Message Font: Serif | Sans-Serif
 
No. of Recommendations: 5
The Sunday WSJ that is featured in local papers had an article entitled "How the Big Money Picks a Manager"
http://online.wsj.com/public/article/SB114754482477452284.html?mod=sunday_journal_primary_hs

I suppose some of this article was predictable, but I thought that the quotes from California's Employee Pension Retirement System (CALPERS) view of the world were, um, interesting:

Excerpts:
Here, word-for-word from the Calpers questionnaire, is one of several dozen questions that prospective managers must answer: "Regarding the investment process explain 1) why the product should add value over time, 2) its shortcomings or limitations, 3) what would cause you to re-evaluate the process, 4) in what market environment will your product have difficulty outperforming, and 5) any enhancements you have made to your investment process in the last five years."

So far, so good. Above seemed resonable to me..

"It's easier to understand the business, the organization, the people, the philosophy and the process," says Ms. Cottrill at Calpers. "Performance comes down in the list." The emphasis is on the long term. Managers who significantly beat a benchmark index in a single year signal weak risk control, Ms. Cottrill says: "If you can outperform by that much in one year, you can underperform by that much in another."

Instead, Calpers has greater confidence in money managers that post consistent, modestly superior results: "You need something sustainable," Ms. Cottrill says. "Short-term outperformance can be luck.'


So there you have it - if you are significantly outperforming your index and you are hoping to land CALPERS, then you'd best try and tank your results to get back to 'modest' superior results!
Print the post Back To Top
No. of Recommendations: 4
So there you have it - if you are significantly outperforming your index and you are hoping to land CALPERS, then you'd best try and tank your results to get back to 'modest' superior results!

You've misinterpreted what she is saying. I think you need to reread the quote and pay particular attention to the part you yourself bolded:

"It's easier to understand the business, the organization, the people, the philosophy and the process," says Ms. Cottrill at Calpers. "Performance comes down in the list." The emphasis is on the long term. Managers who significantly beat a benchmark index in a single year signal weak risk control, Ms. Cottrill says: "If you can outperform by that much in one year, you can underperform by that much in another."

Instead, Calpers has greater confidence in money managers that post consistent, modestly superior results: "You need something sustainable," Ms. Cottrill says. "Short-term outperformance can be luck.'


It's not the significant outperformance that is the problem it is the "single year". Not always, but a great deal of the time, when you see a single year of massive outperformance, it is the result of making a few BIG BETS that worked out. Either having a very, very large percentage of the overall portfolio in 1 sector or industry, or having a very large percentage in 1 or 2 stocks that worked out very well.

IMO, and I'd bet a great deal on this, sustainable outperformance over long periods of time like 10 to 20 years is the result of lots of small to medium bets that work out, not making a couple of big bets each year. Yeah, yeah, Buffett made his fortune on a few big bets, but identifying a potential Buffett ex ante is IMO impossible and having pension funds invested with managers that routinely make big bets is irresponsible. Taxpayers would have to make up any shortfalls from big bets that don't work.

A portfolio that is 50% precious and base metal miners, and 50% energy would have absolutely crushed the market over the past 3 years. I wouldn't invest a single penny with a manager who held such a portfolio even if 3 years ago he had presented me with the most absolutely logical, compelling investment thesis for why he is doing that. And mind you, I've been bullish and still am on both those sectors (we need a sizable pullback though, sentiment is at a bullish extreme). But I know that no matter how much research is done, and how compelling a particular investment thesis is, there is ALWAYS the possibility of being wrong.

Somebody who beats the market by 1-2% each year or on a rolling 3-5 year basis, and does so through multiple stocks or industries that outperform is more likely to continue outperforming then somebody who beats the market by 20% in a single year through having 40% in 2 stocks that win big. The former is most certainly stock selection skill. The latter may very well be luck.


Print the post Back To Top
No. of Recommendations: 1
Hi jvandyke,

Indirectly whats being talked about is tracking error. Tracking error is the standard deviation of excess returns about the manager's benchmark. Excess returns are usually called alpha.

What's probably being implied is that active management of a fund by taking active bets will potentially generate large excess returns but at the risk of greater tracking error - ie returns are volatile. Pension funds in particular operate mostly in a asset-liability framework versus an asset only framework when making investment decisions (and projecting asset returns into the future) so they should value consistency of returns more than reaching for returns.

