlined the Ten Commandments and added some comments along the way.

1) QUIT TAKING RISKS

When you are comfortable in your position there is a temptation to quit taking risks. The one constant for a business is change. A business must adapt to change, try out new products, processes and services and respond to changing technology, economics and customer needs.  

In light of the speed of technological change disrupting industries it is paramount businesses continue to evolve. Evolving means taking risks. I recently read an interview with Jorge Paulo Lemann, the 19th richest person in the world, and a founder of 3G. 3G is an investment company that has had enormous success buying and growing global businesses.

"Something that I always thought college doesn't give is the ability to assess and take risks.  It will teach you how to assess risks mathematically or theoretically, but hardly. And in general, it teaches you not to take risks, which is to say be careful. And I think in life, you have to take risks, and I think the only way you learn to take risks is practicing, practicing. So I practiced on the waves, playing tennis tournaments, later in business etc. I only mention this because I think a lot of people study hard, and I think in order to do more, or do exceptional, you have to take risks." Jorge Paulo Lemann

In the book 'Adapt - Why success always starts with failure', Tim Harford discusses failure when there is a pathological inability to experiment. He offers a method for experimentation known as the 'Palchinsky Principles;' first, seek out new ideas and try new things; second, when trying something new, do it on a scale where failure is survivable; third, seek feedback and learn from your mistakes as you go along.’

Phil Fisher touched on this concept in his writings, 'Developing an Investment Philosophy’,“The company that doesn’t pioneer, doesn’t take chances, and merely goes along with the crowd is liable to prove a rather mediocre investment in this highly competitive age.”

2) BE INFLEXIBLE

Companies and investors, that refuse to change when it is clearly evident a strategy or process isn't working are bound for failure. The newspaper companies that failed to adapt to the rise of the internet are a case in point. They lost their edge in real estate classifieds, employment advertising and general advertising. So too have the TV networks that failed to recognise the global reach of the internet will far surpass free-to-air and cable networks limited geography.

Mr Keough believes, "flexibility is a continual, deeply thoughtful process of examining situations and, when warranted, quickly adapting to changing circumstances. It is, in essence, the key to Darwin's whole notion of the survival of the fittest.”

3) ISOLATE YOURSELF

CEO's who isolate themselves from their businesses or who surround themselves with only ‘yes people’ are likely to fail. Managers that do well understand their marketplace and understand their customers, their staff and their competitors.  

Mr Keough points out Charles Kettering, the great engineering genius who helped steer GM during its glory years, said "Don't bring me anything but trouble. Good news weakens me." If you isolate yourself you will not only not know what you don't know about your business, but you will remain supremely and serenely confident that what you know is right.   

So too, the great investors are seekers of truth. They ask what they do and do not know. They look to have investment ideas tested.  

4) ASSUME INFALLIBILITY

Mr Keough notes "Annual reports often amuse me, particularly the letter to shareholders. In one report after another, even if the company has had a thoroughly disastrous year, the chairman's letter is frequently an artful exercise in finger pointing at a number of causes ranging from unforeseen currency fluctuations to the unusually active hurricane season."

Once again, like good investors, managers must acknowledge and address mistakes, learn from them and move on. Ignoring or sweeping problems under the rug or finger pointing will lead to failure. "If you want to increase your chances of failure, deny the possibility that you are not always 100% perfect in your judgement. Ignore the fact that sometimes others do know a thing or two." Do the same in investing, and you'll fail too.

5) PLAY THE GAME CLOSE TO THE FOUL LINE

Trust is an essential foundation of any business. Mr Keough notes, "All business finally boils down to matters of trust - consumers trust the product will do what it promises it is supposed to - investors trust that management is competent - employees trust management to live up to its obligations.”  

Many of the great investors focus on companies whose culture is win-win. Over time studies shows businesses with good cultures outperform those with poor cultures.

6) DON'T TAKE THE TIME TO THINK

There are plenty of example of business failure which could have been averted if management stopped to think about the consequences of their decisions. Being human, managers suffer the same emotional biases investors do.

Confirmation bias, greed and fear and groupthink are a few examples. Like investors, managers can test ideas, study similar situations/mistakes, and invert concepts to aid their thinking process. Mr Koeugh notes "If you want to fail, don't take time to think. If you want to succeed, take lots of time to think. Thinking is the best investment you'll ever make in your company, in your career, in your life."

“Thinking is the hardest work there is, which is probably the reason so few engage in it.” Henry Ford

7) PUT ALL YOUR FAITH IN EXPERTS AND OUTSIDE CONSULTANTS

Experts and consultants have vested interests, biases and shortcomings. Just like stock market forecasters, business and industry forecasters track records usually tell you more about the forecaster than what’s likely in the future. Be skeptical of companies that cite and rely on industry analysis to support acquisitions or major corporate change.  

Mr Keough notes, "You'll fail if you don't stop to think. Well, you'll also fail big time if you let yourself be flattered, and there is never a shortage of charming con artists in just about every field who will use flattery as a sales tool."

“Anyone who says businessmen deal in facts, not fiction, has never read old five-year projections.” Malcolm Forbes

“I have never seen a management consultant’s report in my long life that didn’t end with the following paragraph: “What this situation really needs is more management consulting.” Never once. I always turn to the last page. Of course Berkshire doesn’t hire them, so I only do this on sort of a voyeuristic basis. Sometimes I’m at a non-profit where some idiot hires one." Charlie Munger

"Organisations that take the word of overconfident experts can expect costly consequences … however, optimism is highly valued, socially and in the market; people and firms reward the providers of dangerously misleading information more than they reward truth tellers.” Daniel Kahneman

8) LOVE YOUR BEAURACRACY

The same limitation and dangers of a committee approach to investing often applies to the process of running a business. Committees suffer from Groupthink. Warren Buffett once reported that in the first month of ownership of one acquired company, they eliminated fifty-four committees that were chewing up about ten thousand man-hours. Berkshire Hathaway operates with 25 people at head office.  

To combat bureaucracy at the Coca-Cola Company, Mr Keough isolated the core of the business to drive decision making, "every expense we made, every department we created, every project we took on had to answer to the basic question: Will this help to create and serve customers? If the answer was not a ringing and positive ‘Yes?’ whatever it was we were spending or undertaking had to be eliminated. Once you decide you have fifty things to do that are unrelated to your customer, soon you have fifty bureaucracies composed of individuals doing things extremely well that they shouldn't have been doing because it didn't serve the customers in any way."

With business, as with investing, focus on the factors that matter.

In his 2014 letter Warren Buffett made the point that his successor would need one other particular strength, "the ability to fight off the ABC's of business decay, which are arrogance [see point 4 above], bureaucracy and complacency [see point 1 above]." He noted "When these corporate cancers metastasise, even the strongest of companies can falter."

9) SEND MIXED MESSAGES

Mr Keough notes, "sending mixed or confused messages to your employees or your customers will jeopardise your competitive position, and result in failure.” 

Companies need to ensure their employees are rowing in the right direction. In part this has a lot to do with having the right incentives, values and purpose. History is littered with companies whose move into unrelated businesses took the focus off their core business.

“A majority of life’s errors are caused by forgetting what one is really trying to do.” Charlie Munger

10) BE AFRAID OF THE FUTURE

Mr Keough notes, "When you focus on the failures of the world day in and day out, it shapes your whole attitude toward life and the future.”

One optimist in a sea of pessimists can make all the difference. If you want to succeed, approach the future with optimism - and passion.

* 11) LOSE YOUR PASSION FOR WORK  - FOR LIFE *

Mr Keough added a little bonus - an eleventh commandment. He notes "I have never met a successful person who did not express love for what he did and care about it passionately.” He suggests making an emotional connection with your customers. Remind yourself every day as to just what the customer is looking for, expects, and wants from your company.  

