Video – Mohnish Pabrai On Forbes

 

Intelligent Investing with Steve Forbes presents Mohnish Pabrai, managing partner, Pabrai Funds

Major take-aways from the interview:

  • Attitude is the most important attribute of any investor
  • The value investor’s attitude advantage is the ability to wait for the right opportunity
  • “All man’s miseries stem from his inability to sit in a room alone and do nothing” channeling Pascal into an investor appropriate format: “All investment managers’ miseries stem from an inability to sit alone in a room and do nothing”
  • Ideal investment industry: gentlemen of leisure who go about their leisurely tasks and when the world is severely fearful is when they put their leisurely tasks aside and go to work
  • People think entrepreneurs take risk; in reality, they do everything they can to minimize risk– low risk, high return bets
  • Pabrai Funds has a “moat” by mirroring Buffett’s 25% performance after 6% hurdle because it aligns his interests with his clients; total fund expenses are 10-15 basis points, with Pabrai’s salary and staff paid for out of performance fees
  • Shorting makes no sense because maximum upside is a double and maximum downside is bankruptcy
  • Do not talk to company management because they are high charisma sales people and will pitch you on optimism, not realism
  • Big fan of the Checklist Manifesto, has a checklist of 80 items he looks over before making an investment
  • Pioneers are the people who get filled with arrows

Geoff Gannon Digest #5 – A Compilation Of Ideas On Investing

Why I Concentrate On Clear Favorites And Soggy Cigar Butts

  • Graham and Schloss had >50 stocks in their portfolio for much of their career
  • They turned over their portfolios infrequently; probably added one position a month
  • To avoid running a portfolio that requires constant good ideas:
    • increase concentration
    • increase hold time
    • buy entire groups of stocks at once
  • With his JNets, Gannon purchased a “basket” because he could not easily discriminate between Japanese firms which were both:
    • profitable
    • selling for less than their net cash
  • Portfolio concentration when investing abroad is based upon:
    • which countries do I invest in?
    • how many cheap companies can I find in industries I understand?
    • how many family controlled companies can I find?
  • Interesting businesses are often unique

How Today’s Profits Fuel Tomorrow’s Growth

  • To elements to consider with any business’s returns:
    • How much can you make per dollar of sales?
    • How much can you sell per dollar of capital you tie up?
  • Quantitative check: Gross Profit/ ((Receivables + Inventory + PP&E) – (Payables + Accrued Expenses))
  • Once an industry matures, self-funding through retained earnings becomes a critical part of future growth; it’s the fuel that drives growth
  • A company with high ROIC isn’t just more profitable, it can more reliably grow its own business
  • Maintaining market share usually means increasing capital at the same rate at which the overall market is growing
  • Higher ROIC allows for the charting of a more reliable growth path
  • Industries where ROIC increases with market share present dangers to companies with low market share or low ROIC
  • The easiest place to get capital is from your own successful operations; tomorrow’s capital comes from today’s profits

Why Capital Turns Matter — And What Warren Buffett Means When He Talks About Them

  • Capital turns = Sales/Net Tangible Assets
  • Buffett nets tangible assets against A/P and accrued expenses; gives companies credit for these zero-interest liabilities, rather than assuming shareholders pay for all of a company’s assets
  • Buffett’s businesses tend to have higher sales per dollar of assets
  • Companies with higher sales per dollar of assets have higher ROIC than competitors even if they have the same margins
  • There’s more safety in a business in an industry with:
    • adequate gross margins
    • adequate capital turns
  • Industries dependent upon margins or turns open themselves to devastating attacks from the player who can maximize key variables you control:
    • price
    • cost
    • working capital management
    • etc.
  • Companies often compete on a specific trait; it has to be a trait that is variable and can be targeted for change

How to Lose Money in Stocks: Look Where Everyone Else Looks — Ignore Stocks Like These 15

  • It’s risky to act like everyone else, looking at the same stocks everyone else looks at, or by entering and exiting with the crowd
  • Don’t worry about which diet is best, worry about which diet you can stick to; find an adequate approach you can see through forever
  • Having Buffett-like success requires every day commitment
  • You should aim to earn 7% to 15% a year for the rest of your investing life if you aren’t going to fully commit like Buffett did
  • A good investment:
    • reliable history of past profitability
    • cheap in terms of EV/EBITDA
    • less analyst coverage
  • A list of such stocks:
    • The Eastern Company (EML)
    • Arden (ARDNA)
    • Weis Markets (WMK)
    • Oil-Dri (ODC)
    • Sauer-Danfoss (SHS)
    • Village Supermarket (VLGEA)
    • U.S. Lime (USLM)    
    • Daily Journal (DJCO)
    • Seaboard (SEB)
    • American Greetings (AM)
    • Ampco-Pittsburgh (AP)
    • International Wire (ITWG)
    • Terra Nitrogen (TNH)
    • Performed Line Products (PLPC)
    • GT Advanced Technologies (GTAT)

Thoughts On Diversification & Ideal Portfolio Management: A Reply

I’ve been having a constructive conversation on the topic of diversification fellow value investor Nate Tobik of OddballStocks.com.

