Which Buffett Quote Best Describes the Place Where You Work?

I’ve recently finished reading Jeremy Miller’s excellent book: Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor. The book is a collection of experts from Warren Buffett’s letters to his partners  in the Buffett Partnership.

The book is jam packed with wisdom along with early glimpses of the inimitable Buffett style of self expression that regular readers of his Berkshire Hathaway annual letters know well.

There are two passages in particular that stood out to me. The first comes from a letter written mid-way through the life of the partnership. The partnership had been running for 8 years and fund had performed exceptionally well, much better than Buffett’s Dow Jones Industrials +10% (yes that’s right, +10%!) target annual return.

Buffett explains why he thinks he’s been able to achieve such spectacular results:

January 18, 1965

In the great majority of cases the lack of performance exceeding or even matching an unmanaged index in no way reflects lack of either intellectual capacity ore integrity. I think it is much more 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 well-regarded organization; (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.

Notice that every factor listed by Buffett is behavioral. It’s not a lack of brains, information or effort that undoes the hard work of most investors; its the institutional environment that they work in and the effect that this has on their behavior.

Buffett decided to close the partnership in late 1969. He was finding it increasingly hard to find new opportunities as more and more investors got caught up in the Go-Go  years, when the share prices of conglomerates were bid up to unsustainably high-levels. He was also now independently wealthy and looking for a new challenge in life.

In one of his last letters, Buffett sincerely thanks his partners for their support:

February 18, 1970

My activity has not been burdened by second-guessing, discussing non sequiturs, or hand holding. You have let me play the game without telling me what club to use, how to grip it, or how much better the other players are doing. I’ve appreciated this, and the results you have achieved have significantly reflected your attitudes and behavior. If you don’t feel this is the case, you underestimate the importance of personal and empathy in maximizing human effort and achievement.

The phrase that stands out to me is this: “the results you have achieved have significantly reflected your attitudes and behavior”.

I believe that there’s a lot of truth to this statement. Success or failure really does depend on our behavior and the culture of the organization that we work for.

 

Q: Why Does Apple Look Cheap to Warren Buffett?

A:  Because it’s as cheap as it’s ever been when measured using Buffett’s preferred valuation metric – Price-to-Owner Earnings*.

AAPL

Buffett explains how he calculates owner earnings in his 1986 Berkshire Hathaway shareholder letter:

If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)

Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since( c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”

Apple is very cheap when compared to other famous Berkshire Hathaway investments.

For example, the price-to-owners earnings ratio of Coca Cola – one of Berkshire Hathaway’s largest stock holdings (14.43% as at 31/3/2016 according to the 13F filings of Berkshire Hathaway) is currently 26.4 times.

KO

Apple is currently offers an attractive owner’s earnings yield of  11.5%, meanwhile Coca Cola’s owner’s earnings yield is a low 3.8%.

Not only is Apple significantly cheaper than Coca Cola, it’s historical revenue growth is more than 10 times as fast.

Rev AAPL and KO.png

Apple is also significantly more profitable. It’s return on assets (RoA), or profitability ignoring the use of debt is 20.5% compared to 8.1% for Coca Cola.

ROA AAPL vs KO

* Charts courtesy of www.gurufocus.com

Flaubert

Dictionary of Received Investment Ideas

My reply to Riccardo’s comment on my previous post got me thinking about putting together a “Dictionary of Received Ideas” for Investments.

The inspiration for my idea comes from the Dictionary of Received Ideas or Le Dictionnaire des idées recues as it is known in French. The book is a short satirical work by the famous Gustave Flaubert, author of the classic novel Madame Bovary.

Despite being a member of the middle class, Flaubert developed a strong dislike of the beliefs, attitudes, prejudices and misinformed opinions of the bourgeoisie. He collected them for over 30 years, eventually compiling a dictionary to lampoon “the silly remarks that almost give me vertigo”.

