Notes on long term thoughtful investing

Month: April 2017

Learning from the Giants

Fortunately for us, in the world in which we live one doesn’t necessarily need to ‘reinvent the wheel’. Someone else has already done that. We just need to absorb that knowledge and add something incremental to it before passing it others.

And investing does not happen to be any different.

Reading & taking time out to think over the work of some of the most successful investors of our times is a sure way to improve our own framework.

In this sense, we guys are a lucky lot! We virtually happen to have access to all the intellectual work done by Buffett all his life in form of his annual letters. And he happens to be one of the finest investors of our times. The fact that he was officially a part time teacher for close to 15 years in his early life is an added advantage for learners like us.

In a similar way, there are several other successful investors which, though, may be somewhat less covered by mainstream media but in every way important to learn from for our purposes.

There is a column to right on this website which has a category titled as ‘learning from the giants’. It is my endeavour to make part of this journal some of the key learnings coming from these giants, overtime.

 

Some of the less talked names

Recently, I finished reading Prof. Greenwald’s book titled Value Investing: From Graham to Buffett and Beyond. In second half of this book, professor discusses the investing framework of some of the successful value investors. What is interesting to note is there is little similarities in way these investors operate but each one has achieved investing success which we all desire!

I thought of writing a post on some of the key learnings from some of these ‘super investors’. Most of the discussion would be centred around these investors and how think of investing.

 

Glenn Greenberg

His track record is one of the best in the industry. He has happened to deliver annual returns somewhere in mid 20s between 1984 to 2008 thereby beating the S&P500 index by a wide margin.

His entire investing philosophy could be summed up in three points:

  • Concentrate: He would frequently take large positions in companies he has conviction generally holding just 8-10 stocks. Contrast this with today’s leading MFs which own 50-80 names! Does this mean he is taking excess risks to earns those returns? No, on the contrary, in order to build enough conviction to take those weights, he reads & learns in order to become an expert on the industry at hand. Can a diversified fund manager even know what his 80 companies are doing? Keep aside the question of knowing how well are those companies doing in their businesses.
  • Buy Strong Companies: His definition of a ‘good’ business coincides with what Buffett would call as ‘Moat’. What he says here is not much different. What is worth observing is that for a long term investor who believes in creating a concentrated portfolio, restricting themselves to invest in stronger businesses helps. How can one put 15% of his assets in a company whose future five years hence cannot be determined with some degree of certainty?
  • Buy them Cheap: Can good business be acquired cheap? Yes, most of the companies tend to have volatility range, from low to high in a year, ranging between 80-100%. And both of these prices cannot be right! Markets happens to be predictably irrational. Thereby trading away long term prosperity for short term pains. What else can we ask for as value focused investors!

He views a company as a cash generating machine which makes him frequently using DCF to value businesses. But given the sensitivity which DCF output shows to seemingly minor changes in assumptions, he prefers to err on the conservative side of the equation.

 

Seth Klarman

For most of guys in the value investing community, this name needs no introduction. His investing style focuses a lot on the behavioural side of investing.

  • Look at the downside: Evaluate the downside first. A 10% return with no probability of downside is worth more than one with some higher returns but with relatively more risk of losing.
  • Motivated Sellers & Missing Buyers: Basically someone who would sell without really answering the question – how much is it worth? It could be for regulatory reasons but more frequently would be for emotional 

 Not everyone is comfortable owning something is somewhat depressing today irrespective of what it could be worth tomorrow. Especially if one would latch up to the next ‘hottest’ thing with just a press of a button.

Important thing here is that generally things here are predictable i.e. they move in a pattern. So, if a company is removed from the index today, there is a high probability that its prices could go in the depress zone sometime later as funds – whose performance (and jobs) depends upon how close they are to their benchmark – along with passively managed index funds go on to a selling spree.

Another example could be an industry facing cyclical slowdown – there would be multiple bargains in the same industry. So, one can work once on the industry and can potentially invest into multiple companies within it.

  • Market-independent situations: This is his way for searching up potential investments which are not dependent in any significant way on market & its fantasies. We could term it as ‘special situation’ investing. These have their own schedule of payoff in terms of returns. Company specific developments would lead to final returns.
  • Geography Agnostic: Basically, geographical boundaries do not bind him. Given his taste for deep value bargains and also how rare are these, he frequently goes outside his home ground.

Given his long experience, well documented history, somewhat unquenchable thirst for bargains, studying his records deeper would be worthwhile.

