Contributed by: Jitendra Chawla, CFA
On 25 April 2017, CFA Society India –Delhi Chapter hosted Prof Sanjay Bakshi and Paresh Thakkar of ValueQuest Capital LLP for a talk on Stock Picking vs Portfolio Construction: The Role of Checklists. The event was a huge success with more than hundred enthusiastic participants attending the talk.
The following is a summary of Prof Bakshi’s and Paresh’s speech/comments during the presentation.
Captain Sully and the Hudson River landing
Prof Bakshi started the talk by showing a clip from the movie Sully. On January 15, 2009, Chesley Sullenberger, better known as Captain Sully, was a pilot in command of a US Airways Flight 1549, an Airbus A320 taking off from LaGuardia Airport. Shortly after takeoff, the plane struck a large flock of birds and lost power in both engines. Quickly determining he would be unable to reach any airport, Sullenberger piloted the plane to a water landing on the Hudson River. All aboard were rescued by nearby boats.
After the incident, there was an investigation and public hearing. During that hearing, it was alleged that Captain Sully made a mistake and endangered lives by landing the plane in Hudson. He should have tried to get to the nearest airport which was seven miles away.
The investigators even tried to replicate the situation on a flight simulator and showed that he could have landed the plane. Sully made a point in his defence that those trying to say he made a mistake are not taking into account the ‘human element’. The pilot who had landed the plane in the simulation exercise had practiced it seventeen times before he could do it successfully. Later on, when they incorporated a 35 second delay (which is the least time any pilot would have taken to react in a real life situation) in the simulator exercise, the plane crashed.
The National Transportation Safety Board ruled that Sullenberger made the correct decision in landing on the river instead of attempting a return to LaGuardia because the normal procedures for engine loss are designed for cruising altitudes, not immediately after takeoff.
What is the difference between what we do and Sully situation?
– A flight lasts only a few hours but our investment operations last more than a decade.
– We can afford to be more reflective (while Sully had all of 208 seconds), though some sort of value investing operations do require a quick response (e.g. if there is massive moat impairment in a position), however, most of the time, most of our decisions are slow decisions.
– Longer decision time means feedback is delayed. It is unlike day trading or for that matter archery or shooting, where you get instant feedback on your performance.
– Life is not long enough to allow for feedback to be a good teacher in long-term value investing. Therefore, we have to rely on vicarious learning or learning from past experience of others.
What is the similarity between what we do and Sully situation?
– Good portfolios are like good airplanes. They do not usually crash as they have multiple engines. If one engine fails, there is a fallback option. In portfolio management parlance, a crash would be equivalent of a decimation of earnings (and not decline in market value) of any position in the portfolio.
– Multiple engines are there to create redundancy. The principal of redundancy is also applied in civil engineering e.g. in the construction of a bridge, where the bridge is constructed to bear 3x the maximum load it is expected to bear.
“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”
– Similarly, to have robust portfolios, one should create redundancy which is actually nothing but a margin of safety. The weights of various investments in the portfolio should be restricted to a maximum number (say 1/6th of the total portfolio) so that any unexpected negative outcome doesn’t threaten its very existence.
Casinos, Insurance companies and Margin of Safety
“In order to take proper advantage of the margin-of-safety principle in investment operations, its almost always essential that the investor practices adequate diversification. A margin of safety does not guarantee an investment against loss; it merely guarantees that the probabilities are against loss – and in the case of common stocks, that the probabilities favor an ultimate profit.”
– One can best understand the concept of margin of safety by understanding how a casino operates. A casino is usually a safe place for an investor/owner as casinos tilt the odds in their favour. The casinos make sure they have the winning edge. Players do not stand a chance. As a collective, they are playing a game that they can never win in the long term as the odds are not in their favour.
– Consider the game of American roulette. It has 38 slots – numbers 1-36, 0 and 00. If player bets on a number and the winning number matches, the player wins 35x. Otherwise, he loses the bet amount. Eg: If a player bets Rs 1,000 on a number his probability of winning Rs 35,000 is 2.63% and the probability of losing 1,000 Rs is 97.37%. Expected value is negative Rs 53.20.
– This is how Casinos make sure they have a winning edge:
- Set the odds against the players. They have a small albeit a clear edge (in the long run, house wins)
- Since they have a slight edge, they need to diversify a lot. So they make sure to get lots of players to play (Any one player’s outsized winnings cannot bankrupt them)
- Put limits on bet size (No player can keep increasing bet size to harm the casinos in case he/she gets lucky on an oversized bet)
Insurance business does something similar to casinos to manage risk.
“What counts in [insurance] business is underwriting discipline. The winners are those that unfailingly stick to three key principles.
1. They accept only those risks that they can properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors including remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions.
2. They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly unrelated risks.
3. They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn’t work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so.”