Now, this conversation all started because of an e-mail I sent entitled “why isn’t AAPL cheap?”, the point of which was to discuss the reasons why a company that looks like it is cheap statistically (AAPL has a low P/E, outstanding balance sheet, huge FCF generation, etc.) still might not be. The diversification discussion arose organically and orthogonally. I mention this only because reading Nate’s comments is kind of like jumping into the middle of a conversation– that’s not his fault.

Below, I reproduce several of his e-mails (with his permission) and add my own commentary as well:

The other thing is most companies I end up investing in are small caps and they do one thing. So I can look at a OPST or MPAD and read the annual report in 20m. Keeping up with them probably requires 45m a year and I can explain them quickly. So having a stable of companies like this isn’t really a big deal at all. Contrast that with how much time it would take to look at BAC or AIG, it’s crazy. I can probably look at 15 small caps in the same amount of time as I’d spend looking at AIG.

My comment: In this first quote, Nate is explaining why he feels comfortable having a diversified portfolio. While I am worrying about scaling the number of positions in my portfolio down, Nate admits he is looking forward to celebrating his 50th pick one day.

I think Nate raises a valid point here. A company like BAC or AIG is so incredibly complicated, it’s hard to imagine how you’d have time to analyze anything else you might want to add to your portfolio after researching and fully understanding the risks of one of them. On the other hand, a lot of these net-nets we look at are simple businesses and while they have risks, the risks are easy to understand and keep track of for the most part. This is a fair response to the challenge I raised in my first post in which I suggested that diversification may add risk to a portfolio by creating confusion and dividing the attention of the portfolio manager.

Yeah, I’m not married to the idea of a single best idea, I mean what is that? Well America Movil has grown the most for me so is that my best idea? What about Mastercard a 10-bagger since 2006. Here’s the problem, when I purchased both of those I had no idea they’d do as well as they would, I just figured they were worth more than I paid.

[…]

In my view as long as every position I buy meets my return characteristics buying one more position doesn’t diworsify me because that next stock added has the same potential return as all the others. So holding 200 stocks that I think are all worth 50-100% more, or are compounding at 10-15% a year is fine, I would be happy with that. The reality is that many probably don’t exist.

My comment: This is probably true. But at the same time, there is nothing being added by diversification. The free lunch remains elusive. If you have 20 positions that all have a 15% per annum return potential with similar risk, you really just have 1 position with a 15% per annum return potential.

So if I looked and had to tell you what had the best prospects I really don’t know, and that’s not because I question my judgement, it’s because in my experience it’s impossible to tell. I could tell you what is growing on my basis the quickest, or what is the cheapest, but absolute best idea, I don’t know. I don’t think that’s in my investor DNA.

I’ll say though when I see something crazy cheap I will try to keep buying up to a limit, I’ll usually max out at 5% or so.

My comment: Nate is responding to my argument in the previous post that, instead of diversifying, you should put everything into your “best idea”, whatever that may be at the time (best defined as highest return potential for lowest risk out of all alternatives being considered). And he’s definitely correct that you can’t know ahead of time which investment out of a “crop” will realize the highest “yield” ahead of time. I agree there.

But my point was slightly different– that if you’ve got three different plants, say, and one of them looks the healthiest of the other two, water that one, a lot. Don’t water all three, a little, and see what happens.

I think this is where Nate’s comments on the subject are weakest. I think he’s essentially making my point (one of my points, anyway), for me. In contrast, where I think his comments are strongest are just below.

So here’s my thinking on ‘best idea’ and diversification. There is merit to it with a big “BUT.” So for you, say you take over the business, you have the ability to affect change, to run it as you like. You can only own the one business and nothing else and that’s fine, plenty of business owners do that. In a classic sense you have no diversification but it doesn’t matter because you have control.

I don’t control anything I own, and there is a limited amount someone can know about a business from the outside. So if your business sent me the financial statements I could learn a lot, but I would never know as much as you because you’re inside. Even if you don’t have statements you know more, you see salesmen walking around, you know if they’re selling a lot or not by their attitude. You know if the carpet has been replaced recently or if the furniture is getting old. All those little intangibles add up. I could go visit every company I invest in and try to learn this, some people do. That is the point of the sleuth investor, he gets to know the customers, sleuths the company, gets to know the employees. he basically gets to know everything you can know without being an insider, then he loads up. So the idea has merit.

I don’t do any of that, I’m reading statements from my basement and even when I get involved in a company all I get back is a nice letter saying thanks they’ll look into it. So I need to diversify my ignorance, I have a 5% rule because I initially don’t want to go crazy on a new position. I let positions run, at one point Mastercard and America Movil were 50% of my portfolio. I know the companies, I didn’t care, I’ve sold them down so they’re about 25% now, but still. I like to scale into something as I get to know it better. A company I’ve owned for five years I know a lot better than a company I just researched no matter how much reading I did on it.

My comment: This makes sense. Essentially what Nate is saying is that you’re taking an undue risk putting 100% into a non-control situation. There are probably few and rare opportunities where the situation is so clear cut and the risks of total concentration so minimal that you can get away with full concentration (zero diversification, or “non-portfolioization” as I put it before).

