Monday, June 16, 2014

Good enough investing

Investing attracts a lot of smart people.  Investors are good with numbers, good with details, and competitive.  Many smart investors are on a quest to find the perfect investment or investing style.  Until he's surpassed Buffett holds the title of the best investor.  He grew almost nothing to a pile of money that makes him one of the richest people in the world.  He isn't just rich, he's also considered a sage with people looking to him for life advice alongside of investing advice.

I've held for a long time that the best investment style is Buffett's style if one can replicate it.  Whether or not Buffett's style can be successfully replicated is up for debate, but his results are not.  He is undeniably the best living investor, and possibly the best investor to have ever lived.

If Buffett is the best then why am I not following his investment style?  Why do I invest in a manner that's similar to Benjamin Graham, Buffett's teacher?  Graham and others who followed his style had great investing records, but none as great as Buffett.  My sense is that many readers don't understand why I would chose to invest in an inferior strategy.

The path most investors take is they start out looking for statistically cheap stocks such as net-nets, low P/B stocks or depressed earners.  Then once they've gained some experience they graduate to companies with moats and quality compounders.  The Coke's of the world that a buy at any price will result in incredible wealth eventually.  It seems to be accepted that investing like Graham is fine for those who are starting out, but all good investors eventually graduate to the big leagues.

Why am I investing in a knowingly inferior strategy when a better one (Buffett investing) is available?  The answer is simple, value investing Graham style is 'good enough' for me.

A good friend uses a great analogy to discuss investing.  He talks about his portfolio like a hardware store.  One one shelf there are hammers, screw drivers, nuts and bolts, ladders and other small items. The owner makes a small margin on each item.  They might make a few pennies on each nail sold, but in aggregate the pennies on the nails and dollars on hammers add up to a living for the owner.  In contrast a Buffett style investor is like someone who owns a Maserati dealership.  Not many cars are sold, or need to be sold, but the dealer makes a larger profit on each transaction.  The Maserati dealer is mostly sitting on their hands, and one can say removes ignorance by sticking to only the best cars.

There isn't much pride in owning a hardware store.  The store provides a living, but doesn't provide great conversation at a cocktail party.  Owning a Maserati dealership is quite different, the owner is probably wealthy and their cars are always great topics for parties.

This analogy works well on many different levels.  The hardware store owner is like a Graham investor.  There is no pride in owning many different types of stocks that no one has heard of.  But in aggregate buying cheap stocks below book value, or NCAV, selling once appreciated and repeating provides a living.  At a party not many people are going to know who Decker Manufacturing, Conduril or West End Indiana Bank are.  Buffett investors have a remarkably different experience, their portfolios are much more party topic worthy.  There's a pride in owning stocks that rise 5x or 10x.  No one wants to hear about little companies that can be churned for 50% gains, people want to hear about the big winners.

The hardware store owner isn't going to earn as much as the Maserati dealer, likewise a Graham investor probably won't ever be as successful as someone who can invest like Buffett.  An obvious question is if someone had the ability to own either the hardware store, or the dealership why would they pick the hardware store?  That same question can be asked about the two investing styles.

There is a cost to each style of investing, the cost is the time to research, the time to follow companies, and the emotional energy required to implement each strategy.  The cost is less to invest in a manner similar to Graham.  There are many companies that I've found, researched and invested in where the time I devoted to do so was less than two hours.  Many of my holdings require an hour to an hour and a half of time annually to stay up to date.

Buffett's style of investing requires obsession.  He is consumed with investing, he lives and breathes it and has since he started.  It took priority in his marriage, in his relationship with his children, and with anything else in his life, investing is number one.  The results of this obsession are apparent, he's become the most successful investor.  I see this same level of obsession with many who are following in his path.  On the Corner of Berkshire and Fairfax message board there are threads detailing Buffett-style companies that stretch into the hundreds of pages.   Seemingly every possibly piece of legal information is rendered useful and important to the investment thesis of these sorts of companies.

I don't have the time or ability to become obsessed about my investments.  I have a family, have a job, have a business and have lots of other activities that I enjoy outside of investing.  In a lot of ways Graham's departure from the investing world later in life is attractive.  He had enough money to pursue other interests that had his attention, didn't need more success, or more money, he had enough.  I enjoy looking at companies and researching investments, but I also enjoy doing other things too. I enjoy playing with my kids on a warm summer after in the backyard.  Time like that is priceless, is giving that up worth it for another 2/3/5% increase in my portfolio?

When I survey the value investing landscape Graham's methods are attractive.  Over the long term they beat the market and reduce risk (the risk of permanent loss of capital).  They aren't glamorous, but they work.  When I look at my own needs, both monetary, and otherwise I realize that finding the best investment strategy isn't important.  If over the next 30 years the market returns 10% annualized and I can earn 10-15% investing on my own I will have more than enough.  It's possible that if I were to graduate to Buffett's style of investing that maybe I could do 15%+ annualized.  I am not investing to impress anyone, and if what's considered beginner value investing achieves my goals why graduate to something more complicated?

Like a hardware store owner who might decide to own the store because of the hours, the location, or the speed of life, I've made a similar choice with investing.  I've taken a path that might not be the best possible, but it's good enough.  Over the long term I believe I'll have acceptable above market returns, but will also have time for life outside of investing.  Because of this choice I'll probably never enter the world of the super rich, but that's something I'm alright with.

In the end I've chosen a good enough investing style, but not the best.

13 comments:

  1. One other reason to follow a Graham-type strategy is that it's probably more reliable and less risky for "mere mortals." Buffett's strategy requires deep insight into businesses and industries and not everyone can pull it off. Graham's strategy is much more formulaic and diversified.