-Warren Buffett on Principles of Insurance Underwriting
– In both the businesses (Casinos and Insurance), there is one common principle:
The lower the edge (margin of safety) of the casino over the customer, the higher the need to diversify, and vice versa.
– Just like casinos and insurance businesses, a prudent investor should reduce the probability of failure (and increase probability of success) by combining margin of safety with proper diversification.
“The individual probabilities may be turned into a reasonable approximation of certainty by the well-known practice of “spreading the risk.” This is the cornerstone of the insurance business, and it should be the cornerstone of a sound investment.”
– Benjamin Graham
What does it mean for Concentrated Investing?
– If a narrow edge warrants a diversified portfolio, a concentrated portfolio would warrant a wider edge.
– In concentrated portfolios, you don’t want even a single position to blow up, as that would be a major setback.
– That means one has to be extra careful while selecting what to include in the portfolio. Rejection rates have to be very high. One needs to add layers of protection, apply strict filters so that the few ideas which can pass those filters are the most robust ones.
Redundancy: Adding layers of protection
– The Idea of “Margin of Safety” is based on the idea of Redundancy in Engineering.
– Critical components of a system are duplicated with the intention of increasing reliability of the system. If one component fails, the other one acts as a backup making it a fail-safe system.
– In such a system, all components must fail before the system fails. If each one rarely fails, and events of failure of each is independent of others, the probability of all three failing (system failure) will be extremely small.
– Similarly, good portfolios also need several layers of protection. All this protection has a cost in the form of reduced return. It is because the investor will sacrifice some return to avoid blow ups. This protection will come from
1. Avoiding what doesn’t work
2. Seeking what does work
– From experience of self and others, one can look for patterns, and decide on a stringent exclusion criterion which very few ideas could pass. It will reduce the clutter.
Avoiding what doesn’t work
– Managing a concentrated portfolio is probably opposite of how most venture capitalists (VCs) work.
– VCs are looking for disrupters, whereas a value investor with a concentrated portfolio would be looking for businesses which are steady and without any threats of disruption
– VCs cast their net wide. They take many small bets initially as there is a high probability that more than half of the investments become zero. On the other hand, a value investor with a concentrated portfolio cannot afford even a single position to end up as a total loss
– As the VCs find a few winning ideas amongst the many small bets, they put larger chunks of capital in those ideas, thereby backing a few outsized winners.
– Conversely, a prudent Value investor with a concentrated portfolio will look at pruning his positions if they become disproportionately high thus limiting their bet size.
– Unlike a VC, this is what we (ValueQuest) do:
- Keep a strict filter and prevent bad ideas from creeping into the portfolio i.e. avoiding what doesn’t work
- Concentrate on a select few ideas, but each of them should be robust and have a higher probability of success, as we can’t afford any blow- ups
- Not seek brilliance but would like to avoid stupidity
- We believe in prevention
“Wisdom is prevention but very few people do much about it.”
“I particularly recommend attention to the idea that an ounce of prevention is worth a pound of cure —except it really isn’t often a mere pound. An ounce of prevention is often worth a ton of cure.”
“Many things are easier to prevent than fix. . .You get in a dumb enough situation, like trying to cross a train track when there’s a train coming, and you end up with a problem that’s extremely hard to fix.”
“You don’t have to be brilliant, only a little bit wiser than the other guys, on average, for a long, long time.”
– Charlie Munger
“It is better to try to be consistently not stupid than to be very intelligent. “
“To some extent, the record of Berkshire— to the extent it’s been good—has not occurred because we’ve done brilliant things, but because we’ve probably done fewer dumb things than most. “
The Importance of CONSEQUENCES as opposed to PROBABILITIES
– In financial markets and in the world of business, lots of people take unnecessary risks – equivalent to jumping out of a plane with a parachute which opens 99% of the time. These actions may have low probability of failure, but the consequences of failure are fatal
– If a CONSEQUENCE of an action is NOT ACCEPTABLE to us, then no matter how low the probability, we must avoid that action.
– Warren Buffett uses a metaphor of a gun with a million chambers in it with only one chamber with a bullet in it. He says that if someone offered to pay him any sum of money to put the gun on his temple and pull the trigger once, he won’t. Irrespective of the offer, he would decline.
– If there is a remote loss scenario with an outcome that’s unacceptable, then no matter how small the probability of that outcome, actions that can produce that outcome must be rejected.
“Obviously, if you leverage enough, you can get higher returns on equity, but you often have a chance of disaster. I think we are more disaster-resistant than most other places. As a friend of mine once said, “I don’t want to go back to go. I’ve been to go.” “
“Huge debt, we are told, causes operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. We’ll acknowledge that such an attention-getter would produce a very alert driver. But another certain consequence would be a deadly — and unnecessary — accident if the car hit even the tiniest pothole or sliver of ice.”