As in investing, management must have a passion for what they do. The business environment does not afford the luxury of complacency.

The same human foibles that undermine investors can undermine management and their businesses. Mr Keough states "Human nature is the reason I have, regrettably, such confidence in the principles of this little book." 

Recognising those common factors and red flags of business failure can assist investors in avoiding companies more susceptible to failure. After all, avoiding the permanent loss of capital is key to successful investing. 

Sources:
'The Ten Commandments for Business Failure' - by Don Keough

Further Study: 
'Adapt - Why success always starts with failure' - Tim Harford
Video: ‘Warren Buffett & Don Keough: The Ten Commandments of Businesses Failure & Buying Coca-Cola’

Avoiding GroupThink

"Society teaches us from childhood that it pays to be part of the group and not be too different." Wilfred Trotter

"Groups can bring out the worst as well as the best in man." Irving Janus

Over the years I've witnessed plenty of costly decisions made by corporate boards and investors as a result of poor group decisions.  

A few years ago I was reading an interview with Adam Weiss of Scout Capital who recommended the book "Groupthink" written by Irving Janus, a Yale psychologist, in 1982. I always like to read the books recommended by investors with solid track records of compounding capital.

“Both James [Crichton] and I recently read Groupthink, Irving Janis’ classic study of how small, cohesive groups of very smart people can make really bad decisions, such as getting deeper into Korea, the Bay of Pigs, and Vietnam. The main point is to make sure you have a culture that questions everything and vets out all the alternatives before zeroing in on one of them.” Adam Weiss

Irving Janus defined the term 'groupthink' as "a mode of thinking that people engage in when they are deeply involved in a cohesive group, when the members' striving for unanimity override their motivation to realistically appraise alternative courses of action. Groupthink refers to a deterioration of mental efficiency, reality testing, and moral judgement that results from in-group pressures."

“When smart men and women combine their intellects to presumably optimise a solution, the result tends to be surprisingly counterproductive. Rather than being boosted by brilliance, groupthink has a perversely dilatory effect on collective reasoning.” Frank Martin

Mr Janus notes "Groupthink is conducive to errors in decision-making, and such errors increase the likelihood of a poor outcome.  Often the result is a fiasco, but not always." 

The book recounts the fascinating historical account of the fiascos of Pearl Harbor, the escalation of the Vietnam War, The Bay of Pigs invasion, the invasion of North Korea and the Watergate cover-up. Each of these catastrophic outcomes was a product of a group decision from a small body of government officials and advisers who constituted a cohesive group. Each instance contained the characteristics of gross miscalculation about both the practical and moral consequences of the decisions by a group of intelligent individuals who ignored contrary information and failed to sufficiently consider alternative outcomes.

Understanding 'groupthink' provides a key to better decision making. While the book's case studies relate to political fiascos they have implications for all types of decision making by groups, particularly financial decisions. Whether a group is involved in managing an investment portfolio or choosing an investment manager or a corporate board is considering a major acquisition, capital is at risk.   

With respect to managing a portfolio, many of the Investment Masters acknowledge the limitations of group decision making, and instead prefer to manage capital on a sole basis. 

"It has been my experience that the more power given to the investment specialist and the smaller the influence of the individuals on investment committees, the better the quality of the work accomplished." Phil Fisher

"If no great book or symphony was ever written by committee, no great portfolio has ever been selected by one, either." Peter Lynch

"Like art, portfolio management can rarely be done in teams (or worst in committees). We can add experience but we lose in personal creativity. Like Warren Buffett once said: “My vision of a group decision is to look into a mirror.” Francois Rochon

"If there were such thing as the Laws of Investing, they would have been written by Graham, Buffett and Munger. A small team size (ideally one) would be one of these laws." Mohnish Pabrai

"Investing probably is not played best as a group sport." Leon Levy

Mr Janus identifies eight major symptoms of 'groupthink' which he splits into three types as noted below [I have included references for investment consideration in italics].

Type 1 - Overestimations of the group - its power and morality

1. An illusion of invulnerability, shared by most or all of the members, which creates excessive optimism and encourages extreme risk taking.

A classic case study is the violent collapse of the hedge fund, Long Term Capital Management [LTCM] , in 1998. This fund comprising legendary traders, a former vice chairman of the Federal Reserve and two Nobel prize winning economists, had an aura of invincibility combined with phenomenal risk, which almost led to the downfall of the US financial system.   

With respect to LTCM, Howard Marks noted "Brilliance like pride, often goes before the fall.  Not only is it insufficient to enable those possessing it to control the future, but awe of it can cause people to follow without asking questions they should and without reserving enough for the rainy day that inevitably comes. This is probably the greatest lesson of Long-Term Capital Management"  

A more recent case study is the significant de-rating of Valeant, a US pharmaceutical company with a successful early track record and strong CEO which led the company to undertake ever larger acquisitions and implement aggressive drug pricing strategies, that became its undoing.  

2. An unquestioned belief in the group's inherent morality, inclining the members to ignore the ethical or moral consequences of their decisions.

The late 1990's collapse of Enron and Worldcom provide two examples of unethical corporate behaviour with respect to corporate accounting and fraud. The more recent conduct of the credit ratings agencies and investment banks in the sub-prime mortgage market that contributed to the Global Financial Crisis is likely a consequence of groupthink.

Type 2 - Closed Mindedness

3. Collective efforts to rationalise in order to discount warnings or other information that might lead the members to reconsider their assumptions before they recommit themselves to their past policy decisions.

"I would say that the typical organization is structured so that the CEO's opinions, biases and previous beliefs are reinforced in every possible way. Staffs won't give you any contrary recommendations - they'll just come back with whatever the CEO wants. And the Board of Directors won't act as a check, so the CEO pretty much gets what he wants." Warren Buffett

4. Stereotyped views of enemy leaders as too evil to warrant genuine attempts to negotiate, or as too weak or stupid to counter whatever risky attempts are made to defeat their purposes.

“I try to assume that the guy on the other side of a trade knows at least as much as I do. Let’s say I buy Texaco at $52 and it suddenly goes down to $50. Whoever sold Texaco at $52 had a perception dramatically different to mine. It is incumbent on me to find out what his perception was.” Michael Steinhardt

“In order to invest, we need to have a sizeable analytical edge over the person on the other side of the trade. The market is an impersonal place. When we buy something, we generally do not know who is selling. It would be foolish to assume that our counterparty is uninformed or unsophisticated. In most circumstances, today’s seller has followed the situation longer and more closely than we have, has previously been a buyer, and has now changed his mind to become a seller. Even worse, the counterparty could be a company insider or an informed industry player working at a key supplier, customer or competitor.” David Einhorn

“I’m not entitled to have an opinion unless I can state the arguments against my position better than the people who are in opposition. I think that I am qualified to speak only when I’ve reached that state.” Charlie Munger

Type 3 - Pressure Towards Conformity

5. Self-censorship of deviations from the apparent group consensus, reflecting each member's inclination to minimize to himself the importance of his doubts and counter-arguments.

"Independent directors have to be hard-working people who will attend meetings diligently, ask tough questions and challenge management. We're in the process of looking for directors for one of our companies. Someone I asked about a prospect said "He'll be a pain in the ass to management". Within reason, that's what I want to hear. Relaxed attitudes negate the concept of independence. Directors who serve in perpetuity should be looked at. After enough years, they can conclude their loyalty is to management." Howard Marks

"The reality is that neither the decades-old rules regulating investment company directors nor the new rules bearing down on Corporate America foster the election of truly independent directors. In both instances, an individual who is receiving 100% of his income from director fees – and who may wish to enhance his income through election to other boards – is deemed independent. That is nonsense." Warren Buffett

"CEO's get very diluted information. They're told what people believe they want to hear. We tell them the facts. We call a spade a spade" Richard Perry

6. A shared illusion of unanimity concerning judgments conforming to the majority view (partly resulting from self-censorship of deviations, augmented by the false assumption that silence means consent).

