The Investor's Consigliere

Moore Capital and Sticky Capital

In his annual letter to Moore Capital investors, Louis Bacon wrote about his fund's new marketing strategy:

Bacon also said it's looking to attract longer-term investors after its performance was restrained by redemptions during the financial crisis.

Moore Capital has a new marketing team, which "has had very good success in attracting what we hope is sticky capital from more institutional investors," he wrote in the letter.

Bacon is a rock star among hedge fund rock stars. His fund has returned over 20% for over two decades. My understanding is that he charges above-market fees and has a long lock-up. If even he needs stickier capital, imagine how difficult it is for everyone else. And how important.

My working hypothesis about attracting sticky capital is that it is a two-part process. The first part involves, as Bacon notes, attracting more institutional investors with a long-term capital base. This is not easy, but it is simple: everyone knows who these investors are. You might think of this as "structural stickiness": that portion of an LP's propensity to redeem capital from your fund that can be explained by the type of investor it is (pension, endowment, fund of funds, high net worth, etc). The way to increase the aggregate structural stickiness of your capital base is to attract LPs in the right categories. Simple but not easy.

The second part of the process is more amorphous and intangible. It is the effort to increase an LP's "non-structural stickiness," which can be defined as that portion of an LP's propensity to redeem capital that cannot be explained by its category. High non-structural stickiness can overcome low structural stickiness. That is, an investor in a category known for being flighty can sometimes be your most loyal investor. Consider Warren Buffett's father-in-law:

"Doc Thompson was the kind of guy, he gave me every penny he had, basically. I was his boy."

That was in 1956, and it worked out well. Non-structural stickiness is a function of persuasion, positioning, and underwriting.

I've created a new category called "The Search for Sticky Capital" in which I plan to explore these issues further, the search for both structural and non-structural sticky capital. I will explain what I mean by "persuasion, positioning, and underwriting." The presence of sticky capital is a significant source of competitive advantage for a hedge fund, so the ability to attract it and create it is crucial.

I confess I am a novice in this area, so I welcome any thoughts you may have.

P.S. On the flip-side, from the perspective of a prospective investor in a hedge fund, sticky capital is also very important. You want to spend time learning about how a fund goes about increasing the stickiness of its capital, both structural and non-structural.

Evaluate Your Money Manager's Business

I don't know whether this is emphasized in the "mainstream" money manager evaluation industry, but your due diligence should include an investigation of your money manager's skill as a businessman (as opposed to investor), i.e. as the head of an enterprise that sells money management services.

A hedge fund management company can be analyzed as if it were a grocery store or lemonade stand or any other business.  Does it spend too much on overhead, the most common cause of business death?  What's the minimum AUM required to keep the lights on?  Vendor relationships, esprit de corps, how long have the secretaries been there, etc.  It's all fair game and relevant.

It's particularly relevant if you are evaluating a money manager who identifies himself as a value investor.  If the guy spends his days searching for good businesses run by great managers, it's fair to ask whether the business he runs meets that description.

Buffett Applied Psychology Lesson 2: How to Behave Well

                                          'I'll tell you all,
so we can die with our eyes wide open now
or escape our fate and certain death together.
First, she warns, we must steer clear of the Sirens,
their enchanting song, their meadow starred with flowers.
I alone was to hear their voices, so she said,
but you must bind me with tight chafing ropes
so I cannot move a muscle, bound to the spot,
erect at the mast-block, lashed by ropes to the mast.
And if I plead, commanding you to set me free,
then lash me faster, rope on pressing rope."

So I informed my shipmates point by point,
all the while our trim ship was speeding toward
the Sirens' island, driven on by the brisk wind.

                                    -The Odyssey, Book XII

Warren Buffett is justly famous for his ethics.  Here is an early example, taken from "The Snowball":

    Diversified Retailing [A Buffett-controlled company later merged into Berkshire Hathaway] had issued unsecured debt ("debentures") to finance the Hochschild-Kohn purchase.  Buffett had taken special care with this, his first public financing, and insisted to his underwriters that the bonds have several unusual features.  The bankers had objected that a novel structure would make the bonds harder to sell.

