I just thought I’d put up a quick post as it’s Sunday night and I’m getting ready for the week and listing some things I’m going to be focusing on and researching this week, as is my routine on Sunday evenings.

I don’t often discuss the overall markets, but as I was doing some homework this weekend on individual stocks, I also spent some time reading the papers and various macroeconomic blogs to get a feel for what people are thinking about the dramatic stock market decline last week. I say dramatic, because although it was a swift a fierce selloff on Thursday and especially Friday, I think we should step back and remember that stocks and markets go up and down, not just up. The markets are only down 10% or so from the highs, the S&P down just 7%, which hasn’t even reached correction mode.

As I am typing this however around midnight EST, the Chinese markets are plummeting (again), and markets in Hong Kong and Japan are down 4% in early Asian market trading, bringing the US futures down with them in overnight trading so it appears we will finally get our much anticipated 10% “correction” in the S&P.

One thing that is interesting to me is how swiftly markets decline in recent years, only to bounce back nearly as swiftly. It seems everyone for the past 3 years has been expecting a 10-20% correction, and so at the first sign of trouble, everyone begins rushing for the exits. Those who aren’t pushing the sell button are frantically buying puts for protection or maybe to outright short the market, which has the effect of sending the VIX skyrocketing. In recent years, despite being in a bull market, the VIX has at times seen shocking intraday rallies. Friday’s spike of 46% was I believe the second largest daily spike ever. To put this in perspective, the VIX spiked 23% the day Lehman filed for bankruptcy on September 15th, 2008. The market participants are very quick to anticipate the worst, and are willing to pay up for this protection at just about any cost.

These violent moves can be also due to forced selling from large institutional investment managers as well—hedge funds and mutual funds that either face redemptions or maybe participate in the panic themselves, rushing to sell stocks at any price to preserve returns or prevent further losses in the event the market does enter bear territory.

All of this said, we will at some point see another 20% decline. At some point, those that “panicked” on Friday might end up being right in that stock prices could certainly go a lot lower.

But of course, this type of behavior often creates significant opportunity. I’ve received a few questions lately regarding what I’m invested in, what my views on the markets are, etc… My investment approach is mostly based on two main strategies:

  1. Special situation investments: locating significantly mispriced investments with catalysts, and
  2. Investing in great businesses when they are priced at pessimistic levels.

My approach is very flexible. I often think of it as an opportunistic approach to value investing. I sometimes spend a significant amount of time in cash or with significant cash holdings while I wait for ideas to present themselves. It’s the most comfortable way I know how to manage capital.

As to the questions on what I’ve been up to: I plan to discuss more investment ideas on this blog. I won’t discuss certain situations as some need to remain quiet to preserve the mispricing. But many of the stocks I look at are very liquid and I find it helpful to write down my ideas, and get alternative perspectives from readers as well. I might even discuss stocks that I don’t own as well, simply because I do a lot of research that often doesn’t turn into actionable investment decisions. As for my portfolio now, I have a few positions but a large portion of the capital is in cash. The few positions I am in currently are special situation investments. I prefer those types of investments in these markets, simply because most of the businesses I love are all priced at levels that indicate they are loved by many others. So my favorite compounders rarely make it into my portfolio. This could change based on the action that we’ve seen over the past few days.

Typically, when it comes to category #2 (the “generals”, or compounders, or stocks without a specific catalyst), I have a hurdle when I think about investing in them. I am basically looking for a large enough valuation gap that provides me with a chance to make 50-100% returns in a year or two. It obviously varies from situation to situation, and larger cap stocks typically provide lower, but more predictable returns. But I’ve found it a useful—if not somewhat unorthodox—checklist item to ask myself if I think the stock can double at some point in the not too distant future. Sort of a forward looking 50-70 cent dollar approach to looking at the valuation. Again, with larger cap compounders this might not be realistic, but even 50% returns over the course of 12-18 months are possible at certain times on the larger high quality compounders. But outside of a few company specific opportunities, we certainly haven’t seen a market environment recently that has brought general valuations down to a level that this hurdle could be achieved.

So the opportunity to invest in one of these high quality companies come from one of two main setups:

  • Pessimism surrounding the company—maybe a short term problem, a poor quarter, or some other temporary negative that allows you to take advantage of time arbitrage (looking out 2-3 years when the market is focused on the next 2-3 quarters)
  • General market fear and lower overall stock prices

I actually welcome either or both of these things, and I hope that stock prices continue lower. However, the market has proved resilient and I don’t necessarily expect a large decline, given the strong economic numbers that have been consistently getting better.

For those that have asked my opinion on the markets—I don’t have one, and I don’t really ever think about where the market will go. Well, sometimes I do—a friend and I have been discussing this over the past week—but I don’t ever make decisions based on where I think the S&P is going to go in the near term. This is simply because I don’t know.

CNBC tonight had a special called “Markets in Turmoil”, which I found to be slightly dramatic, but nonetheless interesting to watch. CNBC of course thrives on market panic. The ratings of financial news media always skyrocket during these times of fear. I can’t blame CNBC—the ratings go through the roof when fear enters the markets. Also, it would have been a thrilling time to be a financial journalist during 2008 when Lehman failed and when markets were crashing. One of my favorite topics to read about is the financial crisis. It’s absolutely incredible to read about the various aspects of the crash including the market turmoil, the investor reaction, the policy decisions, and the general panic.

However, I think it’s a bit premature to begin anticipating disaster. While I said I don’t have a view on where the markets will go—certainly not in the next week, month, or year—I don’t anticipate the worst. Maybe I’m wrong here, but rarely do markets crash when the domestic economy is improving. And rarely do bear markets occur without the economy entering a recession (this has happened twice, but it’s quite rare).

One interesting token of macroeconomics that I read this weekend: The US economy has never entered a recession without the jobless claims spiking 20% year over year first. Again, maybe this spike is going to happen in the coming months, but it hasn’t yet. Like many other economic indicators that are improving, jobless claims continue to decline:

Jobless Claims

Another positive for the US economy is the state of housing. The housing depression was the deepest we’ve seen since the 30’s. The price declines, plummeting sales, and the ensuing near halting of new construction has created a situation that has left a shortage of inventory across the US and pent-up demand in many markets. Housing starts have been climbing for a few years now, but still have a long way to go before reaching levels that would be considered equilibrium:

Housing Starts

I have a spreadsheet of data points that I’ve started to track. I don’t make investment decisions based on economic information, but I find it useful to have a grasp of certain datapoints that impact the overall economy or better yet—specific industries (retail sales, new home starts, railcar loadings, etc…). One other piece of information that I find interesting to look at is investor sentiment. Again, I don’t make investment decisions based on sentiment–I’m looking for specific investment situations that really have nothing to do with the overall stock market. But nevertheless, sentiment–when at extremes one way or another–can provide useful information.

Sentiment isn’t at extreme levels yet, but it is quite bearish. In fact, last week’s AAII investor bullish sentiment was just 26%, which is a level that is fairly close to the bearishness that existed at the March 2009 bottom. Sentiment is volatile, but typically, extreme bearish sentiment exists near market bottoms, not market tops:

AAII Sentiment

Does Any of This Matter?

Things look scary right now, especially if you’re paying attention to the general market perceptions. However, domestic economic data does not seem to indicate impending doom for the US economy and sentiment seems to indicate that it’s probably unlikely that stocks are in for a significant crash.

But that doesn’t mean stocks can’t fall further. They certainly can.

Emerging markets look like they are in real trouble and that could certainly spill over into the US economy at some point, but it doesn’t appear likely as of yet. But we know that stock markets go up and down, and while there is always some reason to point to, the fact that the market is currently going down is nothing to be surprised about.

That said, I agree with some of those who say valuations are stretched, and we are “due” for a correction. I do think in general, that valuations are modestly (but not extremely) overvalued. But this in and of itself doesn’t usually mean that the market will crash. Markets rarely if ever crash because of overvaluation unless it’s the result of a mania (like 1929 or the Nasdaq in 2000, and even in those cases the overall economy was about to enter a recession).

But not having a crash doesn’t mean the markets can’t go down 10-20% (or even more). This is a very normal part of the way markets work, and it’s nothing to be surprised about or panicked about. The memory of 2008 is recent enough to still be in our review mirror, and it probably exacerbates the fear that comes back so quickly, even when the market is less than 10% from all-time highs.

