Improving On Buffett And Desert Cat

[David Sklansky]

In another thread Desert Cat wrote:

"The real challenges of value investing are

1) Intrinsic Value is always an estimate or even an estimated range and its accuracy depends upon the predictibilty of the investment and your skill and experience.
2) You need to buy at a substantial discount to that IV estimate, your margin of safety, to protect against mistakes.

The biggest problem most attempted practitioners have is a lack of fortitude, patience and ignorance of there own limitations. If you think you can buy at a 10% discount because your IV estimates are always within 5%, you are guilty of hubris and will pay dearly. You need to have the patience to wait, even when awash in cash, for those 50% discounts. And when you find one, you have to have the fortitude to commit a big part of your portfolio to it.

Buffett demonstrates awareness of his own limitations when he refuses to look at a stocks price before he estimates its value, he doesnt want to influence his analysis. That is probably a weakness of mine, I sometimes find a set of assumptions that justify buying at todays price to see if I'm comfortable with them, i.e. XYZ is a buy if I believe its merger is at least 85% likely. Thats backwards, I should make my best estimate of the merger happening and the figure what price makes sense."


Pure thought tells me there is probably a better way. Better that is than merely searching for stocks whose price is half of what you think it is worth. Obviously I might be wrong since I am coming to these conclusions without research. More importantly is the problem that my method, nor Desert Cat's for that matter is of any use unless your expertise is at least sometimes better than the market in general.

Desert Cat didn't make clear in his post whether Buffett requires of himself a stock price fully one half of his own valuation before he buys. He also didn't say whether Buffett, after coming up with his valuation (without knowing the price) adjusts that valuation AFTER seeing the price. Surely he should, even though he would still probably profit without doing that, as long as he mainly stuck to big companies.

I mean as good as Buffett it, I'd bet anything that when his valuations differ from the price by a large amount the eventual results, on average do not come close to his valuations. If they did he would be a quadrillionaire. In other words, no matter how good you are, if your opinion differs markedly from the present price, the true valuation is almost certainly somewhere between those two prices. And probably closer to the market price.

In spite of all that, if you stick to big stocks that have little chance of unknowing shenanigans, and you are good, and you don't pull the trigger unless there is a large discrepancey, you ought to make money. But I think I have a better method for the real experts. (A method closely akin to something I wrote about in GBOI regarding horse racing.)
In theory, this method takes into account not only the stuff Desert Cat talks about, but also aspects of human nature, human stupidity, and human dishonesty, that technical analysis claims to deal with. To pull it off you have to know what Desert Cat knows plus more. But if my idea is right it makes for bigger profits. Not only because your picks should have a greater edge (given equal discrepencies between your opinion and the markets). But also because you don't need as big a discrepancy to buy or sell short.

The idea is to first do as Buffett does. Come up with what you think is the right price for the security without knowing that price. But then come up with a second number. Which is your guess as to what the price actually is. When these two estimates are close you should be very wary of making a play, regardless of the actual price. If you think a stock is worth 50 and you think the market will make it 50, don't buy it a 40 or short it at 60.

If, on the other hand your evaluation of a stock's worth is significantly different from your guess as to what the market price is, you have a play if you are about right about the market price. My gut feeling is that the best situation occurs when the actual price is shaded slightly toward you own valuation. In other words if you think a stock is worth 20 and you think the public will price it at 29, I would feel best about shorting it if it is about 27. Its an indication that some rich, smart people might be agreeing with me.

All this of course is related to my Fundamental Theorem Of Investing. Don't invest unless you can explain why people are taking the other side. In fact using that Theorem you can theoretically beat the market without having expertise on the other end of the spectrum. The experts here hate that technique since it results in trades that ignore their abilities. So forget that for now. Combine them both.

Of course combining them might not be that easy for MBA types. They are used to making good estimates as to what a stock is worth. They are not used to estimating what other people are estimating what it is worth. But if you have that first talent, I would be very surprised if learning that second talent doesn't signifacantly improve your results.