Here are some examples:

ABSINTHE. Extra-violent poison: one glass and you’re dead. Newspapermen drink it as they write their copy. Has killed more soldiers than the Bedouin.

MELON. Nice topic for dinner-time conversation. Is it a vegetable or a fruit? The English eat it for dessert, which is astonishing.

OLD PEOPLE. When discussing a flood, thunderstorm, etc. they cannot remember ever having seen a worse one.

ITALIANS. All musical. All Treacherous.

The ideas listed in Flaubert’s dictionary were “received” from other members of the middle class and simply believed. Nobody seemed to examine the logic (or otherwise) of these statements, nor did they make any attempt to check the facts.

In other words, the accuracy of the beliefs was less important that the fact that everyone believed them. Social proof was the only proof that mattered.

I’m guessing that this, together with hearing the ideas repeated over and over, is what annoyed Flaubert so much.

This raises two interesting questions:

  1. Are there “received ideas” when it comes to investing?
  2. If so, what are some of these received ideas?

The answer to the first question is a definite yes. Investors are confronted by these beliefs on an almost daily basis. Sometimes I feel that I can relate to poor Flaubert, especially when these ideas are repeated by people that should know better.

What are some of these received ideas? Here are a few examples (in no particular order):

  • Higher GDP growth results in higher equity market returns.
  • The “illiquidity premium” is a given.
  • Its possible to know the reason why the stock market rose or fell on any given day.
  • Paying attention to economic forecasts will help you to be a more successful investor.
  • Older investors, at or near retirement, should always have a higher allocation to fixed income investments.

The tricky part with some of these received ideas is that they often contain a kernel of truth that either depends on a certain set of conditions being present, or that has been misconstrued or misunderstood.

So rather than simply dismiss the received idea, it’s better if we can identify the point where most investors have gone wrong in their understanding of or their application of the idea.

For example, here’s an article that I wrote several years ago for Investment Magazine explaining why higher GDP growth doesn’t necessarily translate into higher equity returns.*

I think it would be more interesting to hear from you, my readers. What are some of the received ideas that you’ve encountered? Please share them by commenting on this post. Together we can put together a Dictionary of Received Investment Ideas.

* For those of you that are more interested in this topic, I suggest that read the following papers:

Dimson, Marsh and Staunton, Credit Suisse Global Investment Returns Yearbook 2014, pages 18-29.

Dimson, Marsh and Staunton, Credit Suisse Global Investment Returns Yearbook 2010, pages 13 – 19.

MSCI, Is There a Link Between GDP Growth and Equity Returns?

BobbleheadDwight

Are Boring, Predictable and Ostensibly “Safe” People More Likely to be Promoted?

It’s an interesting question. In his excellent book, A Short History of Financial Euphoria, economist John Kenneth Galbraith writes:

Finally and more specifically, we compulsively associate unusual intelligence with the leadership of the great financial institutions – the large banking, investment banking, insurance and brokerage houses. The larger the capital assets and income flow controlled, the deeper the presumed financial, economic and social perception.

In practice, the individual or individuals at the top of these institutions are often there because, as happens regularly in great organizations, theirs was mentally the most predictable and, in consequence, bureaucratically the least inimical of the contending talent. He, she or they are then endowed with the authority that encourages acquiescence from their subordinates and applause from their acolytes and that excludes adverse opinion or criticism. They are thus admirably protected in what may be a serious commitment to error.

What do you, my readers think? Is it true that boring, predictable and safe wins?

If it is true, then how do we reconcile this with the observation of John Maynard Keynes that the best long-term investors usually appear to be “eccentric, unconventional and rash in the eyes of average opinion“?

I think these are interesting questions. I look forward to reading your comments (if you dare)!

How can Investors Avoid Outsourcing Risk Management?

So what’s the answer in the Aussie market with Aussie clients, Fox?

Great question. I have a simple answer but unfortunately not everyone’s going to like it.

