No victor believes in chance. – Friedrich Wilhelm Nietzsche
Thanks to contributions from two readers, Chai and “TC”, who analyzed charlie479–the author of these case studies:http://wp.me/p1PgpH-cg, http://wp.me/p1PgpH-dc and http://wp.me/p1PgpH-cT we can learn what they gained from the cases.
Please excuse the light editing. Chai says,
Three key distinct lessons stand out. First, the key to long-term wealth creation is to invest in compounders i.e., stocks that can grow profitably and preferably with high pricing power and operating leverage and hold on as long as possible. Time would do the compounding magic. While investing in short-term oriented special situations may give you a return uplift you will still face capital reinvestment risk to find another good investment for redeployment of capital.
Secondly, great performance results come from investing in compounders at a valuation as low as possible. Compounders are rare but not cheap, true compounders are even rarer. This means you have to be willing to look at ugly situations (e.g., European stocks now?) or try to identify and recognize the sources of competitive advantage of the companies before anyone else (sometimes maybe even before the management themselves recognize the potential).
Thirdly, it’s crucial to always go to primary sources: 10k, Merger Proxy etc. and not to rely on secondary sources media to gain true informational advantage.
Separately while I am still trying to catch up on the material on Value Vault and your site, a few questions while reading this interview came out are:
(1) How concentrated should a portfolio be i.e., how should you size your portfolio? I know ultimately it would have to be dependent on your risk appetite / temperament (and perhaps if you are a fund manager, your investors expectation) etc. but would be keen to learn your perspective on this. If you use a 5-stock or 10 stocks approach, how do you rank various investment opportunities to take into consideration of non-quantitative consideration such as business quality aside from pure risk-reward /upside-downside ratio?
My reply: Prof. Greenblatt uses the example of the man who inherits $1 million and he has to invest it within 50 miles of where he lives. He wouldn’t put $1,000 in 1,000 businesses. He would walk around looking to put $100,000 to $200,000 in 5 to 10 businesses–the best businesses at the lowest prices he could find. If you can find great businesses at attractive prices then 6 to 8 positions diversify out 83% to 88% of the market specific risk. If you have only 6 positions then each position is 16.67% of your portfolio. If you get the following results over two years:
Most could not stomach the volatility in each stock but overall the portfolio does well. You really have to be unlucky/bad to get a goose egg or lose more than 50%, but your winners are what drive the returns. Buying these compounders that can redeploy capital at high rates is nirvana, but exceedingly difficult and rare to do.
All investing involves context. But you have to choose a philosophy and method that fits you. And you also must know the nuances with the approach. Charlie479 is buying companies that can compound their capital by both being very profitable and by redeploying their capital at high rates. Since these are difficult to find and buy he owns few of them and holds them to allow the compounding to work. For example, I believe Morningstar (Morn) is one example, but the price is too high for my understanding. But I do want to invest as much as possible in these—even no more than 4 or 5 if they have all the signs of a good investment.
But if I was buying net/nets then I might own 5 to 10 companies in a sector—playing a numbers game. If I am buying stable franchises I might by 20 to 25 names because I have no edge other than price. Also, I have to be quick to sell if the price closes my estimate of intrinsic value because then my return is only the return on equity over time. I am taking a long record of stability as my benchmark rather than my edge in understanding of how long the company can maintain its competitive advantage. I assume the company will hold onto it while I am an owner (the odds favor the strong) but I will be wrong occasionally, of course, as franchises (Nokia, Newspapers, radio) get breached or destroyed.
(2) The issue of price vs. business risk. What should one do when share price drops by 25%, 50% of 75%? What if you re-examine the investment thesis and the business risk seems to stay intact, do you double up your stake – given it’s a better bargain now? Do you sell out- perhaps partially as prudent measure just in case your analysis is wrong? Or to stay put?
Reply: All answers rely on context. Are you right or wrong? If you are wrong then you go down with the ship. What specific areas do you have to understand to know that you are wrong? Certain businesses are much riskier operationally then others (selling steel vs. soap). If the assets are solid and the company has no debt and the reason the price is dropping is due to mismanagement (earnings power value below asset value) and you know a strong activist value fund taking a large position, then perhaps you can double up. But, again, what are your choices? Perhaps while this is happening there are even better opportunities elsewhere? Or the tax loss is a good asset to have against an equivalent gain in another new position. There are so many variables, a precise answer is impossible.
