Readers of my blog know that I respect Jason’s ideas, books, and columns on portfolio and wealth management, especially given his connection with the Graham/Buffet/Klarman approach to investing. Jason’s weekly column, which appears on the front page of the Business & Finance section of the WSJ every Saturday, is a must read for me and I hope you, too.

http://blogs.wsj.com/totalreturn/2014/09/06/read-em-and-reap-smart-people-for-investors-to-follow/

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1. He’s super-smart;

Yet, as Buffett himself has said, if you have more than 130 IQ points you should sell the excess because you won’t need it to be a great investor. In fact, that extra IQ may be detrimental if it leads to behavioral flaws such as overconfidence or lack of discipline.

2. He’s guided by an overarching philosophy;

That philosophy is value investing, which can be executed in several forms.

3. He’s mentally flexible;

It may seem as if Buffett had a change in philosophy when he transitioned from Ben Graham’s “Net Net” and “Cigar Butt” approaches to investing to Charlie Munger’s “wide-moat” approach. However, all three approaches are guided by the value-investing tenet that requires a Margin of Safety.

Graham’s margin of safety was found in businesses trading at less than the net value of their assets. Munger’s approach of investing in under-appreciated companies with wide moats found a margin of safety in well-run business with pricing power and even growth. The key is in the qualifier “under-appreciated.”  Value investors love growth, but tend to be more skeptical of growth projections than glamour investors, and are usually better at maintaining discipline when pricing growth, and rightly so.

Hence, value investors usually buy fast-growing, wide-moat companies only when the market does not fully appreciate their wide moats as much as it should. One example: Buffett paid $1.02 billion for shares of Coca Cola by the end of 1989 after the 1987 crash had damaged Coke’s shares. By 1999, that investment was worth $11.6 billion according to Hagstrom.

4. He’s unemotional;

Marks: “Many of the obstacles to investment success relate to human emotion…perhaps worst of all, (most investors) have a tendency to judge how they’re doing based on how others are doing, and to let envy of others’ success force them to take additional risk… (Warren) doesn’t care whether others think he’s right or whether his investment decisions promptly (my emphasis) make him look right.”

My Take: Warren is disciplined, which can make a person appear unemotional. I would be willing to bet that on more than one occasion in his career he lost sleep over a decision, but that his discipline allowed logic to triumph.

5. He’s contrarian and iconoclastic;

As Charlie Munger likes to say, I have nothing more to add.

6. He’s counter-cyclical;

Marks: “Many of the best investors accept that they can’t predict what the macro future holds in terms of economic developments, interest rates and market fluctuations…the greatest bargains are accessed by buying when the economy and companies are suffering…how many acted as boldly (as Buffett) when fear of financial collapse was rampant (in 2009)?”

7. He has a long-term focus and is unconcerned with volatility;

One should only invest in the equity or long-term debt of businesses to cover long term liabilities such as college tuition that is due in twenty years, retirement liabilities, and bequests, so volatility is the friend of the long-term value investor. Volatility gives the long-term value investor the chance to buy low and eventually sell high, in contrast to what most investors do; that is, buying when rising prices make them feel good and selling when plummeting prices are too painful to bear.

This is where a good wealth advisor comes in for an individual investor or family office. He or she will help such investors identify their goals and estimate when the invoices for those goals need to be paid. Then, a good advisor will allocate assets to broad asset categories that “immunize” those liabilities and help make the euphoria of rising prices and pain of plummeting ones easier to ignore and bear because short-term goals are covered in cash or high-quality short-term debt, and opportunities to cover long-term goals will arise over a multi-decade run.

This is known in High Net-Worth Investor (HNWI) Wealth Management circles as Goals-Based Investing (GBI).  The underlying assumption is that all investors would be happy to simply meet their goals and avoid their nightmares so that they can focus on their careers and the things that make them happy.

In GBI, capital for near-term goals is held mostly in cash and short-term bills, and capital for long-term goals is invested in less liquid or more volatile (in the short run) investments such as equities, long-term debt, real estate, and alternatives in order to exploit the return premiums that are available there.

