A very smart friend and I were trading emails recently (comparing notes on a particularly hairy investment) and our conversation veered toward the issue of selectivity in an increasingly expensive and upward moving market. We reminisced about the good ol’ days (2008-2010) when fairly good businesses would trade at 5x FCF, or banks with clean balance sheets and decent ROEs were trading at 50% of book value. Whereas today, the cheap names usually come with patches of ingrown hairs.

So I asked him, “Does it bother you that the market is pushing you into hairy stuff like this? Selectivity standards have obviously come down since a few years ago, but how far down are you willing to let them go?”

His answer: “I’ve been thinking a lot about how the market is pushing us into crappier stuff. The problem is, I think this is closer to normal. 2008 and the following years were something we get only a few times during our careers. Downturns like the summer of 2011 probably happen with more frequency. So in between, we have to figure out how to scrape together money generating ideas. I think this makes your focus on portfolio management more valuable. Portfolio construction is going to be more important.”

All too often we hear cautionary tales of selectivity & patient opportunism, but the actual implementation is far trickier. Howard Marks summed this up nicely a few months ago: “You have to learn lessons from history, but you have to learn the right lessons. The lesson can’t be that we are only going to have a portfolio that can withstand a re-run of 2008, because then you could not have much of a portfolio.” 

Once again, investing forces us to delicately balance two opposing forces, which brings to mind Charlie Munger’s quote: “It’s not supposed to be easy. Anyone who finds it easy is stupid.”