The Ideas Report For Serious Investors

By Nadav Manham

"People give themselves away… They make certain kinds of comments… It’s the very things they talk about. There are a lot of clues in the things they think are important." —Warren Buffett

Most professional money managers, even the best known superinvestors of today, lost money in 2008. Those who “invest in investors” find themselves having to choose whether to redeem their capital, remain invested, or even add to funds. The task is more difficult than it appears, especially for old-fashioned value investors who seek long-term outperformance with little risk of permanent capital loss. On the one hand, “If they lost a lot of money last year, kick them out!” is not always the best course to follow, for investing is an unusual game in that today’s losses can often (but not always) set the stage for tomorrow’s gains. Value investing legends like Charles Munger and William Ruane suffered large losses in the 1973-1974 bear market, as did Benjamin Graham himself during the Great Depression. Those who stayed the course with these managers were more than rewarded, while those who kicked them out ended up kicking themselves. On the other hand, rushing to invest with those few managers who actually made money in 2008 can also be a false guide. Most of the great Wall Street prophets of earlier ages, those who “called” this crash or that, later faded into obscurity. More cynically, some take advantage of their new status as prophets to multiply their assets under management to levels that must penalize future results (for their investors, not themselves).

Ideally, the value hedge fund limited partner evaluates his investor simply by stepping into his shoes and evaluating his current portfolio for its expected return and the all-important margin of safety. Just as a hedge fund manager strives to understand the companies in which he invests as well as their executives do, so too can the LP strive to understand his money manager’s investments as well as the manager himself. The LP can also perform a post-mortem on results achieved so far and try to figure out how that record was achieved, which is more important as a guide to the future than the record itself. However, the real world of the investor in investors, especially those in value-oriented and smaller funds, often falls short of this ideal. Many if not most of these investors are not professional investors themselves and therefore lack the expertise to perform this evaluation. Even those who invest in hedge funds for a living often lack access to the information required to fully step into their managers’ shoes, their protests to the contrary notwithstanding. How then to proceed?

An alternative, perhaps the only alternative for the non-expert LP, is to revisit the character and investing principles of the money manager. Sometimes character flaws are easy to spot after a year of large losses—a manager prevents investors from withdrawing while continuing to charge fees on that “hostage” capital, or he abandons a losing fund only to start up another without any compensation to the old investors—but often they are more subtle, and reveal themselves only in how a manager chooses to communicate with his investors. Ours is a quantitative field, so this kind of qualitative evaluation is not emphasized. But as the above quote from Warren Buffett shows, people unwittingly reveal themselves in how they communicate. Qualities of intellectual honesty, consistency of principles, and “truth in advertising” shine through, and give the non-expert LP a kind of scorecard to follow when judging investment managers. Conversely, money managers themselves should take great care in how they communicate, as they can be judged by their words, by both expert and non-expert investors, especially during difficult periods like the present one.

As an example: Hedge fund managers who espouse a value philosophy often claim to adhere to the following three principles:

1. I invest to maximize long-term results.
2. I don’t believe it’s possible to “time the market” in the short-term.
3. I should make money every year, therefore I should apologize when I don’t.

Each principle in and of itself is admirable, and all are the kinds of things LPs like and probably demand to hear, but a closer look reveals that, for value investors at least, any two principles can be true only at the expense of weakening the third one. A value investor who wants to maximize long-term returns and doesn’t think he can time the market must accept the probability of short-term losses as the unavoidable price of doing so. David Swensen of Yale has been almost alone among endowment investors in making the obvious point that no portfolio with a multi-generational time horizon should concern itself with avoiding occasional losing years. An investor who eschews market timing and also wants to make money every year can do so, but only at the expense of avoiding equity-like assets like stocks in favor of safer bond-like instruments. And finally, there is nothing shameful or even impossible about trying to invest for the long-term while also trying to make money every year, but those who do so should admit that they do try to see around corners and “time the market.” Even the decision to hold cash instead of equities is a kind of market timing call, although it’s impolite to admit it. With the exception of those, like Buffett and Seth Klarman, whose pools of capital are large enough that when they say “I hold cash because I can’t find anything else to buy” they really mean it, investors who hold a combination of cash and equities could simply take the cash and use it to buy more of what they've been recently buying. That they choose not to is not necessarily wrong, nor is it something to hide, but it should be called what it is: something very close to market timing, a bet that tomorrow’s universe of opportunities will be better than today’s. Most great value investors avoid sitting too heavily on this three-legged stool of logic (some still do, but they’ve probably earned the right), and instead openly acknowledge the tradeoffs inherent in trying to achieve all three goals in an uncertain world.