    "I said, 'Well, but bonds should have this in there.'  That was the first bond issue I ever sold, and I put a few things in there that the underwriters had no interest in whatsoever.  But I had thought a lot about bond issues over the years.  And I had thought about how bondholders get taken" . . .

    "One of the things I put in was that if we didn't pay the interest on the bond for any reason, the bondholders took over voting control of the company, so they didn't have to get Mickey Moused by bankruptcy and all that kind of stuff" . . .

    The second unusual provision was that the debentures paid eight percent but, depending on the earnings of the company, could pay up to an additional one percent.

    And Buffett added a third provision.  Because he felt that the bonds would be sold mainly to people who knew him or his reputation, he wanted the bonds to be redeemable if he sold enough stock in DRC that he was no longer the largest shareholder.

    "And nobody had ever stuck anything like this in a covenant.  I said, 'You know, they're entitled to have this in there.  They may not want to redeem them but they're entitled if they want to.  They lent money to me, basically.'"

Like Odysseus, Buffett knew the value of tying himself to the mast.  He knew that the best way to guarantee good behavior--in this case not taking advantage of your lenders--was to force yourself to behave well.  He also knew, not by coincidence, that by publicly and unilaterally forcing himself to behave well, he sent a strong (but accurate) signal to others about his integrity, a signal that, as we all know, has served him well.

Your consigliere has a correspondent, a new hedge fund manager with an excellent pedigree.  When raising capital for his fund he imposed such onerous terms on himself and his limited partners (all designed to force long-term thinking) that he raised only a fraction of what he could have had his terms been more mainstream.  I must confess that when I heard about this my ears pricked up and I started salivating like Pavlov's dog, though at that point I knew little about his investing prowess.  Whether he can invest like Buffett, time will tell.  But I believe that forcing yourself to behave well is so important that I can predict with confidence that he'll do better than average, and he'll certainly do way better than he would have without tying himself to the mast.

"Never Was a Face Less of a Barometer"

The quote is from Stendhal, describing Talleyrand.  I thought of it when I read the following excerpt from the Jeff Matthews book I just reviewed.  To a young shareholder who asked how to learn whom to trust and whom not to trust, Buffett replied:

People give themselves away . . . and maybe it's an advantage being around awhile and seeing how people give themselves away . . . They make certain kinds of comments . . . What they laugh about . . . if they say 'it's so easy' . . . It's never easy.  We get suspicious very quickly.  We rule them out 90 percent of the time . . . It's the very things they talk about . . . There are a lot of clues in the things they think are important.

I sometimes fantasize about writing a book about one of Buffett's less-studied qualities: his skill at "applied psychology," what some people call street smarts and others call seduction or the manipulation of human behavior.  The skill can be used on offense--to manipulate others--and, more ethically, on defense--to protect yourself from others' attempts to manipulate you.

Buffett's answer to the young shareholder was, I believe, deliberately incomplete.  Applied psychology is kind of a dark art--you're not supposed to talk about how you do it, even though all of us do it in one way or another.  In the above case of learning how to read people, yes it's important to learn how people give themselves away, but it's also important to help them along.  If you want to learn about  what someone else thinks is important, you give him every opportunity to do so.  Let the other guy move first, don't show your hand, don't let your face or manner be a barometer of what you're thinking.  Buffett's famous persona--the geniality, the always-open door and seemingly endless willingness to sit and listen, the kind word for everyone, the refusal to criticize anyone by name, even (or perhaps especially) those who deserve it most--all work like a kind of psychological alcohol to create an environment in which people are comfortable and at ease.  And when people are comfortable and at ease, they let their guard down and reveal themselves for better or worse. 

All of us are vulnerable to being seduced, to trusting those we shouldn't, to being played for a fool.  The very wealthy are no exception, and in fact sometimes I wonder if they are not especially vulnerable, notwithstanding their obvious savvy in their chosen sphere.  Politicians, (second/third/fourth/etc.) wives, charities, art dealers, Bernard Madoff, etc. all make a specialty of seducing the rich.  Of all the rich people I've ever studied (and I've studied a lot of them), Buffett is among the least seducible. 

