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Tariq Ali writes a great post about the follies of our fellow investing clan. I disagree with a few of the specific points he brings up but think the overall message is right on.
It’s wrong to judge the quant and technical analysis firms without knowing exactly how they work. If an investor who was just starting out asked me what style I suggested, value investing would be my answer, hands down. It’s much easier to grasp, and anyone can do it—you don’t need a PhD or any extraordinary skills. But that doesn’t mean that the other forms of investing aren’t valid.
Some traders are just lucky. Some value investors are just lucky. Both styles have practitioners who are phenomenal at what they do, and who have proved it over time. Until you’ve practiced all of these forms of investing, it’s hard to judge which is more valid.
Using the number of employees at a firm to judge success is misleading. Again, I don’t know much about them, but many don’t just run a single fund. Citadel for example has a wide range of investment-related activities (much like investment banks like Goldman Sachs). Also, it’s hard to get an idea of exactly how many of those employees are the actual decision makers for the portfolio (what really matters).
Warren Buffett has 1.5 employees (himself plus half of a Munger) on the investing side, and manages over $100 billion. I’d say he has done just fine over the years. There are three clear advantages to having a limited headcount. One, it avoids group-think when making decisions. Two, there’s no need to worry about “one-employee disasters”, Amaranth Advisors and Brain Hunter. And three, more obviously, it lowers overhead for small firms.
Eddie Lampert has a few dozen employees. Mohnish Pabrai has 1.7 employees. Neither is the “correct” amount as it all depends on your investing style. From what I’ve heard, Pabrai does little to no scuttlebutt. Lampert sends his analysts out on research and fact gathering missions and is constantly analyzing mountains of data regarding his positions. Both investors have proven they are highly capable and successful.
Returns Aren’t Comparable
Despite my view that non-value strategies shouldn’t be judged without empathy (especially when they have such great track records), I don’t believe the returns are necessarily comparable.
Many of the quantitative or technical analysis firms use leverage to enhance returns. Now I’m not against the use of leverage in general. Buffett would borrow on margin back in his partnership days to enhance the returns of “sure thing” arbitrage investments. But I believe he would only margin up to about 20% of capital (a more reasonable, but still dangerous amount). When modern-day funds are leveraged up to 3-5x capital (or even over 20x in LTCM’s case), it’s asking for trouble.
Every portfolio—quant or value, leverage or non-leverage—is exposed and vulnerable to Black Swans. But a portfolio with no leverage and a 15% cash position won’t be wiped out by one event (short of the U.S. government itself collapsing). In a fund that has borrowed 5x its equity, a 16% decline in holdings would wipe out 80% of equity. And that’s before taking into account the risk of margin calls or fleeing investors. Victor Neiderhoffer’s recent debacle (see The Blow-Up Artist for more) is the best example of this.
Also, on a side-to-side basis, taking away the affects of leverage, value/growth/momentum investors create more value when looking solely at holdings. Take a fund manager who achieves 20% annualized with an average cash position of 10%. Their individual “picks” have returned 22% (.20/.90). Another manager returns 40% annualized but has borrowed 200% of equity. Individual holdings in this case have returned 13% (.40/3). Now of course, returns to investors are what really matters. But this should still be taken into account when comparing the skill of individual managers.
Investing With the Allocators
I agree with Tariq in that one should always be looking to expand their circle of competence. But I disagree that the capital allocation skills of management shouldn’t be a large part of your investment thesis. When you have investing gurus running a company and allocating capital, it can be a tremendous part of the corporation’s overall success. Hence, it should be a large part of your thesis for any company.
Eddie Lampert realized early on that management has to be able to efficiently allocate and return capital to shareholders for an investment to be successful (long term). Both Lampert and Buffett go a step further and allocate/distribute capital themselves, while letting the managers run operations only (which makes a huge difference in the long run). K-Swiss (KSWS) is a good example of what can go wrong. The major reason I never invested is management’s poor capital allocation skills. Great company, bad reinvestment of capital.
So, should the company itself be of high quality and undervalued? Of course. But there has to be a way for those cash flows to get from operations to more opportunities and into your pocket. This only applies to long-term value investing. The skills of management in the long run matter little to short-term traders. But once again, there’s nothing wrong with that.
One thing I DO disagree with is when investors place 70% of their portfolio in a company like Berkshire Hathaway and then claim they have certain investing skills because of their 20% annualized returns. But as far as individual investments go, in a semi-diversified portfolio, companies run by investing-gurus are alright with me.
Related Article: Jim Simons of Renaissance Technologies