Anyhow, these are just some thoughts I had as we get ready for what could be an eventful week. Not much changes in what I do during weeks like this–lots of reading about companies as usual–but these types of situations do make it more fun when you’re an investor who prefers buying undervalued merchandise.

All in all, it should be an exciting week that hopefully will begin presenting some investment opportunities.

Have a great week.

“One of my friends—a noted West Coast philosopher—maintains that a majority of life’s errors are caused by forgetting what one is really trying to do.” – Warren Buffett, 1965 BPL Partnership Letter

I’ve read a few things lately discussing the benefits of designing a “tax-efficient” investment strategy. I’ve said this before, but I think there is a significant misunderstanding on the tax benefits of a low-turnover portfolio, and there is an even larger misunderstanding on the concept of turnover itself.

I’ve commented on portfolio turnover previously—turnover is neither good nor bad. It gets a bad connotation—especially among value investors—because many people think higher turnover (and more investment decisions) leads to hyperactivity and trading—and eventually results in investment mistakes. While this may be true in many cases, investment mistakes are not due to turnover—they’re due to making investment mistakes, plain and simple. I do believe that too many decisions may lead to this result—and I’m a fan of concentration and a relatively small number of stocks in my portfolio. But it is really important to understand—turnover in and of itself is neither good nor bad.

In fact, as I’ve said in a previous post, turnover is one of the key factors of overall portfolio performance. Just like a business (assuming a given level of tax rates, interest rates, and leverage) achieves its return on equity by two main factors—asset turnover and profit margins—so too does the return on equity (or CAGR) of an investment portfolio get determined by these two factors.

But this post is not about turnover, it’s about taxes. I bring this up because often I find investors lamenting the issue of taxes—especially when it comes to capital gains on their investment portfolio.

I have some thoughts on this topic of taxes and turnover, which I’ll share in the next post. I was going to reference a short passage of the 1965 Buffett partnership letter where he addresses this very same issue. But I thought I’d just post a slightly condensed version of the whole passage here, because I think it’s a good concept to think about.

Here are a few passages that I pieced together from the 1965 Buffett commentary on taxes (emphasis mine):

“We have had a chorus of groans this year regarding partners’ tax liabilities. Of course, we also might have had a few if the tax sheet had gone out blank.

“More investment sins are probably committed by otherwise quite intelligent people because of “tax considerations” than from any other cause. “One of my friends—a noted West Coast philosopher—maintains that a majority of life’s errors are caused by forgetting what one is really trying to do.”…

“Let’s get back to the West Coast. What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound. Quite obviously if the two courses of action promise equal rates of pre-tax compound and one involves incurring taxes and the other doesn’t, the latter course is superior. However, we find this is rarely the case.

It is extremely improbable that 20 stocks selected from say, 3000 choices are going to prove to be the optimum portfolio both now and a year from now at the entirely different prices (both for the selections and the alternatives prevailing at a later date. If our objective is to produce the maximum after-tax compound rate, we simply have to own the most attractive securities obtainable at current prices. And, with 3,000 rather rapidly shifting variables, this must mean change (hopefully “tax-generating” change).

“It is obvious that the performance of a stock last year or last month is no reason, per se, to either own it or to not own it now. It is obvious that an inability to “get even” in a security that has declined is of no importance. It is obvious that the inner warm glow that results from having held a winner last year is of no importance in making a decision as to whether it belongs in an optimum portfolio this year.

“If gains are involved, changing portfolios involves paying taxes…

“I have a large percentage of pragmatists in the audience so I had better get off that idealistic kick. There are only three ways to avoid ultimately paying the tax: 1) die with the asset—and that’s a little too ultimate for me—even the zealots would have to view this “cure” with mixed emotions; 2) give the asset away—you certainly don’t pay any taxes this way, but of course you don’t pay for any groceries, rent, etc.. either; and 3) lose back the gain—if your mouth waters at this tax-saver, I have to admire you—you certainly have the courage of your convictions.

“So it is going to continue to be the policy of BPL to try to maximize investment gains, not minimize taxes. We will do our level best to create the maximum revenue for the Treasury—at the lowest rates the rules will allow.”

Buffett ends the section with a tongue-in-cheek reference to the “tax-efficient” funds of his day:

Buffett Tax Table

I thought these were interesting comments—especially regarding Buffett discussing “changing portfolios”, i.e. portfolio turnover. A portfolio of stocks one year will almost certainly not be the same optimum portfolio with the same risk/reward the next year. This implies that the portfolio should be more dynamic—always hunting for value.

Buffett doesn’t operate this way now, but it’s by necessity not by choice. There is only so much you can do when your stock portfolio is over $100 billion. But in the partnership days, there was higher turnover, higher taxes, and higher returns.

Related Posts:

Since oil prices were in the headlines yesterday after an 8% fall, I thought it might be a good time to comment on something I’ve been working my way through while putting in the miles after a day of looking for bargains.

I’m about halfway through the excellent series of podcast called “A History of Oil”. It’s an outstanding series that starts by introducing George Henry Bissell—the father of the oil industry—who in 1853 began experimenting with “rock oil” that was discovered in northwestern Pennsylvania. Bissell commissioned a $526 study of this strange substance and determined that it could be refined into kerosene—a highly demanded fuel used to light homes at night. Since whale blubber was becoming more costly (you could say the world was witnessing “peak whale”—i.e. whale population was plummeting), this newfound oil could prove to become quite lucrative as a whale blubber substitute.

The History of Oil series then moves to the fascinating beginning of the oil industry at “Oil Creek”, the stretch of the Allegheny River where drilling for oil first started in the small town of Titusville. This tiny hillside town in northwestern Pennsylvania quickly became the 1860’s version of the California gold rush. The population went from a sleepy 250 to a bustling 10,000, real estate prices skyrocketed, and fortunes were made. A lucky man named Jonathan Watson became the first millionaire from oil—Watson owned the land where the first successful well was drilled by Colonel Edwin L. Drake—an employee of Bissell’s Pennsylvania Rock Oil Company.

The guys at Oil Creek didn't care if a rig was in their back yard.

The guys at Oil Creek didn’t care if a rig was in their back yard.

The podcast series recounts the early tales of riches and the many booms and busts. I’ve made my way through the portion of oil history that witnessed a 23-year old grocery store owner named John D. Rockefeller, who began selling kerosene in his store—and eventually transitioned into the refining business that later was built into Standard Oil—one of the world’s most valuable, and most intimidating companies of all time.

Indeed, it was the very first Big Oil—later to be broken up when an ambitious populist from Ohio named John Sherman—whose resume included three terms in the House of Representatives, the US Senate, Secretary of the Treasury, and Secretary of State—introduced a bill called the Sherman Antitrust Act. The bill passed 52-1 in the Senate and unanimously in the House. The law sparked the first of many battles between Big Oil and government regulation.

Standard Oil was broken into pieces, but not before John D. Rockefeller became the richest man in the world—creating a net worth that would approach half a trillion bucks in today’s dollars—far more than Gates, Buffett, or any of today’s titans. Not bad for a guy who, as an ambitious young grocer, set a goal of making $100,000 during his lifetime.

This was no ordinary grocer

This was no ordinary grocer

The Oil Business

I began slowly investigating the oil industry last fall as energy prices plummeted. There is one company I have taken small positions in on a couple occasions, but by and large I have stayed on the sidelines as I continue to watch debt-laden businesses continue to struggle and cash flow dry up. Many of these companies are dead companies walking—almost certain to go bankrupt as their revenues fall, margins evaporate, and fixed costs (i.e. interest payments) persistently eat up a larger share of each barrel produced.

I think the oil business is very interesting, and it is one of the industries (especially the “upstream” exploration/production side) that really lends itself to the classic boom/bust cycle.

Soros once said regarding oil prices in his “real time experiment” in 1985:

“The supply curve is inverted. Most producers need to generate a certain amount of dollars; as the price falls, they will try to increase the amount sold until the price falls below the point at which high cost producers can break even. Many of them will be unable to service their debt.”