[adios]

Interesting post. If a stock has a lot of analyst coverage (we can and probably should have a debate on what constitutes alot of analyst coverage) I'm going to be very reluctant to get involved FWIW. What I've observed about your recommendations over the years (they've been very good) is that seem to be based on:

1) You disagree more or less with how the market is interpreting the news/information on a particular company.

2) You have an insight into into a particular company that others genearlly don't have.

On criteria 1) I can think of your recommendation on the Martha Stewart company options years ago and the recommendation of TASR.

On 2) SHFL comes to mind.

A couple things about Buffet, he tends to buy companies outright. I realize he makes other investments but I'm fairly certain that the major share of his success is acquiring companies and including them in the Berkshire-Hathway conglomerate. Could be wrong about that.

[spider]

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Don't invest unless you can explain why people are taking the other side.

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I think you are underestimating the scope of this. The "other side" is a very large number of people with all kinds of ideas, motives, fears, etc. I mean, can you even predict what your wife/GF is going to say or do on any given day? But you are going to predict the collective actions of millions of other investors? Granted, there are a relatively small number of institutional investors who matter much more than anybody else, but predicting their actions systematically is still close to impossible.

Were you able to predict the Nasdaq would peak in 2000 and US residential housing would peak in 2006? Lots of people saw those for bubbles (and lots said they weren't bubbles) but getting the timing right is really, really difficult. Also, it seems like maybe you are assuming the existence of systematic mispricings over time, which I would dispute. Although US residential housing was and is overpriced, I don't think this is something you can expect to guide you over time. Maybe in 10 years it will be fairly priced or underpriced. If you know, please share with us!

BTW, you really should pick up some books about Buffett if you care to keep using him as an example. With all due respect you are not really characterizing his methods all that accurately. And in particular, the structure and size of Berkshire Hathaway gives him certain advantages and disadvantages that make him a poor comparison case for ordinary investors.

[DesertCat]

[ QUOTE ]

...

Desert Cat didn't make clear in his post whether Buffett requires of himself a stock price fully one half of his own valuation before he buys. He also didn't say whether Buffett, after coming up with his valuation (without knowing the price) adjusts that valuation AFTER seeing the price. Surely he should, even though he would still probably profit without doing that, as long as he mainly stuck to big companies.

I mean as good as Buffett it, I'd bet anything that when his valuations differ from the price by a large amount the eventual results, on average do not come close to his valuations. If they did he would be a quadrillionaire. In other words, no matter how good you are, if your opinion differs markedly from the present price, the true valuation is almost certainly somewhere between those two prices. And probably closer to the market price.

In spite of all that, if you stick to big stocks that have little chance of unknowing shenanigans, and you are good, and you don't pull the trigger unless there is a large discrepancey, you ought to make money. But I think I have a better method for the real experts. (A method closely akin to something I wrote about in GBOI regarding horse racing.)
In theory, this method takes into account not only the stuff Desert Cat talks about, but also aspects of human nature, human stupidity, and human dishonesty, that technical analysis claims to deal with. To pull it off you have to know what Desert Cat knows plus more. But if my idea is right it makes for bigger profits. Not only because your picks should have a greater edge (given equal discrepencies between your opinion and the markets). But also because you don't need as big a discrepancy to buy or sell short.

The idea is to first do as Buffett does. Come up with what you think is the right price for the security without knowing that price. But then come up with a second number. Which is your guess as to what the price actually is. When these two estimates are close you should be very wary of making a play, regardless of the actual price. If you think a stock is worth 50 and you think the market will make it 50, don't buy it a 40 or short it at 60.

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Buffett never lets the market price influence his estimate of value.To better understand Buffett's philosophy, you must first read this.

This interview with Liz Clamen he explains how he did the PetroChina investment.

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“I sit there in my office and read an annual report, which fortunately, was in English, and it described a very good company. It told about the oil reserves, the refineries and everything else and I sat there and read it and said to myself this company’s worth about $100bn. I don’t look at the price first. I look at the business first and try to figure out what it’s worth because if I look at the price first I’ll get influenced by that

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He made a killing on PetroChina, but since he sold it, the market went crazy.