Add transaction costs and manager's fees and some argue that enhanced indexing, where smaller active bets are placed by tilting the benchmark, will return less alpha but with much less tracking error and therefore a superior strategy.

One way you can compare the different managers and their strategies in context of alpha, benchmarks, tracking error, skill, an luck is with the information ratio (alpha/tracking error). The greater the information ratio the greater the chance that one is providing added value on a consistent basis (read statistically significant). The point is that active management might not have as good of an information ratio as an enhanced indexing approach when adjusted for risk of the returns.

You might argue that volatility on the positive side is fine as long as there is little time spent below the benchmark. The Sortino ratio was designed just for that, to compare returns only adjusted for downside volatility. There are also other measures such as the Treynor measure and the Sharpe ratio but the point is that institutional investors tend to use risk-adjusted return measures which tend to temper the issues of chasing fund managers with hot short term track records.

Matthew
Print the post Back To Top
No. of Recommendations: 21
IMO, and I'd bet a great deal on this, sustainable outperformance over long periods of time like 10 to 20 years is the result of lots of small to medium bets that work out, not making a couple of big bets each year.

I might be willing to take this bet if we can flesh out the terms. Of the great investors I know, let's say those whose CAGR's have beaten the market by at least 700 basis points per annum over the last fifteen years with at least $100 million under management on average, the vast majority have done so making large bets. Your statement above seems silent on the magnitude of outperformance over time as if that were irrelevant.

Somebody who beats the market by 1-2% each year or on a rolling 3-5 year basis, and does so through multiple stocks or industries that outperform is more likely to continue outperforming then somebody who beats the market by 20% in a single year through having 40% in 2 stocks that win big. The former is most certainly stock selection skill. The latter may very well be luck.

I agree with you that a manger who beats the market by 100-200 basis points a year by making large, concentrated bets seems less attractive and less reliable than the greatly diversified manager with similar performance. The complication arrives when you compare the concentrated manager who has beaten the market by 1000 basis points a year over ten years via concentration to the diversified manager who has done so by 200 basis points. This is the kind of interesting decision that pensions funds and insurance companies have to make all the time. There are more very long term, significant outperformers out there than you think, and most of them make concentrated bets. To be fair, this is to be expected: Concentration OUGHT to produce greater variance in both directions (if you took a thousand funds and had each pick one stock every year for twenty years, both the best and worst performance would be more extreme than those of diversified managers over the period). But the I don't think this implies so curt a conclusion. The degree of concentration, magnitude of outperformance, and period of exmanation make for difficult questions for allocators as opposed to easy generalizations.

Yeah, yeah, Buffett made his fortune on a few big bets, but identifying a potential Buffett ex ante is IMO impossible and having pension funds invested with managers that routinely make big bets is irresponsible. Taxpayers would have to make up any shortfalls from big bets that don't work.

Pension funds and insurance companies and universities, for the most part, are often their own Fidelity Magellans of money managers. That is, they invest in a very large, often diversified, selection of funds and managers (and often they have their own consultants perform rolled up portfolio risk analysis replete with all the bells and whistles, though this is admittedly subject to the disclosure they receive from their various investors). The concentration of an indvidual fund isn't particularly relevant to their overall concentration, and thus I'm not sure I agree with your concern. Is it less risky to put money with a single mutual fund who will own 1000 names or with 1000 managers who are running single stock "best idea" funds, assuming you have a level of review that makes sure they don't all happen to buy the same stock? I agree with you that a pension fund shouldn't put all of its money into a single, highly concentrated fund that isn't run by Buffett. But that's a straw man.

I admit a big bias here. I run a concentrated fund. My instinctual conclusion is nearly the opposite of yours: When I meet managers who run diversified portfolios, they often don't know the companies they own anywhere near as well as those who run more concentrated funds, and often they know shockingly less*. You can argue that this sort of knowledge has diminishing returns (to some exent I would agree) or that heuristics can replace specificity (i.e. buying a cash heavy company with a reasonable valuation and insider buying in an industry you like as opposed to visiting every plant in Taiwan). You could also argue that large funds allocate reponsibility among employees to mimic the knowledge level of a concentrated fund. I think this is possible but is actually a terrifically difficult institutional feat to pull off effectively. I think there are a lot of ways to do this stuff, but one difficulty with diversification is that one or two decision-makers are unlikely to have the bandwidth to either deeply understand or even have more than a handful of putatively great ideas at any time. The trade off between bandwidth, idea scarcity, institutional effectiveness, and risk, are not simple.