Within asset categories a good advisor will help clients find investment managers who understand each asset’s risks and who can manage those risks well. He will also find managers who can exploit specific premiums in those asset classes such as the value premium in equity investments.

8. He’s unafraid to bet big on his best ideas;

So many active investors have capital spread thinly, and almost all of it is allocated to S&P 500 companies. They have low “active share,” so they are essentially closet indexers who charge higher fees than indexers.

9. He’s willing to be inactive;

According to a speech that Seth Klarman delivered at a Grant’s conference in the fall of 2013, Baupost Group has about 50% in cash. Klarman is fearful of returning cash to his investors because he believes that they may go out and invest it with a hot-hand manager and will suffer during an inevitable shakeout.

PAR views cash as an investment in an option on every asset, an option that has no expiration date. That option is worth quite a lot right now.

10. Finally, he’s not worried about losing his job;

Professional portfolio managers who work for large firms lose their jobs if they underperform. That is why many make the rational decision to become closet indexers in order to hug their benchmark and avoid underperformance.

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The difference between Warren Buffett and most investors has more to do with discipline than just about any other quality. There are plenty of smart investors, and most of them failed to deliver results that compare with Buffett (I will soon write another blog post that summarizes Howard Marks’s forward to this third edition in which Marks identifies ten qualities that make Warren, Warren).

I last read TWBW around 2003 when I picked up the paperback printing of the first edition. The third edition is a worthy update. Every time I read the quote below I am reminded that it is discipline that makes the difference in investing, as in most things in life:

“In 1969, Buffett decided to end the investment partnership. He found the market highly speculative and worthwhile values increasingly scarce. By the late 1960s, the stock market was dominated by highly priced growth stocks. The Nifty Fifty were on the tip of every investor’s tongue. Stocks like Avon, Polaroid, and Xerox were trading at fifty to one hundred times earnings. Buffett mailed a letter to his partners confessing that he was out of step with the current market environment.

‘On one point, however, I am clear…I will not abandon a previous approach whose logic I understand, although I find it difficult to apply, even though it may mean foregoing large and apparently easy profits, to embrace an approach which I don’t fully understand, have not practiced successfully and which possibly could lead to substantial permanent loss of capital.’”

Warren was finding it difficult to find any businesses that were trading with a Margin of Safety. Rather than stretch his logic or his principles, he closed his hedge fund. Of course, he replaced his hedge fund with an insurance holding company in which he also had a decided funding advantage.

As a hedge fund manager, Buffett had to promise the lion’s share of returns to his limited partners in order to entice them to deliver capital for him to invest. As an insurance company, he did no such thing. Instead, he raised his capital for “free.” Buffett invested the float–the premium collected today for insurance claims that did not have to be paid for a long time.

As long as he maintained underwriting discipline (that word again), he could pay claims plus operating expenses that were equal to the premium he received. The ratio of the former to the latter is known as a “combined ratio,” and as long as that figure is 100% or less, Buffett got his investment capital for free. Investing free capital with discipline over several decades is how one becomes one of the richest people in the world.

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In his latest column (3/2/13), Jason refers to a paper about to be published by the University of Rochester’s Robert Novy-Marx (RNV). The column:

http://online.wsj.com/article/SB10001424127887323293704578334491900368844.html

RNV has written often on the value premium–the item that my investment firm has been trying (with some success) to capture. He has been trying to understand why and where it exists, such as in the following paper that I read a few years ago that relates the value premium to operating leverage (Note: the draft of the operating leverage paper that I read was dated May 18, 2007):

http://rof.oxfordjournals.org/content/early/2010/08/16/rof.rfq019.abstract

In RNV’s latest paper, which was the impetus for Jason’s column, RNV introduces a quality formula to improve the value premium. It seems to be generating a lot of buzz because Jason wrote that DFA’s founder David Booth and AQR’s Cliff Asness are planning to create funds based on RNV’s quality paper. Booth even called it one of those investing ideas that only come along once every twenty years or so.

But, RNV compares his measures with several tools that my firm has used since day one, including those with a quality component, specifically value investing tools based on the work of Fama, French, Lakonishok, Shleifer, Vishny (see F&F and LSV tab above), Haugen, Piotroski, and Greenblatt.