This has me “stumped.” I don’t have a great response for this (not that I need to… this is an argument about being right, it’s a discussion about merits and lack thereof). Intuitively it makes sense because my belief all along has been that the more information you have and the more conviction you have about an idea, the more you should be concentrated in it, with the extreme being 100%. But Nate is pointing out that the only place where you can be “certain” or have full knowledge of the business itself, have full conviction about what the world looks like from the business’s perspective, is if you have control of the business. So, outside of that condition, you should not concentrate 100% in normal circumstances.

As Nate mentioned later in an e-mail, he is a “serial investor”, meaning, he is looking at ideas one at a time and evaluating if that investment meets his hurdle. He is not usually comparing multiple investment ideas at once and then picking the “best idea” of the bunch.

This reminds me of a section from early in The Snowball where Schroeder says that Buffett was typically fully invested but, for the first time in his life in the mid-1960s, he was finding the bargain pool to be dried up and felt forced to sit in cash as opposed to deploying his capital.

I think in that situation, you’re forgiven for “diversifying” into cash. But short of that, this “I am holding some cash ‘just in case'”, where the “just in case” is interpreted as “just in case I come across a great bargain or the market crashes” doesn’t hold water. What if that crash never comes, or the bargains you see right now are as good as they’ll get?

Why be “diversified” in cash at that point?

Should You Hedge Currency Risk When Investing Internationally?

I read a white paper by Tweedy, Browne entitled “How Hedging Can Substantially Reduce Foreign Stock Currency Risk” the other day. I actually find the title of the paper misleading because the way it’s written it sounds like they’re recommending you hedge your foreign currency exposure when investing overseas.

Instead, the finding of the paper seemed to be that for long-term investors, currency fluctuations are generally a wash over time and hedged and unhedged portfolios perform similarly.

Here’s a quick, bullet-point list of info from the paper:

  • currency fluctuations are generally more extreme than stock market fluctuations (greater volatility)
  • depending on whether or not home currency interest rates are higher or lower than foreign country interest rates, one can contractually lock-in either a cost or a gain from currency hedging operations
  • the investor who enters into a hedging contract to sell forward the foreign currency of a country whose interest rates are lower than his home country’s interest rates will receive a locked-in contractual gain
  • over long measurement periods, the returns of hedged portfolios have been similar to the returns of portfolios that have not been hedged
  • “Over the 1975 through June 1988 study period, the compounded annual returns on hedged and unhedged foreign equities were 16.4% and 16.5%, respectively” according to one study
  • According to TB’s own experience: “over the 15.75-year period from Jan 1, 1994 through September 30, 2009, the MSCI World Index (Hedged to US$) had an annualized return of 5.7%; this return was nearly the same as the return over the same period for the unhedged MSCI World Index, which had an annualized return of 5.8%”
  • studies have generally indicated that the compounded annual returns on hedged foreign stock portfolios have been similar to the returns on unhedged foreign stock portfolios
  • currency hedging is similar to selling short
  • the cost to an investor of hedging foreign currencies through forward and futures contracts is approximately equal to the difference between interest rates in the home country and the particular foreign country over the contract period

Investor Adam Sues, who blogs over at ValueUncovered.com, wrote in to share Currency Hedging Programs: The Long-Term Perspective (PDF). I appreciate the link and have reproduced my outline notes of key take-aways below:

  • Remember, the floating exchange rate system is relatively new as it began in 1973
  • While median hedging impact numbers were close to zero in the Brandes Institute’s study, the range of outcomes was wide, with almost half outside the range of +/- 3% annualized; be prepared for extended periods of possible hedging losses
  • Japanese and US-based investors have experienced more volatile hedging results than Canadian-based investors; UK investors have had more favorable outcomes from hedging programs than US investors
  • As the timeframe lengthened, the impact of hedging overlays relative to long-term equity returns tended to diminish
  • A US-based currency hedging program for a non-US equity portfolio would have suffered an average annualized 1.8% loss over the entire 34-year period since the start of floating exchange rates (passive hedging programs are costly for US investors in the long-term
  • The dollar, when measured against other major currencies, has more often been at the extremes of valuation than in the middle
  • Currencies exhibited significant volatility in the short term but generally have been mean-reverting in the long term
  • Currency moves and the related hedging impact tended not to wash-out completely over time, and even for 5- or 10-year periods, the range of results remained wide
  • Currency overlay managers have shown evidence of value-add, but this effect has been small relative to the size of overall currency impact
  • Bottom-line: it’s appropriate for investors to choose either a hedged or unhedged benchmark, and then stick to it for the long-term

Review – More Money Than God

More Money Than God: Hedge Funds And The Making Of A New Elite

by Sebastian Mallaby, published 2010

A veritable pantheon of masters of the universe

Mallaby’s book is not just an attempt at explaining and defending the beginning, rise and modern state of the hedge fund industry (the US-focused part of it, anyway), but is also a compendium of all of the hedge fund world’s “Greatest Hits.” If you’re looking for information on what hedge funds are, where they come from, what they attempt to do, why they’re called what they are and how they should be regulated (SURPRISE! Mallaby initially revels in the success “unregulated” funds have had and feints as if he’s going to suggest they not be regulated but, it being a CFR book and he being a captured sycophant, he does an about-face right at the last second and ends up suggesting, well, umm, maybe SOME of the hedge funds SHOULD be regulated, after all) this is a decent place to start.