"It's equally awkward to question a proposed acquisition that has been endorsed by the CEO, particularly when his inside staff and outside advisers are present and unanimously support his decision (They wouldn't be in the room if they didn't)." Warren Buffett

7. Direct pressure on any member who expresses strong arguments against any of the group's stereotypes, illusions, or commitments, making clear that this type of dissent is contrary to what is expected of all loyal members.

"Whistle-blower Sherrin Watkins has said that questioning CEO Jeff Skilling about the proprietary of the partnerships would have been 'job suicide". CFO Andrew Fastow is said to have cursed at the Enron representatives who negotiated against the partnerships he ran and tried to get one fired." Howard Marks [2002 memo 'Learning from Enron']

8. The emergence of self-appointed members who protect the group from adverse information that might shatter their shared complacency about the effectiveness and morality of their decisions.

Peter Bevelin succinctly described the issues with group decisions in his book 'Seeking Wisdom - From Darwin to Munger'…  "In a group we feel anonymous, which reduces our feelings of responsibility. We can't be blamed. This can lead to over-confident risk behaviour. We may also become impulsive and destructive. Imitation, obedience to authority, and the fear of being different are forces that drive crowds. Groups don't encourage differences of opinion. If a member of a group disagrees, he may seem disloyal. Unanimity is better than independent thought. Individuals in the group reinforce each other into believing that they collectively are right. They focus on favourable consequences and ignore the downside."

Mr Janus offers a number of prescriptions to help avoid groupthink including:

1.  The leader of the policy forming group should assign the role of critical evaluator to each member, encouraging the group to give high priority to airing objections and doubt.

“One of the best ways to get confidence in an idea is to find a smart person who has the opposing view and listen to all their arguments. If they have a case that you haven’t considered, then you should get out. But they can also help give you more conviction.” Bill Ackman

“I stress tested my opinions by having the smartest people I could find challenge them so I could find out where I was wrong.” Ray Dalio

2. The leaders should be impartial instead of stating preferences and expectations at the outset.

3. The organisation should routinely set up several independent groups working on the same policy question under a different leader.

4. The policy making group should from time to time divide into two or more subgroups to meet separately and then come together to hammer out their differences.

"These 'social' difficulties argue for outside directors regularly meeting without the CEO - a reform that is being instituted and that I enthusiastically endorse." Warren Buffett

5. Each member of the policy making group should discuss periodically the groups deliberations with trusted associates in his her unit and report back their reactions.

"I have several times leveraged the partners on specific investments because we have so many entrepreneurs and CEO's in our midst with deep domain knowledge. Many times when I have looked at the list and then presented it to one to three of them with my analytics and said to them "Please don't go buy the stock, but could you tell me if I'm thinking about this the right way; What's your take on it or what insight do you have that I may not know?"  Mohnish Pabrai

6. One or more outside experts or qualified colleagues who are not core members of the policy-making group should be invited to each meeting and be encouraged to challenge views of core members.

"I have a lot of ideas. Most of them are terrible. But what saved me – well, to the extent I’ve been saved – is that… I want to get people with the best knowledge and insights in each one of those key aspects and get a challenge from them." Charles Koch

7. At every meeting to evaluate alternatives at least one member should be assigned role of devil's advocate.

"My thought is, if there's no natural sceptic on an investment maybe it would be wise to appoint one to play devil's advocate anyway." Peter Cundill

"I play devil's advocate and make sure the level of analysis has been complete and thorough and that all the relevant resources have been brought to bear." Lee Ainslie

"We’ve also started to assign an “appointed bear” for big positions. This is an insight from one of my favorite books, Groupthink by Irving Janis.. You need to bless someone to take the contrary position because there are a lot of reasons people won’t do it. I think it’s made a big difference in the quality of our discussions."

8. Whenever the policy issue involves relations with a rival nation a sizeable block of time should be spent surveying all warning signals from the rivals and constructing alternative scenarios of the rival's intentions.

"We continually challenge ourselves by asking, "What can go wrong?" with investments we own or consider owning. By playing mental war games against our best ideas we may gain or lose confidence in an initial thesis, or perhaps come to accept that a long-loved holding should be let go. We call this stress testing process "killing the company." Bruce Berkowitz

“The financial markets generally are unpredictable. So that one has to have different scenarios... The idea that you can actually predict what's going to happen contradicts my way of looking at the market." George Soros

"Always remembering that we might be wrong, we must contemplate alternatives, concoct hedges, and search vigilantly for validation of our assessments." Seth Klarman

"Charlie and I both think about worst case scenarios a lot." Warren Buffett

9. After reaching a preliminary consensus about what seems to be best policy alternative, the policy-making group should hold a 'second chance' meeting at which members are expected to express as vividly as they can all their residual doubts and to rethink the entire issue before making a definitive choice.

"We are very careful not to close ourselves off to opportunities to hear a well- developed counterview on any of our investments. Vibrant debate is part of our internal process; however, there is no substitute for the argument of an investor who has risked real capital on a view that is in opposition to ours. Without fail, this shines a light on the potential soft spots of an investment and causes us to work even harder to bottom-out the critical elements of our own thesis." Jim Mooney

Avoiding Groupthink is a necessary pre-requisite for investment success. Many of the Investment Masters employ strategies to combat the negative effects of groupthink. As Barton Biggs asserts in his excellent essay "Groupthink = Groupstink" that ‘Although there are some groupthink countermeasures, the only real defence against this intellectual cancer is awareness’.   

Further Reading: Investment Masters Class tutorials - Investment Committees, Testing Ideas, Alternative Scenarios, What you Know, Hubris & Humility, Understanding History, Invert, Confirmation Bias, and Checklists.

Sources: 'Groupthink - Psychological Studies of Policy Decisions and Fiascos' by Irving Janus [Yale University].  1982 Houghton Mifflin Company
'Hedge Hogging' by Barton Biggs. 2006 John Wiley and Sons" - see Chapter 12
"Dare to be Great" Memo - 2006 Howard Marks - Oaktree Capital
'The Essays of Warren Buffett' by Laurence Cunningham, 2nd Edition 2008 - see 'Boards and Managers' and 'Acquisition Policy'

 

 

10 Timeless Lessons from Bernard Baruch

Known as "The Lone Wolf of Wall Street", Bernard Baruch was one of the the world's most famous speculators of the 20th Century. By the age of 30, Mr Baruch had amassed a fortune.  He went on to advise US presidents and congressional leaders from 1918 to 1948.  

His memoirs, "My Own Story", written in 1957, provides a fascinating account of Baruch's life, his insight into human psychology and the history of speculation. His first hand account of market panics, bull markets and short squeezes and the associated emotional reaction of the markets provide timeless wisdom.  

Mr Baruch lays down 10 guidelines from his lifetime of experience in the markets which he notes 'may be worth listing for those who are able to muster the necessary self discipline'. Like all of the Investment Masters there are many common threads that form the foundation of his success. With the exception of Mr Baruch's commentary on taxes, all of the 10 guidelines are tutorial topics in the Investment Masters Class.

1. Don't speculate unless you can make it a full-time job

2. Beware of barbers, beauticians, waiters - of anyone - bringing gifts of "inside" information or "tips."

3. Before you buy a security, find out everything you can about the company, its management and competitors, its earnings and possibilities for growth.

4. Don't try to buy at the bottom and sell at the top. This can't be done except by liars.

5. Learn how to take your losses quickly and cleanly. Don't expect to be right all the time. If you have made a mistake, cut your losses as quickly as possible

6. Don't buy too many different securities. Better have only a few investments which can be watched.

7. Make a periodic reappraisal of all your investments to see whether changing developments have altered their prospects.