*There are of course big execptions to this. There is always a Lynch or Tillinghast floating around who has the frightening ability to be both a Jack and Mater of all trades.



Print the post Back To Top
No. of Recommendations: 0
There are more very long term, significant outperformers out there than you think, and most of them make concentrated bets.

He will correct me if wrong (right MDC!), but I think MDC speaks from a viewpoint that most people have, including me, when they look at mutual fund performance and see how people do and then make conclusions from that. Uusually when you see great outperformance in the fund world it is precisely from the things MDC points out - a concentrated bet that eventually will take the fund in a completely different direction. If I were picking funds I'd probably go with the logic he suggested, if only because there usually isn't a cap on how big funds can get so you have to get a sense they can handle ever larger amounts of money.

There are more very long term, significant outperformers out there than you think, and most of them make concentrated bets.

How do you know this?
Print the post Back To Top
No. of Recommendations: 4
How do you know this?

Well, I don't literally know what MDC thinks (though I'm pretty I know that he can kick my a** given his knowledge of Creatine P and what not), that was an expression. But if you're asking how I know that there are a surprising number of decent sized managers with 10-20 year track records well above market averages...I get their letters.

Print the post Back To Top
No. of Recommendations: 7
HR,

Thanks for the reply. You make several good points.

As DM pointed out, I was thinking more from the perspective of mutual funds. If you look at the top-performing mutual funds in any given year, they are almost always sector or industry specific, or country specific. As I'm sure you know, the worst-performing mutual funds in any given year also tend to be highly concentrated in a particular sector, industry, or country.

I might be willing to take this bet if we can flesh out the terms. Of the great investors I know, let's say those whose CAGR's have beaten the market by at least 700 basis points per annum over the last fifteen years with at least $100 million under management on average, the vast majority have done so making large bets. Your statement above seems silent on the magnitude of outperformance over time as if that were irrelevant.

Just curious, are those great investors running public mutual funds or private hedge funds and/or private, separate accounts? I'm guessing more hedge fund guys then mutual fund managers? Pure supposition on my part, but I would think alot of your truly great stockpickers migrate to the hedge fund world instead of running public mutual funds, because that is where the value of great stock-picking will be better rewarded and where a concentrated portfolio might be beneficial. I realize this isn't true in all instances. There are a couple of great stock-pickers who regularly post here who don't run hedge funds (you know who you are).

Before we make any kind of bet though :), we have to define what exactly is diversified versus concentrated. It's not like it is a black or white thing, but more along a spectrum. What some consider diversified is actually considered concentrated to most of the money management world. Bill Miller's portfolio at Value Trust is considered by most as concentrated yet there are a few posters on the BRK board who don't think it is concentrated one bit. My own personal taxonomy is something like

1. Hyper-concentration - 3 to 5 stocks at 20%+ each
2. Extreme concentration - 5 to 10 stocks at 10% to 20% each
3. Concentrated - 10 to 50 stocks at 2 to 5% each
4. Diversified - 50 to 200 stocks
5. Over diversified (stupidly diversified) - 200+ stocks

When I say a few, large bets I am talking about category #1 and to some degree category #2. When I say small to medium sized bets I am talking about category #3.

My own opinion is the #1 is just plain, sheer insanity. You have too much exposure to the risk of a single blow-up that decimates overall portfolio performance. I would have a hard time investing with a manager like that regardless of how good his long-term record is. I know of 2 guys who arguably are very, very smart who got burned on ACLN a few years back. Hopefully, it wasn't such a "compelling value" that they had 20 to 30% of their portfolio in it. At the same time, I'm no huge fan of category #4 and especially category #5, especially as it relates to large-cap funds. My statement (about medium bets versus large bets) really was that I believe that category #3 is more likely to have sustainable outperformance then category #1. I have zero doubt at all that category #3 is likely to sustainably outperform category #4 or category #5. I understand if you don't want to answer for proprietary reasons, but you say you run a concentrated fund. I'd be curious to know where you fall in that spectrum.

