The investment manifesto (1/2)

It’s been a while since I last posted anything here on the blog. I’m sure that this isn’t the last time I zoom out and remain silent for a while. In the end, although I’m always interested in hearing your thoughts and getting your feedback, I write for an audience of one, me. If that selfish audience is not keen on or have the time to listen the blog will be a quiet one from time to time. I hope you understand.

Nonetheless, after a long break I will try to distill the mess of thoughts that have accumulated in my head and in this case present the reason why I haven’t posted anything “portfolio related” since the mid of July.

A clean sweep

Although I haven’t posted anything you might have noticed, if you had a look at the Portfolio-page, that I sold all previous holdings during the last couple of months. In order to understand the why-question for my reason to do so I would like to start with a underappreciated Warren Buffett quote from the 1998 Berkshire shareholder letter:

Once we knew that the General Re merger would definitely take place, we asked the company to dispose of the equities that it held. (As mentioned earlier, we do not manage the Cologne Re portfolio, which includes many equities.) General Re subsequently eliminated its positions in about 250 common stocks, incurring $935 million of taxes in the process. This “clean sweep” approach reflects a basic principle that Charlie and I employ in business and investing: We don’t back into decisions. Berkshire Hathaway Shareholder letter 1998

What caused me to do a clean sweep of my previous portfolio holdings was that I came to develop a new investment manifesto. Rather than retrospectively trying to fit my previous investment decisions into the new manifesto I decided that the approach applied by Buffett and Munger would be a good and reasonable one for me as well.

One could question the rationality behind the clean sweep since the approach I had used up on till that point in time had worked out fairly well. On that note, I would like to stress that the development of a new manifesto is not a reach for more alpha or that I was dissatisfied with the track record that I had produced up on till that point in time. To the contrary, I realize that the new manifesto could possibly produce a worse outcome than a simple quant based approach. Especially in the short-term. However, at the core of my investing foundation is a firm belief if one is to be a long-term successful investor one should always focus on improving the process applied not the outcome. In other words, focus on what you can control. Over periods of time I will therefore be more than happy to look like a fool and have an audience that questions the rationality of my decisions as long as I believe that the process I apply is the correct one for me. Note that I in the previous sentence say the correct one for me not the correct one in some form of absolute sense. We will come back to this almost egocentric view of investing and its importance several times during the presentation of the manifesto.

The seeds to a new manifesto

Before presenting the process behind my new investment manifesto I would like to share the story and the circumstances that lead to its development.

At the start of the summer I decided that it was time for me to read all the Berkshire Shareholder Letters since I haven’t done so previously (you can find my extracts of wisdom from all the letters here). Defining oneself as a value investor, not having read the Berkshire letters is like being a Christian not having read the Bible. The same could be said about not having read Poor Charlie’s Almanack which I read and then re-read during the period I was reading the Berkshire letters. Having read all the Berkshire letters and Poor Charlie’s Almanack twice I could honestly say that I was on the brink of leaving the classic value investing school for the more modern value investing school. Still to this day I agree on almost all of Buffett and Munger’s points of argument as it relates to the advantages of the modern value investing school and their rational for leaving the classic school of value investing. But after countless of days thinking about a possible change I still came to the conclusion that the modern approach would be too hard for me to implement successfully.

Both Buffett and Munger are famous for the too-hard-pile analogy as it relates to individual investment ideas. I would argue that the concept can equally be applied to investment philosophies in general and their implementation. Placing an investment idea in the too-hard-pile will be a personal dependent evaluation and the same should be true for the investment philosophy too-hard-pile. I would argue, in the same way as one has to have conviction in the ideas that one invests in one has to have an even larger conviction in the philosophy that one applies. This off course has to do with the ability to “stick to your knitting” in both the good and the bad times. Not having conviction in your philosophy and your ability to successfully implement it will bring out the worst enemy of them all, you.

The investor’s chief problem – and even his worst enemy – is likely to be himself. – Benjamin Graham

Even though I was not “transformed” in the same way that Buffett once was by Munger I will without hesitation say that reading the Berkshire Shareholder Letters and Poor Charlie’s Almanack is by far the best “investments” I have made in my “investing life”. As you will see in the investment manifesto below, there are now principles at the core of it inspired by Buffett and Munger that did not exist before. These where the seeds to the new manifesto and has since then evolved into its absolute foundation. As many others do, I owe them a lot of gratitude.

Four investment principles

Sound investment principles produce generally sound investment results – Benjamin Graham

As it relates to Benjamin Graham’s quote above I would like to use the famous Munger expression:

I have nothing to add. – Charlie Munger

Therefore, I thought I would go straight to the point of presenting the four core principles of my investment manifesto (if you have read Poor Charlie’s Almanack you will recognize them):

1. Preparation. Continuously work on investment idea generation and the accumulation of mental models and worldly wisdom.