Charlie Munger would tell you, “The importance of knowing what you know and don’t know. There is a lot of wisdom in this remark from Eitan Wertheimer: “I had a big lesson from Warren: the use of the word discipline…We learned very quickly that our most important asset is our limitations… the second thing we understand is that when we respect our limitations we don’t suffer from them anymore.”
(3) Cash portion of portfolio. What shall be the cash % a portfolio should have? I see that both charlie479 and Seth Klarman routinely set aside 25 – 30% cash. I would have thought instead of letting the cash sitting idle, it could be better deployed by upsizing into existing positions given these positions are well researched?
Cash allows them future optionality. Also, they allow for being wrong. You never know. Cash can build up because you sell one position or part of it and you can’t redeploy the capital at the prior discount to intrinsic value thus you wait until an opportunity arises and you don’t do anything stupid with cash burning a hole in your pocket.
I will ask Confucius, Buffett and Dwight Schrute (the Office) to help with your question.
In no particular order of wisdom:
Dwight Schrute– The secret to investing is not being an idiot (15 second video) http://www.youtube.com/watch?v=yVqhxMEf1jc&feature=related
Confuscius: “The superior man, when resting in safety, does not forget that danger may come. When in a state of security he does not forget the possibility of ruin. When all is orderly, he does not forget that disorder may come. Thus, his person is not endangered, and his States and all their clans are preserved.”
As Buffett said (about absence of the need to invest all the time): “You only have to do a few things right in your life as long as you don’t do too many things wrong.” Also, Seneca said, “The mind must be given relaxation; it will arise better and keener after resting.”
I wish I could give you easy rules to follow, but investing is an art more than a science and the biggest part of your investing success is YOU. Spend time thinking about your inherent flaws as well as the next 10-K.
“TC” comments on the charlie479 interview
Prior to even being interested in the stock market, charlie479 developed two excellent traits for successful investing – he was confident in his ability to solve problems, and he questioned conventional wisdom.
Charlie learned early on that investing in high quality, undervalued equities and allowing them to compound over many years was far superior (both in terms of excess return and the required effort) to the analysis and investing he was doing in his day job).
Charlie resonated with Buffet’s twenty punches philosophy. He realized (separately) that finding high quality companies at low valuations did not occur often, and portfolio concentration allowed him to take full advantage of his best ideas while acting a filter on those that did not make the cut. Buffet’s quote was reassuring to him, that yes, taking a 25% position in your best idea does not make you crazy, it makes you intelligent!
Charlie focuses much of his effort on the qualitative side of his analysis – knowing the industry well and a deep dive on the competitive advantages and their sustainability at the company level. I get the impression he would first identify a high quality company by its quantitative factors – high ROIC relative to peers, high margins, etc. but would then thoroughly explore the qualitative causes of this advantage. A critical component of his best ideas was that they could reinvest their cash flows and earn similar high levels of return on large amounts of capital – i.e., a long and wide runway.
What I learned:
It is nice to see someone investing successfully with a model of extreme concentration. Buffet and Greenblatt preach it, but Charlie proves once again it can be done.
In my opinion, the best part of a concentrated portfolio is that, with fewer investment decisions, I can devote more time to finding more ideas, or doing non-investment related things. A common complaint I hear from fellow investors is they don’t have enough time to find good ideas. Portfolio concentration fixes this problem.
I love his analogy of investors jumping from fire to fire, trying to determine if the stock is worthy of investment, while he seems to do his preparation well ahead of making a buying decision. This sounds like what people do who are following the 52-week low list. Right out of Buffet’s playbook, he follows many high quality companies on a regular basis and reads 10-ks consistently – two of his investment examples showed this (7-10 years of following I believe). I can picture him thumbing through a 10-k asking himself “is the competitive advantage still present? Does the company still have a long runway for reinvestment?”
If Charlie is able to find these type of companies at low prices, it means the market does not always see the true competitive advantages underlying a company – even if you can know their presence from a quantitative standpoint. Having an absolute understanding of a company’s competitive advantages is an edge over the market, and the confidence to load up when the price is right.
I hope you found my report satisfactory!
My reply: Yes, excellent insights and thanks for sharing your thoughts. You noticed charlie’s inquisitive, skeptical mind and his disciplined habit to read original documents like 10-ks not broker reports. Also, this investor thinks deeply about what creates and sustains an excellent business. Well done.
I will post a few more case studies of charlie479 as good examples of an investment thesis.