The truth is that most Australian fund managers are unlikely to offer a highly concentrated Australian equity portfolio that’s invested in a handful of stocks. The are very well aware of Professor Greenwald’s warning.

It’s a kind of suicide pact on your future because sooner or later you, if you’ve got a three, four or five stock portfolio in one industry it’s going to blow up.

This is especially true in Australia. The concentration of the Australian market at both the industry and the stock-level greatly increase the risk of short-to-medium term under-performance (for a detailed explanation of the reason why see l my earlier post HERE).

This greatly raises the stakes for Australian equity fund managers that dare to be different.

For example, I know a fund manager that manages a Sharia-compliant Australian equities fund. The fund does not invest in banks due to the Koran’s restriction on lending in exchange for interest.

The fund continually bounces from being the best-performing fund manager over the last month to the worst performing fund manager over the last month.

The swings in performance have very little to do with the stocks the fund manager is invested in and everything to do with the performance of the big four banks, which the strategy obviously does not invest in, that make up approximately one quarter of the Australian equity market.

Fortunately for this fund manager, the clients invested in this Sharia-compliant fund are not primarily motivated by benchmark-relative performance, otherwise they would probably be out of business.

There are other reasons why a fund managers are unlikely to offer highly-concentrated portfolios. One reason is that it limits the amount of money that they can manage, which obviously limits the amount that they can earn in management fees (for more information, see my earlier post HERE)

Still, I have a lot of sympathy for fund managers because it’s not all their fault. The truth is that their clients are also to blame.

Many institutions want to hire managers that can beat the market, however they find it difficult to be patient and to accept the short-to medium-term under-performance that inevitably comes from active management (for example, see my earlier post HERE and HERE)

So back to your question, what can Australian investors do? There are several possibilities:

  • Buy the index. This is not as dumb an idea as it sounds (please see my earlier post HERE).
  • Index the top 10 or 20 stocks and use active managers to invest in mid cap and small cap stocks.
  • Use factor based strategies, Momentum and low volatility have historically worked well in Australia.
  • Renegotiate with fund managers and only pay for the active investment component. I think this is fair but it will be hard to get fund managers to accept this.
  • Use no more than 2-3 fund managers in an Australian equity portfolio. This helps to reduce the problem of redundancy (or offsetting positions between managers).
  • Centralize your trading and only execute the net trades (see Professor Greenwald’s comments about AT&T in my last post HERE.

Each of these possibilities has potential benefits and drawbacks.

There is another possible solution. Some may think its risky but I think there’s an excellent chance that it will work. It looks something like this:

  1. Fire all of your current active fund managers. This will save a lot of time, money and effort.
  2. Appoint an index manager to implement a custom index supplied by you quarterly. This will be very cheap for an institutional investor.
  3. Find a group of fund managers that you think have skill.
  4. Figure out what their top mid and small cap stock picks are. This is easier to do that it sounds but I’m not going to tell you how to do it because I don’t give trade secrets out for free.
  5. Select the 10-12 highest conviction positions held by your group of preferred fund managers.
  6. Decide how much you want to invest in the 10-12 highest conviction names and how much you want to invest in the index. This will depend on your willingness to go through short-to medium-term under-performance.
  7. Create a custom index by blending the 10-12 stock “best ideas” portfolio and the index in whatever percentages you need to get your desired outcome.
  8. Get your index manager to implement the custom index.
  9. Repeat/rebalance quarterly.