Fama and French (F&F) were not the first to point out that high book-to-market (BtM) stocks (value) trounced low BtM stocks (glamour) in generating returns, but their 1992 paper brought the issue to the forefront because they are staunch defenders of the Efficient Market Hypothesis (EMH), which their paper seemed to discredit. F&F swiped that cognitive dissonance aside by claiming (“hoping” actually) that the extra returns were compensation for risk (that they did not quantify).

LSV and Haugen later showed that value’s better performance was earned with less risk than the market leaving F&F with only hope. In 2000, Piotroski showed that the performance of the F&F model could be further improved with a nine-point measure of quality based on nine financial statement metrics. Piotroski called it an F score. And Greenblatt used a two factor joint measure of quality and price.

When executing its strategy, my firm has leaned on F&F’s BtM research and on Piotroski’s F score in addition to the research from the others mentioned above. I have always thought of our process as a joint value/quality approach, so I find it interesting that many feel as if this is something new. It may be new in that the research is presented in a new way with data through 2011, but this approach has been practiced by many value investors for a while and RNV’s results are not very different from the results of other Value/Quality practitioners. In addition, I have called my process a sorting process and not a screening process, because we sort rather than screen for the best investment ideas. RNV used a similar sorting process.

In the end, however, most of a practitioner’s ability to capture the value premium is going to be determined by whether they have the stomach to enter the order and buy some temporarily ugly looking businesses at the height of their grotesqueness (when their prices are dropping) and to sell those businesses when those prices bounce back to intrinsic value. As cliff Asness once said, a model never loses its nerve. I would add that a model never gets greedy. The ability to manage fear and greed are paramount.

Here is a draft of RNV’s paper to which Jason refers in his column:

http://rnm.simon.rochester.edu/research/QDoVI.pdf

It’s good stuff if only to help explain why so many value investors have beaten the market for so long.

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http://online.wsj.com/article/SB10001424052970204662204577200862677176998.html?KEYWORDS=zweig

Here Jason talks about the column:

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The speakers included:

Fred Speece, Moderator, Speece Thorson Capital

Aswath Damodaran, NYU

James Valentine, CFA, AnalystSolutions

Andrew W. Lo, MIT

David Maris, Healthcare Analyst

Nicholas J. Colas, ConvergEx Group

Jean-Marie Eveillard, First Eagle Investment Management

David Cowan, GMO

Richard Bernstein, Richard Bernstein Advisors LLC

Michael L. Mayo, CLSA

Howard S. Marks, CFA, Oaktree Capital Management 

Although I quote some speakers more than others, it is not necessarily because the less-quoted speaker was any less interesting. After writing the notes for the first speaker, Aswath Damodaran, I realize that this will be a long post, so I am breaking it up into several parts. 

Fred Speece, Conference Moderator: Introduction

•          Occam’s Razor: Don’t make valuation more complicated than it has to be
•          Remember the importance of dividends: they made up 44% of returns since 1926
•          Know your stuff: fundamentals and valuation

Aswath Damodaran (AD) of NYU; The Dark Side of Valuation: Across Life Cycles and Businesses

The speech is on the essentials that can be found in his latest book of the same title, which I just added to the bookstore above. Professor Damodaran loves discounted cash flow models and walked us through several valuations that he performed over the years, some of which can be found on his blog (see blogroll to the right);

 Young Companies:

•  Valuing young companies in young industries is a challenge: don’t succumb to nouveau valuation methodologies like the 1990s’ “value per eyeball;” don’t be swayed by stories like “there are 2 billion new consumers” in Chindia; and when someone starts talking about paradigm shifts remember it is because he has no explanation for what is happening;
•  AD ran his model on Amazon (AMZN) in 2000 and came up with a value of $34. The stock was trading at $84 at the time. His first thought was “What am I missing?” (I think this is a perfect example of the experience most thoughtful investors have. So many investors pay ridiculous prices for companies because of the story or a paradigm shift, and not for the business’s fundamental value, that it leaves thoughtful investors scratching their heads. Successful  investors refuse to attend those parties);
• Work backwards (or as Charlie Munger would say, “Invert!!!”). AMZN could not have had margins and revenue growth that far exceeded brick and mortar retailers for too long. Eventually the cost to grow AMZN’s business would increase and AMZN’s competitors would adapt by competing directly on AMZN’s turf. The e-tailers and retailers’ margins and growth will converge. What will the values of those businesses look like when they do converge? (INVERT!!!);
• Whenever he told professionals of his lower valuations for companies like AMZN, he usually heard dismissive comments like, “You are just an academic, you don’t know the ways of Wall Street;”
• Keep it simple (the S word again);
• “If you are a pessimist at heart, don’t bother trying to value young, growth companies because they are all overvalued;”
•  “There is always a scenario that you can run in which the market price can be justified” (no matter how ridiculous). Our job is to resist basing our valuations on those;
•  ”No matter how careful you are in your projections, you will be wrong 100% of the time” (yes, very true!). You will never get all of the numbers perfectly right in every period. Then what is the point in running these models? “You just have to be more right than the market or next best analyst.” (Part of the reason I rarely do discounted future flow models is because of the inherent optimism bias in such models. When it comes to valuation of assets, I am a skeptical pessimist. I started my career as a credit analyst—possibly the most skeptical people on Wall Street— because it came naturally to me. So, if a skeptical pessimist like me knows that he should not use models that base valuations on projections because they are likely to be too optimistic, what does an irrational optimist who has no self-knowledge come up with in their discounted future flow valuations? I suspect it is something close to the market consensus);
• “Bias is the biggest enemy of good valuation;”
• “Thank God for institutional investors because they buy when everyone else buys and sell when everyone else sells, which creates opportunities for us;”

 Mature Companies in Transition

•  “Run two models: a status quo model and one where an ideal manager—you—could optimally restructure the firm;”
•  “Unless you are a depressed person, your restructured firm will always be worth more than the status quo firm;”
• How do you get more cash flow out of existing assets? “Two ways to lower the cost of capital that few think about: 1) match funding to lower default risk in the company’s bonds (and so pay less in interest); 2) make products less discretionary (e.g. branding).” Cell phones were a discretionary product when they first came out. Now they are indispensible;
• “Watch out for legacy costs” (I always look for unfunded pension and health liabilities before I invest in any company. Many companies and municipalities are going to be bankrupted by these costs. These important liabilities should be placed in the liabilities section of the balance sheet and deducted from book equity, but they are not. They are relegated to footnotes that take time to be dissected);
• “I always sell when a growth company makes a large acquisition.” Acquisitions are the worst of all possible growth strategies for improving shareholder wealth. The worst of the worst is acquisitions of public companies because the buyer must pay a significant premium over market value;
• The best managers for companies and industries in a decline are those who do not fight it. The best harvest in a decline. Eddie Lampert’s problem is he cannot harvest and sell the real estate as he had planned through the decline of Sears and Kmart;
• Truncation risk—i.e. default—cannot be accounted for by adjusting discount rates (that is obvious and truncation risk is the most dangerous for valuing deep value companies. An equity analyst needs to have strong credit skills in order to account for these risks);
• Financial services companies are opaque (So true, we gave up trying to analyze multinational banks a long time ago. A quote by Joe Rosenberg in the 12/5/11 Barron’s says it all: “…it’s impossible to figure out what banks own, even if you are on the inside.” I have been saying the same thing since 2007; there is no way that Prince and Corzine had a clue of what was happening right under their noses);
• By AD’s estimation, Citigroup could devote all of its free cash flow over the next five years in an attempt to meet the new Basel rules and that still would not be enough to pass. How on earth can they be paying a dividend?

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• Who is this guy? Why would Buffett pick an unknown manager/firm?
• How could someone be such a good investor and remain relatively unknown?
• Weschler has one investment employee working at his firm and one assistant. How could someone running a tiny office fill Buffett’s shoes?
• Why is Buffett once again tapping a hedge fund manager for a successor? Is he changing his approach to value investing?

I will address each question:

Why Would Buffett Pick an Unknown?

Of course Buffett has to pick an unknown investor from an unknown firm. Virtually all of the known investors at known firms are employees of great marketing firms–that’s how you know who they are–but they are usually not great investors. Virtually all of the known firms have business models that rely on well-oiled marketing machines to gather assets because they are paid on the size of the assets that they manage, not on their performance.