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    1. Walter,

      I agree, and at some levels having that extra knowledge is helpful. But we also need to remind ourselves that we're outsiders and will alway be at an informational disadvantage.

      Nate

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  2. Nate-

    Great post but why do you consider Buffet's approach to be the best. Like Walter above Buffett's strategy worked for him but he is often imitated and never really duplicated so you may have the optimal model as its one that can actually be followed.

    My problem with replicating a model like yours is sizing. If I understand your portfolio at a general level you buy companies that are net-net or trade at a substantial discount to book. Many of these don't have a well defined catalyst, such as a sale of a money losing division either.

    How many companies do you hold? I'd expect you to hold 100 companies. For a small investor like myself splitting up my portfolio into even 50 companies I would get eaten alive in transaction fees even using IB or TDAmeritrade. How do you think about that?

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    1. I think Buffett's approach of buying companies with durable advantages that can compound capital at high rates will win out over the long term. Less action is required, an investor finds a company like that once and sits back and reaps the returns.

      You're right that sizing is an issue for a smaller portfolio. I own about 60 stocks, although some are part of smaller 'baskets'. For example I own a number of Japanese net-nets, each position is less than 1%, but in total they're a 7-8% position in my portfolio. The same with small cheap banks, I own a lot of tiny positions, but in aggregate it's about 15% of my portfolio. If you count the Japanese stocks and the cheap banks as one position I have 27 positions.

      In terms of costs to get into 60 positions is about $600 or so at Fidelity if done all at once. My portfolio turnover is about 20%, which means I'm buying/selling about 12 positions a year or less. So the total trade cost is maybe $120 or so, manageable for sure.

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  3. "PHOS" is an interesting turnaround play in the fertilizer space. Down from over $40. Third Avenue filed 13G recently.

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  4. Good enough should be fine for most of us yet we all strive to beat the averages, when in reality, given enough time, simply achieving a return that is in line with the averages will be "good enough." i like the hardware store analogy too. Thanks for sharing.

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  5. Hi Nate! I like using analogies too when it comes to explaining my Ben Graham style quantitative investment strategy to friends/family. I think there are lots of similarities between a quantitative value investing strategy and the insurance/casino business.

    In any of these businesses, we must feel comfortable not ‘understanding’ everything about the commitments we make (in our case, the businesses we are investing in). A bit like a insurance company owner who feels comfortable not knowing the driving habits of each of his clients. The reason for that is that we trust the fact that our calculations tend to put the odds on our side on average, over many commitments.

    But to profit safely from any business where profit margins relies on statistics there are two things that are absolutely needed :

    1. Diversification though many commitments: maximum % of assets in one commitment at any time and a minimum number of new commitments made each year.

    2. Understanding why the odds are on your side on average: Conviction that our calculations put us at an advantage is key for long term success. Without solid conviction, chances are we’ll get discouraged by badluck or underperformance and sell our business at exactly the wrong time.
    Like value investing, casinos and insurance businesses are dependent on fear and greed, so in order to achieve profitable operations they need a 'long term' horizon.

    The casino owner does not think about selling is business because someone won the mega jackpot yesterday. Bad luck happens and he knows it. He does not get depressed and blame himself by saying “I should not have let this smartass in my casino” or “I should have selled my casino two days ago”. Sure insurance companies would never lose money if disasters wouldn't exist, but they wouldn't have any clients/reason to exist either. The point is, we need to be happy when our strategy doesn't work, because it is the reason why it actually works overtime.

    We need to focus on logic, statistics, patience and diversification while putting emotions on the side.

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  6. Nate:

    I am sure you would agree that Buffet has a very carefully crafted public image...

    He has had many advantages that "average" investors could never dream of.

    For example, his father was a US Senator. I am sure that opened many doors, and gave him entry into areas that others will never have. His family also had wealth/assets/connections.

    Not to denigrate his success, but he had a starting advantage that is often overlooked or forgotten.

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  7. Why dont you just invest in BRK-B, let Buffett do all the work for you while you enjoy the gains and all the extra time?

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  8. Spent the last 24 years looking for those durable companies like Buffett. It is a lot of work, spending far more time just to understand one company. I think WB had to go this way because the NCA, arbitrage, thinly traded opportunities dried up as time went on and BRK got bigger, requiring the big positions. Overall, there really isn't an advantage either way, as long as you control your temperament, do the research and buy at a discount. Keep in mind too, he went the old way when buying Korean stocks several years ago, so it's really a matter of what opportunities he finds.

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  9. I just want to say, that I have a bit of a different view. Yes, buffets way requires a real investing obsession and costs time. How ever, the current modern Buffet/Muncher investing style is it, the old buffet when he just started out was close to Grahams method. I think its handy to look at the earlier buffet to enhance grahams methods, while still retaining Grahams method.

    -Rens

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    1. Have your cake and eat it too.

      I read somewhere that Buffett's portages (Ted & Todd) spend 100's of hours on a single investment before committing to it. After listening to Monish Pabrai (a "shameless" cloner he claims he is), I started taking stakes in the positions Ted and Todd initiate. I have had decent success (DVA & PSX to name a couple) just riding the coat-tails of the 13F.

      And I just took a position in VZ after hearing BRK initiated a position. I probably spend 2 hours (at most) on these investments - mostly just to understand the business they are in. Why immerse myself? If WEB, Ted or Todd thinks its a good buy, surely I am not going to have a credible thesis taking the opposite side of the trade.

      Great article....food for thought.

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  10. Amazing article and great analogy!

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