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On PetroChina:

“We sold it [all stakes], but we sold it based on price [not politics]. At the time of the annual meeting it was around $100 and since then it has more than doubled so, unfortunately, I sold it a little too soon. It was a decision based 100% on valuation.”

“If it went down a lot I’d buy it back.”

“We made about $3.5bn on a $500m investment but we still sold it too soon. I left a lot of money on the table.”

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Buffett didn't really make a mistake, but he often uses that term self-deprecatingly about investments like that. There is no way he thinks PetroChina is worth $500B or whatever it's trading for today, so there is no way for him to hold hoping the market gives him a price well over value. If you read his writings back into the 50s, it's a theme that pops up regularly, he sold too soon or bought too early, had he omniscience about market prices we (his investors) would have done much better.

Despite that, Buffett has doubled his net worth on average every three years for fifty years. It was faster when he started, and slower now due to portfolio sizes, but that's still very fast. He left the Graham Partnership in the mid-50s worth $100k, and turned that into what would be worth around $65B (if he hadn't shipped a bunch to the Gate's charity recently) now. So not a quadrillionaire, but he's done better than any other long term investor in history. If he can be the audited, certified best without being able to predict price action or market psychology, how likely is that to be a big leak? Maybe, what you propose is way too hard to offer a significant edge in practice?

It's interesting that you did this "pure thought" experiment, because it's similar to what Buffett would do (I've often thought you and he share many characteristics, besides high IQ's, being intellectual leaders in your chosen fields, maintaining an intellectual curiousity throughout your lives, and I'd bet you have a photographic memory similar to his). You should read more of his writings.

But you should also give him some credit. He's been thinking and rethinking this stuff for over 50 years and he's never espoused anything similar to what you propose. I can almost certainly say, that it's because he concedes his inability to estimate what other people will do with any measure of accuracy, especially a mass of strangers with differing financial objectives and philosophies.

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Its an indication that some rich, smart people might be agreeing with me.

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To me as an investor it is a mistake to make a decision because some smart people agree with you. Smart people make mistakes too. You can only make correct decisions if your facts, not your heroes, are in agreement with the action.

[ QUOTE ]

All this of course is related to my Fundamental Theorem Of Investing. Don't invest unless you can explain why people are taking the other side. In fact using that Theorem you can theoretically beat the market without having expertise on the other end of the spectrum. The experts here hate that technique since it results in trades that ignore their abilities. So forget that for now. Combine them both.


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When you decide to make an investment, you should always have considered the risks that others have weighed so heavily to give you this bargain. In the case of my 1/3 book value investment, it is a smaller, less liquid stock, that has no analyst coverage that I'm aware of. And this little illiquid "market" thinks the company will not be able to monetize this large asset without hugely punitive taxes, and is concerned about how long it will take. They are probably also worried about it's being majority owned by a rather colorful billionaire with a "interesting" and litigious past. I see those same risks, but based on the facts it's pretty easy to see that I'm getting a great price for the potential return.

Oh, and the 50% discount is something I should look for because I run a small very liquid portfolio. Buffett has had to adjust his filter because his portfolio has grown so enormous that his investment choices have become much more limited, and the markets he can buy in are much more liquid and hence efficient. My guess is he'd be really happy with a 30% discount right now, and probably is forced to take some 25% discounts. Discount of course isn't the exact right way to think about it, it's really expected rate of return which depends on holding periods, but discount is a nice short cut rule of thumb. I buy lots of stuff at 20% discounts if I think my holding period will be 3 or 4 months.

And lastly, It's DesertCat, not Desert Cat. I don't go around calling you Sk lanksy, do I [img]/images/graemlins/smirk.gif[/img]?

[DesertCat]

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Interesting post. If a stock has a lot of analyst coverage (we can and probably should have a debate on what constitutes alot of analyst coverage) I'm going to be very reluctant to get involved FWIW.

