BeyondProxy linked to this rare footage of Cundill speaking of his investment philosophy (Value) and approach to capturing the value premium. Peter, a Canadian, found that no matter what was happening in the home market, there was usually a market in which one could find plenty of beaten up stocks. He made it his mission to spend several months each year in the country that had stocks that had been beaten up the most in the prior year. Hence, There is Always Something To Do, which can be found in the bookstore above.

Peter suffered from a neurological condition, which was diagnosed soon after he gave this lecture, and he died in 2011.

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“Every day you’re not selling an asset that’s in your portfolio, you’re choosing to buy it.”

The idea is that managers have to look at everything fresh every day in light of all new information, so that holding a position is no different from buying it, especially if there are no tax implications for selling (e.g. positions in retirement accounts, endowments, etc.). That perspective helps prevent managers from falling in love with their positions. It’s akin to Sir Arthur Quiller-Couch’s admonition for writers to “Murder your darlings.”

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Among my clients’ ten corporate exposures is a gambling-related company (and it’s also a spinoff) and a defense-related company (a spinoff)–the “bets and bombs” components of the “butts, booze, bets and bombs”. PAR previously invested in the butts (UVV) and booze (TAP) and other bomb (NOC) components. It is much easier to find a Margin of Safety in these areas. Enjoy:

http://blogs.wsj.com/moneybeat/2015/02/13/sin-vestors-can-reap-smoking-hot-returns/?mod=djintinvestor_t

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“Over the past 100 years the returns from smaller companies have exceeded those of larger companies. It is also true that stocks with low valuations (i.e. lower prices relative to earnings and book values) have generated better returns than those with high valuations. What is less certain is whether these tendencies will continue in the future…”

–Burton G. Malkiel, criticizing investors like Buffett who have captured factor premia for decades

To be fair, Malkiel goes on to list other reasons to be skeptical of smart beta, but number one is that it might not work in the future. Malkiel’s comment is almost akin to a health policy expert telling us, “Sure, Jonas Salk’s polio vaccine has worked for 62 years, but let’s give it a little more time before we declare victory.” I guess we will never know whether the polio vaccine will become ineffective, but that doesn’t mean we shouldn’t exploit its use today. But, Malkiel would condemn investors into accepting market risk in order to receive reduced fee invoices. What if you didn’t want market risk? Or, what if you wanted more risk than the market provided (as PAR did in 1Q09 when it used some leverage to become fully invested)?

Factor premia have existed for more than 100 years. The premia exist either because of sub-optimal investor behavior (mostly my view) or because factor investors are being compensated for risk (mostly the view of EMH proponents). Either way, factor premia are not likely to disappear for the long-term investor, so we might as well exploit factor premia for the long-term portion of our portfolios.

https://blog.wealthfront.com/smart-beta/

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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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“…around 50% of our assets are in cash, and that’s a very high absolute number, now around $14 billion and rising…”–Seth Klarman

I recently came across this quote from Seth Klarman of the Baupost Group, which he said during a speech that he gave at James Grant’s Investment Conference in October 2013 (http://www.grantspub.com/mygrants/viewarticle.cfm?aid=4995).

If anything, Seth has less capital employed now than he did then.

If I had to pick one investor with whom I felt closest philosophically (and operationally), it would be Seth. PAR is currently sitting on cash equal to 55% of client capital because our bottom-up process has revealed few bargains and PAR has just about enough invested in the bargains PAR has uncovered.

As readers of PAR’s holiday card may have noted, I now view cash the way Buffett’s biographer believes Buffett views it: Cash is an option on thousands of companies and each option has no strike price, no expiration date, and no premium cost other than the lost purchasing power due to inflation. At current inflation rates, the premium is low.

This is the strongest argument to the oft-asked question: Why should I pay [Investment Manager] to hold cash? The answer, of course, is that they are paying [Investment Manager] to have the discipline to buy perpetual options on companies that will one day provide a margin of safety. [Investment Manager] “finds” these perpetual options by selling positions that become fully valued in inflated markets. It takes discipline to sell at or near full value when markets have been rising. Clients who believe that they could do the same as [Investment Manager] need to be introspective and seriously question (and answer honestly) whether they held significant amounts of cash in 2007 and employed it fully in 2009.

Coming into 2014, the market in general was overvalued as evidenced by the CAPE, Tobin’s Q, profit margins, etc., but patient investors will get their opportunities. Those with dry powder, who have been sitting on a perpetual option on every company–i.e. sitting on cash–will be the ones who exploit those opportunities.

My friend Chris Cannon attended Grant’s conference last fall and took some notes from Klarman’s speech that day that I have condensed. Enjoy:

“Seth is a great worrier.  He worries top down but invests bottom up.  He says top down analysis is a lot like sports talk radio – lots of talk and opinions…

Most investors/portfolio managers feel a gun to their head to get fully invested.  This is a weakness…

…if (Baupost) thought the world was going to collapse tomorrow then they wouldn’t return the cash. So he can’t figure out the timing.  But if it does collapse he will ask his investors for more cash…

His biggest concern is that his investors take the cash he returns them and place it with a manager putting up big numbers over the past few years, especially the last two. “This is a recipe for disaster.”  He’s encouraging them to protect it…

Nobody in the White House or the Fed has any practical business experience and handing the reigns to another academic seems totally nuts to him…

He thinks big cap companies (like Jeremy Grantham’s high quality) aren’t mispriced enough for him to do anything interesting with them…

(Because of LBO recaps and refinancings, Y)ou don’t need an economic downturn for a crack up (in high yield), just slightly higher yields… So a crackup in high yield is very, very, likely…

It’s embarrassing that after a crisis that nobody saw, government policy continues pouring on more gas to fuel more speculation to get things (stocks, real estate, debt) back to the same place we were, or maybe even worse now…

It took him at least 15 years of repeating his ideas so clients can see them really work and then they sink in.”

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http://post.nyssa.org/nyssa-news/2011/05/book-review-the-big-secret-for-the-small-investor.html

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