And if you want to gag and gog and salivate and hard-to-fathom paydays and multiple standard deviations away from norm profits, there are many here.

But that wasn’t my real interest in reading the book. I read it because I wanted to get some summary profiles of some of the most well known hedgies of our time — the Soroses and Tudor Joneses and such — and understand what their basic strategies were, where their capital came from, how it grew and ultimately, how they ended up. Not, “What’s a hedge fund?” but “What is this hedge fund?” As a result, the rest of this review will be a collection of profile notes on all the BSDs covered by the book.

Alfred Winslow Jones – “Big Daddy”

  • started out as a political leftist in Europe, may have been involved in U.S. intelligence operations
  • 1949, launches first hedge fund with $60,000 from four friends and $40,000 from his own savings
  • By 1968, cumulative returns were 5,000%, rivaling Warren Buffett
  • Jones, like predecessors, was levered and his strategy was obsessed with balancing volatilities, alpha (stock-picking returns) and beta (passive market exposure)
  • Jones pioneered the 20% performance fee, an idea he derived from Phoenician merchants who kept one fifth of the profits of successful voyages; no mgmt fee
  • Jones attempted market timing as a strategy, losing money in 1953, 1956 and 1957 on bad market calls; similarly, he never turned a profit following charts even though his fund’s strategy was premised on chartism
  • Jones true break through was harvesting ideas through a network of stock brokers and other researchers, paying for successful ideas and thereby incentivizing those who had an edge to bring him their best investments
  • Jones had information asymetry in an era when the investment course at Harvard was called “Darkness at Noon” (lights were off and everyone slept through the class) and investors waited for filings to arrive in the mail rather than walk down the street to the exchange and get them when they were fresh

Michael Steinhardt – “The Block Trader”

  • Background: between end of 1968 and September 30, 1970, the 28 largest hedge funds lost 2/3 of their capital; January 1970, approx. 150 hedge funds, down from 200-500 one year earlier; crash of 1973-74 wiped out most of the remainders
  • Steinhardt, a former broker, launches his fund in 1967, gained 12% and 28% net of fees in 1973, 74
  • One of Steinhardt’s traders, Cilluffo, who possessed a superstitious eating habit (refused to change what he ate for lunch when the firm was making money), came up with the idea of tracking monetary data, giving them an informational edge in an era where most of those in the trade had grown up with inflation never being higher than 2% which meant they ignored monetary statistics
  • One of Steinhardt’s other edges was providing liquidity to distressed institutional sellers; until the 1960s, stock market was dominated by individual investors but the 1960s saw the rise of institutional money managers; Steinhardt could make a quick decision on a large trade to assist an institution in a pinch, and then turn around and resell their position at a premium
  • Steinhardt’s block trading benefited from “network effects” as the more liquidity he provided, the more he came to be trusted as a reliable liquidity provider, creating a barrier to entry for his strategy
  • Steinhardt also received material non-public information: “I was being told things that other accounts were not being told.”
  • In December 1993, Steinhardt made $100M in one day, “I can’t believe I’m making this much money and I’m sitting on the beach” to which his lieutenants replied “Michael, this is how things are meant to be” (delusional)
  • As the Fed lowered rates in the early 90s, Steinhardt became a “shadowbank”, borrowing short and lending long like a bank
  • Steinhardt’s fund charged 1% mgmt fee and 20% performance fee
  • Anecdote: in the bloodbath of Japan and Canada currency markets in the early 90s, the Canadian CB’s traders called Steinhardt to check on his trading (why do private traders have communications with public institutions like CBs?)

Paul Samuelson & Commodities Corporation – “Fiendish Hypocrite Jackass” (my label)

  • Paul Samuelson is one of history’s great hypocrites, in 1974 he wrote, “Most portfolio decision makers should go out of business– take up plumbing, teach Greek, or help produce the annual GNP by serving corporate executives. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed.”
  • Meanwhile, in 1970 he had become the founding backer of Commodities Corporation and also investing in Warren Buffett; he funded his investment in part with money from his Nobel Prize awarded in the same year
  • Samuelson paid $125,000 for his stake; total start-up capital was $2.5M
  • Management of fund resembled AW Jones– each trader was treated as an independent profit center and was allocated capital based on previous performance
  • Part of their strategy was built on investor psychology: “People form opinions at their own pace and in their own way”; complete rejection of EMH, of which Samuelson was publicly an adherent
  • Capital eventually swelled to $30M through a strategy of primarily trend-surfing on different commodity prices; in 1980 profits were $42M so that even net of $13M in trader bonuses the firm outearned 58 of the Fortune 500
  • Trader Bruce Kovner on informational asymetries from chart reading: “If a market is behaving normally, ticking up and down within a narrow band, a sudden breakout in the absence of any discernible reason is an opportunity to jump: it means that some insider somewhere knows information that the market has yet to understand, and if you follow that insider you will get in there before the information becomes public”