As asset gatherers, the known investors must ensure that they never fall too far behind the rest of the market and their competitors. The only way that they can ensure that they keep pace is by becoming a closet indexer–someone who pretends to spend a lot of effort on security selection but who, in reality, merely invests in each of the large companies in a large-company index, plus or minus minor adjustments for aesthetics. Of Course, Buffett, a value investor, does not invest that way even now.

How Could Someone be a Good Investor and Remain Relatively Unknown?

For almost their entire careers, most of the world’s best investors remained unknown by the overwhelming majority of the investing public. They generally have long periods when they are accessible to only a few savvy people/firms, and then they suddenly find themselves in the spotlight after reaching a tipping point. Welcome to Ted Weschler’s “moment.” Another example: Hardly any but a small number of savvy professionals heard of Peter Cundill before he died in January 2011. It took a posthumously published biography for many to know his record and style, and even now few have heard of him. Ironically, the lack of attention is what helps make value investors, great investors. By the way, it is no coincidence that most of the world’s best investment managers (by long-term performance) also happen to be value investors.

How Could Someone Running a Tiny Office Fill Buffett’s Shoes?

Are you kidding me? Most of the world’s best investors work alone; they avoid investment committees like the plague. Committees lead to group-think and group-thinking leads to bad investment decisions. They diligently read through financial statements, talk to a company’s customers, and meld dozens of pieces of information to form a unique view; they do not delegate that very important work.

The general attitude behind this third question is: “You aren’t structured like Fidelity or American Funds, you don’t have the resources that they do, and you don’t have a lot of experts on staff to which you can delegate work, so how can you be any good?” They fail to grasp that great investing does not take a lot of experts and IQ points, and that because of technology, a single investor has more resources at his fingertips than Fidelity did just ten years ago; it is how those resources are used that matter, not the number of them. As Buffett himself once said about what it takes to be a successful investor (I paraphrase), “Any IQ points over 125 are wasted.”

Also, contrarian value investors who run concentrated portfolios don’t need experts on staff as much as they need a strong constitution. Great investing is simple, but it is not easy. It is not difficult to read financial statements, have a view of a business’s competitive position, draw conclusions about the business’s prospects, and know whether its market price is low enough to offer a margin of safety. But, it is difficult to invest only when one has a margin of safety because for the price to be low enough to provide a margin of safety, nearly everyone else has to disagree with your view.

Contrarian, margin-of-safety investors must go against the herd. As Michael Mauboussin has explained about great investing: “A proper temperament beats a high IQ every time.” Finally, most of the Superinvestors that Buffett highlighted in his Superinvestors speech at Columbia University (see tab above) worked alone or with minimal staff. It is only the marketing machines that need a large staff and that consists mostly of marketing and legal professionals. Oh, and by the way, Buffett himself invests alone in a tiny office.

Why is Buffett Hiring Another Hedge Fund Manager to Succeed Him?

True value investors must use something like a hedge fund structure (or be an insurance company like Berkshire Hathaway with permanent capital) to improve the odds of generating alpha. Value investors must have a long-term view and hedge funds can be structured so that their investors cannot redeem for extended periods. Value investors must run concentrated portfolios and hedge funds allow the most freedom to do that. Value investors must be contrarian and hedge funds help insulate hedge fund managers from the daily scrutiny that would make contrarianism nearly impossible for the average person.

Finally, as I demonstrated in investor communications, Warren Buffett began his career as a hedge fund manager and remained one for ten years. Buffett contributed $700 of capital at the launch of his hedge fund in 1957 and his friends and family contributed another $100,000; most of today’s great investors started that way with small amounts of capital from friends and family.

Today, Buffett still behaves as a hedge fund manager but one with the ultimate luxury–permanent capital. I listed Buffett’s first business model as one that I  would emulate for my own fund. It should not be a surprise that many still relatively unknown, but extremely successful value investors also emulated Buffett’s hedge fund structure and philosophy. It should not be a surprise that virtually all of these great investors started small and stayed small for a long, long time thus enabling them to stay under the radar.

