The Investor's Consigliere

Buying with What?

Whenever you read or hear an investor crowing that "valuations are the lowest we've seen in years--we're buying bargains everywhere"--and if you're like me you're hearing this a lot--ask yourself "Buying with what?"

There is an enormous difference between the investor who was fully invested going into the crisis and is currently selling stocks (that have almost certainly gone down) in order to buy bargains, and the investor who held cash, or maintained spare borrowing capacity, or had in place a disaster hedge going into the crisis and is now deploying that capital to buy bargains.  It's not really a bargain if you have to pay for it with realized losses on other investments.

I hope to develop this into a longer post on asset allocation soon.

Operational Due Diligence--in Practice

My sense is that for most hedge fund investors, operational due diligence is a purely theoretical exercise: "What would you do if bad thing X happened?"

Now we finally have a chance to see how hedge fund operations performed in practice.  So add the following questions to your due diligence questionnaire:

1)  In the Great Crisis of 2008, how did you manage counterparty risk in your derivatives book?

2)  In the Great Crisis of 2008, how did you manage your exposure to vulnerable prime brokers?

Another Simple Statistic: Hitting in the Clutch

NateCarrFan made the following comment to my batting average post:

. . . might it be that managers who have a relatively low batting average but a good return because decisions that do go well go REALLY well simply put more thought and effort into those successful calls, forseeing their potential? The analog here would be a player who has a much better RBI number than batting average because he hits well in the clutch.

The analogy is a good one as long as you add one point--money managers create their own clutch hitting opportunities by the extent of the concentration of their positions.

Start from the premise that really good investment opportunities are scarce, and when they come along, you want your money manager to have conviction.  You want to see big bets when big opportunities come along.  Then you want to see those big bets turn out well, better even than the rest of the portfolio, the way a no-limit Texas Hold 'Em player wants to win every time he goes "all in."

So here are two more things I look for when evaluating a money manager:

1)  Does he/she have the conviction to make big bets in the first place?  I'm from the Buffett school of thought when it comes to diversification.  It's protection against ignorance, and you're not paying a hedge fund manager 2 and 20 to protect against his own ignorance.  Besides, if you want diversification you can and should do it yourself--much better to own a diversified group of concentrated hedge funds than a diversified group of diversified hedge funds.  Do the latter and on a look-through basis you own a little of everything, which you don't need to pay a lot for. Furthermore, you can get plenty of diversification in a ten-position portfolio if you choose your positions correctly.

2)  How well do the highest-conviction bets--the most concentrated positions--work out relative to the rest of his portfolio?  By "work out" I mean "achieve a very high risk-adjusted return."  Think of George Soros' bet against the pound, which although highly leveraged was not very risky because the pressure exerted by the bet itself pushed it from "very likely to work out" towards "fait accompli."  Or the latest Greatest Trade of All Time, the short subprime trade of 2007, which for a long time was a supercheap put.  Or the Buffett Partnership's 40% position in American Express after the salad oil scandal of 1963, or Berkhire Hathaway putting 35% of its common stock portfolio in Coca-Cola in 1989.

There are a few caveats--a huge fund may not be able to bet as much as it would like on its highest conviction positions, it's OK for a few small position outliers to turn out extremely well, etc.--but in general these are simple quantitative measures of the qualitative traits that you want your money manager to possess.

To my knowledge, the conventional money manager evaluation industry does not calculate this kind of statistic.  If I'm wrong please let me know.

Update:  I could be wrong.

A Simple Statistic: the Batting Average

When I was a young boy, like many young boys I loved and followed baseball.  For bookish kids like me, the great part about baseball was its grand tradition of statistics.  More than any other American sport, baseball offers up a wealth of statistics to analyze and memorize.  When I got older, however, I moved onto other things, and never thought all that memorization would mean anything.

Now that I'm older I'm starting to change my mind.  If you're following the presidential election, and like me you're frustrated by how un-analytical and non-evidence-driven most political coverage is, then check out this site.  It's the creation of Nate Silver, who also works as an analyst for Baseball Prospectus. 