Why do I think this will work? There are several good reasons:

  • You are ahead by 0.3% – 0.5% per year before you’ve even started thanks to the investment management fees you’re saving.
  • You’re probably saving a lot of money on brokerage and tax too.
  • You are relying on the “wisdom of crowds” by using the combined insights of several fund managers that you believe have skill.
  • You are removing the principal and agent conflicts that result in most fund managers failure to fully back their best ideas.
  • You are extracting the fund manager’s best ideas. There is ample academic research showing that best ideas beat the market.
  • You aren’t paying a high management fee for “risk management”.
  • You can switch managers at ZERO cost. Simply add or subtract a manager from your research and adjust your portfolio at the next quarterly rebalance.
  • The problem of redundancy or off-setting positions disappears.
  • You have full control of how different or similar to the market you want the portfolio to be.
  • The overall portfolio is really no different to the overall portfolio that you get when you invest in 5-6 fund managers. Only difference is you’ve cut out the middle men. If you want to know why I say this, use the contact form to get in touch and I’ll send you a detailed explanation.

I would be very interested to hear what my readers think of this idea. I look forward to reading your comments.

Bruce Greenwald

Lessons from Columbia Business School Part 1: You Cannot Outsource Risk Management

The Value Investing program at Columbia Business School was a fantastic experience. I was amazed at how much information we were able to learn. Professor Bruce Greenwald is an insightful and engaging teacher who commanded our rapt attention for 3 full days.

On Day 3 we discussed risk management and portfolio construction. It was here that Professor Bruce Greenwald explained why institutional investors simply can’t outsource risk management. Here’s a summary of Professor Greenwald’s logic.

  • For a fund manager, the risk of active management is under-performing the market and consequently losing clients.
  • From the perspective of an investor who can diversify across multiple fund managers, the risk of active management is paying a fund manager for active investment and getting market returns at a high cost.
  • The two definitions of risk are irreconcilably different. Clients want fund managers to concentrate their investments in a handful of their best ideas. Meanwhile fund managers want to hold portfolios that are more diversified and more closely resemble the market.
  • Unfortunately, institutional investors often try to outsource risk management by awarding benchmark-relative investment mandates.
  • Doing so leads to poor results as this invariably leads to managers holding off-setting positions.
  • In effect, the client pays an active fee on the whole amount invested, while only a small fraction of their investment can truly be considered active.
  • Thus, the true fee paid by the client for active management (fee divided by the amount of the portfolio that differs from the benchmark) is enormous.
  • The only way to avoid this is to stop outsourcing risk management.
  •  This can be done by hiring specialist managers that each concentrate on a different set of investment opportunities (assuming you can find them), instead of multiple fund managers benchmarked against the same market index.
  • The only investors that seem to do this are sophisticated endowments and high net worth individuals.

I know from personal experience that the problems that Professor Greenwald described are much worse in markets where the market capitalization-weighted index is heavily concentrated in a few industry sectors or stocks such as Australia, Scandinavia and Canada. 

His observation about the investment habits of sophisticated endowments is corroborated by Peter Bernstein in his excellent book Capital Ideas Evolving. Bernstein writes of David Swensen, the Chief Investment Officer of the Yale Endowment.

The experience with US equities is a clear example of how Swensen operates. Yale hired no big-name managers in this market, and all of the managers of U.S. equity run specialized portfolios with relatively few holdings. One manager, for example, invests only in energy-related stocks, another only in real estate stocks, another only in biotech, and so forth. Moreover, these portfolios are highly concentrated in only a few stocks; the largest manager tends to hold only five to ten stocks, and at one point was down to three.

The result is huge tracking error against any of the major indexes like the S&P 500 or the Wilshire 5000. “There is no way you can succeed with active management if you try to control benchmark risk” Swensen declares: “You must be willing to deviate from the benchmark if you want to earn returns commensurate with the risks of owning equities. And you must be patient. These managers often lag, but they have done their homework and have no hesitation in just hanging in.”This is not a recipe for smooth returns, and the Yale U.S. equity portfolio has had a sequence of bumpy short-term rides to reach its spectacular long-term performance.

Many institutional investors have been heavily influenced by Yale’s success and have tried to obtain similar results by investing in private equity, property, real assets, hedge funds and other asset classes and strategies that are part of the “endowment model”.