8. Study your tax position to know when you can sell to greatest advantage.

9. Always keep a good part of your capital in a cash reserve. Never invest all your funds.

10. Don't try to be a jack of all investments. Stick to the field you know best. 

[Source: "Baruch - My Own Story" Published by Henry Holt & Co., 1958.]

100 Common Threads of the Investment Masters

The Investment Masters Class is based on the wisdom of the world's greatest investors.  Over the last few decades following investors with strong track records of compounding capital I've found that many common threads consistently surface. These common threads encompass a broad range of areas such as investor's goals, processes, opportunities, obstacles, psychological construct, outlook and market views. Many are timeless. Below are 100 common threads of the Investment Masters which form the foundation of the Investment Masters Class tutorials. 

1. The Number One Rule is don't lose money

2. Harnessing the power of compounding is the key to investment success

3. It’s better to be street smart than book smart when it comes to the market

4. Investing is an art, study the Masters

5. There are no get quick rich schemes, NIL, ZILCH

6. Successful investing is hard work

7. The Investment Masters read  

8. Continuous learning is one of the keys to successful investing

9. As an Investor you must have an edge

10. The Investment Masters love their jobs

11. Checklists help avoid human biases

12. Studying history gives you an edge, most things have happened before

13. All Investors make mistakes, the Investment Masters learn from theirs and others

14. Being an Investment Generalist helps one widen the scope of view

15. Understand what you own

16. Value Investors dominate the Investment Masters ranks

17. Prices maybe wrong

18. Risk and return are not correlated

19. Volatility is NOT risk. Volatility creates opportunities

20. Cash is an asset in a portfolio

21. Investment Masters understand the folly of forecasts

22. Don't forget, markets can turn on a dime

23. Pessimism can be a clarion call

24. Weak markets set the stage for high returns

25. Ignore tips

26. Investment Masters don't stray outside their circle of competence

27. Outperforming in down markets is the key to investment success

28. No Index Hugger has made the Investment Masters Hall of Fame

29. Only an Absolute Return focus is consistent with the First Rule of Investing: Preserve Capital

30. The Investment Masters get on base [rather than hit home-runs]

31. Valuation is a range not a number

32. Don't invest without a Margin Of Safety

33. Opportunities arise when prices don't reflect Private Market Value

34. Having a longer Time Horizon can give you an investment edge

35. Never assume interest rates will stay low indefinitely

36. Find Compounding Machines

37. The Investment Masters count the Cash coming out of the business

38. Don't waste your time trying to pick the bottom

39. Testing Investment Ideas helps identify where a thesis may be wrong

40. Don't let your investments go stale

41. Never forget things are always evolving

42. High levels of Correlation can lead to trouble

43. The Investment Master looks at less and sees more, their Unconscious skill-set is more highly evolved

44. The greatest Investment Master of our time thinks the Efficient Market Hypothesis is garbage. Most Business Schools study the hypothesis not the Master

45. Shorts can help protect capital, but the analysis of shorts differs significantly than for longs

46. You need to understand the benefits and pitfalls of Diversification

47. Focus on the Variables that are going to drive or destroy a company

48. There is no One Size fits all. Positions should be sized depending on a multitude of factors

49. Portfolio management is a LOT more than picking the right stocks

50. Management can break a company

51. Understanding Psychology can be the most important thing

52. The key to successful investing is overcoming your Emotions

53. The market humbles everyone

54. All you need is a little Patience

55. Don't fall in Love with three letters

56. It's Mr Market who provides the opportunities for high compound returns

57. The more people you have the more likely you will suffer from Groupthink

58. Human nature evolved for the survival of the species, not individual investors

59. It's important to understand the Bounds of your Knowledge

60. When people Hate a stock, there's more chance it's going to be mis-priced

61. The Investment Masters use Leverage sparingly if at all

62. Excessive Debt on a company's balance sheet can lead to investment ruin

63. Be on the lookout for Value Traps

64. The higher the rating the higher the potential for de-rating

65. There are Bubbles everywhere, be careful

66. The Investment Masters are the only Crowd you should follow

67. Don't put your faith in a Computer Model, keep thinking

68. Make sure you keep your eyes on the road ahead or you might drive off a cliff

69. New Eras ordinarily turn out to be mirages

70. Ignore the Macro at your peril

71. What is RISK? …  Permanent Loss of Capital

72. Don't be unprepared for the Unexpected

73. You can drown in the absence of Liquidity

74. Capital Allocation is a required skill-set for Corporate Management

75. Be careful when companies are on an M&A binge

76. It's Asymmetry that's beautiful in investing

77. Trawl through the New Low Lists

78. Take notice of what Investment Masters are active in

79. Playing in Spin-offs can be profitable

80. Catalysts can speed up the crystalization of profits

81. Invert [a thesis] so you don't face plant

82. The Investment Masters seek Quality

83. In Win-Win situations, you're less likely to lose

84. Industries that are Gonna Change the World for the positive may change your P&L for the negative

85. There is no margin of safety in Commodity Companies

86. The Investment Masters eat their Own Cooking

87. GOLD isn't a compound[er]

88. The Investment Masters age like a good wine

89. The dark art [of charting] is still practiced

90. Sometimes you need a removed view

91. Don't confuse skill with luck

92. The scorecard is the P&L

93. Buy well

94. When it's not working get off the Tracks

95. Conventional is Not Conservative and vice versa

96. Projects suffer from Time Asymmetry and Human Biases

97. Only at the right price, Buybacks add value

98. Evolutionary biases can kill you in the market

99. It's important to understand the crowd behaviour in Bull Markets

100. Be mindful of Technological Obsolescence

DISCLAIMER - TERMS OF USE

Investing - Art or Science?

One of the premises behind the Investment Masters Class is the belief that investing is far more art than it is science. Whether it is an art or science has implications as to how one should approach investing, what one should study and the necessary skills for success.

This paper will draw together many of the tutorial topics included in the Investment Masters Class [including 'Art or Science', 'Education and Smarts', 'Invert always Invert', 'Rear-view mirror', 'Keeping Stock Valuations simple', 'Investment Factors', 'Investing Instinct'. 'Stock Market Magic Formula'].

"Investing is more art than science." Howard Marks

Science is associated with consistent, independent and timeless outcomes. Science can be studied in a textbook, applied in an experiment and deliver an expected result. If investing were a science, in theory, you should be able to buy an investing textbook, apply the knowledge and achieve excellent returns. There would be an investment formula you could apply to achieve results. Unfortunately, there are no magic formulas or formulaic textbooks that guarantee success.

"If there was one formula, one way to do it, we'd all be zillionaires." Paul Tudor Jones

If investing were a science it's likely that investors with the highest IQ would outperform. You would expect investors that attended pre-eminent business schools to be the finest. The fact that the majority of professional money managers do have highly regarded education qualifications and under-perform the market indices, suggests finance courses don't correlate well with performance. In fact, I'd be prepared to wager there is no statistically significant correlation between, say those holding a CFA or Applied Finance qualification and those that don't, and their respective investment performance.

"Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ. " Warren Buffett

Building more detailed and complex investment models doesn't ensure investment success either. There is no relationship between the detail or complexity of an analysts model and the likelihood of investment success. In fact the Investment Masters tend to keep valuations simple and instead take the time to think about the key factors that impact a common stock's performance. A much more fruitful exercise than building a 2,000+ line spreadsheet model.

“Keep it simple. Your thesis should be on the back of a postcard if it’s right.” Bruce Berkowitz

Relying on the science of formulas such as 'Value at Risk' as opposed to a common sense assessment of risk has blown up plenty of investment funds.  

