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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LinkedIn (LNKD) announced that they met Thomson Reuters analysts’ expectations for earnings at $0.16 per share this quarter. In addition, second quarter revenue at $228.2 million, beat analysts’ expectations of $215.7 million. The stock is currently up over 12% on that news.

Then there is the pesky bit about profits and cash flows; you know, those items that compensate investors for allocating capital to a firm. Net income was $2.8 million, down 38% from the same quarter a year ago. Why? Well it seems earnings took a big hit when executives congratulated themselves with large option and stock payouts this quarter compared with one year ago. In fact, the $0.16 EPS figure was a non-GAAP measure.

When taking executive comp in stock and options into account, EPS was actually $0.03. The company would like investors to look the other way on the latter number. I would too if I just confiscated 81% of my firm’s profits in the quarter.

If we extrapolate these best-ever quarterly revenue numbers over a whole year, then LNKD is trading for 10.6 times sales (it is actually trading at 15 times TTM sales). LNKD has a market capitalization of nearly $10 billion. In order for LNKD to turn itself into the next growth story like Apple and bring its price-to-sales ratio in line with Apple’s very high 3.8 multiple, LNKD would have to almost double its sales. In order to bring that multiple in line with the rest of the large-cap market, it would have to increase sales 768% (almost 8 times!!!!).

Don’t get me wrong, I like LinkedIn’s services. I am already contemplating abandoning Outlook contacts. But, aren’t all unemployed professionals already on LinkedIn? Where is growth going to come from?

Then there are the other pesky metrics. Trailing PE of 952. Forward PE of 152 (not including the 38% decline in profits). Price-to-cash flow multiple of about 100. Price-to-book of about 100. And, a 2% net profit margin after management takes its exorbitant cut. If you are an investor in LNKD and don’t know who the mark is at this poker table, it is you.

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In Hedgehogging, among other topics, Biggs writes of the trials and tribulations of starting a fund, the difficulties of shorting (the hedge in hedge fund) and he reminisces about how he appeared as a dunce to the young, upstart managers (and some of his fund’s investors) because he warned repeatedly in the late 1990s that the internet bubble was going to end badly and so he refused to participate in it.

To many young guns he was past his prime, out of touch, should be put out to pasture, he did not understand that “it was different this time.” And, of course, the knowledge that he accumulated over the years–wisdom–turned out to be absolutely correct in the end. Unfortunately for many fund managers, value managers in particular, the bubble inflated for too long and it put them out of business as their investors redeemed to put their money in the latest, hottest fund.

One of the most insightful parts of the book for me was his discussion of the value of gold and other jewelry. As a value investor, I find it hard to appreciate precious metals and stones because I find it hard to place a value on them. Their value is almost completely subjective. Biggs drove home the point that they are literally lifesavers in the most distressed of periods–e.g. the get-out-of-Nazi-Germany kind of periods when the only assets that you can keep are the jewelry you can carry and hide on your person.

Unfortunately, I strongly disagreed with Biggs in the last chapter, so it stayed with me and allowed me forget the value of the previous chapters. Biggs defended Keynesianism with the kind of vigor reserved for zealots, as in this sentence (emphasis mine), “To be truly taken as the economic savior of civilization, Keynes needed to present a conventional face to the world” which discussed his marriage to Lydia. Biggs attributes the end of the Great Depression to Keynesian economics.

I suspect that when the current debt crises that are cascading in practically every western economy are finally resolved, objective minds will have an entirely different view of Keynesian economics. It was Keynesianism that justified large government spending after all, and a sheep-like political class was only too happy to use Keynesianism in their re-election bids. There is no easier way to get re-elected than to spend taxpayer dollars (not your own) on your constituents. Keynesianism will have had a century-plus run, but century-plus runs are not uncommon for many failed ideologies. The latest century-survivor to fail is communism, which was considered by many in its day as more economically efficient than western capitalism and therefore unstoppable. It was considered efficient in the west in part because of Keynes.

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Really? See what CNBC’s Cramer said at the end of September, long after NFLX peaked in July:

http://www.youtube.com/watch?v=aTOXlWi96Gw&feature=player_detailpage#t=2s.

Most of the people who today are saying that they expected this are lying…to themselves. They are not trying to pull the wool over your eyes; they have pulled the wool over their own. They extrapolated out for several more years the rise from $50 in January 2010 to $304 on July 2011. They envisioned what they would do with the proceeds of a sale in 2015 of their 100 or 1,000 shares when the price of NFLX reached $7,000. So, paying six times sales in July was as natural as breathing. 

If you think it is easy being short a company like NFLX, then were you? An analyst as thorough as there is and an experienced short seller—Whitney Tilson—could not hack it. It seems he could not stand the day-after-day upward momentum in this stock, often in large chunks, and he covered his short earlier this year just a few months after writing an excellent piece on why NFLX was a great short.

I am beginning to firmly believe that contrarianism is something that one is born with or seriously conditioned for at a young age. To be a good short seller, one has to have contrarianism in their DNA or their brain needs to be wired a certain way early in life.

I have attached a chart of NFLX’s price movement. The numbers are staggering to me, it had a momentum all its own. If you were not short in this period but today believe the 75% drop was inevitable, try to imagine what it was like at the various inflection points in this chart before July 13, 2011.

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“…the fact he is seeking cash from any source is somewhat encouraging.”

A closer look will reveal that the last time Klarman sought capital was early 2008, which Klarman verified in a speech that I attended at the CFA Institute’s Annual Conference in 2010. He raised that cash in early 2008, not because he wanted to put that cash to work immediately, but because he felt it was highly likely that markets would become distressed soon and that the best time to raise capital was before they became distressed.