Opportunity meeting the prepared mind: that’s the game. – Charlie Munger

2. Discipline. Stay within the boundaries of the investment manifesto.

You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital. – Warren Buffett

3. Patience. Be selective and cautious in the buying- and selling process.

Resist the natural human bias to act. – Charlie Munger

4. Decisiveness. Believe in the investment manifesto and execute accordingly.

When proper circumstances present themselves, act with decisiveness and conviction. – Poor Charlie’s Almanack

Margin of safety

Beyond the four principles, but still at the heart of the manifesto, lies a focus on the concept of margin of safety, i.e. downside protection. By focus I mean that only after one has established a population of ideas with an adequate margin of safety one should move on and start to think and rank the ideas remaining in terms their possible return opportunities, i.e. upside potential.

The concept of margin of safety was first developed (as far as I know) by Benjamin Graham and David Dodd in the classic value investing book Security Analysis that was first published in 1934. However, I think most investors that are familiar with the concept relate it to the 1949 book by Graham, The Intelligent Investor, and more specifically the last chapter in that book called “Margin of safety as the Central Concept of Investment”. As most of you will know, “the margin of safety” is a wide concept and one that has been defined in a variety of ways by both Graham himself and many others since the books first publications. In my opinion, there is nothing wrong with that. To the contrary, I would say that it is both natural and needed considering the variety of investing philosophies in existence and more specifically how one defines the concepts of value and risk. However, I would argue that the margin of safety purpose is a universal one that all can ascribe to (?). In my opinion that purpose was best defined in the original text of The Intelligent Investor:

It’s available for absorbing the effect of miscalculations or worse-than-average luck. – Benjamin Graham

Based on the definition for the margin of safety purpose and with the help of little inversion we can narrow in on my definition of margin of safety. Again, note that what I present below is my definition of margin of safety not a universal one. I would strongly suggest that one goes through the same process as I present below in order to come up with a definition that is your own.

In order to make the starting point of the margin of safety definition process a little bit less vague consider the following excerpt from Poor Charlie’s Almanack:

Why should we want to play a competitive game in a field where no advantage – maybe a disadvantage – instead of in a field where we have a clear advantage?

We’ve never eliminated the difficulty of that problem. And ninety-eight percent of the time, out attitude toward the market is … [that] we’re agnostics. We don’t know. […]

We’re always looking for something where we think we have an insight which gives us a big statistical advantage. And sometimes it comes from psychology, but often it comes from something else. And we only find a few – maybe one or two a year. We have no system for having automatic good judgement on all investment decisions that can be made. Ours is totally different system.

We just look for no-brainer decisions. As Buffett and I say over and over again, we don’t leap seven-foot fences. Instead, we look for one-foot fences with big rewards on the other side. So we’ve succeeded by making the world easy for ourselves, not by solving hard problems. – Charlie Munger

In other words, your margin of safety definition process should start by focusing on what you define as “no-brainer decisions” or “one-foot fences” to hurdle over and where you believe that you have a “big statistical advantage”. The outcome of that evaluation will allow you to invest in ideas where the purpose of the margin of safety concept will likley be fulfilled. I won’t, since I can’t, go into details about the specifics of the evaluation process for me personally. This is something that has taken years to develop and where the number of inputs now are numberless. Therefore, note that what I will present below is only the end product of a long evaluation process.

My margin of safety definition

Based on my investment beliefs and my accumulated investing knowledge I have developed my margin of safety definition. The population of companies that fit into this definition I call The Liquidation Oxymorons. These will constitute the population of companies that I’m allowed to invest in, i.e. they have an adequate margin of safety:

1) Selling below liquidation value (i.e. price below readily ascertainable net asset value)

2) Proven business model (i.e. historically profitable)

3) Sound financial position (i.e. low risk of bankruptcy)

4) Shareholder friendly management (i.e non-fraudulent management with a thoughtful capital allocation track record)

If you are an old reader of the blog you will find similarities in the above definition to the investing checklist I have previously used (see for example this post about PFIN). That is true. Whats has changed is that evaluation process for each of the four criteria is now qualitative rather than quantitative. Again, if that is a rational and wise move, especially from a return perspective, remains to be seen.

Since the post became longer than I first thought I will split it up into two parts. In the next post I will present the stock picking process for which companies from the Liquidation Oxymoron population to invest in, i.e. the evaluation of upside potential and catalysts. I will also present the guidelines for the manifesto’s portfolio construction and the selling process.