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

Understanding the efficient market hypothesis and the capital asset pricing model hasn't secured a place for any investor in the ranks of the Investment Masters. Most of the Investment Masters are critical of such theories.

"The elegance of the efficient market theory is at odds with the reality of how the financial markets operate." Seth Klarman

So if investing isn't a science, is it an art? What is Art? Most of the Investment Masters do consider investing more art than science. 

Art can be defined as the 'expression or application of human creative skill and imagination.' The ability for an investment manager to consider alternative outcomes, to connect disparate information, to step away from the crowd, and to imagine and contemplate business performance are prerequisites for investment success.  

So how do you study art? If you were to study classic art you would likely start by studying the great masters - Picasso, Renoir, Van Gogh, Monet and the like. You would explore their work, style and techniques. You would contemplate their thought processes, the times in which they lived and their creative progression. It's unlikely you would spend time studying the physical process of painting or the composition of the paint.

Investing is no different. To become a successful investor it pays to start learning from the Investment Masters. How do/did they operate, their psychological considerations and the common themes behind their success.   

Art involves creativity and imagination and is associated with the right-side of the brain. This is the side that also deals with ideas and intuition. 

These are functions commonly cited by the Investment Masters as prerequisites for investment success. Examples include the ability to create unique investment theses and to imagine alternative investment scenarios and the implications for a stock or market.  

"Creativity and independence of thought are the essence of the hedge-fund craft.” Paul Singer

“We put great emphasis on a consistent investment process that demands enormous creativity, energetic sourcing, outside-the-box thinking, intellectual honesty, and vibrant debate.” Seth Klarman

“We think we try harder than most to be rational and creative.” Nick Sleep

"I always tried to balance risk aversion with some measure of creativity." John Neff

The ability to stand against the crowd is a key ingredient for investment success. It also requires creativity ..

"From our empirical observations, it seems that some members of our species are immune to this call of the herd. They can go left when the rest of the tribe goes towards the right. Their attitude isn’t influenced by the behaviour of the tribe. Their genetic code seems to not have the “tribal gene”. It’s difficult to evaluate what percentage of humans have this particularity but it’s a minority. And it’s probably those who eventually become creators (artists, scientists, writers, entrepreneurs, etc), as the act of creation requires the capacity to make something new and to forge a new path different from others. To create is to go where there was nothing before. Creating is the antonym of following." Francois Rochon

“It’s imperative to be creative because a stock currently is selling at a price that the average investor thinks is the right price, so you have to come to a decision that that price is wrong and that the stock deserves to sell at a higher price for some reason. That reasoning is creative thinking because other people aren’t thinking that way because if other people were thinking that way, the stock would be at a higher price. Every idea is a creative idea.” Ed Wachenheim

The ability to subconsciously connect seemingly unrelated pieces of information to provide an insight is a right-brain function. As is the intuition that comes from years of time in the market.

"Creativity is the power to connect the seemingly unconnected." William Plomer

“Intuition, whether positive or negative, is quite another matter. It is a vital component of my art.” Peter Cundill

“Being an investor and running a fund requires you to be part financial analyst, part accountant, part financier, part social scientist, part philosopher. You have to tie the right brain and the left brain together. If there’s an edge to be had, it’s in understanding the different components of the analytical process or the selection process. Understanding there’s an element of creativity, emotion, analytics and intuition. Maybe the thing we call intuition is the ability to tie all those things together.” Dan Loeb

Conversely, the left-side of the brain deals with the 'science' functions. These functions - logic, verbal reasoning, mathematics, linear thinking, factuality - commonly get investors into trouble.  

For example, making the assumption recent trends will continue into the future [looking in the rear-view mirror], investing according to a strict formula and considering only the observable facts without seeking further information or disconfirming evidence are key investment pitfalls. Focusing too much on the numbers at the expense of the big picture is another common investment mistake.  

"Computers and their endless databases cause investors to focus on the past. More than ever before, people are looking backward into the future." Shelby Davis

Most business school curriculums are focussed on learning and testing utilizing the left-side of the brain. It's much easier.

"Testing is best suited for left-brain-dominant students. It's much easier to test for sequential thinking and problem solving, recall, etc., than for right-brain attributes. For example, how do you test for intuition or artistry? So economics has become largely quantitative. Of course, modern portfolio theory (MPT) is the ultimate in the application of mathematics to what really is a soft science. So even though MPT is an important part of the CFA program and the curriculum in most graduate business schools Buffett and I consider it almost laughable. Yet it continues as core curriculum because that's what teachers have been taught to teach, and it's hard for this battleship to change direction. In a recent New York Times edition, Bob Schiller, with whom I've had communications, wrote that behavioural economics is the new frontier. Even though it's gaining currency at Harvard, Yale, and a number of other leading schools, it's going to be difficult to institutionalise because it's so intuitive. So l would love for schools to teach right-brain thinking and applications as well, but it won't be easy to quantifiably integrate it into the curriculum." Frank Martin

It's no surprise that many of the Investment Masters have backgrounds or experiences in areas associated with the right-side of the brain. For example, Leon Levy, George Soros, Paul Singer and Peter Lynch studied psychology. Michael Steinhardt majored in sociology. John Burbank, Glenn Greenberg and Bruce Kovner spent time as a teacher while Stanley Druckenmiller wanted to be an English Professor. Chuck Akre obtained a BA in English Literature. Paul Tudor Jones learnt more in journalistic studies than business school while Warren Buffett has said if he wasn't an investor he'd like to be a journalist.

"In college, except for the obligatory courses, I avoided science, math, and accounting all the normal preparations for business. I was on the arts side of school, and along with the usual history, psychology, and political science, I also studied metaphysics, epistemology, logic, religion, and the philosophy of the ancient Greeks. As I look back on it now, it's obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics. Investing in stocks is an art, not a science, and people who've been trained to rigidly quantify everything have a big disadvantage." Peter Lynch

Julian Robertson took time off to write a novel in New Zealand. The study of Japanese [and Lao Tsu] were instrumental in shaping Howard Mark's investment philosophy. Peter Lynch, Chris Davis, Carl Icahn and Jim Rogers studied philosophy while David Abrams, Terry Smith, James Anderson and Nick Train majored in history. Nick Sleep studied Geography. James Dinan credits his liberal arts studies as most valuable. Meditation, a form of engaging the right side of the brain, has been instrumental to Ray Dalio and Dan Loeb's success. 

"I think yoga and meditation are good for your brain and good for your body. They help you think more clearly, improve your memory, and help you become a more balanced, self-aware person. And I think those are all really important things that make a good investor." Dan Loeb

To help avoid the pitfalls of relying too much on the left-side of the brain, some common tools used by the Investment Masters include checklists and inverting.

Checklists developed with reference to realised investment mistakes help overcome common missteps by ensuring key items are not overlooked.  

“I’m a great believer in solving hard problems by using a checklist. You need to get all the likely and unlikely answers before you; otherwise it’s easy to miss something important.” Charlie Munger

Inversion helps engage the right side of the brain by introducing unfamiliar concepts. Some of the classic artistic masters would turn their paintings upside down to find fault in them. So to, the Investment Masters turn an investment thesis upside down to identify faults.

“Once a person has an idea, we then start whacking at it. We invert the concept. Instead of trying to prove a person’s idea, we try to kill it, and if we can’t kill it then the person is onto something. Whether it is my own idea or someone else’s, that is the process we go through.” Bruce Berkowitz

Successful investing requires more than an excel spreadsheet. It requires thoughtfulness, intuition, creativity and an edge. It amazes me that the majority of business schools focus on theories that practitioners with long track records of investment success consider ineffectual. 