Here is a quote of Bill Miller's I found interesting:

http://www.leggmason.com/thoughtleaderforum/2005/conference/miller_transcript.html

"We're in the process of adjusting something right now. There is evidence that concentrated portfolios outperform widely diversified portfolios. Unfortunately, the circumstances under which this evidence arose were very different from today's circumstances. In today's world, much more broadly diversified portfolios ought to perform better. Our portfolios will gradually expand. They will be concentrated compared to the rest of the world, but not as concentrated as they have been. Concentrated portfolios work best when valuation discrepancies are wide. The valuation discrepancies out there are not wide, so you're better off spreading your portfolio across a wide variety of sectors because you're not getting paid to take the volatility risk or the estimation error."

The complication arrives when you compare the concentrated manager who has beaten the market by 1000 basis points a year over ten years via concentration to the diversified manager who has done so by 200 basis points. This is the kind of interesting decision that pensions funds and insurance companies have to make all the time.

FWIW, I'd pick the concentrated manager. It would be an absolute no-brainer if I could find 3-5 concentrated managers with those type of results who have little to no overlap in their portfolios.

There are more very long term, significant outperformers out there than you think, and most of them make concentrated bets.

This is a very interesting fact to me. Do they go out of their way not to be known? I have to admit I am not aware of this fact or of these managers. I try to read alot from varied sources. This would seem to me to be a fact of great importance. It would essentially be the death blow to the efficient markets hypothesis.

The degree of concentration, magnitude of outperformance, and period of exmanation make for difficult questions for allocators as opposed to easy generalizations.

I completely agree! I didn't mean to generalize :). I think when analyzing managers you just want to do the best you can to distinguish luck from skill (and there is probably some overlap), and the fewer, really large bets you have, there is a greater possibility of luck entering the equation then skill. Even in my own case, I've made some sizable bets that have worked out that are probably a combination of skill and some luck. Since the beginning of 2004, I've had an average of a 20% allocation to commodities (in the form of a highly diversified commodity mutual fund), and a good deal of my outperformance has come from that position. I've been lucky to a degree, but I'd also argue that skill was involved. I wrote this back in early 2004 in a letter:

Return Expectations

It is important to have reasonable expectations for total returns, especially given the current market environment, which is characterized by high stock valuations and 50-year low interest rates. In 2003, pretty much everything (stocks-all market caps and styles, REITS, commodities and precious metals) all increased in value by an abnormally high amount. It is highly unlikely that the remainder of 2004 and 2005 will experience similar returns. And with interest rates as low as they are (Fed funds rate is 1%), bonds and bond funds will have reduced returns. The one asset class that I believe may experience continued above-average returns is commodities and precious metals which is why I have overweighted them in the portfolio relative to a more typical allocation


This is off on a tangent, but I'd love to hear your thoughts if you have an opinion, and don't mind sharing them. One of the biggest things I am struggling with every day is whether to trim my commodity exposure. Based on what I've heard from the notes from the Berkshire meeting, it seems like Buffett thinks there is a commodity bubble. At the same time, there are numerous, intelligent individuals with solid long-term track records who think this bull market still has alot of room to run. In your opinion, do you think it is valid to adjust nominal commodity prices for inflation, or is that a sort of double-counting? One of the great difficulties here is that there are no historical valuation levels like with stocks to determine relative expensiveness or cheapness, only historical price levels. Whether you adjust for inflation or not makes a huge difference as to where in the range we are at.

Pension funds and insurance companies and universities, for the most part, are often their own Fidelity Magellans of money managers. That is, they invest in a very large, often diversified, selection of funds and managers (and often they have their own consultants perform rolled up portfolio risk analysis replete with all the bells and whistles, though this is admittedly subject to the disclosure they receive from their various investors). The concentration of an indvidual fund isn't particularly relevant to their overall concentration, and thus I'm not sure I agree with your concern. Is it less risky to put money with a single mutual fund who will own 1000 names or with 1000 managers who are running single stock "best idea" funds, assuming you have a level of review that makes sure they don't all happen to buy the same stock? I agree with you that a pension fund shouldn't put all of its money into a single, highly concentrated fund that isn't run by Buffett. But that's a straw man.