The more things change, the more they stay the same. In 1985 Saudi Arabia became frustrated that their production cuts weren’t having the impact they desired (which was oil price increases). This led them to decide to shift its focus from prices to market share. In December of 1985, OPEC shocked everyone by formally announcing its intention to maintain market share (i.e. maintain or increase production levels). The price of oil collapsed 50% over the next 6 months from $30 to $15 per barrel.

1986 Oil price collapse

Does this look familiar?

This 1986 price collapse was quite similar to the chain of events that unfolded starting last November 2014 when OPEC again announced its intention to maintain production in an effort to squash US high cost producers and maintain market share.

In both 1985 and 2014, these decisions by producers (both OPEC and US domestic producers) defied the logic of the “rational economic man”.

Where is the “Rational Economic Man”?

The “rational economic man” theory in economics basically says that this hypothetical figure will always act with perfect knowledge and complete rationality in pursuit of his own economic interests—meaning he will act in such a way that the supply/demand balance will always stay close to equilibrium. For example, as the price of a commodity falls, demand should theoretically increase and/or production should decrease—this balance should always trend toward equilibrium.

This makes a lot of sense. For example, chemical companies add capacity and/or increase utilization when prices are rising in order to satiate demand. Like most commodity businesses, this eventually leads to excess capacity and bloated cost structures. As the cycle surpasses its peak, companies are forced to lay off workers, cut back production, and sometimes take capacity out of the system as prices are falling, which then sets the cycle up for another repeat.

So eventually the economic man shows up and the cycle ends. But in the meantime—before this self-correcting process occurs—a self-reinforcing behavior (as Soros calls it) is prevalent—a behavior that takes prices (and supply/demand) far from “equilibrium”—or where they should be based on economic theory.

So sometimes there is a disconnect between reality and economic theory and the “economic man” is nowhere to be found.

For example, banks influence the value of the collateral as they lend more. In the recent case of the mid-2000’s housing bubble, securitization and newfangled financial products such as synthetic CDO’s reinforced home prices—these new products created an entire new market for CDO’s and the demand from investors for these securities fueled more lending. The more loans that were packaged up and sold in the form of securities, the more lenders were willing to give loans, which meant easier credit and more demand for the actual product—the house. This circular cycle was self-reinforcing for a period of years. Banks were willing to lend up to 100% (or more in some cases) on the ever-rising value of a house, but this value was rising in large part because of the fact the bank was willing to lend on it. It’s the chicken and the egg.

This is the same concept that has occurred in virtually every boom/bust cycle in the past.

The oil industry behaves in a similar way. Interestingly, what has happened over the past 9 months has surprised many economists and industry analysts. When prices started falling, many predicted drastic cuts in production by the high cost shale producers. Eventually, this would have to be true as producers run out of money. But what is interesting is that they continue to produce more as long as they have the cash in the bank to do so—even if they destroy value with every barrel that they pull out of the ground. By April 2015, six months after the price declines began, US production was at multi-decade highs:

US Crude Production Chart

So despite what economic theory says, what has actually happened on numerous occasions is that as energy prices decline, sometimes production increases (or at least remains stable) by producers who desperately try to maintain market share or by countries (such as the OPEC nations) who increase volumes to offset price declines in order to meet budgetary needs.

This was true in the late 1960’s when Soros was formulating his reflexivity theory, it was true in 1986 when Saudi Arabia dropped the hammer on the oil market, and it is true today as OPEC—at least for now—continues to maintain its production level.

Interestingly, this very same behavior was prevalent in the 1880’s at Oil Creek.

Even back then, or maybe especially back then, oil prices swung violently as supply/demand fluctuated and the boom/bust cycles repeated themselves over and over again. This nonsense was much to the dismay of Rockefeller, who specialized in the “downstream” business of refining oil—which means he had to buy his raw material from these irrational producers and was thus at mercy to the wild swings of the market.

One of the episodes of A History of Oil describes the fascinating turn of events as Rockefeller defies the advice of his own board of directors and—in an effort to fight this irrational behavior of the producers who frantically began drilling more and more in a “race to the bottom” as prices plummeted—began buying up “every barrel” of oil that was produced. Rockefeller eventually forced his company into the upstream (production) business in order to try and get more control over the raw material needed for his kerosene, and thus add an element of “economic man” behavior to the industry.

But whether its human nature or the nature of the oil business (or probably both), this defiance of economic logic repeats itself over and over.

Just this past weekend, Iran pledged to double its own production when/if sanctions get lifted—despite oil prices at half of where they were trading at a year ago.

Meanwhile, US oil production has begun to slow down in the past couple months, but as recently as April, crude output was rising and reached a high not seen since 1972—leaving analysts, economists, and Middle East oil producing nations scratching their heads.

It’s very interesting theater.

I’d recommend A History of Oil to anyone who is interested in locating bargains (or short opportunities) among the carnage in oil that is certain to continue if prices stay where they are. The business is a difficult one—like most commodity businesses. But it’s one that probably provides significant opportunity for the skilled bargain hunter who can be greedy when everyone else is fearful.

Caveat Emptor…

Have a great week.

Someone on the Corner of Berkshire and Fairfax board recently posted this comment referencing Buffett’s well-known piece on inflation from 1977.

In the article, Buffett describes the variables that drive a company’s return on equity. There are only five ways that a company can improve returns:

  1. Increase turnover
  2. Cheaper leverage (reduce interest charges)
  3. More leverage (increase the amount of assets relative to a given level of equity)
  4. Lower income taxes
  5. Wider margins

Notice three of the five drivers of ROE have to do with taxes and leverage. So the pretax returns (as opposed to capital structure variations) are really driven by just asset turnover and profit margins.

Some executives at the DuPont Corporation also noticed these drivers in the 1920’s when analyzing their company’s financial performance. They broadly categorized the drivers as turnover, margins, and leverage. For now, I want to leave leverage out of it and think about turnover and margins.

Portfolio Turnover

I wrote a post a while back discussing the misunderstood concept of turnover in the context of portfolio management. Specifically, the topic of realizing gains (and paying those dreaded taxes). Basically, the idea of short-term capital gains is taboo among many value investors.

I think it’s very important to try and be as efficient as possible with taxes. However, I think that tax consideration is only one of (not the only) factor to consider.

We could take Buffett’s five inputs that increase or decrease a company’s ROE and apply them to the portfolio. Basically, as investors, we are running our portfolio just like a business. We have a certain level of equity in the portfolio, and we are trying to achieve a high return on that equity over time. The exact same factors that Buffett talks about above apply to our portfolio. Those five factors are the inputs that will increase or decrease our portfolio ROE (aka CAGR) over time.

Notice that taxes is one of the (but not the only) factors.

Turnover is also one of the (but not the only) factors.

Michael Masters is not a value investor, but he runs a fund that has produced fabulous returns over the past 20 years or so (from what I’ve read, north of 40% annually). You can read about him in the book Stock Market Wizards by Jack Schwager.

Now, I don’t understand his specific strategy, and I’m not suggesting it’s one that should be cloned, or copied, etc… I’m just focusing on the turnover concept here. Masters, according to the interview, runs a strategy focused on fundamental catalysts, and holds stocks an average of 2-4 weeks. When he was running a smaller amount of money, he was compounding at 80%+ per year.

Of course, he was paying a lot of taxes. His investors—the ones in the highest tax bracket—might be “only” netting 40% or so after tax. But who would be upset with paying a lot of taxes if it means achieving a 40% return on the equity in your capital account?

Obviously an extreme example, but the concept illustrates the point that just because you hold stocks for years and years and pay very low taxes doesn’t mean that your after tax ROE will be any better than an investor who pays a lot of tax and achieves a much higher pretax return.

I think it’s very difficult to compound capital at 20% or more without some amount of turnover in the portfolio. This doesn’t mean I’m promoting higher levels of activity. I’m not. I think making fewer decisions is often better, and trying to do too many things is very often counterproductive. I’m just saying that the math suggests that some level of turnover is needed if your goal is to compound capital at north of 20% over time.

This is one of the reasons I love bargains and deep value special situations in addition to the compounders.

As I’ve said before, very few companies compound their equity and earnings at 20% or more over years and years. Those that do often are priced expensively in the market. But to achieve portfolio returns of 20% without paying taxes, you’d have to not only properly identify these companies in advance, but you’d have to have the foresight to invest your entire portfolio in them.