 

Walter Schloss

A disciple of Graham, he never moved out of the fast shrinking pool of asset based bargains. So devoted was he that he preferred to keep his fund small by giving his clients periodic exits and focus on the coveted space of bargain investing.

His 45-year track record of outperformance is excellent – 15.3% CAGR for their fund vs S&P’s 11.5%

His investment process is one of the most simpler ones I happen to come across.

  • Significant fall in stock price: He would buy something which has declined relentlessly in recent past. More often than not, these are stocks which now have all the negatives priced into it. 
  • Avoid levered companies: One of the most difficult problems to solve in a deteriorating business is that of debt. So he would avoid companies which are levered 
  • Patience: He is ready to hold on for years. Given how poor health of the business is when he buys into it, it takes time for things to resolve and market to revalue the company. His average holding period is ~4-5 years. 
  • Diversify: His approach is statistical. For any statistical approach to work, it requires sufficiently large sample size else, sample biases can creep in. Hence, he would frequently buy into 100 or so names – similar to Graham.

But more than statistical, I find his approach behavioural i.e. market overacts to bad news and he supplies patient capital and then waits for business problems to get fixed. The result – he earns the cumulative improvement in earnings over his holding period along with some bit of re-rating in stock’s trading multiples. He frequently says that his preferred rate of return from such investments is 50% ! 

  • Avoid meeting management: He feels this is not required. His approach is polar opposite to that of currently famous technique – ‘scuttle-butt’ – where one meets company insiders, suppliers, customers, competitors and what not!

In all, most of what Schloss does is temperamental.

If Greenberg’s strategy is to own a concentrated portfolio of good businesses which is somewhat undervalued by the market, Schloss would look to cash upon market’s behavioural mistake of punishing a non-fatal mistake too much.

For Greenberg, it is important to study the industry in detail and think like an owner while Schloss thinks of himself as a retailer i.e. buying cheap merchandise to be sold at a profit at some later date.

If Greenberg prefers to invest within a smaller selected universe of 80-120 stocks, Klarman would literally call entire universe as his universe!

All of these giants have their own way of thinking about investing.

But one thing is unifying – all happen to have patience to look beyond the immediate quarter or the year ahead. They take a far longer view of the scheme of things. Stock price movement does not seem to be their problem – after all, most of the times, its someone else’s mistake super imposed on them by way of quotational losses!

Our job – to learn from a role model who’s thinking closely resonates with our way of thinking and then make incremental improvements based on our own idiosyncrasies. But never stop learning from those who are different from us. After all, they have a record stretching over decades which one needs to respect!

Focus Investing

“Diversification is protection against ignorance. It makes little sense if you know what you are doing.” – Warren Buffett

Portfolio construction is a topic which, literally speaking, is not given adequate ‘weight’ as compared to its relation with overall portfolio returns alongwith the effort which an investor needs to put in to generate those returns.

If one were to invest in 50 or so stocks, we can be sure that quality of ideas – and hence overall portfolio quality – may not be as strong as one that is built on 7 or 12 stocks. Why? For the simple fact that the quality of ideas tapers down as one moves down through the list. If it is so obvious then why do highly paid ‘professionals’ would do something this dumb too frequently? Well, in a world which measures risk by volatility, it shouldn’t be a surprising outcome.

A portfolio with say 7 stocks would generally be more volatile than one with 50 stocks. But so be it! By selecting 50 stock portfolio over 7 one does an irrational trade-off – he gives away an opportunity to profit from 7 conservatively chosen ideas and instead gets into one with large number of stocks and hence lowers the overall portfolio quality while also reducing its chances to generate excess returns.

You might argue how can one be sure that a concentrated portfolio is bound to perform better than others? To this an answer would be: It may not outperform every time (i.e. every given year) but over a longer period (at least >3yrs) if the manager has done his job right in terms of selecting conservatively assessed businesses and acquiring them at substantial discount to their intrinsic values, sooner or later he should be able to earn his deserved reward. In this sense, markets test more of our patience and our ability to keep emotions under check than our IQ or intelligence.

Robert Hagstrom has beautifully explained all of the above by way of a case study on this topic in his book The Warren Buffett Way –

Using the Compustat database of common stock returns, we isolated 1,200 companies that displayed measurable data – including revenues, earnings, and return on equity. We then asked the computer to randomly assemble, from these 1,200 companies, 12,000 portfolios of various sizes, forming four portfolio groups:

  1. 3000 portfolios containing 250 stocks
  2. 3000 portfolios containing 100 stocks
  3. 3000 portfolios containing 50 stocks
  4. 3000 portfolios containing 15 stocks – the focus portfolio group.