When I interview professional investors, I try to imitate Talleyrand and Buffett: 

First, I try very hard to fight my natural instinct to show off my knowledge and pontificate (that's what blogs are for).  If anything I try to hide some of the things I (think I) know.  There is an interesting dynamic that often arises when a non-expert interviews an expert to evaluate his expertise:  Instead of making the expert impress him, the non-expert gets intimidated and finds himself trying to impress the expert with his own knowledge--the patient tries to impress the doctor with his knowledge of medicine, the homeowner trie to impress the architect with his knowledge of architecture, the art collector tries to impress the art dealer with his knowledge of art, etc.  This is not only a waste of time, but it gives the "expert" (who may in fact only be an expert at seduction) too much of a road map as to what he should talk about.  I want the ratio of my listening to my talking to be extremely high. 

Second, I avoid the traditional Wall Street interviewing posture of intimidation and openly aggressive questioning, which I'm temperamentally unsuited for anyway.  I want people at ease, not in "job interview" mode.  I never make anyone wait or arrive late to a meeting.  I never ask someone to open a window on the 50th floor of a skyscraper.

Third, within reason I don't say in advance exactly what I'm looking for an investor to tell me.  As much as I can I want the investor to tell me what he thinks is important.

10 Due Diligence Questions

Felix Salmon links to and discusses a short piece by Corgentum about how to do due diligence on your hedge fund advisors' due diligence.

Does [Finger] Size Matter?

Intriguing article in the Economist about evidence that ring finger size can predict the success of a trader.  Whether it applies in the same way, or even in the opposite way, to long-term investors is the subject of a future study, which I (and my relatively tiny ring finger) await anxiously.  Next time you're in a due diligence interview, sneak a peak at your potential money manager's hand . . .

Money Managers and the Contemporary Art Bubble

Felix Salmon links to this essay which argues that the contemporary art bubble was a classic bubble that's about to pop. 

Many hedge fund managers and other money managers participated in this mania.  In my amateur psychologist opinion (and getting a sense of the psychology of a money manager is part of the art of money manager selection, no pun intended), a mindset that would participate in this bubble is incompatible with the mindset favorable to long-term investment success.  Anyone who bought this kind of art "as an investment" can be dismissed out of hand--they are speculators pure and simple.  Speculation is not evil but should not be confused with investing.  But even those who bought such art as a status symbol--a motivation I can understand--should be questioned, because the status to be gained from owning such symbols would only last as long as the bubble itself, which is to say not that long.  Spending two million dollars to get two year's worth of coolness is an expensive way to impress a woman.  Compare this to the 19th century American robber barons who amassed collections of European Old Masters from impoverished continental aristocrats via such dealers as Joseph Duveen: not only did the scarcity value of such works help them hold their value, but the status derived from owning them has endured as well.  Now their descendants are called aristocrats and are admired for their taste.

So add this to the due diligence questionnaire:  If your potential money manager participated in the tulip mania of our day (and it's not difficult to find this out, as they made themselves known), be wary.

 

Update: Now for the exceptions--Oh dear, there are a lot of them.  I may have to take this post back:

In The $12 Million Stuffed Shark: The Curious Economics of Contemporary Art, author Don Thompson produces a list of the world's top active collectors of contemporary art.  It includes a number of people whose records of long-term capital allocation success would shame most hedge fund managers, such as Bernard Arnault, Eli Broad, Joseph Lewis, George Lindemann, Francois Pinault, Charles Schwab, and Steve Wynn.  Also mentioned in the book is David Geffen. 

In my defense though, contemporary art as a whole is not the same thing as the contemporary art bubble.  The former includes many artists and collectors born before WWII, while the latter refers to a more recent phenomenon of the past few years that focused on the work of the more prolific living artists.  I'd be interested to know how many of the above list of exceptions were net sellers of art during the bubble, or who declined to buy what everyone else went crazy for.

   

Yes, but are they the MOST Undervalued?