How Did Buffett and Munger Achieve Their Results?

It’s a difficult proposition to be able to seek out in advance the truly great compounders that will compound at 20%+ for a decade or more, and that’s why investors who focus on bargains and special situations often are the ones with the extreme performance numbers (like Buffett doing 50% annual returns in the 50’s, Greenblatt doing 40% annual returns in the 80’s and 90’s, etc…).

It’s unlikely to do 20% annual returns by buying and holding great businesses for a decade without selling. It’s basically impossible to do 30%+ without ever selling.

Charlie Munger has promoted the idea of low turnover—and I think his reasoning (as usual) is very sound, but I think he was using the Washington Post as an example–and I think that might be (dare I say) somewhat biased in hindsight. But if you’re looking for decent after tax returns, he’s right. If you can find a company that compounds at 13% per year for 30 years, you’re going to achieve good after tax returns on your capital. But, I think finding the Washington Posts of the world are easier said than done in hindsight, especially when thinking about a 30 year time horizon.

Another example I’ve discussed before is Disney. Buffett bought Disney for $0.31 per share and sold a year later for a 50% gain in the mid-60’s. He laments that decision as a poor one, but in fact his equity has compounded at a faster rate than Disney stock over time, making his decision to sell out for $0.50 a good one. And that is an extreme example using probably one of the top 10 compounders of all time. Not every stock is a Disney, thus making the decision to sell at fair value after a big gain in a year or two much more likely to be the correct one.

Back to Munger’s Washington Post example… I like to consider his audience. I don’t necessarily think he was saying this is the highest way to achieve attractive investment results. My guess is he was trying to convey the importance of long term thinking and lower turnover. However, when Munger ran his partnership, he was trying to compound at very high rates, and for years did 30% annual returns. He didn’t do this by buying and socking away companies like the Washington Post. He may have had a few ideas like that, but he was a concentrated special situation investor who was willing to look at all kinds of mispriced ideas.

Buffett/Munger of Old vs. New

I think there is a disconnect between the Buffett/Munger of old, and the Buffett/Munger of today. Their strategies have obviously changed, and their thinking has evolved. But their best returns were in the early years when they could take advantage of the (often irrational) pricing that Mr. Market offered.

They were partners with the often moody Mr. Market back then and they took advantage of his mood swings. When they came into the office and Mr. Market was downtrodden, they’d buy from him. And on the days when Mr. Market was excited and overly optimistic, they’d sell to him.

Their bargain hunting days provided them and their investors with 20-30% annual returns.

They made a lot of money.

They paid a lot of taxes.

As they compounded capital, they began to evolve. Buffett and Munger both have discussed this, but they both have said with smaller amounts of capital, they’d invest very differently. Buffett bought baskets of Korean stocks in his personal account in 2005 when some were trading at 2 times earnings with net cash on the balance sheet. He’s also done arbitrage situations, REIT conversions, and other things in his personal account that provided attractive, low-risk returns (and very high annualized CAGRs).

By the way, this is not an indictment against compounders. As I’ve mentioned before, my investments tend to fall into one of two broad categories: compounders and special situations/bargains.

I actually enjoy investing in compounders the most, since they do the work for you. But bargains are the ones that often get more glaringly mispriced for a variety of reasons (not the least of which is the fact that the compounders are great businesses—and everyone knows they are great).

But I don’t have a dogmatic approach to investing, and I will look for value wherever I can find it.

I’m not sure if this post really has a hard conclusion and maybe this is more of a ramble than anything else. I’m not sure how to sum it up, so I’ll just stop here. These are just observations I have had, and the COBF post on Buffett’s 1977 piece (which is a great piece to read if you haven’t) prompted some of these thoughts which I decided to write down and share.

I think it’s important to understand the drivers of investment results (portfolio returns on equity) are the exact same factors that drive the ROE of a business.

Feel free to add to the discussion if you’d like.

Have a great week, and for the golf fans, enjoy the US Open.

Earlier this year I watched Lang Lang play Grieg’s Piano Concerto in A Minor—one of my all-time favorite pieces of music. The concerto is a monster—full of big octaves, virtuosity, excitement and power. It has around 30,000 notes, but the music is tied together with a simple 10 note melody that is repeated throughout the piece.

I am currently working on a few different investment ideas that have numerous moving parts, but as I conduct my research, I continue coming back to just a few key variables that will largely determine the outcome of the business operations and the investment situation. I think that when analyzing a business or a special situation, this is one of the most important things to remember: there are many complicated aspects to analyzing a business—hundreds of data points, thousands of potential outcomes, pages and pages of SEC filings—all which often create a fuzzy view of the future. Sometimes there is no view of the future at all (or at least one that I can’t see), in which case I simply move on to the next idea. But sometimes through the complication and the inevitable unknowns that come with investing, one or two key variables emerge as the only things that really matter in the end.

I came across this quote last week in one of the posts over at Value Investing World, so thanks to Joe Koster for the link.

This is an interesting quote from Buffett from his 2004 shareholder letter, describing how important it is to know the one or two variables that really matter to an investment. There are a lot of things going on with a business, but if you can pinpoint the one or two variables that really matter, you’ll vastly simplify the investment process, you’ll focus your mind on researching and understanding those variables, and you’ll also improve the probability of a successful outcome.

Here is Buffett discussing the importance of simple propositions (emphasis mine):

“Last year MidAmerican wrote off a major investment in a zinc recovery project that was initiated in 1998 and became operational in 2002. Large quantities of zinc are present in the brine produced by our California geothermal operations, and we believed we could profitably extract the metal. For many months, it appeared that commercially-viable recoveries were imminent. But in mining, just as in oil exploration, prospects have a way of “teasing” their developers, and every time one problem was solved, another popped up. In September, we threw in the towel.

“Our failure here illustrates the importance of a guideline – stay with simple propositions – that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for – if you’ll excuse an oxymoron – mono-linked chains.”

Hopefully Joe doesn’t mind me borrowing the other (very relevant) quote he chose to highlight from Buffett’s 2008 letter. For those who are familiar, Buffett bought an oil stock at the height of the commodity boom just prior to the financial crisis and subsequent crash in oil prices. He liked a lot of things about this company (Conoco), but when it was all said and done, just one variable determined the outcome of this investment: oil prices.

Here is Buffett from the 2008 letter:

“I told you in an earlier part of this report that last year I made a major mistake of commission (and maybe more; this one sticks out). Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.”

Here is a look at the chart of Conoco—a solid company in the energy sector, but not immune to the downturn in the price of the one key variable that really made all the difference:

Conoco Chart

While reading through the transcripts of some of Greenblatt’s classes at Columbia, I noticed he mentioned a similar point about being average at valuation work (not really better than anyone else in the business), but being above average at putting the information in context, remembering the big picture, and being able to pinpoint what factors really matter to an investment.

“Explain the big picture. Your predecessors (MBAs) failed over a long period of time.  It has nothing to do about their ability to do a spreadsheet.  It has more to do with the big picture.   I focus on the big picture. Think of the logic, not just the formula.”

So the footnotes are crucial, and occasionally you’ll be able to sleuth out some detail that might give you a big advantage, but I think more often than not, the big picture (in other words, the key variables that matter) is more important than the footnotes. Markel’s advantage is the prudent underwriting, a value investing mindset, combined with a management team that thinks like owners. It’s really that simple—sometimes too simple. Wells Fargo takes deposits in cheaper than just about everyone else. Some of the special situation investments I look at have just one thing that will determine the outcome of the investment—a pending lawsuit, a regulatory resolution, a new order, a sale of an asset, etc… This is a topic for another post, but sometimes I think the best investment theses are also the simplest.

Just like the Grieg concerto—a complex piece of music that is centered on 10 simple notes that make all the difference.

Michael Burry’s story is captivating. And in fact so good of a story that excellent financial storytellers like Michael Lewis and Greg Zuckerman turned it into main portions of best-selling books on the financial crisis.

The story goes something like this: Burry was just a guy writing a blog (before people knew what a blog was). He was discussing his ideas in early internet chat rooms. He picked stocks. He was a value stock picker at a time when value investing couldn’t have been less popular—the late 1990’s. But Burry did well investing his own account, and he got a small following on these early message boards. One day, he posted that he had decided to leave medicine, and he was starting his own fund. Joel Greenblatt—who had been reading, and profiting, from Burry’s posts—promptly contacted Burry, offered him a million bucks for an equity stake in his new business, and help seed Burry’s tiny fund.