Next, we calculated the average annual return of each portfolio in each group over a 10-year period (1987-1996). Then we compared the returns of the four portfolio groups to the overall stock market (defined as the S&P’s 500 index) for the same period.

  • Among the portfolios containing 250 stocks, the standard deviation was 0.65 percent; the best portfolio returned 16% annually, and the worst was 11.4%
  • Among the 100 stock portfolios, the standard deviation was 1.11 percent – 18.3% best, 10% worst
  • Among the 50 stock portfolios, the standard deviation was 1.54 percent – 19.1% best, 8.6% worst
  • Among the 15 stock portfolios, the standard deviation was 2.78 percent – 26.6% best, 6.7% worst

Notice that higher the number of stocks, lower is the standard deviation from mean returns. So a manager working for an institution happens to love his job, it is obvious that his interest would lie in creating a portfolio which is fairly diversified and which mimics the index against which his performance is assessed.

And if another manager happens to outperform index and his fund by a significant margin, he can always show up Sharpe ratio, beta, standard deviation, etc. of that manager’s portfolio, compare it to that of his fund – which would obviously be on lower side – and announce to his clients that he took much less risk than the manager in question and hence on risk adjusted basis, his performance and that of any other outperformer is not much different. Clients are happy that the manager took much less risk (risk in terms of volatility) and manager has retained his job. What a win-win combination – but only for the manager!

Clients with decades in hand for investing were short changed for manager’s need to maintain his job. He chose to lower the probability of generating excess returns and traded off higher returns for lower volatility. Knowing the power of compounding where every percentage point counts over one’s investing life time, it looks like a terrible idea. And yet in economics they still preach the concept of ‘rational economic man’.

He further concludes by saying –

From all this, one key finding emerged: When we reduced the number of stocks in a portfolio, we began to increase the probability of generating returns that were higher than the market’s rate of return. But, not surprisingly, at the same time we also increased the probability of generating lower returns.

To reinforce the first conclusion, we found some remarkable statistics when we sorted the data:

  • Out of 3000 250-stock portfolios, 63 beat the market.
  • Out of 3000 100-stock portfolios, 337 beat the market.
  • Out of 3000 50-stock portfolios, 549 beat the market.
  • Out of 3000 15-stock portfolios, 808 beat the market.

With a 250-stock portfolio, you have a one-in-50 chance of beating the market. With a 15-stock portfolio your chances increase dramatically, to one in four.

So we now know that less is better when it comes to investing. But what are challenges one needs to consider while adopting this strategy? These are the ones I think is necessary for any focus investor:

  • Understand how institution imperative works: As outlined above, markets can remain irrational for period longer than the investor-manager can hold on to his job. Similarly, one can say that for someone who manages third party money – he needs to be sure that his clients are compatible with how he thinks about portfolio construction.
  • Temperament: One needs to have correct mindset in order to reap the rewards from concentrated investing. Markets are volatile. In fact, on average, a listed company has 80-100% price movement from yearly low to yearly high. But as Buffett says, volatility is a friend of an investor enemy of a speculator. With right temperament one can harness the fleeting power of volatility into compounding wealth & generating excess returns. Focus on the value part of the equation rather the more easily available counterpart – price.
  • Own the right businesses: Another unsaid part of the above exercise is time horizon and business quality. In my mind both are inter-linked i.e. with stronger businesses, which are also compounding their intrinsic values at good enough rates, it is easier to hold on to them for years versus a weaker or below average quality business. Focus investing requires an investor to take very long horizon for the business in question. Higher the competitive advantages which a company enjoys, easier it becomes to hold on to them as market takes its own sweet time to reevaluate company’s prospects.
  • Stock Selection: This is possibly the most important thing for a focus investor. Which fewer stocks in place, one needs to be sure of the business, understand it deeper, value it conservatively and acquire it at a substantial discount to its value five – seven years down the line. This is something which one learns by experience over time.

 

Finally, is 7 is the right number or should one go with 20? I believe there are no right or wrong answer for this. One needs to understand & introspect and come up with deems fit for him. As they say to each, his own! But what we need to ensure is to not spread ourselves unreasonably thing than what the situation would warrant.

 


Niraj Bardia