I meet lots of graduates with formal finance qualifications who know nothing of Warren Buffett, Charlie Munger or Peter Lynch, know zero financial history and have spent little time understanding human psychology.

The world's greatest investor Warren Buffett considers the efficient market hypothesis garbage. Yet, most business schools study the hypothesis not the master. In contrast, the Investment Masters Class focuses on the lessons of the Investment Masters.

Phil Fisher on Mergers & Acquisitions

Over the past few decades I've found I have learnt the most about investing from reading the books recommended or written by the Investment Masters.

I was recently reading Francois Rochon's annual letters and came across a reference to a Phil Fisher book called, "Paths to Wealth Through Common Stocks." Far less well known than Mr Fisher's highly regarded, "Common Stocks and Uncommon Profits" of 1958, this book was published in 1960. I managed to pick up an original copy at AbeBooks.  

What I find most insightful from older books are the lessons and ideas that contribute to investment success that have remained constant over long periods of time. In the terms of Nicholas Nassim Taleb, these ideas are ‘anti-fragile’. In his book of the same name, Taleb notes ..

"If a book has been in print for forty years, I can expect it to be in print for another forty years. But, and that is the main difference, if it survives another decade, then it will be expected to be in print another fifty years. This simply, as a rule, tells you why things that have been around for a long time are not "ageing" like persons, but "ageing" in reverse.  Every year that passes without extinction doubles the additional life expectancy. This is an indicator of some robustness. The robustness of an item is proportional to its life!"

Reading Phil Fisher's book, I was surprised how timeless the commentary was on Mergers & Acquisitions. Remember this book is nearly 60 years old yet its lessons are as relevant today as they were then. A lot of that has to do with the fact that human nature doesn't change and also that the basis of Mr Fisher's analysis, when you take the time to think about it, really is common sense.

In recent months I've witnessed a whole host of companies that have blown up investors capital due specifically to Mergers & Acquisitions. Investors may have saved themselves a lot of heartache over the last 50+ years if they'd taken note of the observations of Phil Fisher all those decades ago.

"Why do mergers and acquisitions carry such a high degree of risk?" Mr Fisher asks.

"There are three main sources of danger to investors from mergers or acquisitions. These possible dangers should be kept in mind at all times, both by managements considering acquisitions and by stockholders in companies where such matters are under consideration"

The three dangers are, firstly that the struggle for top positions in the combined firms will so engross and disturb key personnel that former smooth working teams will degenerate into a hotbed of internal fighting and friction. I like to think of this as a clash of cultures.

Secondly, that top management will get involved with so many problems in fields with which they were not previously familiar with that they will find themselves unable to carry on with their former efficiency. The classic example of this is when management spends an inordinate amount of time dealing with their new 'problem child' at the expense of their core business.

Finally, the seller nearly always knows more about his or her business than the buyer such that the acquirer subsequently finds faults far worse than allowed for in the price of acquisition.

"Many acquisitions do not turn out as planned. The sellers know more than the buyers and may know of problems or uncertainties that are not apparent to the buyers." Ed Wachenheim

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

Mr Fisher notes that acquisitions that help integrate a company backward, such as acquiring a captive source of some of its raw materials, component parts or other supplies, seldom involve a sizeable degree of investment risk. This is because there is less likely to be a power struggle in management, the acquirer likely knows the business well and is unlikely to be out-traded with regards to purchase price. These acquisitions are unlikely, however, to be tremendously beneficial to the shareholder.

When it comes to acquisitions that integrate forwards, such as acquiring a captive customer outlet, similar expectations ordinarily apply. The exception to this is if management makes the mistake of acquiring one company that competes with a number of its existing customers and fails to allow for a loss of sales to these former customers as they are now deemed competitors. Mr Fisher notes ‘such a move can be very costly.’

Ordinarily small bolt-on acquisitions tend to be of limited risk yet too small to make much of a difference to the stock holder. Mr Fisher recognises "occasionally this is not true". Such a scenario is where the tiny acquired company brings a new product line which can be scaled by the acquiring company or when one or two outstanding individuals from the small company can make a major contribution to management; "Acquisition of this sort can not only be the least hazardous but also the most profitable in the entire field of mergers."

Mr Fisher finds the mergers or acquisitions that have the greatest prospect of being a long term success involve companies in similar lines of business that have been aware of each others activities for years and have a thorough understanding of each others problems.

Conversely, the greatest chances of a costly failure occurs when a merger or acquisition happens quickly between two companies in quite dissimilar lines that were previously only vaguely aware of each other. This is a red flag for shareholders. I can think of plenty of cases over the years where companies have acquired businesses outside their core competencies with disastrous results.  

"If a company must acquire something, I'd prefer it to be a related business, but acquisitions in general make me nervous. There's a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them, and then mismanage them." Peter Lynch   

“The fact of the matter is that, for most declining businesses, management tends to redeploy cash flow into things outside of their core competencies in a desperate attempt to save their jobs.” Jim Chanos

Mr Fisher notes the most successful record has been made by companies that only make acquisitions very occasionally, in similar businesses, and when all measurable factors seem overwhelmingly propitious. Such deals are usually a good deal for shareholders because the acquiring company "only does what comes naturally" and, is not “straining to be making deals" all the time.

“With acquisitions, patience is a virtue .. as is occasional boldness.” William Thorndike

“Two thirds of acquisitions don’t work. Ours work because we don’t try to do acquisitions — we wait for no-brainers.” Charlie Munger

Conversely there maybe quite a high degree of investment risk in a company that as a matter of basic management policy is constantly trying to grow by acquisition.These companies are what are commonly referred to today as 'roll-ups' - think Valeant [see more on the history and risks associated with 'roll-ups' here].  

Mr Fisher notes the risk is even greater when the CEO spends a sizeable amount of time on mergers and acquisitions or the company assigns one of its top officer group to making such matters one of its principal duties. In either event, powerful figures within a company usually acquire a sort of psychological vested interest in completing enough mergers and acquisitions to justify the time they are spending. I've witnessed a lot of permanent capital loss arising when the psychological forces of greed, groupthink, commitment and confirmation bias come to the fore in mergers and acquisitions.

"In the field of mergers and acquisitions, multi-million even billion-dollar deals get under way and the momentum builds, the rivalries among the players come to the fore, the game - a game it becomes - goes ahead, no holds barred. Someone is determined to win! They can taste it! All the cash lying on the table, all the supposedly solid rationale behind the deal, all the people involved-nothing matters except winning! "I want my way," says the biggest ego in the room! There are dreams of being in the press conference spotlight and big headlines in the Wall Street Journal. It's all too glamorous  and we convince ourselves that the numbers do add up - even when they are about as sound as astrological predictions. The "animal spirits" that John Maynard Keynes wrote of are more powerful than most business people would like to admit. Look at the recent dreadful fits - Daimler and Chrysler Time, Warner and AOL, Kmart and Sears, Quaker Oats and Snapple. Should these really have ever happened?" Donald Keough

"Berkshire, by design, had methodological advantages to supplement its better opportunities. It never has the equivalent of a "department of acquisitions" under pressure to buy. And it never relied on advice from "helpers" sure to be prejudiced in favour of transactions." Charlie Munger

The least desirable acquisitions are those where a not particularly attractive business is acquired at a very low price in relation to existing assets and past earnings. Mr Fisher notes that companies that would otherwise have been a magnificent opportunity for shareholders have a number of times been made quite unattractive by a management with one good line of great intrinsic strength and potential, acquiring several weak or run-of-the-mill businesses. Usually this is done with the explanation to shareholders that by diversifying the company's activities, the shareholders position is being strengthened. When this happens, the previously steady upward trend of the price of the company's shares sometimes comes to an abrupt and perhaps permanent halt.