I agree with you here completely, and I was aware that institutions diversify across managers. Diversification is still happening, its just occuring in a different way. Instead of diversifying across numerous stocks in a single, comprehensive portfolio, diversification is occuring across numerous funds who are individually concentrated.

When I meet managers who run diversified portfolios, they often don't know the companies they own anywhere near as well as those who run more concentrated funds, and often they know shockingly less*.

I'm not surprised at all. In fact, I think many people would be absolutely shocked at how little some institutions know about the stocks they hold. I graduated with my MBA in 2001 and job opportunities at that time were not plentiful. I took a job as an analyst with a bank trust department. I was the first true "analyst" position there. I recently read a Munger comment about bank trust departments. I could only laugh and nod my head in agreement. To say many of these people were complete morons/idiots would be generous. They knew little to nothing about the stocks that were held. I had a buddy who worked for a major mutual fund company. I was surprised by some of what he told me as well.

or that heuristics can replace specificity (i.e. buying a cash heavy company with a reasonable valuation and insider buying in an industry you like as opposed to visiting every plant in Taiwan).

What's your opinion on this? I must admit I sometimes wonder about how much true value added there is in terms of particular, specific knowledge (I suppose what the specific knowledge is makes a huge difference) versus relying mainly on certain heuristics or quantitative factors. Does it bump up the probability of winner from say 60 to 95%?

Thanks again for your post. Your posts always get me thinking or rethinking stuff.












Print the post Back To Top
No. of Recommendations: 29
Just curious, are those great investors running public mutual funds or private hedge funds and/or private, separate accounts? I'm guessing more hedge fund guys then mutual fund managers?

Yes, I was really talking about private investing partnerships.

My own opinion is the #1 is just plain, sheer insanity. You have too much exposure to the risk of a single blow-up that decimates overall portfolio performance. I would have a hard time investing with a manager like that regardless of how good his long-term record is. I know of 2 guys who arguably are very, very smart who got burned on ACLN a few years back. Hopefully, it wasn't such a "compelling value" that they had 20 to 30% of their portfolio in it. At the same time, I'm no huge fan of category #4 and especially category #5, especially as it relates to large-cap funds. My statement (about medium bets versus large bets) really was that I believe that category #3 is more likely to have sustainable outperformance then category #1. I have zero doubt at all that category #3 is likely to sustainably outperform category #4 or category #5. I understand if you don't want to answer for proprietary reasons, but you say you run a concentrated fund. I'd be curious to know where you fall in that spectrum.

You're not the first to plead insanity on behalf of the five and below club. By concentration, I was really talking about groups from category 1 and 2. Lampert (like some years of Early Buffett, i.e. 40% in American Express), for example, has largely been a category 1 storm, and I know a few others with similar track records in the same league of concentration -- 4-5 stocks on average. Most are closer to the 2 or maybe low 3 range. Now, let me say something potentially annoying (and offensive to lurkers).

No great investor would have made a huge bet on ACLN. I realize that this was merely an example meant to illustrate the idea that nobody expects the Spanish Inquisition. Even so, there is probably a worthwhile point to be made here. I'm a pretty strong believer in the idea that most great investors overstate high probability into Platonic certainty -- it sounds like you would agree. There is always a remote possibility that even an inevitable, easy to understand, business becomes totally worthless. If you asked me 15 years ago whether it was more likely that Coke and American Express would go bankrupt, both towers of the World Trade Center would be destroyed by commercial airplanes, or the Terminator and the Body would both become State Governers, I'm not sure which I'd have picked. Stuff happens. Or, as Bill Miller might say, elements of highly complex systems interact through countlessly iterations and permutations, careening endlessly among an ocean of unobservable variables rendering the precise predictability of particular system constituents elusive.

Even so, examples like ACLN overstate the inherent uncertainty of concetrated investing. No good investor who put 25% of their clients' capital into ACLN can credibly say they did the kind of work required to understand the downside of that situation well enough to justify this size position (note that this is a hell of a lot different than saying no good investor could have credibly bought it at all). Again, this is not close to saying that there is some magical level of diligence that can eliminate risk altogther. My point is only that you often see the same "inevitable" overstatement in the other direction, but that all downsides are not created anywhere near equal. The fact that you can't eliminate risk doesn't mean that all blowups with intelligent owners are evidence of the level of risk you're taking with a concentrated position.