George Soros – “The Alchemist”

  • Soros had an investment theory called “reflexivity”: that a trend could feedback into itself and magnify until it became unavoidable, usually ending in a crash of some sort
  • Soros launched his fund in 1973, his motto was “Invest first, investigate later”
  • Soros quotes: “I stood back and looked at myself with awe: I saw a perfectly honed machine”; “I fancied myself as some kind of god or an economic reformer like Keynes”
  • Soros was superstitious, he often suffered from back pains and would “defer to these physical signs and sell out his positions”
  • Soros believed in generalism: know a little about a lot of things so you could spot places where big waves were coming
  • Soros had a “a web of political contacts in Washington, Tokyo and Europe”
  • Soros hired the technical trader Stan Druckenmiller, who sometimes read charts and “sensed a panic rising in his gut”
  • As Soros’s fund increased in size he found it harder and harder to jump in and out of positions without moving the markets against himself
  • Soros rejected EMH, which had not coincidentally developed in the 1950s and 1960s in “the most stable enclaves within the most stable country in the most stable era in memory”
  • Soros was deeply connected to CB policy makers– he had a one on one with Bundesbank president Schlesinger in 1992 following a speech he gave in Basel which informed Quantum fund’s Deutschemark trade
  • “Soros was known as the only private citizen to have his own foreign policy”; Soros once off-handedly offered Druckenmiller a conversation with Kissinger who, he claimed, “does know things”
  • Soros hired Arminio Fraga, former deputy governor of Brazil’s central bank, to run one of his funds; Fraga milked connections to other CB officials around the world to find trade ideas, including the number two official at the IMF, Stanley Fischer, and a high-ranking official at the central bank of Hong Kong
  • Soros was a regular attendee at meetings of the World Bank and IMF
  • Soros met Indonesian finance minister Mar’ie Muhammed at the New York Plaza hotel during the Indonesian financial crisis
  • Soros traveled to South Korea in 1998 as the guest of president-elect Kim Dae-jung
  • In June 1997, Soros received a “secret request” for emergency funding from the Russian government, which resulted in him lending the Russian government several hundred million dollars
  • Soros also had the ear of David Lipton, the top international man at the US Treasury, and Larry Summers, number 2 at the Treasury, and Robert Rubin, the Treasury secretary, as well as Mitch McConnell, a Republican Senator

Julian Robertson – “Top Cat”

  • Managed a portfolio of money managers, “Tigers”
  • Used fundamental and value analysis
  • Once made a mental note to never buy the stock of an executive’s company after watching him nudge a ball into a better position on the golf green
  • Robertson was obsessed with relative performance to Soros’s Quantum Fund
  • Called charts “hocus-pocus, mumbo-jumbo bullshit”
  • Robertson didn’t like hedging, “Why, that just means that if I’m right I’m going to make less money”
  • High turnover amongst analysts, many fired within a year of hiring
  • Tiger started with $8.5M in 1980
  • A 1998 “powwow” for Tiger advisers saw Margaret Thatcher and US Senator Bob Dole in attendance
  • Tiger assets peaked in August 1998 at $21B and dropped to $9.5B a year later, $5B of which was due to redemptions (Robertson refused to invest in the tech bubble)

Paul Tudor Jones – “Rock-And-Roll Cowboy”

  • Jones started out as a commodity trader on the floor of the New York Cotton Exchange; started Tudor Investment Corporation in 1983, in part with an investment of $35,000 from Commodities Corporation
  • “He approached trading as a game of psychology and high-speed bluff”
  • Superstition: “These tennis shoes, the future of this country hangs on them. They’ve been good for a point rally in bonds and about a thirty-dollar rally in stocks every time I put them on.”
  • Jones was a notorious chart reader and built up his theory of the 1987 crash by lining up recent market charts with the 1929 chart until the lines approximately fit
  • Jones was interested in Kondratiev wave theory and Elliott wave theory
  • “When you take an initial position, you have no idea if you are right”but rather you “write a script for the market” and then if the market plays out according to your script you know you’re on the right track
  • Jones made $80-100M for Tudor Investment Corp on Black Monday; “The Big Three” (Soros, Steinhardt and Robinson) all lost heavily in the crash
  • Jones, like Steinhardt, focused on “institutional distortions” where the person on the other side of the trade was a forced seller due to institutional constraints
  • Jones once became the catalyst for his own “script” with an oil trade where he pushed other traders around until they panicked and played out just as he had predicted
  • PTJ never claimed to understand the fundamental value of anything he traded
  • PTJ hired Sushil Wadhwani in 1995, a professor of economics and statistics at the LSE and a monetary policy committee member at the Bank of England
  • PTJ’s emerging market funds lost 2/3rd of their value in the aftermath of the Lehman collapse

Stanley Druckenmiller – “The Linebacker” (my title)