For example, I tried desperately to raise capital for the first time in late 2008 and early 2009. I would eventually be more than fully invested by March of 2009 as I exploited all of the bargains that existed in that period. But, it was too late to raise cash in late 2008 and early 2009 when the best opportunities were just sitting there; trying to raise capital to invest was nearly impossible given the rampant fear.

As any good contrarian would, Klarman waited until the markets became distressed in late 2008 and then put all of that fresh capital to work.  When Jason Zweig asked him at the CFA conference how easy it was for him to do that given all of the fear that existed, Klarman said it was remarkably very easy for him. I agree, the amount of low-hanging fruit was remarkable, which was why I went all in and even used leverage for the first time in the first quarter of 2009.

The point is this: the author of the attached story has it wrong. Klarman is not seeking fresh capital because he believes that there are plenty of bargains available now, which would be an encouraging sign. No, Klarman is seeking fresh capital now because he believes that markets will soon become distressed again. He will bide his time until then, and then he will pounce.

That is exactly what we are doing….again. We are nearly at a net long position of zero, the lowest since launching the fund. We have plenty of cash and shorts waiting for what seems like the most-telegraphed debacle in a long time. People do not change their behavior overnight on their own volition, but a massive change in perspective and behavior is what is required to make a real, permanent fix in the global economy.

Equity is going to have to be king again and that equity is not going to come from China, much as the optimists are hoping; it is going to have to come from savings and retained earnings, which is going to require a new way of viewing the world and of operating. Because most around the globe believe that they are entitled to much more than what they can earn, the disruptive forces could be devastating.

One important note: We are not macro investors nor do we place much weight on forecasts. In fact, we believe it is best to ignore forecasts and search for value company-by-company from the bottom up–to seek asymmetric opportunities–which is exactly how we operate. Our research is uncovering few bargains–few asymmetric opportunities that have a high margin of safety–so we think risks are high. To manage risk, we focus hard on seeing the world–the big picture–as it exists today based on facts that are knowable today, not forecasts. The biggest risk is not volatility, but high levels of asset prices relative to knowable, fundamental values–the lack of a margin of safety.

Those who think that the Mr. Market has already factored a debacle into asset prices must explain why, in equity markets, the CAPE is way above its historical average and Tobin’s Q is near its all-time high except for the peak reached during the dot com bubble. They must believe that one of the most outstanding spurts of global growth in history is just around the corner, as if the cotton gin, combustion engine, or microchip were just invented last month and will be put into mass production this month. Is the iPhone 4s or iPad 3 the equivalent of the cotton gin?

http://www.institutionalinvestor.com/Article.aspx?ArticleID=2919905&LS=EMS579703

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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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http://viewer.zmags.com/publication/d1f7adef#/d1f7adef/36

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Our fund declined 13.7% in August vs. -5.4% for the S&P 500, -4.0% for the Dow and (minus) 6.4% for the Nasdaq.  Year to date, it’s down 22.1% vs. -1.8% for the S&P 500, +2.1% for the Dow and -2.2% for the Nasdaq.

On the long side, our portfolio got clobbered across the board despite generally good company-specific news regarding our major holdings (discussed below).  Amidst a tumultuous month in the markets, investors dumped stocks that were even slightly illiquid, or that are valued primarily on future, rather than current, profits – both traits that characterize many positions in our fund.

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“Since the investors of the ‘I Know’ school, described in chapter 14, feel it’s possible to know the future, they decide what it will look like, build portfolios designed to maximize returns under that one scenario, and largely disregard the other possibilities. The suboptimizers of the ‘I don’t know’ school, on the other hand, put their emphasis on constructing portfolios that will do well in the scenarios they consider likely and not too poorly in the rest. 

Investors who belong to the ‘I know’ school predict how the dice will come up, attribute their successes to their astute sense of the future, and blame bad luck when things don’t go their way. When they’re right, the question that has to be asked is ‘Could they really have seen the future or couldn’t they?’ Because their approach is probabilistic, investors of the ‘I don’t know’ school understand that the outcome is largely up to the gods, and thus that the credit or blame accorded the investors—especially in the short run—should be appropriately limited.

The ‘I know’ school quickly and confidently divides its members into winners and losers based on the first roll or two of the dice. Investors of the ‘I don’t know’ school understand that their skill should be judged over a large number of rolls, not just one (and that rolls can be few and far between). Thus they accept that their cautious, suboptimizing approach may produce undistinguished results for a while, but they’re confident that if they’re superior investors, that will be apparent in the long run.”

Marks opened his Chapter 14 with three great quotes, one of which I use all of the time:

We have two classes of forecasters: Those who don’t know–and those who don’t know they don’t know. –John Kenneth Galbraith

He closed the chapter with a quote that I will have to start using often:

It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that just ain’t so.”–Mark Twain

As Marks said, “…investing as if you know what’s coming is close to nuts.”

Are you prepared to pick off bargains, or are you one of the people in the “I know” school who was fully invested on July 7 and selling indiscriminately today? Can you trust your contrarian instincts when those instincts are supported by hard, knowable data, or will you follow the herd and the prognosticators? Which way you answer often accounts for the difference between investment success and failure.

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Like Klarman, Prem focuses on managing the downside and lets his value-investing philosophy and process take care of the upside. Prem had opened large short positions and bought Credit Default Swaps in the known bad guys–Bear, Lehman, Fannie, Freddie, etc–before the financial crisis and his investors profited handsomely. Here are some of his thoughts about current macro conditions:

First and foremost, we take a long-term, value-oriented view. That said, we currently believe that most markets are overpriced and we are not being adequately paid for risk. As a result, we have taken a number of steps to hedge our portfolios.

Amen, brother.

Source: CFA Magazine: http://viewer.zmags.com/publication/d42aa7ee#/d42aa7ee/25

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