Another example of intellectual dishonesty and less-than-truthful advertising: If you are a long-term investor in a hedge fund, and your manager boasts loudly of having preserved your capital during the difficult last months of 2008, whatever comfort you take should be tempered by the knowledge that such heroics come at a price. Your manager either believes himself capable of calling the bottom, which is fine as long as he admits it (which he likely doesn’t, or in fact claims is impossible) or perhaps he has chosen to forgo investing in undervalued opportunities for fear of losing money in the short term, in which case he’s not serving your interests as a long-term investor. Contrast this with the candor of Jeremy Grantham in a recent Fortune interview, who with the wisdom of King Solomon admitted that the only way out of this problem is to somehow split the baby:

“How bad will you feel if you put in your cash reserves and the market continues to go down? You’re going to feel awful. And how will you feel if you don’t buy in the cheapest market for 20 years and it runs away and leaves you? Horrible. You have to step your way through so that the regret, which is going to be huge anyway, is about neutral.”

Another example: The common “apology” for poor 2008 performance, preceded by the inevitable “We’re seeing great opportunities in XYZ” from previous years’ communications. Any money manager who accepted exposure to equities going into 2008 presumably believed that at prices then prevailing such exposure promised long-term outperformance. In 2008, however, all forms of equity—that is, of ownership of enterprise—were punished, even those whose long-run intrinsic value has not changed much if at all. If you’re in the business of owning businesses, as most value investors are, you had nowhere to hide in 2008. That’s a risk inherent in ownership. If your money manager apologizes for it, does he also apologize for what he wrote in 2007? Does he take it back?

Here’s another one, a particular pet peeve of mine: When a manager writes, “We feel awful about 2008, but the good news is we’ve never seen better buying opportunities [so please stick around!].” This kind of advertising should make an LP wary, even if strictly speaking it’s true. If a money manager does not endorse market timing (and most don’t), he shouldn’t ask his investors to engage in money manager timing either. The manager who can only promise a good spring after a terrible winter sets himself too low a task—his job is to outperform in all seasons. Either he can do that or he can’t. Those who advertise their ability to achieve high highs only after low lows (the implication that you end up where you started) should consider a career in roller coaster design, not money management.

Finally, perhaps the most popular recent example of “principle drift” I’ve seen among professional value investors. Most value investors swear by the notion of staying within their circle of competence. Most, until recently, have also disdained macroeconomic forecasting, many with great pleasure. Therefore it’s ironic to see so many “going Soros” for the first time by filling their investor letters with bold macro pronouncements on currencies, metals, the next six months, what the Fed should do, etc., like atheists who suddenly get religion when they find themselves in foxholes. Some say “I have to in today’s market,” and some will no doubt succeed at this new kind of investing, but experience suggests that it’s both difficult and dangerous for value investors to change their stripes, even if the environment seemingly cries out for them to do so.

It’s also easy to forget in these dark times that today is not the first time the macro environment has looked bleak, and that such turmoil does not require an investor to become an expert in macro predictions. Both Benjamin Graham and John Maynard Keynes thought long and hard and brilliantly about the economy during the Great Depression, but as theorists only. As investors they avoided any attempts to profit from macro forecasting, with good results. The 1973-1974 bear market kicked off an unprecedented period of political and macro instability: Post-Watergate malaise, post-gold standard fears of paper money, oil shocks, stagflation, a 20% federal funds rate, etc. If ever there was a time you “needed” to have a macro view it was then. But that period turned out to be the best time to forget all that and invest in the straight-ahead Graham and Dodd style. From 1975 through 1982, when the economic environment finally calmed down a little, Berkshire Hathaway’s worst annual gain in book value was 19.3%. Tweedy, Browne averaged over 25% per year, Sequoia over 30%. And Walter Schloss, who probably couldn’t even spell “macroeconomic,” returned 37.5% in that period of turmoil. The best modern value investors are aware of this paradox of investing history, and don’t try to seduce their LPs with their economic brilliance at the expense of value investing principles. Seth Klarman said it best: “We worry top-down, but we invest bottom-up.”

I don’t mean to judge too harshly those money managers who I find guilty of flawed communication, although I’d point out that those with the best long-term performance records almost never make these errors. Many would protest that it’s almost a job requirement to communicate this way, or else investors will desert them. They may be right, but there is a lesson in the exceptions I’ve cited—Buffett, Grantham, Klarman, and Swensen. They all happen to live and work away from Wall Street, which is probably not a coincidence. They also happen to be geniuses at what they do, with credibility that only comes with decades of superior performance.

But they have another thing in common: By a combination of deliberate choice and the credibility won over years, they’ve taken great care to have “bosses” who share fully their investment goals and principles, true partners whose behavior contributes its fair share to their performance. Therefore, money managers, consider the unexpected upside of being truly honest with your existing and potential investors, even if it drives some away. It’s impolite to say so, but there is such a thing as a bad limited partner, one who makes his manager’s life much more difficult and takes him away from the ideal of being able to manage outside money as if it were his own. Not only that, but the money manager who accepts bad LPs punishes not only himself, but also his good LPs, who bear much of the costs. Eventually, everyone gets the investors they deserve. It works the other way too, so make sure your investors deserve you too.

Nadav Manham is the president of Elera Advisors LLC, an investment advisory firm in New York. He publishes “The Investor’s Consigliere,” a blog focused on investment manager selection with an emphasis on value investors. He can be reached at nmanham@eleraadvisorsllc.com.