Burry gained success as a stock picker who preferred bargains over market darlings, but he became famous when Michael Lewis wrote a book about the famous subprime trade. Burry went from a complete unknown (but very successful) stock picker to a fund manager who brilliantly predicted and profited from the biggest bubble in decades. His trade became the focal point of the financial crisis books, and his name became known by the heaviest of hitters such as Warren Buffett and Alan Greenspan.

Burry’s story is often told as a Cinderella type story about “just a guy” who was a good stock picker, got discovered, and then made it big in a Soros-esque trade of a lifetime.

Not exactly… That is how the sequence of events unfolded, but I think the story of Burry’s success in the subprime trade actually downplays how talented a stock picker the guy really is. He deservedly gets attention for his investment in the credit default swaps that soared when housing crashed. But as he himself states in his investor letters, he’s a stock picker at the core. He is classic value investor, hunting for bargains in the nooks and crannies of the market. As he said of his own philosophy in an early post:

“My strategy isn’t very complex. I try to buy shares of unpopular companies when they look like road kill, and sell them when they’ve been polished up a bit.”

The thing I admire most about Burry is his ability to think independently. He studied Buffett, but realized Buffett couldn’t be cloned. His style was originally much closer to Ben Graham’s—he was a bargain hunter. But he didn’t clone Graham either. From what I can tell, he simply looked for bargain-priced stocks by turning over a lot of rocks. Many of his early investments were sort of special situation type bargains—some with catalysts that played out fairly quickly, others just unloved and neglected bargains selling for less than a private buyer would be willing to pay for the business.

This weekend, I happened across a link to a very nice write-up and summary of Burry’s original posts on the message board I referenced above. It prompted me to re-read the compilation of Burry’s original articles he wrote for MSN Money, as well as review a couple old letters that I printed off. Unfortunately, I don’t know if Burry’s original Scion Capital letters are still in the public domain, but if anyone would be willing to share them with me, I’d love to read them. I only have a few of them. As for the MSN articles, they were written for the lay-person investor, but they provide a glimpse into how Burry thought about his investments.

I thought I’d highlight just a few clips from the investor letters and the MSN letters. The first thing I thought was remarkable was the fact that Burry was very bearish on the stock market in 2001, yet he remained fully invested and produced incredible results from buying bargains: +36% annually for the first 2+ years of his fund, even as stocks were in an extreme bear market, with the S&P dropping 50% and the Nasdaq falling 80% from their 2000 highs.

He describes his pessimism on the overall stock market in an early investor letter:

Burry Scion Letter Bearish View

He describes a situation that could easily describe 2015. Established companies with durable products, competitive advantages, and stable long term prospects (but with no real hope of growing much faster than 7 or 8% annually) are priced at 20 to 30 times earnings in many cases (I’m referring to large, high quality stalwarts at these valuations. This isn’t to mention the ridiculous valuations of some of the more recent IPO’s). The popular argument for this seemingly pricy valuation among high quality companies rests on the fact that interest rates are so low—a dubious justification in my view.

But back to 2001… Despite Burry’s lack of enthusiasm for the overall stock market and general valuations, and despite his bearishness on the economy, he remained fully invested in stocks he thought were undervalued. This is a good lesson—his bearish assumptions were correct, but he still preserved capital and made remarkable returns by staying focused on identifying undervalued securities and not worrying about where the market will go next:

“So, I will go on record right now as saying that this is a time of tremendous uncertainty about market direction—but no more so than at any time in the past. I continue to believe the prudent view is no market view. Rather, I will remain content in the certainty that popular predictions are less likely to come to pass than is believed and the absurd individual stock values will come along every once in a while regardless of what the market does.”

Burry turned out to be correct in his assessment that the market was overvalued, even after a significant drop. But what’s interesting to me is that he still maintained a fully invested portfolio filled with bargain securities.

In his early letters he describes how he maintained his portfolio filled with cheap stocks, and despite his bearishness, was long bargain stocks that did extraordinarily well as the overall market dropped 50% from 2000-2002. Here are his early results (Burry started his fund in November 2000):

  • 2000: +8.2% (vs -7.5% S&P 500)
  • 2001: +55.4% (vs. -11.9% S&P 500)
  • 2002: +16.1% (vs. -22.0% S&P 500)

So for the first 2 years and 2 months of his fund, he had compounded at a rate of 36.1% per year vs. a CAGR of -18.8% for the S&P 500.

And it’s remarkable that this was done primarily being long stocks with basically no shorting. Burry said in his 2006 investor letter that:

“A Scion portfolio will be a concentrated portfolio, though, and I have generally thought that in any market environment I should be able to spot the handful of investments that will make all the difference.”

So I think it’s notable that although Burry was extremely bearish (as described in his letters and the MSN articles), but he still stuck to his knitting—looking for low risk bargains.

Buffett and Munger said something similar at the recent meeting about just looking for undervalued companies and let the macroeconomic tide take care of itself.

Burry eventually got much more interested in the macro tides, and profited from it, but I think his early results as a stock picker are a good reminder that regardless of how overvalued we think the market is, there are always opportunities to invest in low risk, high probability bargain situations.

As for the MSN articles, Burry’s value stock picks there also did very well, even as the broad stock market indexes got crushed. His picks returned +23% while the S&P 500 dropped 22% and the Nasdaq plummeted 58%—a testament that in most markets, good old fashioned value can in fact protect capital from permanent capital loss.

One other comment from Burry on why it’s more important to focus on bottom-up stock picking than to try and predict stock market movements:

“Regardless of what the future holds, intelligent investment in common stocks offer a solid route for a reasonable return on investment going forward. When I say this, I do not mean that the S&P 500, the Nasdaq Composite or the market broadly defined will necessarily do well. In fact, I leave the dogma on market direction to others. What I rather expect is that the out-of-favor and sometimes obscure common stock situations in which I choose to invest ought to do well. They will not generally track the market, but I view this as a favorable characteristic.”

Here are Scion’s returns over the life of his fund until he liquidated the partnership:

Michael Burry Scion Capital Returns

Here are a few other links of interest regarding Burry and the financial crisis:

Charlie Munger is not only insightful, but he’s an entertaining guy to listen to. These Munger comments below were compiled by Aznaur Midov from the annual meeting for Daily Journal Corporation, a company that Munger chairs.

I just thought I’d highlight a few comments that I thought were interesting.

Munger talked about moats a couple times during the meeting. The first time he recited a few examples of formerly great companies that had significant competitive advantages, but due to the nature of capitalism, eventually wound up bankrupt:

“The perfect example of Darwinism is what technology has done to businesses. When someone takes their existing business and tries to transform it into something else—they fail. In technology that is often the case. Look at Kodak: it was the dominant imaging company in the world. They did fabulously during the great depression, but then wiped out the shareholders because of technological change. Look at General Motors, which was the most important company in the world when I was young. It wiped out its shareholders. How do you start as a dominant auto company in the world with the other two competitors not even close, and end up wiping out your shareholders? It’s very Darwinian—it’s tough out there. Technological change is one of the toughest things.”

Munger had this story when asked to identify a moat:

Question: What is the least talked about or most misunderstood moat?

Munger: You basically want me to explain to you a difficult subject of identifying moats. It reminds me of a story. One man came to Mozart and asked him how to write a symphony. Mozart replied, “You are too young to write a symphony.” The man said, “You were writing symphonies when you were 10 years of age, and I am 21.” Mozart said, “Yes, but I didn’t run around asking people how to do it”.

This was an interesting response. Moats are all the rage these days among value investors—especially Munger and Buffett disciples (a group of which I consider myself a part of as well). This is for good reason—all things equal, we’d ideally prefer to own a company with a competitive advantage (a “moat”). The problem is that it’s relatively easy to identify a company that is doing well. It’s much harder to look into the future and determine if said company will continue to do well. The durability of moats is much harder to identify than the moat itself. And the durability is really what is most important, since most of the time the company that is doing well currently is often priced to reflect that.