Everyone knows that overambitious marketing statements like "I guarantee to make you rich if you invest in my fund" are a huge red flag.  But beware of underambitious statements too:

These days, especially among professional value investors who appear in the media, I hear a lot of "this is a great time to buy" and "the market is very undervalued" and "Finally I can own all these great companies I've always coveted but were too expensive."  The subtext of these public declarations, of course, is that the investor is looking to keep his existing clients and add new ones.

All these statements may be true, and there is nothing evil about a professional investor marketing himself, but remember the goal of active investment management is to earn, after fees, a higher risk-adjusted return than the client could earn on his own.  If the client is completely passive, he could simply invest in an index fund.  So the statement "the market is undervalued, it's a great time to buy" does not in itself justify active investing because the client is perfectly capable of acting on that statement without paying a fee.

If the client is a little more sophisticated--enough to separate a great company from a mediocre one--then he can simply pick a basket of great company stocks on his own.  In this case, the statement "finally I can own the great companies I've always wanted to own but were not undervalued" does not in itself justify active investing because again, the client can act on it without paying a fee.

In order to justify his existence, the active investor must be much more ambitious.  He cannot simply identify that the market is undervalued, he cannot even identify that the world's best companies are undervalued.  His goal MUST be to identify those opportunities that are the MOST undervalued, on a risk-adjusted basis and with the required margin of safety.  He has to do something the client cannot, and he must do it well enough to justify his fee.

Buffett and "Investing" vs. "Business"

Jason Zweig's "Intelligent Investor" column in last week's WSJ featured some interesting Buffett tidbits:

1)  Buffett, whose powers of mental calculation are legendary, confessed that he doesn't know how well Berkshire Hathaway's portfolio of stocks has done in recent years: 

"I've no idea what the rate of return would be.  But, knowing myself how hard it would be to do the calculations right, I'm suspicious of anybody's numbers."

The reason it's so hard to calculate is that you can't just take the ending value of the portfolio and compare it to the beginning, because he added outside money along the way (generated from operating earnings, interest and dividends) and also took out money (to buy operating business, fixed income instruments, raise cash, etc.).  Keep this in mind the next time someone pitches you a fund with a fantastic historical "IRR".

2)  Buffett talks about the advantages of being both a businessman and an investor, rather than one or the other:

"Being a businessman makes me a better investor and being an investor makes me a better businessman . . . Most businessmen limit themselves to their own field, and most investors don't really think about businesses.  And many businessmen are semi-oblivious to to the yardsticks other people use outside that field.  I'm always comparing everything to everything else."

"Most investors don't really think about businesses" is a pretty strong statement.  At the end of the day most investments--stocks and corporate bonds--are simply claims on the assets and cash flows of businesses.  It's a damning indictment to say that most investors, including professionals, don't think about what's actually behind the pieces of paper they own.  Conversely, as I've said before, to be able to approach investing from the perpective of someone who understands businesses can be of great advantage.  Most family offices are in this position, since they're started and seeded by sucessful businessmen who've sold their business. 

Disclosure:  Long Berkshire Hathaway

Wealth, War & Wisdom, a Follow-Up Thought Exercise

Inspired by the book I just reviewed, here is a little game for those who, like money manager selectors, make their living evaluating people:

Suppose you must choose between two potential money managers, A and B.  Person A:

1)  Is very popular with all his subordinates, known for his friendliness and consideration.
2)  Is frugal in all his personal habits
3)  Neither smokes nor drinks
4)  As of the date you're considering him, enjoys a reputation for prescience and amazing judgment in his profession.

On the other hand, Person B

1)  Is rude to underlings and is unpopular among most of his colleagues.
2)  Has extravagant tastes and is careless with money
3)  Speculated on margin in his personal portfolio, with disastrous results
4)  Starts drinking before noon and continues until just before bedtime
5)  As of the date you're considering him, is considered by most to be a washed up loser, a failure in his profession.

As a professional "judge of character," on whom would you place your bet?

Person B is Winston Churchill in the late 1930s, while Person A is, at about the same time, Adolf Hitler.