I try to do something similar to Nate in my job as a money manager selector.  I recognize that quantitative factors are very important, but I'm not gifted in the higher mathematics employed by most in the industry.  So I try to use my own quantitative measures, based crudely on the baseball stats I used to love as a kid.

For example, the investor's batting average.  Every time your money manager deploys capital in a given position, think of it as "taking a swing."  In baseball, when you take a swing your first goal, before you worry about singles vs. doubles vs. home runs, etc., is to avoid making an out.  In investing it's the same thing--your first goal when allocating capital, before you worry about how much money you're going to make, is to avoid being wrong: to avoid losing money.  This is especially true if you're investing capital for an already-wealthy individual or family.  As Buffett famously says, "you only have to get rich once."

So, when I research a potential money manager, I want to know his batting average:  of all the positions he's put on (excluding hedges meant to offset another bet), how many have been "not wrong", measured over the appropriate timeframe of the investment?  The advantage of the "batting average" over the ubiquitous annualized return calculation (closer to the slugging percentage) is that the former gives a better measure of the consistency of the money manager's intelligence, and won't be dominated by a few very lucky bets that turned out well.  Also, especially when a fund employs leverage, a money manager's batting average gives you a better sense of "how likely is this fund to blow up?"

I believe the batting average stat has an advantage over standard deviation (aka volatility) because a) std dev is a measure of short-term volatility, which is less useful to a long-term investor, and b) a fund can have an attractive overall standard deviation as a result of a few winners dampening the volatility effects of the losers.

What's a good batting average?  In his book Simple but not Easy, Richard Oldfield states that "the gap between the successful money manager and the unsuccessful is between one who gets it right 55% or 60% of the time and another who gets it right 40-45% of the time."  I would go a little higher, to 70-80%, although I can't tell you why exactly.

Interestingly, George Soros had a mediocre batting average during his career.  He was wrong about as much as the average money manager, but he knew how to change his mind better than anyone, and when he was right he was REALLY right. 

Evaluating Value Investors: Two Questions

Some well-known value investors are selling stocks they very recently thought were undervalued bargains.

When I evaluate a money manager who espouses the value investing philosophy, the first question I ask myself is "Is this person really a value investor?"  This question carries more weight than you might think.  For while it's not remarkable that (given its association with very successful practitioners like Warren Buffett) many describe themselves as value investors, what is remarkable is how few really are.  Scratch the surface of a self-described "value investor" and you'll often find a momentum player who simply buys what's popular and is going up, a closet macro short-term speculator who says things like "in a recession people play the lottery, therefore lottery stocks will go up this year", someone who can identify a great business but not the greatly inflated price it's selling for, or some other wolf in sheep's clothing. 

This first question filters out a lot of money managers.  But even if I've found a value investor who actually practices value investing, I'm not done yet--there are good value investors and less-than-good ones, and my job is to separate the two.  The next question I ask myself is "Is this money manager essentially a 'naive' value investor or does he/she add value as a business analyst?"

By "naive" I mean this:  The value investing strategy has been demonstrated to work successfully even when relatively little attention is paid to the businesses being bought.  Simply buy stocks that are "cheap" based on various historical measures like low P/E or P/B ratios and you can do OK.  Fama and French, Ben Graham's "net-nets," even Magic Formula Investing all demonstrate this.  It's the kind of thing you can do yourself with a computer stock screen. 

Naive value investing may work well, but it's not something you should have to pay for.  A jockey isn't great simply because the horse he's riding is.  Nor is a money manager worth paying if what he/she is ultimately doing, when all is said and done, is buying stocks that are "cheap" based on historical measures.  What makes a value investor good is the ability to go beyond the naive stock screen to really understand and evaluate the businesses being purchased.  This is what I try to answer with my second question.

I won't name names, but read the WSJ article I linked to above and ask yourself whether some of those money managers, all very famous, really understood certain businesses well enough to commit capital to them. 