Thus, the other problem is valuation. Munger again:

“Everyone has the idea of owning good companies. The problem is that they have high prices in relations to assets and earnings, and that takes all of the fun out of the game. If all you needed to do is to figure out what company is better than others, everyone would make a lot of money. But that is not the case. They keep raising the prices to the point when the odds change. I always knew that, but they were teaching my colleagues that the market is so efficient that no one can beat it. I knew people in Omaha who beat the pari-mutuel system. I never went near a business school, so my mind wasn’t polluted by this craziness. People are trying to be smart—all I am trying to do is not to be idiotic, but it’s harder than most people think.”

Munger’s comment above reminded me of the comment that he made years ago in a speech in California. In this lecture, Munger points out how important it is to think in decision trees and simple probability. He references the concepts of two 17th century mathematicians: Pierre de Fermat and Blaise Pascal.

In the summer of 1654, one of Pascal’s friends—a gambler who was smart, but consistently lost money—came to Pascal asking for help with why he consistently lost money. This problem was interesting for Pascal, and a series of letters ensued that summer between Pascal and another mathematician, Fermat. By the end of the summer, these casual letters ended up proving to be a linchpin in the fundamentals of modern day probability.

Munger didn’t get into detail of this in his talk, but he did state how important the concept of thinking probabilistically is. And he even attributed this skill as one of the reasons for Buffett’s success:

“One of the advantages of a fellow like Buffett, whom I’ve worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations…”

But the main point of bringing up a couple of 400 year old mathematicians was to describe how the pari-mutuel system works:

“Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position, etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal.”

So the pari-mutuel system that is the stock market is fairly good at leveling the playing field between the high quality stallions and the broken down nags. Munger says a railroad company at 1/3rd of book value might not necessarily be as attractive a value as IBM at 6 times book value. Of course, it’s not perfectly efficient, and sometimes the nags provide more value relative to the price you can buy them for, other times the stallions do.

Reducing the Probability for Error

I think the stallions (the good businesses) often prove to be the lowest risk, highest probability outcomes, but this is not always the case. I’ve always thought generally speaking—most investment mistakes are made because an error was made evaluating the business as opposed to an error based on the valuation given the current state of the business. Of course, you could argue that a bad business (or one that gets progressively bad) turned out to be overvalued. But I’m just referring to the idea that very few serious investment mistakes come from buying great businesses at too high prices. Sometimes this happens—like buying Coke in 1998 or Microsoft in 2000. Business results at both of those companies continued to be good, but the stocks performed poorly. But usually, this type of mistake (while still a mistake) means mediocre results going forward, and not necessarily significant loss of capital. The big losses tend to come from being wrong about the business.

So I find I spend a lot of time trying to reduce errors, and this leads me to preferring high quality businesses. And Munger and Buffett have obviously proved the merit of this idea over time. As Munger said in that same lecture:

“And so having started out as Grahamites—which, by the way, worked fine—we gradually got what I would call better insights. And we realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual…”

So moats are important, valuation is crucial, but thinking in terms of probability is also very important. Evaluating what Walmart will look like in 10 years will probably lead to a more predictable outcome than evaluating Facebook (note: more predictable, not necessarily better). There are no sure things, but there are probabilities, and the probabilities—unlike card games or dice—are dynamic and ever changing. It’s not an exact science.

What you’re trying to do is locate what Munger calls the “easy decisions”. The low risk, high probability bets. Sometimes those come from the best companies in the world with significant advantages, other times they come from off the beaten path—companies that are involved with some sort of special situation that might not have these sought after moats, but nonetheless offer significant value and low risk of permanent capital impairment.

I think what Munger is really saying—if I can be so bold to put words in his mouth—is that identifying moats is not a science, and it’s not easy to describe to someone who is asking about them. (After all, the quote above is from a speech called “The Art of Stock Picking”). Each situation is different and each company has its own set of circumstances. Despite how much we’d like to boil this down into a checklist and a simple box checking exercise, investing just doesn’t work that way. It takes a lot of preparation to put yourself in the position to identify these low risk, high probability investments, and it also takes a lot of patience and discipline to wait for them in the meantime when they aren’t available.

Munger succinctly summarizes this point when he was asked at the meeting “what system do you use to identify great investments?”

“We tend to look for the easy decisions, but we find it very hard to find “easy decisions”. We found just barely enough and they had their own problems. So, I don’t have a system.”

It is certainly a lot harder for Munger than the rest of us. He is 91, he’s a billionaire, and he unfortunately has far fewer investment opportunities than most of us.

But his experience is relevant, and we can take away certain aspects of his investment philosophy as we hunt for our own bargains.

I have been busy over the past couple of weeks. My wife gave birth to twins about two weeks ago, and now that I am back in the office, I am catching up on some reading. While we were in the hospital for about a week, I did have some time to do some reading, and I have some comments on two annual reports of current holdings of mine—JP Morgan and Markel—which I may turn into brief posts.

But briefly, I thought I’d share two videos I recently watched of two great investors—one I talk a lot about, and one who I’ve rarely mentioned.

Joel Greenblatt and Stanley Druckenmiller have put together two of the all-time great track records.

Stanley Druckenmiller

Druckenmiller has arguably one of the four or five most impressive track records of all time when you combine CAGR, assets managed, and longevity. If there was an NCAA-style bracket for all-time great investors, he’d probably be a 2 seed, or possibly even snag the final 1 seed spot—he’s that good. He compounded at around 30% annually from 1981 until he retired from active money management in 2010. He started with a few million and was managing tens of billions by the time he retired. He also famously co-managed the Quantum fund with George Soros for a period of time (Druckenmiller actually managed the fund and came up with most of the investment ideas—including the famous British Pound short. Soros was busy traveling around Europe and mostly just provided Druckenmiller with general advice on position sizing and portfolio management).

Druckenmiller generally stays out of the limelight, and rarely gives interviews. There is a chapter on him in New Market Wizards when he was a young manager in 1992, but there isn’t much in the public domain relative to the size of his success. But recently he gave a talk that was very interesting (transcript is here).

He runs a strategy that is very different from my investment approach, but I still find him to be an interesting investor and his talk had a few conceptual things that I think are important for any investor who hopes to achieve significant outperformance over time. In fact, I think there are a few simple, if not overgeneralized reasons for his success.

These are mentioned in the lecture, but I’ll highlight my takeaways here:

  • He waits for the fat pitch. I’ll paraphrase something he once said: “the best thing to do is sit around and do nothing, and then when you see something, go a little bit crazy”.
  • He is very willing to admit he is wrong (when the facts change, he changes his mind).
  • He takes big positions when he finds high probability ideas.

I think these points were a big part of his investment philosophy, and despite his strategy being one that I find difficult to replicate or emulate, I think these concepts had more to do with his success than his ability to analyze macro events, currency movements, or secular trends.

And in fact, those three points are usually exemplified in all the great value investors. Druckenmiller says in the lecture that he really sees no point in watering down your best ideas with marginal ideas just for the sake of diversification. It only will lead to mediocre long term results. He also says something I strongly agree with: there just aren’t that many great ideas. In order to get great results, you have to capitalize on great ideas. And you might only find 1 or 2 or 3 really great ideas in any given year.

It takes patience and discipline to be willing to reject most everything that comes across your plate, and then really capitalize when you locate a high probability idea.

So it’s not much different in terms of philosophy, just the way the philosophy gets implemented: I tend to prefer undervalued high quality businesses that I can easily understand, but Druckenmiller and Soros found an edge by analyzing macroeconomics.

Joel Greenblatt-Different Strategy, Similar Concept, Similar Success

Joel Greenblatt—on the other hand—ran a much simpler (in my opinion) strategy that is much more akin to my own investment approach (thus the reason I mentioned him often and rarely have talked about Druckenmiller).

Greenblatt made 50% annually for a 10 year stretch from 1985-1994 (something not even Druckenmiller and his mentor Soros could match in their famous Quantum fund). Greenblatt and his partner Rob Goldstein then returned outside money, but continued running their own money using the same strategy for another ten years, achieving great results.

Greenblatt’s strategy is nothing like Druckenmiller’s, but there are a few philosophical similarities, namely that Greenblatt tended to put most of his capital into the 5 to 8 best ideas he had at any one time. He felt strongly that beyond this level, diversification didn’t really reduce any additional risk, but did water down results.