It is ultimately impossible to define the particular risk of a selected, well understood investment, once you get past the idea that it is always going to be much higher than zero but potentially much lower than what might be expected of a "typical" investment. Impossible for me, at least. But even seemingly extreme concentration doesn't necessarily demand zero risk tolerance. The difference between having five investments and one investment is enormous, though you often see commentary implying the difference is small or minimal. I'd rather not ramble about myself except to say that I tend to be pretty concentrated...in your hierarchy maybe dangling safely above rubber roomdom, but perhaps not fit to join polite society. Murdoch from the A-Team comes to mind (sudden urge for a name change).

Do they go out of their way not to be known? I have to admit I am not aware of this fact or of these managers. I try to read alot from varied sources. This would seem to me to be a fact of great importance. It would essentially be the death blow to the efficient markets hypothesis.

I guess the degree of notoriety is relative. Dan Dennett is one of the world's most famous living philosophers and is instantly recognizable within his world, but probably has worse mainstream recognition than the winner of any of the Survivor seasons. ESL has become a celebrity name in the mainstream, but a few years ago its incredible performance didn't generate much more recognition than Glenview or Lone Pine or Caxton or Moore or Greenlight gets today. The no solicitation rules play some role in limiting the proliferation of specific performance numbers. But the multiple hypothesis problem means that even several long term substantial outperformers do not necessarily disprove EMH, particularly given the difficulty of determining the population of spins out of which all these double zeroes arrived.

In your opinion, do you think it is valid to adjust nominal commodity prices for inflation, or is that a sort of double-counting?

My opinion on this issue isn't worth your time. I worthlessly think there are specific commodities whose current prices seem almost laughably high and likely to come down eventually, regardless of how fast China grows, given the economics of renewal and the history of substitution. I also think that people tend to underestimate the power of the forward curve in producing innovation and investment just when their seems to capacity, regulatory or technology constraints, and that it takes a while for spot prices to actually take root in the fingers of the supply side. But I really have no idea.

What's your opinion on this? I must admit I sometimes wonder about how much true value added there is in terms of particular, specific knowledge (I suppose what the specific knowledge is makes a huge difference) versus relying mainly on certain heuristics or quantitative factors. Does it bump up the probability of winner from say 60 to 95%?

If I pretended to be able to quantify this I would be full of crap. It's a great question. I think about it a lot. I tend to do a lot of work. Most of it, I think, is useless. There are huge diminishing returns when it comes to diligence, and one of Marty Whitman's great comments is that most investment ideas usually turn on two three important things. It's also interesting to think about what information you are really considering when you're actually making decisions, versus all the information you'ved scavenged, stored, and pretty much left to rot on a spreadsheet or in a notebook. Then again, the accumulation of knowledge and experience with respect to companies, patterns, people and industries is enormously important in being a good investor, and often seemingly minor things can crawl their way into your instinct without you knowing it.

Then again, there are occasionally mundane results from extreme diligence -- in the statutory insurance filings, in the lawsuit documents, in the master trust reports, in the head of the regional store manager or the ex-syndicate lender -- that make a big difference. This is much more often the exception than the norm, but for concentrated investors even the once-in-a-while difference matters.



Print the post Back To Top
No. of Recommendations: 1
Interesting thread. I would argue that some of these highly concentrated fund managers are also considered “active” fund managers. Meaning that they directly influence the direction of the company in which they take a concentrated, large position. For example, you mentioned Lampert as one of these managers. Let's look at his big bets that made him famous:

K-Mart – He bought the debt at distressed levels, then influenced the reorganization process so that the returns for holders of that debt were maximized at the expense of other classes.

Autozone – He brought in a new CEO and started a massive share-buyback program.

Other examples are Mr. Ackman with McDonald's and Pershing Capital with Wendy's. Even Warren has been observed as having taking an active role in his large positions. Recently, he had Berskshire back the USG rights offering, which is a key part of their reorganization.
Print the post Back To Top
No. of Recommendations: 4
But if you're asking how I know that there are a surprising number of decent sized managers with 10-20 year track records well above market averages...I get their letters.