 

What to Evaluate

In a rare speech a few years ago, Edward Lampert of ESL made the following (paraphrased by the listener) remarks about choosing a money manager:

By the way, past performance as a measure of quality is wildly overrated.  It would make a lot more sense to place more emphasis on and think about the people that put the track record together and the quality and value of the portfolio that they are managing.

Read this article (via Felix Salmon) about "superstar" mutual fund manager Nancy Tooke for a good example of this.  As Felix recommends, read the comments too.  My consigliere sixth sense tells me that based on the way she speaks about investing, and on her current picks, her record of outpeformance will not last. 

Howard Marks Memo

Oaktree Capital Management's Howard Marks' latest memo to clients is available on the web.

The first section of the memo, called "Letting the Market Call the Tune," reminds me of a major point in investor due diligence.  Just about every professional investor, especially value investors, will tell you that they are contrarians, that they love to bet against conventional wisdom.  The problem is that by definition not everyone can be a contrarian.

In my opinion, a contrarian investor must satisfy two conditions.  First he/she must be contrarian by temperament.  This, believe me, is rare enough.  Human beings are simply not wired to go their own way.

But that's not enough.  In order to be effective for you the investor, your money manager's contrarian temperament must be accompanied by a "platform" that allows for contrarian behavior.  To take Marks' example, it doesn't matter how astute and early Charles Prince was in foreseeing the credit  crisis.  Neither he nor his company was in a position to behave any differently from the crowd.  If he did he would have been punished severely.

Similarly, your money manager's willingness to be contrarian means nothing without the ability to do so: 

If a hedge fund allows quarterly redemptions and has a fickle, short term investor base, it doesn't matter if the general partner is a farsighted long-term investor.  If a fund's overhead (or the maintenance of the general partner's lifestyle) requires constant or growing assets under management without any tolerance for hiccups, then that will drive its behavior more than maximizing long-term investment performance.  Incentives govern the world.

So look for the ability to be contrarian, not just the willingness.  Some signs of what to look for:

• Permanent capital.  All else equal, a fund with a longer lockup can behave better than one that allows quarterly redemptions.  
• Low overhead.  If a fund can survive 50% of its investors withdrawing without firing anyone, it's in a better position to be contrarian.
• Large investment by the general partner and employees.  The closer a hedge fund is to a personal investment vehicle, with outside investors just along for the ride, the better.
• A congenial investor base.  If your fund manager makes an effort to recruit only those investors that share its long-term orientation, even without a formal lockup, it has a better chance of being able to behave as such.

It's no coincidence that who-know-which-company satisfies all of these conditions.  Buffett has not only the psychology of a contrarian, but he has very deliberately set up his company to permit contrarian behavior.  This is an often overlooked aspect of Berkshire's success.

The Berkshire Hurdle

A month ago Fortune published an article about a hedge fund of funds group that made a bet with Warren Buffett that it could pick a group of hedge funds that would outperform the S&P over the next ten years.  I remember in particular the last line of the article, in which Ted Seides, one of the bettors, said the following:

"Fortunately for us, we're betting against the S&P's performance, not Buffett's."

Wait a minute, say I.  That statement might be true in terms of the specific bet, but it's certainly not true in real life.  As I see it, every money manager who accepts outside investors' money, especially those who call themselves value investors, is essentially "betting" that he can beat the performance of Berkshire Hathaway.  Imagine the following scenario:  You're interviewing a potential hedge fund manager and he says the following:

1)  "I'm a value investor.  All my life I've idolized Warren Buffett.  I go to Omaha every year.  He inspired me to start my own hedge fund.  I own Berkshire shares myself."

2)  "I will charge you 2% of assets and 20% of profits for the benefit of my investment prowess, which is a combination of my own ability and the principles I've learned from my idol, Warren Buffett."

So far so good.  Some variation of the above can be heard all the time in Midtown Manhattan conference rooms.  Now it's your turn.  You should say the following in reply:

3)  Your idol, Warren Buffett, is still alive and still working hard.

