This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details.
Selectivity, Hurdle Rate, Risk
“The higher level of the market, the fewer the undervalued securities and I am finding some difficulty in securing an adequate number of attractive investments. I would prefer to increase the percentage of our assets in work-outs, but these are very difficult to find on the right terms.”
All investors practice some degree of selectivity, since not all ideas/securities/assets we examine makes it into our portfolios. Selectivity implies that, for each of us, there exists some form of selection criteria (e.g., hurdle rate, risk measurement, good management, social responsibility, etc.).
In 1958, Buffett talks about finding it difficult to locate “attractive investments” on the “right terms” as the market got more expensive. Perhaps it’s a comfort to know that Buffett grappled with problems just like the rest of us mere mortals!
Jokes aside, as markets rise, what happens to our standards of selectivity? Do we change our usual parameters (whether consciously or subconsciously) – such as changing the hurdle rate or risk standards?
It’s a dynamic and difficult reality faced by all investors at some point in our careers, made more relevant today as markets continue to rally. I believe how each of us copes and adapts in the face of rising asset prices (and whether we change our selectivity criteria) separates the women from the girls.
Intrinsic Value, Exposure, Opportunity Cost
“Unfortunately we did run into some competition on buying, which railed the price to about $65 where we were neither buyer nor seller.”
“Late in the year we were successful in finding a special situation where we could become the largest holder at an attractive price, so we sold our block of Commonwealth obtaining $80 per share…It is obvious that we could still be sitting with $50 stock patiently buying in dribs and drags, and I would be quite happy with such a program…I might mention that the buyer of the stock at $80 can expect to do quite well over the years. However, the relative undervaluation at $80 with an intrinsic value of $135 is quite different from a price $50 with an intrinsic value of $125, and it seemed to me that our capital could better be employed in the situation which replaced it.”
Once a security has been purchased, the risk-reward shifts with each price movement. Any degree of appreciation naturally makes it a larger % of NAV, alters portfolio exposures, and changes the theoretical amount of opportunity cost (to Buffett’s point of his “capital could better be employed” in another situation).
So what actions does a portfolio manager take, if any, when a security appreciates but has not reached the target price, to a place where it’s neither too cheap nor too expensive, where we are “neither buyer nor seller”?
Unfortunately, Buffett offers no solutions in the 1958 letter. Any thoughts and suggestions from our Readers?