There is a case study in Greenblatt’s first book that outlines an average company that was trading for less than liquidation value (or more likely, the value that the business could be sold to a private buyer for). The twist was that the company had a very small retail subsidiary that was growing and had enormous potential. The main business was mundane, lowly profitable, and generally unattractive. The small retail operation was just a small fraction of the overall value, but if the concept worked, it could grow into a much larger piece of the pie—perhaps equaling or exceeding the market value of the entire company.

Greenblatt recognized the growth potential of the growing retail subsidiary, and in fact underestimated the possibilities. But he knew that since he could buy the whole company for less than what the main business could be sold to a private buyer for, he got what amounted to a free call option on the retail business.

Things worked out as planned, and the retail business reported strong growth and Greenblatt subsequently sold when the value and prospects of the retail subsidiary became more recognized.

The case is interesting, but the thing I took away is that Greenblatt said that his favorite ideas consist of finding an investment opportunity where there are very few ways to lose money and multiple ways to win. In the case above: the main business could have been sold, assets could have been liquidated, or maybe the operations could have turned around. And of course, the growing retail business was just gravy. There were multiple “good things” that could happen and very few “bad things”. In fact, I don’t recall exactly how the situation resolved itself, but I think the bad business didn’t really get better. I think assets ended up getting sold and the company more or less closed down the unprofitable line in order to focus on the good business.

The point is that Greenblatt’s favorite ideas were the ones where he felt there was very little chance of losing money—not necessarily the highest potential returns.

In the video below, he emphasizes this point. (By the way, thanks to Joe Koster who posted this video—I found it on his site—and Joe also emphasized this quote, which is a good one):

“My largest positions are not the ones I think I’m going to make the most money from. My largest positions are the ones I don’t think I’m going to lose money in.”

I think that’s a very important thing to consider. Bill Ackman made about 50% last year. His largest position—because of a catalyst that he himself was very much a part of—was a position that had a very, very low probability of causing a permanent capital loss. As it turns out, the investment worked out great—maybe better than Ackman expected, even though they were unsuccessful in achieving the outcome they originally set out to achieve (which was getting Allergan sold to Valeant). Instead Allergan sold itself to a higher bidder and Ackman probably smiled the whole way.

Some people don’t care for Ackman—I’m not particularly fond of big egos myself, but this was a brilliant investment by a very smart manager. Very low chance of losing money. Upside uncertain, but very low downside. Thus the reason Ackman had around a third of his capital in it.

I think both Greenblatt and Druckenmiller, despite running completely different strategies, both were successful in part because they understood the importance of that concept.

Here is the Druckenmiller lecture: great read even for us much more simple minded value investors.

Here is a video of Druckenmiller in a recent Bloomberg interview.

And here is the Greenblatt interview with Howard Marks that I referenced above:

Last weekend I spent a couple hours reading through Buffett’s old partnership letters (again). I was looking for something specific that I remembered him talking about, but then as I was flipping through them trying to find this comment, I just decided to read them again. I’ve always found it extremely valuable to read Buffett’s letters. Although I’ve read both the partnership letters and the Berkshire letters multiple times, I feel like I pick up something new each time I read them, or maybe I notice something helpful or relevant to a particular investment situation I’m currently working on.

I think the best way to learn and improve as an investor is by doing it—just invest. You learn a lot by reading about companies and researching situations. The second best thing you can do outside of investing itself is by reading and reverse engineering case studies. There aren’t many in the Buffett letters, but there are a few. (I found it interesting that he lists an oil stock arbitrage in an appendix to the 1963 letter, and discusses how it was very profitable to invest in merger arbitrage deals during that time—Buffett would buy stocks of smaller oil producers that were selling out to the larger integrated oil majors, with the objective of making 20% annualized returns on the investment operations).

Anyhow, maybe I’ll review a case study or two some other time. For now, I wanted to write a post with a few comments that Buffett made in those early letters that were thought provoking. Another thing for me personally, I think the partnership letters are interesting because Buffett was operating with a much smaller sum of capital, and was engaging in investment operations that were much different than he engaged in even a decade or two later at Berkshire.

For instance, he was managing $4 million in 1961, which was a small sum even then (however, it was large enough for Buffett to engage in activist investment operations even back then).

A good friend and I have considered writing a series of posts, or some sort of compilation at some point discussing these letters, but for now, here are just a few clips that made me think while flipping through them over the weekend.

1962 Letter

Buffett talks about his strategy here. I’ve always liked his approach to categorizing investment ideas. Although I’ve said before that I don’t seek out investments in any specific category, I do think it helps to know which investment idea belongs in which category—but the horse has to come before the cart (seek out value first, not categories of investments). As far as Buffett is concerned, he described his approach in the 1961 letter. I might summarize his portfolio strategy in a separate post, because I think it is generally misunderstood by the casual investing public, especially in the early years.

In the 1962 letter (and most letters thereafter), he briefly summarizes his portfolio strategy:

“Our avenues of investment break down into three categories. These categories have different behavior characteristics, and the way our money is divided among them will have an important effect on our results, relative to the Dow in any given year. The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon available factors.”

I’ll go into more detail in another post, but he lists his three categories of investments as:

  • Generals—plain vanilla investments in stocks that are undervalued without any specific catalyst
  • Workouts—special situations such as merger arbitrage, spinoffs, etc…
  • Controls—investments where Buffett became the largest or majority shareholder and pushed for change (a category that would now be referred to as activism).

Buffett and the Activist Put

Since the title of this post is “Things You Didn’t Know About Buffett”, here is the first comment I jotted down that I hadn’t noticed before (the title is presumptuous… maybe you did know!). Buffett, when discussing the general investment category said this:

“Many times generals represent a form of “coattail riding” where we feel the dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use. We have done that ourselves in Sanborn and Dempster, but everything else equal, we would rather let others do the work. Obviously, not only do the values have to be ample in a case like this, but we also have to be careful whose coat we are holding.”

This sounds like what has recently been referred to as the “activist put”. Basically, a large shareholder takes a stake in a company and announces the “changes” they’d like to see (usually, it’s something really creative like loading the company with debt to buy back stock in the name of “unlocking shareholder value”). Investors who believe in the merit of this “activist put” will then invest in this company under the assumption that if things get better and operations improve or the stock price rises, great… if the stock price falls, then the activist will buy more and continue rattling the cage until things do improve. The theory is that this creates a floor (or “put”) under the price.

I’ve never been a big fan of such a strategy, and I wouldn’t make an investment decision that is founded on this type of theory. But I do understand that in reality this type of situation exists. Heck, there was even talk of a “Buffett put” a year or two ago when Buffett announced he would buy back stock at 1.1 (later increased to 1.2) times book value.

So the activist put can be real—I just wouldn’t make it a primary reason for being interested in an investment. And as Buffett says, value has to be present, and probably most importantly when evaluating the activist put is to “be careful whose coat we are holding”.

Using Borrowed Money

The second thing that some people might not have known is that Buffett used borrowed money in his partnerships. He didn’t borrow a lot, and he didn’t borrow against the “general” investments, but he did use leverage when investing in special situations, or “workouts” as he called them.

Buffett describes workouts as “securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities… Corporate situations such as mergers, liquidations, reorganizations, spin-offs, etc… lead to workouts.”

He describes the benefits of investing in these special situations:

“This category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout the year with a large portion of our portfolio in workouts, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year.”

So the workouts provide, as the portfolio academics would say, uncorrelated and attractive risk-adjusted returns. While any one deal could go sour, a basket of these investments over a period of time would provide quite predictable results.

This is why Buffett decided to add leverage:

“Over the years, workouts have provided our second largest category. At any given time, we may be in five to ten of these; some just beginning and others in the late stage of their development. I believe in using borrowed money to offset a portion of our workout portfolio, since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior.”

Buffett goes on to say that these situations typically provide 10-20% annualized returns (before the benefits of leverage), and that he limits the leverage to 25% of the partnership’s assets.

Quick Comment on Buffett’s Evolution as an Investor

Obviously, Buffett uses leverage at Berkshire, but it’s interesting to read about how opportunistic he was during his partnership days as well. His plan was certainly not to buy and hold Coke for decades in the 1950’s and 60’s.