I’ve always wondered why these investors were happy to follow Yale’s lead when it comes to expensive unlisted assets (where they almost certainly don’t have Yale’s competitive advantages), while at the same time ignoring Swensen’s advice on how to create a sensible multi-manager equity portfolio?

It seems to me that it’s because they just can’t bear the pain of short term under-performance in the pursuit of long-term gain (you can read a post on this subject HERE).

Another factor might be the widespread application of the Fundamental Law of Active Management.

The law states that a fund manager’s risk adjusted performance is a function of two variables. The first variable is the portfolio manager ‘skill’ in selecting securities. The second variable is breadth; the number of independent investment opportunities.

In other words, a fund manager can try to beat the market by improving their ability to select stocks, by considering more stocks as part of their investment research process, or by a combination of both. This is fairly straight-forward and makes sense.

Many institutional investors and consultants use this law as basis for recommending fund managers that cover a very wide opportunity set. For example, a consultant may recommend a global equity strategy where a fund manager is benchmarked against an index containing thousands of stocks.

But most people forget that the fundamental law of active management assumes that the quality of information that the fund manager has about each stock is constant.

Is it logical to assume that a fund manager has the same level of knowledge and understanding of each of the hundreds or thousands of stocks that make up the market? Unlikely. *

The reality is that a research analyst or a fund manager can only really cover a small number of companies in detail at a time. For example, James Valentine, former Associate Director of North American Research and Director of Global Training and Development at Morgan Stanley explains in his book Best Practices for Equity Research Analysts: Essentials for Buy-Side and Sell-Side Analysts.

One study showed that buy side analysts who covered fewer than 40 stocks, which was the mean for the sample group, did a better job in identifying the risks than those covering more than 40 stocks. In a study of sell side analysts, those in the bottom 10 per cent for forecasting accuracy covered 21 more firms than analysts in the top 10 percent.

…As a general rule, limit it to 35-50 closely covered stocks for an individual buy-side analyst and 15 to 20 stocks for a three person sell-side team. Analysts new to a sector or the investment process altogether should cut these figures in half. There are exceptions to this rule, but based on my experience, the top 10 to 20 percent of buy-side analysts who knew their stocks well enough to be ahead for the crowd and generate alpha were closely covering fewer than 50 stocks. From my perspective as a research manager, the best sell side analysts were those covering 5 to 7 stocks per team member.

Professor Greenwald seemed to think that even this was too many stocks for one person to cover successfully. He recommended that investors aim to develop specialist knowledge in 3-4 industries; offering Warren Buffett as an example of an investor who’s most successful investment are in a handful of industries (insurance, consumer non-durables, old media and banking) and in only a few stocks.

Even if you cover a handful of industries and companies, it doesn’t necessarily follow that all of them will be attractive investments at any given time. In other words, the number of stocks that a fund manager has genuine conviction in will be relatively few.

You can find out more about why focusing on a small set of stocks in my earlier blog posts.

Please follow my blog (click the button in the bottom right-had corner) if you would like to find out more about what I learned at the Value Investing program at Columbia Business School.

Finally, here’s  an extended  quote by Professor Bruce Greenwald’s taken from his lecture on risk management and portfolio construction.

Ok, what we’re going to talk about next then is building a portfolio. And here you have to understand a crucial difference between people who actually make investments and your clients. You (MF speaking of fund managers) have reputational and other risks they (MF institutional investors) have their wealth at risk.

They all invest in multiple managers, that means they are diversified across managers. That means in turn they’re not particularly interested in individual managers being diversified. They want you, especially the big smart endowments and the big smart family offices, they want to be specialized and concentrated. They are perfectly happy to have you hold 5 stock portfolios in one industry or two industries or three industries.

That is an unhappy situation for you because it exposes you to a lot of risk. There is always going to be that conflict if you’re managing money for other people and you are going to have to manager that.