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For anyone running less than $100M, this is always the correct strategy, as long as you are good at estimating risk. Better bargains are always found in less traveled markets.

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A couple things about Buffet, he tends to buy companies outright. I realize he makes other investments but I'm fairly certain that the major share of his success is acquiring companies and including them in the Berkshire-Hathway conglomerate. Could be wrong about that.

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Buffett didn't really start buying lots of companies until his portfolio got enormous. He did buy BRK in the early 60s, Sees Candies in the early 70s, but until the late 90s (his first 40 years) he was predominantly a stock market investor. I think it was his purchase of Gen Re in 2000 that finally shifted the mass of the company to wholly owned subsidiaries.

The problem with having a $30B portfolio as a value investor is ideally you only want to invest in your best ideas, five or so at a time is ideal. That would be $6B each. There are a very limited supply of companies that are liquid enough to allow you to buy $6B in stock in a reasonable time frame without driving the price sky high.

So he tends more and more to just buy companies outright. It's the same skill/decision as purchasing stock in a public company, finding the right price on a good business based on the cash flow that will accrue to him as a shareholder. There just isn't an end game since he'll never sell subsidiaries.

A recent example is his $4B purchase of the Israeli company Iscar. But he'll also buy smaller companies, right now the bar is a minimum of $75M in net operating income per year. He actually has an "ad" in every annual report that lists his criteria, and mentions he'd like to do a $20B acquisition.

One of the most interesting things about Buffett is how much he's changed from just an investor who sits alone in an office reading thousands of annual reports a year (with his PC gathering dust), to a CEO of a company with 73 subsidiaries. The change is, none. When he buys a company he leaves it in the owners hands to run, and just expects a monthly report from them on results. Buffett still spends his time reading annual reports.

Berkshire's 73 subsidiaries have 217,000 employees and nearly $100B in annual revenue. Headquarters headcount is 19 people, almost entirely to produce Berkshire's 9,000 page federal tax return. Buffett's management techniques are counter to everything you would learn in an MBA program or from the GE school of hard driving CEOs.

But so far it's worked very, very well. Not by accident, but by careful design. Buffett may not be able to predict the behavior of crowds in the stock market, but he's an expert on individual human nature. He is really good at buying good companies at good prices where the owners are honest, trustworthy, enjoy what they do, and he is able to motivate them to continue to work hard even after he buys them out. All while he's still plugging away reading annual reports and finding gems like Petrochina.

[DesertCat]

I always recommend people read Buffett's annual reports. This year contained the following ode to Walter Schloss. Walter's track record is around 17-20% annualized for 47 years, or nearly double market returns. He's an even more extreme example than Buffett, no acquisitions, no access to any special information or any care about prices, and holds stocks for long periods until they reach intrinsic value. He's also unique among value investors, as he's not concentrated, he holds as many as a hundred stocks at time. He can manage so many positions because he buys solely based on simple fundamental valuations gleaned from reading financial reports. No need to visit management, build complicated models, or understand what the market thinks.

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Let me end this section by telling you about one of the good guys of Wall Street, my long-time friend Walter Schloss, who last year turned 90. From 1956 to 2002, Walter managed a remarkably successful investment partnership, from which he took not a dime unless his investors made money. My admiration for Walter, it should be noted, is not based on hindsight. A full fifty years ago, Walter was my sole recommendation to a St. Louis family who wanted an honest and able investment manager.

Walter did not go to business school, or for that matter, college. His office contained one file cabinet in 1956; the number mushroomed to four by 2002. Walter worked without a secretary, clerk or bookkeeper, his only associate being his son, Edwin, a graduate of the North Carolina School of the Arts.

Walter and Edwin never came within a mile of inside information. Indeed, they used “outside” information only sparingly, generally selecting securities by certain simple statistical methods Walter learned while working for Ben Graham. When Walter and Edwin were asked in 1989 by Outstanding Investors Digest, “How would you summarize your approach?” Edwin replied, “We try to buy stocks cheap.” So much for Modern Portfolio Theory, technical analysis, macroeconomic thoughts and complex algorithms.