4)  I can become partners with Buffett today, simply by buying a share of Berkshire Hathaway.  If I did that I'd get the benefit of his ability and his principles firsthand, cutting out the middleman as it were.

5)  Berkshire's stock price, $111,770 as we speak, certainly does not seem overvalued, and may in fact be significantly undervalued.

6)  It does not cost 2 and 20 to become Buffett's partner.  It costs maybe $10 to buy one A share, plus my share of Buffett's $100,000 salary:  about 6.5 cents per A share per year.

7)  Berkshire Hathaway is rated AAA and it's a "real" AAA.  Chances are your hedge fund holds positions in sub-AAA names, so on a look-through basis it's less than AAA.  Chances are it also borrows money on such terms that would make it less than AAA.

8)  Given all this, doesn't it make more sense for me to buy Berkshire than to invest in your hedge fund?

If your potential money manager answers this question by saying "Fortunately, we're not betting against Buffett's performance," you should then say "You may not be, but I certainly am, relatively speaking, if I invest with you instead of him." 

My point is this:  Your money manager should be able to articulate why he expects the high-cost investment option--his hedge fund--to outperform the readily available low-cost option.  I'm not saying it's impossible to beat Berkshire, but your money manager should have the integrity to concede that that should be his goal, and you are entitled to know how he expects to do it.

Questioning Growth Assumptions

This NYT article about Starbucks' recent store closing announcement reminded me of a good question for my due diligence questionnaire:

When your potential money manager is pitching you his best idea, and that idea happens to be a company that's growing by adding more units, especially an already well-known retailer adding stores, question him mercilessly on the growth assumptions he's making.  Why?  Because as surely as night follows day, a publicly traded retailer will try to grow too fast in order to please Wall Street.  Then the day will come when it announces it's closing stores and "returning to basics" by trying too improve its existing stores, which to no one's surprise have been neglected.  It's amazing how strong this force is.  A few short years ago Starbucks was considered a savant at choosing locations, but the demands of Wall Street proved stronger.  Mickey Drexler at the Gap could do no wrong, but he opened too many stores.  Wal-Mart in recent years, same thing.  McDonald's too I think, until they turned it around.

Are there exceptions?  Yes.  A small company obviously has more room to grow, but it had better be small.  There are others, but often there is a catch, some insight that helps to explain things.  Wal-Mart under Sam Walton grew very quickly, but in a very disciplined way.  Check out this neat video that shows graphically how he went about adding stores.  Note how he waited a long time before entering New York and California, which no other retailer would have done.  This unusual growth pattern reflected Wal-Mart's desire to avoid having to compete with other large retailers for as long as possible, its desire to maintain Wal-Mart's focus on non-urban shoppers (and employees too, by the way), and its famous rule about only building stores within easy distance of existing distribution centers.

The point is, your money manager should understand these dynamics and should have already thought about them.  If he's confident in his growth assumptions he should have a good answer for why. 

     

Does He Add More?

In investing, says William Miller of Legg Mason, "The lowest average cost wins."  If two investors are both going to sell the same stock at the same price on a given Thursday in 2011, whoever managed to buy it at the lowest price (discounted for date of purchase) will have the better return.

Broadly speaking there are only two ways to achieve the lowest average cost:

1. Initially identifying the lowest-priced opportunities relative to future intrinsic value and putting on a position
2. Given success at 1), adding more to the position when the price goes against you.

The ability to add to a position that is going against you is, in my opinion, one of the supreme tests of a great investor.  In one act you can evaluate not just the quality of the opportunity your investor has identified, but also the strength of his conviction about his own ideas, as well as the ability to act rationally when he might be expected to act emotionally.  In fact, it may be one of the only ways to probe the psychology of your investor. 

So when you're doing your investor due diligence, seek evidence of when he added more in the face of short-term losses, especially big ones.  Written evidence please, as it's much easier to say you do this than to actually do it.