"A serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette). Loss of focus is what worries Charlie and me when we contemplate investing in businesses that in general look outstanding." Warren Buffett

"Instead of buying back shares or raising dividends, profitable companies often prefer to blow the money on foolish acquisitions. The dedicated di-worsifier seeks out merchandise that is (1) overpriced, and (2) completely beyond his or her realm of understanding. This ensures that losses will be maximised." Peter Lynch

Mr Fisher concludes that mergers or acquisitions, other than between companies in vastly different size in quite different lines of business, should be studied with the greatest care and greatest suspicion.  

"Mergers then may be summed up as matters the investment significance of which can vary enormously, one from another, depending on the nature of each. The really big ones, I believe, usually contain far more pitfalls to the shareholder than they do promise."

The more things change the more they stay the same. 

Roy Neuberger and Anti-fragility

I enjoy reading biographies and autobiographies from the Investment Masters, successful business icons and interesting individuals. I recently read Roy Neuberger's "So Far, So Good - the First 94 Years". Born in 1903, Mr Neuberger was a founding partner of the investment firm Neuberger & Berman. Mr Neuberger was a mentor to Jim Rogers and counted Alfred Winslow Jones [credited with starting the first modern hedge fund] as a client. At the time of writing he had spent 68 years on Wall Street. In that time, he'd never had a down year!

While the majority of the book is devoted to his love of art, there are nuggets of investment wisdom throughout including Chapter 11 which outlines the "Ten Principles of Successful Investing."

What I find most insightful are the lessons and ideas that contribute to investment success that have remained constant over a long period of time. In the terms of Nicholas Nassim Taleb, these ideas are "anti-fragile." In his book of the same name, Taleb notes,

"If a book has been in print for forty years, I can expect it to be in print for another forty years. But, and that is the main difference, if it survives another decade, then it will be expected to be in print another fifty years. This simply, as a rule, tells you why things that have been around for a long time are not "aging" like persons, but "aging" in reverse. Every year that passes without extinction doubles the additional life expectancy.  This is an indicator of some robustness. The robustness of an item is proportional to its life!"

The Ten Principles:

1) Know Thyself - Mr Neuberger advises that before you begin studying companies for investment study yourself. Emotion is the great undoing of most investors and it's important to understand your own strengths, weakness, fears and biases.

2) Study Great Investors - Mr Neuberger advises, that while you should study the great investors, you should not follow them blindly. You must find a style that is appropriate for you. Mr Neuberger cites numerous examples (eg Warren Buffett, Ben Graham, Peter Lynch, George Soros), and all (with the exception of the private investors) feature prominently in the Investment Masters Tutorials.

3) Beware of the Sheep Market - Mr Neuberger recommends not falling in with the crowd. He cites the importance of doing your own research and choosing stocks based on merit not crowd behaviour.

4) Keep a Long Term Perspective - while the Wall Street community appears to be obsessed with finding out what is happening to corporate earnings from minute to minute, Mr Neuberger recommends keeping a long-term perspective. This is a common trait amongst the Investment Masters and is commonly referred to as "time arbitrage". He recommends four criteria that stand the test of time (1) a good product (2) a necessary product (3) honest, effective management, and (4) honest reporting.

5) Get in and out in time - timing might not be everything but it is a lot. Mr Neuberger notes timing is partly intuitive and partly contrary. He advises additional caution in bull markets and counsels to be quick getting out when you're wrong. 

6) Analyze the companies closely - Mr Neuberger recommends analysing company's management and assets. The trick is to find growth stocks before others and he warns against paying high P/E's for stocks. 

7) Don't fall in Love - Mr Neuberger highlights the need to be sceptical and flexible, not stubborn, about a stock. The last thing you want is to fall in love with a security.

8) Diversify, but don't hedge [short] - Although Mr Neuberger did indeed short stocks himself, he recommends it be done only with the help of someone experienced. He also suggests diversifying your investments.

9) Watch the environment - by environment, Mr Neuberger is referring to the general market trends as well as the world outside the market. He advocates the need to adjust to market conditions in which you are operating. He proffers watching energy supplies, auto sales, economic conditions and interest rates.

10) Don't follow the rules - Finally, Mr Neuberger suggests you find your own style, learn from your mistakes and be prepared to change.

Investing Nuggets

"The difficulty lies, not in the new ideas, but in escaping the old ones.” John Maynard Keynes

“If you don’t keep learning, other people will pass you by. Temperament alone won’t do it – you need a lot of curiosity for a long, long time.” Charlie Munger

"Read as many investment books as you can get your hands on. I've been able to learn something from almost every book I have read." Lee Ainslie

While most analysts spend their time building spreadsheet models, you’ll find the world's greatest investors spend their time reading and thinking. The tutorials that form part of the Investment Masters Class seek to identify the common threads within their thought processes. As each Investment Master is unique there are often differentiated insights and learnings to be garnered to complement these common threads. Studying investor letters, interviews and books can open up novel ways of thinking about companies, help with analysing investments and develop new insights previously not considered. It is the accumulation of knowledge across a broad spectrum of topics which builds wisdom.

Over the years, I’ve learnt something from almost every book I've read [my favourites are here]. Usually there’s at least one or two ‘Investing Nuggets’ to be picked up. An Investing Nugget often reinforces a view, at times it challenges a previously held conviction and occasionally it can open up a completely new way of thinking.  

I've included four 'Investing Nuggets' below ...

The Alchemy of Finance [George Soros] - "escalator up, elevator down"

Mr Soros effectively defined his own theory for markets noting ‘existing theories about the behaviour of stock prices are remarkably inadequate. They are of so little value to the practitioner that I am not even fully familiar with them. The fact I could get by without them speaks for itself.’

The Alchemy of Finance provides an alternative explanation for asset bubbles, offering an explanation as to why markets tend to drift higher, yet decline rapidly. A market euphemism that ‘Stocks take an escalator on the way up and an elevator on the way down’. 

Why should that be so?

Soros noted that markets can become irrational when participants lose sight of the fundamentals, ‘those who are inclined to fight the trend are progressively eliminated and in the end only trend followers survive as active participants. As speculation gains in importance, other factors lose their influence. There is nothing to guide speculators but the market itself, and the market is dominated by trend followers."

As all trends eventually end, ‘when a long term trend loses it's momentum, short term volatility tends to rise. It is easy to see why that should be so: the trend-following crowd is disorientated.’

It is then that the market can decline precipitously, ‘when a change in trend is recognised, the volume of speculative transactions is likely to undergo a dramatic, not to say catastrophic, increase. While a trend persists, speculative flows are incremental; but a reversal involves not only the current flow but also the accumulated stock of speculative capital. The longer the trend has persisted, the larger the accumulation.’

Soros concludes, ‘speculation is progressively destabilising. The destabilizing effect arises not because the speculative capital flows must be eventually reversed but exactly because they need not be reversed until much later. If they had to be reversed in short order, capital transactions would provide a welcome cushion for making the adjustment process less painful. If they need not be reversed, the participants get to depend on them so that eventually when the turn comes the adjustment becomes that much more painful.’ 

Capital Returns [Marathon Asset Management] - "here comes the supply!"

This recent book edited by Edward Chancellor contains a collection of investment letters from the UK's Marathon Asset Management. The Marathon Global Equity Fund has delivered 9.7% pa since inception in 1986, outperforming their benchmark by almost 5% per annum.

The book is chock full of investing wisdom. The key theme of the book is an industry's 'capital cycle' and how that cycle impacts investment returns. 

The book contains Marathon’s prescient newsletters on global house prices, credit markets and the commodity super-cycle. Each event resulted in significant investment losses for those investors oblivious to the capital cycle. Other letters reflect on capital allocation, industry dynamics, company culture, corporate management, technological disruption and the associated themes of 'network effects' and 'winner takes all'.