  • Druckenmiller joined Soros in 1988; while Soros enjoyed philosophy, Druckenmiller enjoyed the Steelers
  • He began as an equity analyst at Pittsburgh National Bank but due to his rapid rise through the ranks he was “prevented from mastering the tools most stock experts take for granted” (in other words, he managed to get promoted despite himself, oddly)
  • Survived crash of 1987 and made money in the days afterward
  • Under Druckenmiller, Quantum AUM leaped from $1.8B to $5B to $8.3B by the end of 1993
  • Druckenmiller stayed in touch with company executives
  • Druckenmiller relied on Robert Johnson, a currency expert at Bankers Trust, whose wife was an official at the New York Fed, for currency trade ideas; Johnson himself had once worked on the Senate banking committee and he was connected to the staff director of House Financial Services Committee member Henry Gonzalez
  • Druckenmiller was also friends with David Smick, a financial consultant with a relationship with Eddie George, the number 2 at the Bank of England during Soros and Druckenmiller’s famous shorting of the pound
  • Druckenmiller first avoided the Dot Com Bubble, then jumped aboard at the last minute, investing in “all this radioactive shit that I don’t know how to spell”; he kept jumping in and out until the bubble popped and he was left with egg on his face, ironic because part of his motivation in joining in was to avoid losing face; Druckenmiller had been under a lot of stress and Mallaby speculates that “Druckenmiller had only been able to free himself by blowing up the fund”

David Swensen & Tom Steyer – “The Yale Men”

  • Swensen is celebrated for generating $7.8B of the $14B Yale endowment fund
  • Steyer and his Farallon fund were products of Robert Rubin’s arbitrage group at Goldman Sachs; coincidence that Rubin proteges rose to prominence during the time Rubin was in the Clinton administration playing the role of Treasury secretary?
  • Between 1990 and 1997 there was not a single month in which Steyer’s fund lost money (miraculous)
  • Farallon somehow got access to a government contact in Indonesia who advised Bank Central Asia would be reprivatized soon and Farallon might be able to bid for it
  • Some rumors claimed Farallon was a front for the US government, or a Trojan horse for Liem Sioe Liong (a disgraced Indonesian business man); it is curious that Yale is connected to the CIA, Farrallon is connected to Yale

Jim Simons & Renaissance Capital – “The Codebreakers”

  • Between the end of 1989 and 2006, the flagship Medallion fund returned 39% per annum on average (the fund was named in honor of the medals Simons and James Ax had won for their work in geometry and number theory– named in honor of an honor, in other words)
  • Jim Simons had worked at the Pentagon’s secretive Institute for Defense Analyses (another possible US intelligence operative turned hedgie?)
  • Simons strategy was a computer-managed trend following system which had to be continually reconfigured due to “Commodities Corporation wannabes” crowding the trades by trending the trends
  • Simons looked to hire people who “would approach the markets as a mathematical puzzle, unconnected to the flesh and blood and bricks and mortar of a real economy” (this is distinctly different than the Graham/Buffett approach, and one wonders how this activity is actually economically valuable in a free market)
  • “The signals that we have been trading without interruption for fifteen years make no sense. Otherwise someone else would have found them.”
  • Renaissance treated employee NDAs like a wing of the CIA– anyone who joined could never work elsewhere in the financial industry afterward, and for this reason they specifically avoided hiring from Wall St in the first place; they were required to invest a fifth of their pay in the Medallion Fund and was locked up as bail payment for four years after they departed (money hostage)

David Shaw & D.E. Shaw

  • Began trading in 1988, the same year as the Medallion fund
  • Shaw was originally hired by MoStan in 1986 into their Analytical Proprietary Trading unit which aimed at beating Steinhardt at his block-trading game using predictive computer technology
  • In 1994, Shaw’s 135-member firm accounted for 5% of the daily turnover on the NYSE
  • Jeff Bezos, of Amazon, was originally a DE Shaw employee
  • The strategy was heavily reliant on pair-trade “arbitrage”, looking for securities in similar industries which were temporarily misaligned in price/multiple
  • Circle of competence: in 1995 the firm launched the ISP Juno Online, as well as FarSight, an online bank and brokerage venture

Ken Griffin & Citadel

  • Created in 1990, grew to $15B AUM and 1400 employees by 2008
  • Griffin’s goal was to develop an investment bank model that could compete with traditional, regulated ibanks, but which was actually a hedge fund
  • Flagship funds were down 55% at the end of 2008, losing $9B (the equivalent of two LTCMs)

John Paulson

  • Paulson graduated from HBS in 1980 and went to work for Bear Stearns; he launched his hedge fund in 1994 with initial capital of $2M which grew to $600M by 2003; by 2005 he was managing $4B
  • Paulson’s main strategy was capital-structure arbitrage
  • He looked for “capitalism’s weak spot”, the thing that would blow up the loudest and fastest if the economy slowed even a little; cyclical industries, too much debt, debt sliced into senior and junior tranches, risk concentrated
  • Paulson spent $2M on research related to the US mortgage industry, assembling a proprietary database of mortgage figures and statistics
  • Many of Paulson’s investors doubted him and threatened to pull capital in 2006
  • Paulson enlarged his bets against the mortgage market through derivative swaps on the ABX (a new mortgage index) and eventually acquired over $7.2B worth of swaps; a 1% decline in the ABX earned Paulson a $250M profit, in a single morning he once netted $1.25B
  • By 2007, he was up 700% net of fees, $15B in profits and made himself $3-4B

Conclusion

I’m actually even more bored with this book having finished typing out my notes than I was when I finished the book the first time I read it. The book actually has some great quotes in it, from the insane delusions of grandeur of government officials and central bank functionaries, to wild facts and figures about the statistical trends of the hedge fund and financial industries over the last 60 years. I am too exhausted to go back and type some of it out right here even though I kind of wish I had some of the info here even without an idea of what I’d use it for anytime soon.

