Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details.
Creativity, Trackrecord
“…although I consider myself to be primarily in the quantitative school…the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a ‘high-probability insight.’ This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and of course, no insight is required on the quantitative side…So the really big money tends to be made by investors who are right on the qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.
Such statistical bargains have tended to disappear over the years…Whatever the cause, the result has been the virtual disappearance of the bargain issue as determined quantitatively – and thereby of our bread and butter.”
Rome wasn’t built in one day. Neither was Warren Buffett’s investment philosophy. Here, he is debating the merits of quantitative vs. qualitative analysis. In the 1966 & 1967 letters, we see Buffett gradually shifting his investment philosophy, drawing closer to the qualitative analysis for which he’s now famous, under the influence of Charlie Munger.
The necessity of this debate grew as AUM increased and markets got more expensive (disappearance of the quantitative “bread and butter”), and as Buffett considered next steps in career progression. By the end of 1967, he had proven that he can compound capital in a treadmill, fund-style vehicle, but what next, especially as the market environment became difficult and opportunities rare? (More on this in Part 2)
Today, it’s difficult to imagine the Oracle’s investment philosophy ever requiring improvement or change, but here we see evidence that suggests it has indeed evolved over the years. The ability to adapt & improve is what separates the one-trick ponies from the great investors of today and tomorrow.
This brings us to a corollary that’s very much applicable to the asset allocation and investment management world. During the fund manager evaluation process, most clients and allocators focus intensely on historical performance trackrecords because they believe it’s an indicator of potential future performance.
But by focusing on historical figures, it’s possible to lose sight of a very important variable: change.
Our personalities and investment philosophies are products of circumstance, in life and in investing – sensitive to external influences, personal or otherwise. Examples include: emergence of new competition, availability of opportunity sets, increased personal wealth, marriage & family, purchase of baseball teams, drug habits, etc. Even great investors like Warren Buffett have evolved over the years to accommodate those influences.
It would be wise to pay attention to external influences and agents of change (the qualitative) during the fund manager evaluation process, and not rely solely on the historical trackrecord (the quantitative).
Cash, Liquidity, Volatility
As of November 1st 1967, “we have about $20 million invested in controlled companies, but we also have over $16 million in short-term governments. This makes a present total of over $36 million which clearly will not participate in any upward movement the stock market may have.”
Around this time, BPL had ~$70MM AUM. This means cash accounted for 23% of NAV, and control positions for 29% of NAV.
The control positions likely had very limited liquidity if Buffett needed to sell. This leads me to wonder if the high cash balance was kept for reasons other than dry powder for future opportunities, such as protection against possible investor redemptions. (Remember, at this juncture, Buffett did not yet have permanent capital).
Also, notice that Buffett’s is very much aware of the expected volatility of his portfolio vs. his benchmark – that over 50% ($36MM) of the portfolio will likely not participate in any upward market movement.
Expected Return, Volatility
“We normally enter each year with a few eggs relatively close to hatching; the nest is virtually empty at the moment. This situation could change very fast, or might persist for some time.”
Quoting Ben Graham: “‘Speculation is neither illegal, immoral nor fattening (financially).’ During the past year, it was possible to become fiscally flabby through a steady diet of speculative bon-bons. We continue to eat oatmeal but if indigestion should set in generally, it is unrealistic to expect that we won’t have some discomfort.”
Expected Return ≠ Expected Volatility
Making Mistakes
“Experience is what you find when you’re looking for something else.”
Probable Munger-ism.