But don’t just take my word for it, read what Buffett wrote in a letter to his hedge fund partners on January 20, 1966:

“Last year in commenting on the inability of the overwhelming majority of investment managers to achieve performance superior to that of pure chance, I ascribed it primarily to the product of: “(1) group decisions – my perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions; (2) a desire to conform to the policies and (to an extent) the portfolios of other large well-regarded organizations; (3) an institutional framework whereby average is “safe” and the personal rewards for independent action are in no way commensurate with the general risk attached to such action; (4) an adherence to certain diversification practices which are irrational; and finally and importantly, (5) inertia.”

In each of these ways, Ted Weschler is an ideal candidate to eventually replace Buffett.

For some of the media reaction, see:

http://online.wsj.com/article/SB10001424053111903532804576569142588655126.html?KEYWORDS=weschler

I’ll bet that Jason Zweig, a Ben Graham biographer, is as amused by the reaction as I am, but he keeps it together on the video in the story.

For an interesting take on Buffett’s transition from an obvious hedge fund manager to a less obvious one with permanent capital, see the Joe Taussig paper embedded in a link at the bottom of this blog post:

 http://www.santangelsreview.com/2011/09/05/dan-loeb-of-third-point-to-create-a-reinsurance-company/

Taussig Capital is a Zurich based consultant to hedge fund managers.

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I liberally copied from the business models used by Ben Graham, Warren Buffett, David Einhorn, Seth Klarman, and Mohnish Pabrai. Those investors started small with family-and-friends capital; employed a value-investing philosophy; invested through a private partnership structure (i.e. a hedge fund); recruited smart investors; and were willing to return capital in order to protect returns when there were few opportunities. So, it is comforting to know that my partnership’s returns are virtually identical to Greenlight’s (Okay, we are doing better than Greenlight YTD). We, like Einhorn, do not believe it is time to go all-in, to understate the issue, but that day may come soon, to the market bulls’ chagrin. We can only hope that investors reward our caution with a flood of capital when the appropriate time arrives.

The Money quote in Einhorn’s second quarter letter:

On the losing side, the consumer cyclical short that hurt us most in the first quarter hurt us again in the second quarter. In this bifurcated market, there are a small number of stocks that seem to be going up simply because they are going up. Stock price momentum investing is not a new strategy; we saw how it worked in the extreme during the internet bubble. One difference between then and now is that during the internet bubble, the market categorized stocks into “new economy” and “old economy.” It was relatively easy to pick out the dangerous stocks. This time the distinction is less clear. A number of the momentum stocks have good stories, but many others really have very little going for them, except for a rising stock price. Earnings disappointments, dilutive acquisitions, slowing growth rates, regulatory problems, heavy insider sales, rising competition and even SEC investigations seem to have no impact on the handful of momentum stocks leading the market at this time. Despite trying to carefully pick our spots and to size the positions appropriately, we continue to have exposure on the short-side to a couple of these freight trains. Though we don’t know when the turn will come, we believe that there is substantial downside to the prices of these short positions.

Amen, brother.

Enjoy: http://cache.dealbreaker.com/uploads/2011/07/Greenlight-Capital-Q2-Letter.pdf

H/T: Santangel’s Review (Link can be found on the right)

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The Google document:

https://docs.google.com/viewer?a=v&pid=explorer&chrome=true&srcid=0B7X_KYnqpniZNTY4YjdkY2UtNjU5Ny00ZmYxLTg0YWItODJkMWY0ZjBhNzA1&hl=en_US

I disagree with the conclusion (Munger’s or II’s? page 2) that Ridley fell in love with the division of labor as the sole explanation for economic success. Ridley showed that throughout history and in various cultures, trade led to specialization which led to Ricardo-like increases in wealth. He showed that the freedom to trade is one of the most important drivers of economic success and that such success usually leads the powerful collective elements–clergy, military, government, etc.–to appropriate for themselves larger shares of wealth from the less powerful individual entrepreneurs. That is, the success that was born on political and economic freedom often leads to conditions that are less free.

Ridley’s prescription for stagnation isn’t that we need more division of labor; it is that we need more freedom.

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