On the one hand everybody says “Oh you just have to serve your clients” if you do that, that is in some sense taking on enormous risk for yourself. It’s a kind of suicide pact on your future because sooner or later you, if you’ve got a three, four or five stock portfolio in one industry it’s going to blow up. You’re going to be out of business, it’s going to be 4% of their portfolio and they’re not going to care.

You have to be aware of that conflict and you have to manage the balancing act between risk for yourself and risk for your clients.

If you are a client, the first thing you have to understand is you actually cannot delegate risk management. I’m going to tell you a story in a slightly different context but I hope you’ll see the implications for risk management.

The very first job that I did in Finance was at AT&T. I was working at Bell Labs and we were asked to look at the AT&T Pension Fund. At the time, it was a company that was one of the biggest companies in the world, they employed 1.1 million workers. They had 200 portfolio managers, each of whom operated independently.

This is back in 1979 when fees are very significant. So the first question we simply asked was: in any given week, how much of what one manager was buying was another manager selling? And what do you think that number was?

It was slightly over 90%.

That’s exactly what you’d expect with 200 managers. They are going to be replicating market sentiment and trading around it. And the reason it was so low, was that every year AT&T was putting more money into these pension portfolios, so they were net buyers as a whole so they couldn’t completely cancel each other out.

So the first thing we made them do was submit their orders to a facility, we time dated the orders so they got credit for the price when they wanted to sell or buy it, and then we only executed the net orders at the end of the week and that was an enormous saving.

Of the net orders – because we then knew what the net orders were – what percentage of it do you think was just buying the market?

93%, not quite 100%.

Because, you know, when you’ve got 200 fund managers, some of them are going to be optimistic about some sectors; some are going to be pessimistic about other sectors. When you average over 200 managers you are going to be basically buying the market.

So they were paying 50-70 points in fees for a lot of activity that cancelled out. And then just buying the market plus a 7% deviation. Well 70 bps on 7% means that for the actual investing process, they were paying fees of over 10%.

So what we wanted to do was, was buy index stocks and only pay these managers for the deviations. Needless to say that did not fly (MF the class erupts with laughter).

What does this have to do with risk management? If you decentralize risk management, if you’ve got a lot of managers, in the aggregate the positions of managers A, B and C are going to be offset consistently by the positions of managers X, Y and Z and you’re going to be paying them both for managing offsetting risks. Just like you’re paying these guys for offsetting transactions or offsetting net positions relative to the market.

Therefor this whole idea that hedge funds (MF or any other fund manager for that matter) can manage risk on a decentralized basis and they can do it so well that they’re going to charge enormous fees is just a really bad mistake.

You want to decentralize the process of investing, and you can do it both long and short, but you want to do the risk management yourself. If they do short ideas, they ought to do them because they believe they’re grossly over-valued stocks, not because they’re trying to manage the risk. Because I guarantee you one other of your managers is going to be doing that same stock long.

And it’s just going to be offsetting and you don’t want to pay for that. So you have to manage risk centrally.

* That said it is reasonable for quantitative investment managers to rely more on the breadth of the opportunity set to beat the market. This is because they generally aim to create portfolios of stocks that share one or more common attributes or factors (such as value or momentum) that have historically out-perfumed the market.

This is quite different to a fund manager employing a fundamental investment process to research and value each individual company. Therefore, the signal to noise ratio of quantitative investing is quite low, making breadth a more important variable in the performance of quantitative investment strategies.

On my way to Columbia Business School…

Columbia-Business-School1

Who says dreams can’t come true? I am lucky enough to be on my way to New York to study the Value Investing program at Columbia Business School – the intellectual capital of value investing!

The program is taught by Professor Bruce Greenwald, author of two excellent books, one on value investing and the other on business strategy.

All up, I will be in the US for a few weeks spending half of my time studying and working and the other half enjoying a well-earned vacation.

Unfortunately, this means that I won’t be posting for a few weeks. But it also means that I’ll come back full of ideas for interesting posts. So please stay tuned.