“The roads of business are riddled with potholes; a plan that requires dodging them all is a plan for disaster.”
Other Things We Avoid
– Week Financial Structures – You don’t need 30 ratios, but maybe two or three to determine whether the financial structure of a company is weak or not. Avoid weak ones and your chances of survival increase.
– Complexity and Unpredictability – If we do not understand a business and can not visualise it a decade down the line, we would like to avoid it.
– Models Prone to Disruption – If we don’t know whether the company is strong enough to survive or some other rival can disrupt it with new technology, we will avoid it.
– Binary Outcome Situations – Cases where either the company is a big success or they perish completely (e.g. e-com companies).
– Lack of Pricing Power – Businesses which do not have the ability to pass on pain of inflation to customers (e.g. power companies in India).
– Corporate Mis-governance – No amount of margin of safety can justify being partners in a business which doesn’t respect minority shareholders.
– Overvaluation – This is a functional equivalent of a bet where the odds are against you.
Seeking what does work
– Moats – High RoC businesses which have a competitive edge. These businesses have inbuilt shock absorbers.
– Entry Barriers – Businesses which are not easy to compete with by new entrants. Strong brands, Long gestation etc.
– Owner Operators (Soul in the Game) – Business should be the only/primary source of income. Reputation/identity of promoter associated with that business.
– Difficult to replicate, Admirable Corporate Culture.
– Growth – Good sustainable growth. Long runways. Growing size of the overall industry. Growing market share because of low cost or better management. Unlike Buffet, not interested in non-growing or declining businesses (e.g. newspapers) as we can not take out cash as he can. Would prefer to pay up for quality rapidly growing company.
– Ability to self-finance growth – Happy with entrepreneurs conscious about leverage, asset allocation, using incremental capital wisely. More happy with those who never dilute capital to grow. If they have diluted, it should be for a good reason.
– Good Governance
– Reasonable Valuation
Role of Checklists
– A checklist is needed to protect ourselves against our own mental flaws, biases and laziness. A checklist forces you to look for contradicting evidence.
– Qualities of a Good Checklist
- It should focus on things that really matter
- It should be short (for example you don’t need six ratios to determine if a business has strong balance sheet or not)
- There should be some deal breaker questions while other questions may require trade-off
Our Initiation Checklist
- Focuses on three things: Business, People, Price – in that order (no tradeoffs)
- We try to make it short
- We have deal-breaking questions. For example, if a business is pro-social or not
System of Redundancy in Stock Picking
– Layer 1 – Avoid things that don’t work
– Layer 2 – Seek good businesses, run by good people, at good prices
– But this is not enough because of risk tend to gets aggregated at the portfolio level.
– Some examples of Risk Aggregation in Portfolio
- Customer/Supplier Concentration
- B2B vs. B2C
- Local vs. Exporters
- Market Capitalisations
– For example, let’s say we invest in five companies which are
1. Dominant in their industries
2. Run by great owner operators
3. All exporters
4. in different industries but have customers in the US
– They are all wonderful investments individually but have one common factor which leads to aggregation of risk. What if USD/INR goes to 45? The probability of that happening may be very low but if it happens, the Consequences for the portfolio could be and would be significant. If such a scenario is unacceptable to you, then you have to take care of it in portfolio formation. It will probably involve sacrificing returns as you may have to forgo some investments which may be suitable individually but may not fit well with the rest of the portfolio by creating a probable outcome which may not be acceptable.
– It is just one way to demonstrate how risks get aggregated at the portfolio level. There could be many other ways depending on what is there in the portfolio. You have to be creative and think about these scenarios as you don’t know where risk is going to come from. You have to carry the worry gene not just in initiating a position but also in building the portfolio.
– So, in a good, robust system, the Risk Manager Should be allowed to overrule an excitable stock picker. But in reality, the stock picker and the risk manager are the same guys. They are just wearing different hats. The stock picker wears the “creative” hat and his “worry gene” prevents him from recommending ideas that have a significant risk of permanent capital loss.
– The risk manager’s worry gene making him think about how “shit happens” at the portfolio level (recall what happened to a respected fund because of an oversized position in Valeant) and how to put in limits to rein in the excitement of the stock picker.
– A Well-constructed portfolio will almost always cost money in terms of sacrificed returns
– We are not trying to maximize returns, because that may also mean that we may go to zero (or anywhere close to zero). We do not want that.
– That is why Risk matters as much as returns.
- Slide deck for the presentation by Prof Sanjay Bakshi and Paresh Thakkar
- The Investment Checklist: The Art of In-Depth Research by Michael Shearn
- The Checklist Manifesto: How to Get Things Right by Atul Gawande
- Buffet comments on LTCM
- Clip from the movie “Sully”