His thoughts on investing evolved, but I think the reason for the evolution was much more due to the rising asset base than for the more commonly attributed reason—Charlie Munger’s influence (and this is not a slight to Munger at all-he’ll tell you the same thing). The latter was certainly a big factor, but the former was (and still is) the driving reason behind Buffett’s continual evolution as an investor. We may be entering a new phase of Buffett’s career in present years as he gets more involved with 3G and their hands-on approach to the operational side of businesses.

Buffett has always taken what the defense has given him. I think deep down, he probably longs for the days of the cigar butts, the oil stock arbitrage deals, and the quantitative bargains. But that’s a moot point—Buffett has always been opportunistic, and has maximized his returns with a minimum of risk by investing in the opportunity set that was in front of him at any given time.

There are a number of other things I’d like to discuss, but we’ll save them for another post. The letters are good reads, and I think there are beneficial discussions on investment philosophy, portfolio strategy, and also some interesting case studies.

Have a great weekend!

I wrote a post recently on intrinsic value, and I received some comments and questions that made me think a lot of readers are still looking for a formula to calculate a stock’s value precisely. I really don’t think this is the case. I think the best result that an investor can hope to achieve when it comes to appraising business values is to come up with a fairly sizable range of values, and then wait for the market to offer you a price that is significantly below the lower end of the range—which gives you both a margin of safety in the event your analysis is wrong and high returns on your investment if you’re right.

Investing should be simple. The concept of intrinsic value is simple. The value of a business is simply the present value of the cash that you can pull out of it over time. Graham and Buffett both agreed that this is the intrinsic value of a security—either a bond or a stock. But it’s hard to determine the precise level of future cash flows of a business. I think both Graham and Buffett would agree that instead of trying to crunch numbers into a spreadsheet and using DCF’s to value businesses, they thought of intrinsic value in terms of private owner value. Essentially, what is the normal future earning power of this business and what is that earning power worth to a rational private buyer? This is just a more practical way to think about what something is worth. What will a rational buyer pay for this business?

This, to me, is the simplest way to think about value and it’s how I think about intrinsic value.

I like to think of each investment as a separate business that I am about to buy. And with each business, I want to consider the sum of cash flows that I’ll be able to take from the business each year on average in the future. Then, given all of the other qualitative/quantitative factors that go with each individual business, I will decide how much I’m willing to pay to acquire that stream of earnings.

Each business is different. $10 of earnings from Costco is obviously worth more to me than $10 of earnings from Sears. So you have to look at each business’ earning power along with the future prospects of the business to decide how much you’re willing to pay to acquire that business’s future cash flows.

So keep in mind the two questions I referenced in a previous post:

  • How much does the business earn?
  • What is that worth to me?

Remember, you want “normal” earning power of a business. You’re not looking at the P/E ratio or the EPS from the last twelve months. You’re trying to understand the business to make a judgment on what their earning power will look like over the long term (over the next 3-5 years, or even longer perhaps). This is an art. You’re not trying to predict down to the penny what EPS will be in 2017. You’re just trying to understand the business to make an informed estimate on what the cash earnings will look like in a normal year going forward.

I sometimes use a simple real estate investment as an example, and I referenced this example in the last post. Imagine you own a duplex that rents for $900 on each side ($1800 per month of gross rent). This duplex has a gross potential rent of $21,600 per year. Of course, in any given year, a smart duplex owner understands that he might sustain a vacancy in one of the units, so maybe you’d take 8% off of that potential rent to arrive at a gross effective rent of just under $20,000. Then you have taxes, insurance, utilities, property management fees, and routine maintenance. Let’s say after paying all of these expenses, you’re left with $12,000 of annual net operating income from your duplex (NOI is a real estate term, but this is technically a pretax number, as we aren’t factoring in personal income taxes that you’ll owe on your duplex earnings, and we’ll assume for simplicity that there is no mortgage).

In this example, the duplex earns about $12,000 per year of pretax cash flow before depreciation, but since you’re a smart duplex owner, you’ll set aside around $2,000 per year for maintenance capital expenditures (larger outlays of capital for non-recurring items such as a new roof or a new air conditioner, etc…). These are maintenance capital expenditures—real expenses that are required of an owner of a duplex to maintain the current competitive position of this duplex (i.e. without a functioning roof, it will be hard to attract tenants).

So let’s say the pretax owner earnings are around $10,000 per year.

Once you know this, you can then decide how much that is worth to you. If this duplex is in a slow growth, average neighborhood that hasn’t changed much over time and won’t likely experience any abnormal appreciation, maybe you’d be willing to pay $80,000 to $90,000 for the property. If the duplex is newer and is located in a great part of town that is growing rapidly, you might be willing to pay $110,000 to $120,000. If the duplex sits in town on a half-acre lot across the street from a piece of land that is getting developed into luxury condominiums and land is trading at $300,000 per acre, maybe you’d be willing to pay more still to get this same $10,000 of earning power.

And to make a different point, it’s pretty safe to assume that the duplex has earning power of $10,000. This is a “business” that is pretty easy to understand—it’s easy to estimate the future earning power of this asset. Even if in one year you had to make some renovations and sustained an abnormally high level of vacancy and your duplex only earned $5,000 in the last 12 months, you’d still consider the “normal earning power” of the duplex to be around $10,000.

But in each case, you’d decide on the earning power of the duplex (how much does the business earn?), and then you’d weight the other factors such as age, location, neighborhood, population growth, job market, etc… and you would decide how much you’d be willing to pay to acquire that duplex’s earning power.

So just like the duplex, when you’re looking at the earnings from Costco, you’re going to capitalize that earning power differently than you would for the earnings from Sears.

Like the Concert Pianist, Practice Makes Perfect

Start with the businesses you know how to value. For practice, read a book called Analyzing and Investing in Community Banks and then go out and read a few annual reports of tiny community banks–which are fairly transparent and relatively easy to value. Or pick an industry that you have some expertise in and begin reading some annual reports of businesses in those industries. Pick simple things–I recently read a 10-K on a business that sells hot dogs and has a nice competitive position in that niche. It’s easier to understand–and value–a business that has been selling hot dogs for the past 100 years than it is to value a business that sells pharmaceuticals (at least for me–others might have an advantage with drug companies, or software, or oil and gas, etc…).

So if you’re going to value individual businesses, you have to understand that business. As Joel Greenblatt says, if you don’t understand it, move on to the next one. There are 10,000 stocks in the US, and probably over 50,000 worldwide in developed markets. You only need to find a minuscule percentage of them to fully allocate a portfolio.

Also, value investing comes in many different shapes and sizes, and if you choose not to value individual businesses, there are alternative measures such as quantitative investing in the Graham or Schloss tradition, or even Greenblatt’s “formula”. This quantitative approach values the basket as whole, removing the need to value each individual business. It relies on the law of large numbers, similar to the insurance underwriting business. I personally enjoy reading about those types of strategies, and the results from Schloss are absolutely phenomenal, but I prefer to think of the stocks in my portfolio as fractions of businesses, and thus I endeavor to understand them and value them individually.

Anyhow, valuation is an art form, and it takes practice. Just like practicing the piano, you’ll get better the more you practice. And the best way to practice is to just start reading reports. Over time, you’ll begin to understand the different metrics that are important for each business, and you’ll be less inclined to use hard and fast rules (ROIC above X, P/E below X, etc…) and more inclined to think inquisitively about the business and its operations.

The last thing I’ll mention: over time, as business owners our results are tied to the internal results of the businesses we own. A business that is growing intrinsic value over time will reward us as owners. Over the longer term, quality is the most important determinant of our results as equity owners. A business that can compound value over time at 12-15% annually will create fabulous amounts of wealth for the owners of that business.

So quality is crucial for long term owners. BUT, valuation is the most important determinant (or at least as important) over the shorter term (say 1-3 years). If you overpay–even for great businesses–you’ll have to wait a long time for your investment returns to “catch up” to the internal compounding returns of the business. Conversely, if you buy a great business that compounds value at 12% per year–if you can buy it at a discount to its fair value, then your returns will generally exceed the business’s results in the early years of the investment.

The market is a weighing machine, and over 3-5 years, it tends to weigh things properly. So valuation is an absolutely crucial factor over the near term.

Have a great week!