Following a strategy that involved no real risk – defined as permanent loss of capital – Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500. It’s particularly noteworthy that he built this record by investing in about 1,000 securities, mostly of a
lackluster type. A few big winners did not account for his success. It’s safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made a purchase; and then c) selling when Walter sold his pick, the luckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.

I first publicly discussed Walter’s remarkable record in 1984. At that time “efficient market theory” (EMT) was the centerpiece of investment instruction at most major business schools. This theory, as then most commonly taught, held that the price of any stock at any moment is not demonstrably mispriced, which means that no investor can be expected to overperform the stock market averages using
only publicly-available information (though some will do so by luck). When I talked about Walter 23 years ago, his record forcefully contradicted this dogma.

And what did members of the academic community do when they were exposed to this new and important evidence? Unfortunately, they reacted in all-too-human fashion: Rather than opening their minds, they closed their eyes. To my knowledge no business school teaching EMT made any attempt to study Walter’s performance and what it meant for the school’s cherished theory. Instead, the faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture. Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope.

Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was “right” (or, more accurately, not demonstrably wrong) and that attempts to evaluate businesses – that is, stocks – were useless. Walter meanwhile went on overperforming, his job made easier by the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, it’s helpful to have all of your potential competitors be taught that the earth is flat.

Maybe it was a good thing for his investors that Walter didn’t go to college.

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[PRE]

Desert,

I'm currently around extremely smart/successful investors who in their careers have produced above-average returns over long stretches of time. Whenever someone like Buffett or Lynch is mentioned, it seems like one of them will go out of their way to make the point that both (especially Lynch, but I'd like to hear your take more on Buffett since you've follow him closely) know a lot more than they make it out to be. Would you agree or disagree with this point?

[DesertCat]

[ QUOTE ]
Desert,

I'm currently around extremely smart/successful investors who in their careers have produced above-average returns over long stretches of time. Whenever someone like Buffett or Lynch is mentioned, it seems like one of them will go out of their way to make the point that both (especially Lynch, but I'd like to hear your take more on Buffett since you've follow him closely) know a lot more than they make it out to be. Would you agree or disagree with this point?

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I would disagree. Lynch wrote a series of books, Buffett has his annual reports, gives interviews, lectures. Both seem to genuinely want to teach others what has worked for them.

Of course, since I admire both, it's easy to wonder whether I'm allowing my biases to influence my opinion here. So it's important to look at their track records rationally (esp. Buffett whom I'm much more familiar) what they have done matches up well with what they say to do.

[David Sklansky]

"Buffett never lets the market price influence his estimate of value"

I'm sure you are wrong. You are misreading his words. He is only saying that he makes an estimate of value without letting the price (which he would prefer to be unknown to him while he is making this estimate) influence him.

But if the price is signifantly different than his estimate he would be an idiot not to revise it. No expert in any field would do otherwise. In other words lets say he thought a stock was worth 100 and the market made it 60. a He has to bet whether or not it will over or below 90 in three years. Disregarding interest rate considerations, I'm sure he would bet under. He might bet over 70, or even 80. But he would have to believe that his estimate is probably too high once he saw the price. You basically admitted this yourself. Otherwise why give yourself this large margin of error?

[Jimbo]

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"Buffett never lets the market price influence his estimate of value"

I'm sure you are wrong. You are misreading his words. He is only saying that he makes an estimate of value without letting the price (which he would prefer to be unknown to him while he is making this estimate) influence him.

But if the price is signifantly different than his estimate he would be an idiot not to revise it. No expert in any field would do otherwise. In other words lets say he thought a stock was worth 100 and the market made it 60. a He has to bet whether or not it will over or below 90 in three years. Disregarding interest rate considerations, I'm sure he would bet under. He might bet over 70, or even 80. But he would have to believe that his estimate is probably too high once he saw the price. You basically admitted this yourself. Otherwise why give yourself this large margin of error?

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Errr, what does the current market price of a given stock have to do with an estimation of it's "true" value?

Jimbo