8 thoughts on “The investment manifesto (1/2)

  1. Great article and I have also been thinking long and hard about making a similar move…Particularly inspired by the same sources and Pabrai’s presentation https://www.youtube.com/watch?v=bLjoL5zhBxA&t=4248s

    Somewhat surprised though to see that you also sold out of the French banks. Having done a tremendous amount of research myself and read your articles I would have thought that these investments would still meet your new manifesto. Would be great to hear on what basis you decided to sell. Also, are you now fully cash and waiting for the right opportunity to meet your prepared mind?

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    1. Thanks for your comment and feedback Woyzecksr! The Pabrai presentation is awesome, as are all of his lectures.

      I understand that you and others are surprised by my actions. As I described it in the text, no assessment of my previous holdings was made in the sense of trying to retrospectively fit them into the manifesto. In other words, I decided the clean sweep was the best way for me to move forward and that was the end of the story for the French banks as well. But since you ask I will say this, the French regional banks a still dirt cheap (both on a relative and absolute basis) seen from a quantitative perspective. Also, I think the French banks could be a really good investment going forward (and had been for me for me since I bought them). However, I would have hard time making the case that they fulfill my margin of safety definition as it relates to both point 1 and 4. What I’m saying is that I think the upside exists but I’m more restrictive in my assessment of the downside protection than I was before.

      As it relates to my cash position it’s about 85-90 % at this point in time if I’m not mistaken. I will adress the buying process and the guidelines for the portfolio construction in the next post.

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  2. Cigarr, I am happy to see you continue this blog!

    I am a bit surprised by your clean sweep approach, mainly because I expect good future returns from your former holdings which I still own myself. But it makes sense if you want to focus on your new process, even though I would have held the old positions until new ones have been identified.

    Regarding your new manifesto I like what you have shared so far and I am glad you will stay in the “fair company at a wonderful price” corner for the time being. The evolution you try to enforce is the same I would like to do myself in the next years. Adding quality analysis to solid quant fundamentals.

    I have looked into one of your new holdings already, because I was holding it myself for a few years until I sold a few month ago. I agree Saga Furs is an interesting and cheap company, but does it meet your new criteria “Selling below liquidation value”? Could you explain your thoughts here?

    Looking forward to more posts from you!

    UncleFry

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    1. UncleFry, thanks for your feedback and your thoughts!

      I hear you and I understand you. I thought for a long time about slowly implementing the new process while I was holding/selling of my the old positions as you suggest. Then I came to remember the clean sweep quote from Warren and that was it for me.

      I think that is a great way to put it, “Adding quality analysis to solid quant fundamentals.”! The best of two worlds in my opinion.

      Regarding Saga and my view of that the company is selling below liquidation value. Without going into specifics, this conclusion is based on an assement of the quality and the security of their assets (both current and non-current). In other words, I believe that most of them could be valued at 100 % and also be seen as “readily ascertainable”. I will post an analysis in the near future but exactly when I don’t know.

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      1. Glad my interpretation of your manifesto/principles were accurate. It will be even more interesting to follow your blog now.

        Looking forward to your Saga Furs analysis. All the best!

        Liked by 1 person

  3. Intressanta reflektioner! Tycker också att investeringsprocessen blir roligare om man väver in mer kvalitativa aspekter än att enbart bygga upp en portfölj rent kvantitativt. Även om resultaten från en net-net portfölj blir rätt bra så finns det ju ett egenvärde att lära sig mer om ett bolag, management, industrin som man sedan kan applicera på liknande situationer.

    Tror också att investerare lider av alldeles för stort “aktivitetsbias” vilket resulterar i mediokra idéer så bra att ha en process som belönar inaktivitet

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    1. Tack för din kommentar och feedback!

      Jag håller helt med dig om att en kvalitativ approach är roligare än en kvantitativ. Man bör dock ställa sig frågan, vilket även jag gjort, huruvida “roligt” ska vara en del investeringsprocessens utformning och design. Jag har personligen kommit fram till att det är viktigt del för att långsiktigt lyckas med en investeringsstrategi varför jag nu placerat mig i mitten av två extrempunkter. Den ena extremen förespråkar ett strikt fokus på kvantiativa faktorer som genererat avkastning historiskt och den andra som förespråkar ren frihet och kvalitativ bedömning. Där i mitten tror jag att jag personligen kommer ha mest roligt. Huruvida jag kommer vara mer framgångsrik där återstår dock att se… Tror även du har helt rätt vad gäller ackumulerad kunskap om bolag, management och industrier och egenvärdet i detta.

      Du slutliga poäng ang inaktivitet är otroligt viktig! Återkommer kring detta i del 2.

      Like

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