What Howard said.
There are a lot more 'great managers' than you think, an amount that has suprised myself as well as I get more and more of their letters. They can't solicit or advertise to the general public, so they are less known.

Steve Mandel is an easy example:
#1 ranked retail analyst at GS - didn't run money,

PM for Tiger Mgmt - didn't directly run a fund, Julian allocated him some capital, you couldn't invest directly with him,

Lone Pine - a closed fund. You had to get in early and know whom he was to invest. He has never been able to 'tout' his superior returns.

But at least people know who he is. I'm lookin at a quarterly letter right now from a NYC partnership, with over $100mm, that's done 22% net since 1991 and they are virtually unknown. That ain't too shabby.

Naj
Print the post Back To Top
No. of Recommendations: 1
Interesting thread. I would argue that some of these highly concentrated fund managers are also considered “active” fund managers. Meaning that they directly influence the direction of the company in which they take a concentrated, large position. For example, you mentioned Lampert as one of these managers. Let's look at his big bets that made him famous:

K-Mart – He bought the debt at distressed levels, then influenced the reorganization process so that the returns for holders of that debt were maximized at the expense of other classes.

Autozone – He brought in a new CEO and started a massive share-buyback program.


Marty Whitman, in his book Value Investing: A Balanced Approach, makes the distinction between Control Investors and Outside Passive Minority Investors (OPMI). There's a world of difference between the two and one should not compare the investment performance of one with the other. It's almost like comparing apples with oranges.

jkm929



Print the post Back To Top
No. of Recommendations: 25
No great investor would have made a huge bet on ACLN. I realize that this was merely an example meant to illustrate the idea that nobody expects the Spanish Inquisition. Even so, there is probably a worthwhile point to be made here. I'm a pretty strong believer in the idea that most great investors overstate high probability into Platonic certainty -- it sounds like you would agree. There is always a remote possibility that even an inevitable, easy to understand, business becomes totally worthless. If you asked me 15 years ago whether it was more likely that Coke and American Express would go bankrupt, both towers of the World Trade Center would be destroyed by commercial airplanes, or the Terminator and the Body would both become State Governers, I'm not sure which I'd have picked. Stuff happens. Or, as Bill Miller might say, elements of highly complex systems interact through countlessly iterations and permutations, careening endlessly among an ocean of unobservable variables rendering the precise predictability of particular system constituents elusive.

Even so, examples like ACLN overstate the inherent uncertainty of concetrated investing. No good investor who put 25% of their clients' capital into ACLN can credibly say they did the kind of work required to understand the downside of that situation well enough to justify this size position (note that this is a hell of a lot different than saying no good investor could have credibly bought it at all). Again, this is not close to saying that there is some magical level of diligence that can eliminate risk altogther. My point is only that you often see the same "inevitable" overstatement in the other direction, but that all downsides are not created anywhere near equal. The fact that you can't eliminate risk doesn't mean that all blowups with intelligent owners are evidence of the level of risk you're taking with a concentrated position.


I think Munger's recent book recommendation, Fortune's Formula, and many of the papers referenced in the bibliography are pertinent to this discussion. The book is about Kelly's criterion, which is a formula for sizing bets to maximize long-term compound return from a series of bets where the winnings are reinvested.

Kelly's criterion has two components: edge and odds. Edge is the amount of profit that YOU BELIEVE that you will make if you could repeat this bet many times with the same probability. Odds are the market place or tote board odds. Your odds must be different from the market place odds or you don't have an edge.The optimal return is obtained by betting a fraction of your portfolio equal to the edge/odds.

Overbetting and underbetting result in sub-optimal results. However, overbetting is more serious because it leads to a large variation in returns and to eventual blowups (LTC and Eifuyu were examples of overbetting). Underbetting reduces returns and variance. The book presented Ed Thorpe's (one of the best Kelly criterion investors) hedge fund results which were spectacular for the degree of over-performance and the small variance over a 20 year period. Ed Thorpe always underbet – specifically made bets of half the Kelly criterion because he was worried about being too confident about his assumptions in investing and unconsciously overbetting.