My biggest takeaway from MMTG is that most of these masters of the universe have such huge paydays because they use leverage, not necessarily because they’re really good at what they do. Many of their strategies actually involve teasing out extremely small anomalies between asset prices which aren’t meaningful without leverage. And they’re almost uniformly without a meaningful and logically consistent understanding of what risk is– though many are skeptics of EMH, they seem to all see risk as volatility because volatility implies margin calls for levered traders.

There were so many displays of childish superstition. Many of these guys are chart readers. The government intelligence backgrounds of many was creepy. And it was amazing how many relied on informational asymmetries which are 100% illegal for the average investor. These people really travel in an elite, secretive world where everyone is scratching each other’s backs. How many one on one conversations have you had with central bank presidents? How many trips to foreign countries have you been on where you were the invited guest of the head dignitary of the country? Are you starting to put the picture together like I am?

Overall, it seems so arbitrary. The best word that comes to mind to describe these titans and their success is– “marginalism”. We have lived in an inflationary economy for the last 60+ years and these players all seem to excel in such an environment. But inflationism promotes marginalism; the widespread malinvestment of perpetual inflation confuses people looking to engage in real, productive economic activity, and paper shuffling necessarily becomes a high value business.

The author himself is incredibly ignorant of economic fundamentals and the role monetary intervention plays in the economy. All of the various crises these hedgies profited from seem to come out of nowhere according to his narrative. The incredible growth in volumes of money managed by the hedge fund industry over time goes without notice, as if it was just a simple, unexceptional fact of life. Shouldn’t that be interesting? WHY ARE THERE HUNDREDS OF FIRMS MANAGING TENS OF BILLIONS OF DOLLARS EACH? Where did all this money come from?!

That makes the book pretty worthless as it’s key.

One thing that does strike me is that many of the most successful, most levered trades of Soros, Druckenmiller and others were related to currencies. These guys are all Keynesians but they probably don’t fully believe their own economic theories. However, they do understand them well enough to make huge plays against the dope money managers who DO put all their credence into what they learned at university. I should think an Austrian econ-informed large cap macro fund would have quite a time of it playing against not only the dopes, but the Soroses of the world– they’ll get their final comeuppance as this system of artificial fiat exchange finally unwinds over the next decade.

And, little surprise, the guy with the nearly perfect trading record for almost a decade (Farrallon) was involved in arbitrage trades.

Trend following is for slaves. It may have proven to be a profitable strategy (with gobs of leverage) for the contemporary crop of hedgies but I feel fairly confident in saying most of these guys will get hauled out behind the woodshed in due time if they keep it up, to the extent their strategies truly are reliant on mystic chart reading and nothing more.

Bon voyage!

Notes – A Compilation Of Ideas On Investing

How To Think About Retained Earnings

  • Grab 15 years of data from EDGAR and compare receivables, inventory, PP&E, accounts payable and accrued expenses to sales, EBITDA, etc.; E.g., if receivables rise faster than sales, this is where “reinvestment” is going
  • For a quick comparison, look at:
    • Net income
    • FCF
    • Buybacks + dividends
  • Compare debt (total liabilities) between the start of the period and the end and subtract the difference to get growth in debt
  • Then, sum all dividends and buybacks over the period, and all net income over the period
  • Then, subtract the change in debt from dividends/buybacks; what is left is dividends/buybacks generated by the business, rather than growth in debt
  • Then, compare this to net income to see the ratio of earnings paid out to shareholders
  • You can compare the growth in net income to retained earnings to get your average return on retained earnings
  • Look at the change in net income and sales over 10 years and then the ratio of cumulative buybacks and dividends to cumulative reported earnings
  • You’re looking for the central tendency of return on retained earnings, whether it is approx:
    • 5%, bad business
    • 15%, good business
    • 30%, great business
  • Companies with single products easily generate high returns on retained earnings, but struggle to expand indefinitely

One Ratio to Rule Them All: EV/EBITDA

  • EV/EBITDA is the best ratio for understanding a business versus a corporate structure
  • Net income is not useful; FCF is complicated, telling you everything about a mature business but nothing about a growing one
  • General rule of thumb: a run of the mill business should trade around 8x EBITDA; a great business never should
  • Low P/E and low P/B can be misleading as it often results in companies with high leverage
  • P/E ratio punishes companies that don’t use leverage; they’re often worth more to a strategic buyer who could lever them up
  • The “DA” part of a financial statement is most likely to disguise interesting, odd situations; if you’re using P/E screens you miss out on companies with interesting notes on amortization
  • Control buyers read notes; why use screens that force you to ignore them?
  • FCF is safer than GAAP earnings or EBITDA because it’s more conservative and favors mature businesses
  • EBITDA misses the real expense in the “DA”, but FCF treats the portion of cap-ex that is an investment as expense, so they’re both flawed; investment is not expense
  • No single ratio works for all businesses in all industries; but to get started, EV/EBITDA is the best for screening
  • Example: cruise companies have huge “DA”, but no “T” as they pay no taxes
  • “Only you can calculate the one ratio that matters: price-to-value; there is no substitute for reading the 10-K”
  • Empirical evidence on ratios:

Blind Stock Valuation #2: Wal-Mart (WMT) – 1981

  • There is something wrong with believing a stock is never worth more than 15 times earnings
  • “Growth is best viewed as a qualitative rather than a quantitative factor.”
  • Buffett’s margin of safety in Coca-Cola was customer habit– repeatability
  • Buffett looks for:
    • Repeatable formula for success
    • Focus
    • Buybacks
  • “The first thing to do when you’re given a growth rate is not geometry. It’s biology. How is this happening? How can a company grow 43% a year over 10 years?”
  • Stable growth over a long period of time tells you a business has a reliable formula; look for businesses that behave like bacteria
  • Recognizing the value of changes after they happen is important, not predicting them ahead of time
  • You can’t post the kind of returns Wal-Mart did through the 1970s without a competitive advantage
  • Buffett gleans most of his info from SEC reports, things like 10-year records of gross margins, key industry performance metric comparisons, etc.

GTSI: Why Net-Net Investing Is So Hard

  • The challenge of net-nets is you often have no catalyst in sight and no wonderful future to visualize as you hold a bad business indefinitely
  • Graham’s MoS is integral– you can be off in your calculation of value by quite a bit but Mr. Market will often be off by even more
  • Focusing too much on time could be a problem in net-net investing
  • Two pieces of advice for net-net investing:
    • Put 100% of focus on buying and 0% on selling
    • Put 100% of focus on downside and 0% on upside
  • Money is made in net-nets not by the valuing but by the buying and holding
  • “You want to be there for the buyout.”
  • The hardest part of net-net investing: waiting
  • Graham and Schloss were successful likely because they built a basket, so they were always getting to buy something new that was cheap instead of worrying about selling
  • Focus on a process that keeps you finding new net-nets and minimizes your temptation to sell what you own

Can You Screen For Shareholder Composition? 30 Strange Stocks

  • Shareholder composition can help explain why a stock is cheap
  • A company’s shareholder base changes as the business itself changes; for example, a bankruptcy turns creditors into shareholders
  • Shareholders often become “lost” over the years, forgetting they own a company and therefore forgetting to trade it
  • Some companies go public as a PR ploy, so investors may be sleepy and inactive
  • Buffett understood this and understood that a stock could be a bargain even at 300% of its last trade price– National American Fire Insurance (NAFI) example
  • Buying a spin-off makes sense because many of the shareholders are stuck with a stock they never wanted
  • An interesting screen: oldest public companies with the lowest floats (in terms of shares outstanding); a lack of stock splits combined with high insider ownership is a recipe for disinterest in pleasing Wall St

How My Investing Philosophy Has Changed Over Time

  • Info about Geoff Gannon
    • high school dropout
    • bought first stock at 14
    • read [amazon text=Security Analysis (1940 Edition)&asin=007141228X] and [amazon text=The Intelligent Investor (1949 Edition)&asin=0060555661] at 14
    • over time, became more Buffett and less Graham
    • made most money buying and holding companies with strong competitive positions trading temporarily at 6, 10 or 12 times earnings
  • I like a reliable business with almost no history of losses and a market leading position in its niche
  • Geoff’s favorite book is Hidden Champions of the Twenty-First Century, which is part of a set of 3 he recommends to all investors:
    • You Can Be a Stock Market Genius (by Joel Greenblatt)
    • The Intelligent Investor (1949 Edition)
    • Hidden Champions of the Twenty-First Century
  • Everything you need to know to make money snowball in the stock market:
    • The Berkshire/Teledyne stories
    • Ben Graham’s Mr. Market metaphor
    • Ben Graham’s margin of safety principle
    • “Hidden Champions of the 21st Century”
  • Once you know this, if you just try to buy one stock a year, the best you can find, and then forget you own it for the next 3 years, you’ll do fine; over-activity is a major problem for most investors
  • Bubble thinking requires higher math, emotional intelligence, etc.; that’s why a young child with basic arithmetic would make a great value investor because they’d only understand a stock as a piece of a business and only be able to do the math from the SEC filings
  • There are always so many things that everyone is trying to figure out; in reality, there are so few things that matter to any one specific company
  • One key to successful investing: minimizing buy and sell decisions; it’s hard to screw up by holding something too long
  • Look for the most obvious opportunities: it’s hard to pass on a profitable business selling for less than its cash
  • Extreme concentration works, you can make a lot of money:
    • waiting for the buyout
    • having more than 25% of your portfolio in a stock when the buyout comes
  • I own 4-5 Buffett-type stocks (competitive position) bought at Graham-type P/E ratios
  • “There is a higher extinction rate in public companies than we are willing to admit.”
  • Most of my experience came through learning from actual investing; I wish I had been a little better at learning from other people’s mistakes