So what is the capital cycle? Marathon explains, ‘The first notion is that high returns tend to attract capital, just as low returns repel it.  The resulting ebb and flow of capital affects the competitive environment of industries in often predictable ways - what we like to call the capital cycle’. 

‘The key to the 'capital cycle' approach is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns.’ 

Most investors spend 90% of their time focused on the demand side of the equation, an area inherently subject to large forecasting errors. In contrast, Marathon spend the majority of their time focused on supply, which is far less uncertain.   

Focusing on the magnitude of capital entering or exiting an industry can provide an investment edge, aiding the discovery of potential investments and/or highlighting risk to an existing thesis.

Influence [Robert Cialdini]  - "why can't we change our minds?'

Charlie Munger has credited Robert Cialdini's bestseller, 'Influence' with filling many of the gaps in his mental framework. 

The book contains a fascinating short story of a cult of thirty members of otherwise ordinary people - housewives, college students, a high school boy, a publisher, a doctor, a hardware-store clerk - which had been infiltrated by two scientific researchers.  

The leader of the cult informed her members that she had begun to receive messages from 'Guardians', spiritual beings located on other planets. These transmissions gained significance when they began to foretell of an impending disaster - a flood that would eventually engulf the world. Alarmed at first, further messages assured the members they would be saved; before the calamity, spacemen were to arrive on a specific date and carry off the members in flying saucers to a place of safety, presumably on another planet.

Two specific aspects of the member's behaviour was noted by the two scientific researchers. First, the level of commitment to the cult's belief system was very high. Evidence included the irrevocable steps many members had taken; quitting their jobs and giving away personal belonging ahead of the 'specific' date. Secondly, members did surprisingly little to spread the word and avoided publicity when an inquiring newspaper started investigations into the cult.

On the 'specific' date, at the specified time, unsurprisingly, no spaceship arrived. The group seemed near dissolution as cracks emerged in the believers confidence. But then, the researchers witnessed a pair of remarkable incidents. The cult leader told the members she had received an urgent message from the Guardians stating, ‘the little group had spread so much light that God had saved the world from destruction’. Having previously shunned publicity, the cult leader then at once called the newspaper, to spread urgent message. Other members followed suit placing calls to various media outlets. 

Mr Cialdini noted the group members had gone too far, and given up too much for their efforts to see them destroyed. From a young women with a three-year old child:

"I have to believe the flood is coming on the twenty-first because I've spent all my money.  I quit my job, I quit computer school .. I have to believe"

So massive was the commitment to the cult that no other truth was tolerable. Member's beliefs should have been destroyed when no saucer landed, no spacemen arrived and no flood had come. In fact, nothing prophesized happened. 

The group had one way out. Members had to establish another type of proof for the validity of their beliefs: social proof. The leader still believing let other members believe.

This short story helps explain why analysts and investors so often remain non-fussed in light of obvious disconfirming news about an investment - they are too committed. The fact other investors and analysts are steadfast in their views reinforces the behaviour. Watching stocks fail to respond to what should be negative news maybe a case in point. Everyone is watching each other.

Common Stocks and Uncommon Profits [Phil Fisher] - "Small  Price Really"

Phil Fisher's writings are recommended by many of the great investors, Buffett, Munger and Li Lu included.  

In 'Common Stocks and Uncommon Profits', Phil Fisher's analysis of factors that can sustain high profit margins reminded me of Berkshire's AGM this year when Munger, reflecting on competitive structure, divulged his preference for Precision Castparts above the reinsurance business. Munger opined that Precision Castparts’ customers ‘would be totally crazy to hire some other supplier because Precision Castparts is so much more reliable and so much better’.

Mr Fisher touched on the characteristics which can sustain high profit margins; a company can create in its customers the habit of almost automatically specifying it's products for re-order in a way that makes it rather uneconomical for a competitor to dispace them.  

When a reputation for quality and reliability in a company’s product is ackowledged as very important for the proper conduct of a customers business, the company is in a powerful pricing position. It’s even better if it’s likely an inferior or malfunctioning product would cause serious problems [think Aircraft parts!]. When there are no competitors serving more than a minor segment of the market the dominant company is nearly synonymous with the source of supply.  Finally, the cost of the product should only be quite a small part of the customer's total cost of operations such that moderate price reductions yield only very small savings for the purchaser relative to the risk of taking a chance on an unknown supplier.  

Mr Fisher went even further to note that even this was not enough to sustain an above-average profit margin year after year. The product needs to be sold to many small customers rather than a few large ones. The customers must be sufficiently specialized in their nature that it would be unlikely for a potential competitor to feel they could be reached through advertising media such as magazines or television. The company can be then displaced only by informed salesmen making individual calls. Yet the size of each customer's orders make such a selling effort totally uneconomical!  

Such a company can, through marketing, maintain an above-average profit margin almost indefinitely unless a major shift in technology or a slippage in its own efficiency should displace it.

A Zebra in Lion Country [Ralph Wanger] - "who benefits from the technology"

Ralph Wanger's 1996 book, 'A Zebra in Lion Country', contains a chapter titled ‘Downstream from Technology’, which discusses the opportunities and obstacle of new technology. In today’s era of disruption, it's worth thinking through the implications for investing.

Many of the Investment Masters are cautious in the technology sector due to short product cycles and the risk of technological obsolescence. As Mr Wanger notes, ‘New products are dangerous, especially in the computer field as technological breakthroughs bring price slashing every year.’

Mr Wanger continues, ‘What I have always looked for instead are the downstream users of new technologies. I’ve bought the stocks of companies that buy, use, and exploit the computers and electronics to reduce costs, revitalise their businesses, and add functionality to their products.’

‘Since the Industrial Revolution began, going downstream – investing in businesses that will benefit from new technology rather than investing in the technology companies themselves – has often proved the smarter strategy.’

‘Those who really made money out of the new technology (of steam locomotives) were not the transportation people but those who bought real estate in Chicago in the 1880’s and 1890’s.’

‘Recognizing a transforming technology and then investing downstream from it should be a key concept for any direct stock investor.’

‘With the internet small companies can now compete against giants.’

‘The armoured knights couldn’t beat armies of commoners with muskets, and the corporate nobility of today is similarly vulnerable to upstart companies with smart, energetic, and competitive management.’

The ability for companies to harness technology is not a new phenomena. Charlie Munger recognised the enormous value of technology that arrived with the invention of the VHS player.

‘Disney is an amazing example of autocatalysis .. They had all those movies in the can. They owned the copyright. And just as Coke could prosper when refrigeration came, when the video cassette was invented, Disney didn’t have to invent anything except take the thing out of the can and stick it on the cassette. And every parent and grandparent wanted his descendants to sit around and watch that stuff at home on video cassette. So Disney got this enormous tail wind from life. And it was billions of dollars worth of tail wind.’ 

More recently we've witnessed an exponential increase in digital disruption. The combination of Youtube, Facebook and Amazon webservers has allowed Dollar Shave Club to take on the once invincible Gillette. High speed internet has allowed Netflix to harness and monetise the world population causing havoc for free-to-air TV and cable operators and their finite markets. The internet and GPS has allowed Uber to disrupt the global taxi industry. Facebook and Google have disrupted the global advertising markets. 

The future will bring increasing threats to old world industries who are not embracing technological change while providing the potential for significant investment opportunities.  Maybe it’s time to look downstream.

The Goal of Investing

The Investing Goal? What Is It?

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

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

It raises some industry issues…

Relative Returns

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

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

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

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

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

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

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

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

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

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

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

Asset Allocation

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

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

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

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

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

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

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

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

What do the Investment Masters do..

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

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

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

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

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

Profits and Losses are Not Symmetrical

Consider the following two investment funds:

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

Which would you prefer?  

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

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