Long story short, the book and especially the papers show that if you really good at finding investments with large edges, you could get decent returns without a lot risk holding only four or five positions. If you can only find investments with smaller edges, you will get less return and need more positions to reduce risk.

From reading the book and the papers, I found that I was intuitively doing the right thing. However, I am planning to now track the edge and odds on investments to see if I can improve.

What's your opinion on this? I must admit I sometimes wonder about how much true value added there is in terms of particular, specific knowledge (I suppose what the specific knowledge is makes a huge difference) versus relying mainly on certain heuristics or quantitative factors. Does it bump up the probability of winner from say 60 to 95%?

If I pretended to be able to quantify this I would be full of crap. It's a great question. I think about it a lot. I tend to do a lot of work. Most of it, I think, is useless. There are huge diminishing returns when it comes to diligence, and one of Marty Whitman's great comments is that most investment ideas usually turn on two three important things. It's also interesting to think about what information you are really considering when you're actually making decisions, versus all the information you'ved scavenged, stored, and pretty much left to rot on a spreadsheet or in a notebook. Then again, the accumulation of knowledge and experience with respect to companies, patterns, people and industries is enormously important in being a good investor, and often seemingly minor things can crawl their way into your instinct without you knowing it.


I am in the camp that you don't need many things to make the investment decision. I think that if you can answer Buffett's five questions that is almost all the work that you need.

1. certainty with which the economics characteristics of the business can be evaluated over the investment timeframe

2. certainty with which management can evaluated, both in its ability to realize the full potential of the business and to allocate its cash flows wisely

3. certainty with which management can be counted upon to channel rewards of the business to shareholders instead of itself

4. the purchase price of the business compared to value

5. the level that taxation and inflation will reduce the investor's purchasing power return from total return.

Then again, the accumulation of knowledge and experience with respect to companies, patterns, people and industries is enormously important in being a good investor, and often seemingly minor things can crawl their way into your instinct without you knowing it.

I agree. Good practice makes you better. I think that we have all gotten better over the last five years on the board.
Print the post Back To Top
No. of Recommendations: 5
I would argue that some of these highly concentrated fund managers are also considered “active” fund managers. Meaning that they directly influence the direction of the company in which they take a concentrated, large position. For example, you mentioned Lampert as one of these managers. Let's look at his big bets that made him famous:

K-Mart – He bought the debt at distressed levels, then influenced the reorganization process so that the returns for holders of that debt were maximized at the expense of other classes.

Autozone – He brought in a new CEO and started a massive share-buyback program.


You missed one:

Deluxe Corp - Buy the stock. Get the company to lever up to do a massive share-buyback program. Quietly exit the stock, leaving said business hugely overlevered with a core business that is accelerating downward.

I like Lampert too, but let's not forget that activist investors don't always use their influence to bring about changes that are in the best interests of the companies that they are invested in.

(Your point is obviously a good one though. Unless you are fairly concentrated, being an activist isn't even an option.)
Print the post Back To Top
No. of Recommendations: 3
There are huge diminishing returns when it comes to diligence, and one of Marty Whitman's great comments is that most investment ideas usually turn on two three important things.

That said, since every investment is unique, it can obviously often take a lot of work to figure out just what those 2 or 3 things are. Phoning up the European ship registry to verify the ownership rights of the ship might have seemed like an excessive amount of diligence for an ACLN investor at the time, but history has proven that "the CEO is an international criminal mastermind" was precisely one of those 2 or 3 important things that would determine the fate of this company.
Print the post Back To Top
No. of Recommendations: 2
Then again, the accumulation of knowledge and experience with respect to companies, patterns, people and industries is enormously important in being a good investor, and often seemingly minor things can crawl their way into your instinct without you knowing it.

'often' is probably too weak a word. the fact of the matter is that we all consider ourselves to be roughly as good/knowledgeable/intelligent today as we were yesterday, yesterday as the day before, on 1/1/2003 as on 12/31/2002, and on 1/1/1993 as on 12/31/1992. So almost by definition there must be tons on little things that crawl into the memory and help future decision-making. Then again, there are some 'eureka' moments but even then they mostly get forgetten a month later. I can't recall any eurake moment off the top of myhead right now then when I was reading the Intelligent Investor which I remember as a pretty intense reading.
Print the post Back To Top
Advertisement