I once watched a video of a very old speech Buffett gave to MBA students. In it he talked about the failure of Long-Term Capital Management (LTCM) – formerly led by a notable team including 2 Nobel Prize Winners.
Here’s the link:
In this speech he explains a simple risk management concept in investing by using the game of Russian roulette as an analogy.
Let’s do a quick thought experiment. Suppose we have a once in a lifetime potential investment with a 99% chance of 1000000000000% upside and a 1% chance it goes to 0 in 1 years’ time. Some (or many) of you may think I’m crazy or stupid but I would allocate maximum only 10% of my book in such an idea. Why? Because any more than that then I may be at risk of failing to reach my long-term return goal. I can probably afford to have 1 bad year, but I definitely can’t afford to be out of the game permanently. Some people may look at the risk/reward and say “but that’s crazy, that’s an amazing risk/reward, you should definitely put 50-100% of your book in that idea”. If you’re thinking to put somewhere between 50-100% of your portfolio in such an idea, you run the risk of losing everything or at the very least setting yourself up in an almost unrecoverable position. My point is that no matter how miniscule the probability is, in reality the 1% chance can happen. In order to build a great long-term track record, these situations always have to be sized appropriately. I think it’s safe to say that LTCM took outsized risk.
How this applies to my favorite investment heroes Buffett and Malone:
Buffett could have easily used more leverage in Berkshire and become even richer than he is today, without increasing the probability of a permanent impairment of value. He simply chooses not to use more leverage. Back to Buffett in a later point.
Many value investors might not like Malone’s use of substantial leverage in his companies, but I do. Malone is a genius in applying just the optimal amount of leverage. This doesn’t mean he doesn’t consider having a large margin of safety when using the right amount of leverage. He understands his industry incredibly well, including the nature of the business and the financial structures of all the major players involved. Even in a realistic worst case scenario, he knows that the equity will not be permanently impaired in value. He is, after all, typically the largest shareholder in his companies. Malone is probably greedier than Buffett today. He typically likes his companies undervalued so that they can buy back more stock at cheaper prices and at a discount to intrinsic value. (I hope he doesn’t see this because I love him and should have sent him a Christmas card over the holidays).
Buffett obviously has superb portfolio management skills. In his earlier days when running his private investment partnership he would have 40%+ positions, and he was ultimately right. If in reality the “right” weighting for a certain investment in a portfolio is 25%, Buffett would probably figure that out and allocate somewhere between 24-26% of his portfolio in it – that’s how good he is.
I think portfolio management is much more of an art than science. Most professional fund managers diversify in over 100 names because they probably think that makes a much “less riskier” portfolio. They certainly teach you this bullshit in business school. According to modern portfolio theory these idiots (oops, pardon my French) tell you that the greater number of names in your portfolio, the greater the diversification and the less “riskier” a portfolio is. This is obviously wrong, because the right definition of risk is the probability of a permanent impairment of capital. In order to avoid a permanent impairment of capital you need to buy – at the right price – shares in a business at a deep discount to intrinsic value. To arrive at a business’ intrinsic value involves conducting intensive, deep, fundamental research, especially for industries and businesses with a lot of moving parts. See where the art part is coming from?
So back to my original point: How the fuck is any portfolio manager supposed to know the risk/reward in over 100 portfolio names, especially in this complex, ever fast-evolving capitalist economy. The answer is he/she doesn’t, because as far as I know we as humans can only store a limited amount of knowledge in our brains at any given time (doesn’t mean we can’t compound general knowledge over time). If you don’t know the risk/reward in all of your portfolio names, well then guess what? Maybe your portfolio is riskier than you think it is. Remember, the price you pay is the ultimate factor that decides your margin of safety. My point is that I think the chances that one investor finds over 100 great investment ideas at any one time is pretty close to 0 – especially in today’s ever increasing efficient stock market. If one day you wake up and know the risk/reward in over 100 public companies given their current market prices, you might have turned into a super intelligent alien. The last time I checked, Sir Isaac Newton was still dead. Maybe Elon Musk is a candidate.
“Diversification is a protection against ignorance” – Warren Buffett
Michael Mauboussin, Howard Marks and Thinking about a Probabilistic World
I think the art of winning in poker has a lot of similar aspects to being a successful investor. Poker, like investing, is largely a zero-sum game. In poker, you have to know how to size your bets, and you absolutely have to understand risk management. The best portfolio managers know how to best size a position – whether it should be a 30% or 10% weighting for example – and they definitely know what they know and know what they don’t know. As value investors we should be obsessed about the downside. I personally ask myself before I make any investment: what can go wrong? Like it or not, I think this point is even more important for concentrated investors. As concentrated investors we may hold only a handful of names at any given time. Let’s just say if we’re wrong on any of these names, we can potentially get fucked. I talked about how having over 100 names in a portfolio can be risky, but what can potentially be even more risky is a concentrated bet with a miscalculation of the downside. I see a ton of fund managers in Canada that seem to have a love with investing in resource-based companies because they think commodities will go to the moon. I’m no commodity expert, but even I’m smart enough to know that if the underlying commodity tanks – which it easily can, or certainly there’s a real probability of it happening – your gold or gas or oil or whatever project can become permanently uneconomic. These fund managers probably aren’t stupid, but don’t properly control risk. On the other hand you have to know when to bet big when the odds are clearly stacked in your favor. If you think in the worst case scenario you’ll still make money then you should clearly size the position as a top holding. I don’t think it helps if you’re constantly scared of losing money. I think the best investors, like top poker players, probably have some sort of “desensitized” relationship with money. You have to think rationally to perform your best. In essence when you transact it’s an act of arrogance, as Klarman says, and you better not be the sucker at the poker table. It’s hard and often it takes “second-level” thinking, especially for well-followed, liquid companies.
One in a Million
My final point is that there are tons of very smart, great analysts out there who can regularly find great investment ideas. But only a tiny fraction of these guys will ever achieve legendary-type returns (if they attempted to) because of poor portfolio and risk management. I really don’t know if you’re “born” a great investor or not, all I know is that it’s pretty fucking hard. Of course achieving great returns is waaaaay easier said than done, and a lot of it has to do with having the right temperament and psychology. I’m not talking about just beating the S&P for 100-200 bps by the way (which most people fail to do), I’m talking about 20%+ annualized over a 20+ year period. The best we can probably do is to study the great investors we admire, reverse engineer their best investments, apply their lessons and mistakes learned in your own portfolio by developing your own theses, and in time you’ll start developing pattern recognition skills. Did I mention that you should read a shit ton of annual reports?
I think on both ends on the spectrum (being concentrated versus being “widely diversified”) there are lessons to take away from this. Personally I’m a concentrated investor and will likely remain that way for the rest of my life. I seem to have a style that is a mix of Malone, Buffett and Greenblatt. I love to dive deep into companies and industries and learn the most important things and key drivers I need to know to have an edge over the person on the other side of the trade. I also think it’s important to identify catalysts that will unlock value or else it’s a value trap and I won’t know what the fuck I’m doing. It’s important to discern whether you’re catching a falling knife from the 30th or 2nd floor right? And that’s why I love this field. It’s more of an art than a science, and if you want to compete with the very best analysts out there and generate legendary-like returns you will be constantly intellectually stimulated. Hopefully in this blog you’ll see what I’m talking about.
So the next time you’re thinking about putting on a huge weight on a company that has even a slight chance of going to 0, think about that revolver with a million chambers in it, but with 1 bullet, and pointing that at someone you deeply care about, or at yourself.
Back to reading eBay’s 10-k and learning about John Danahoe’s brilliance.