Some years ago, Buffett created a stir of sorts when he stated that if he were investing $1 million today he could generate annual returns of 50%. I wrote about it in an earlier post.
In an interview with blogger Jacob Wolinsky, value investor Whitney Tilson was asked if Buffett’s investment style had changed as a result of his different circumstances at Berkshire and if he would be a net-net investor if he was managing less cash. Here’s Tilson’s answer:
Yes, that is absolutely true. He has been asked this question many times and responded that if he were to be managing very little money he would be looking in the nooks and crannies looking for extreme temporary mispricings. If you know where to look, you can sometimes find extreme temporarily mispriced stocks. However these stocks are usually small and it is hard to put much money into them. Not in a million years would Buffett own Kraft if he was managing $10 million.
Recently on The Corner of Berkshire & Fairfax Message Board, an excellent investing forum run by value investor and investment manager Sanjeev Parsad, the question was asked “What percentage of your portfolio is in Fairfax Financial?” The level of discussion on the board is quite high and it’s clear many of the members are capable investors.
For those who are not familiar with the company, Fairfax is an insurance company with outstanding investing capabilities that has compounded book value at a rate of 25% over the past twenty-four years under the leadership of Pre Watsa. Fairfax is often compared to an earlier stage Berkshire Hathaway. Many members of the forum have a material investment in Fairfax.
One member, rick_v, criticized having a large investment in Fairfax because, in his view, it is easy to find cheaper micro-caps with greater opportunity. In response, another member, coc, defended investing in Fairfax and challenged the idea that it is easy to find micro-cap investments that will outperform the market.
I thought the exchange crystallized some of the important decisions investors face when defining their own investment process and philosophy. The exchange also provides some food for thought to those who, inspired by Buffett’s remark, choose to seek opportunity in micro-caps.
I truly hope that all you guys mentioning stakes of 20-30%+ in Fairfax are either passive investors or older in age.
I think its a shame for a young or professional value investor to have such a large percentage of their portfolio in a stock like Fairfax. Afterall, even if Fairfax doubles in a few years that is not how you are going to generate alpha or get rich for that matter…
As a young or professional value investor you should be studying Fairfax and Buffet’s performance to identify your own value plays. Thats where the alpha will come from.
It is very easy with permanent capital to find securities which will outperform the market when you are looking in the 0-250m range. This range is not looked at by Prem, Buffet, and most of the other major value investors anymore due to their size. As such it represents where I see most of the opportunity for up and coming value investors.
Just my thoughts…
Here’s coc’s response:
I’m surprised you all let this go. I’d like to comment on two things, both of which I consider nonsense.
1. It is “very easy” to find securities that will outperform the market.
2. Holding Fairfax is inferior to running around finding these “very easy” securities.
I think investors vastly underestimate how good Warren Buffett was at his job back in the 1950’s and 1960’s when he was buying these niche securities. He’s even better now, but obviously runs so much capital that his returns are lower. There seems to be this “Buffett envy” going on in value investing circles whereby investors feel the need to look for little cigar butts similar to what Warren used to – largely influenced by his talks to students and his biography.
And yet, I have seen precious few investors who have successfully done it. Beyond the platitude that smaller areas of the market are “inefficient,” there are considerable risks. You are usually investing in second rate businesses that destroy value, or at least are not really building any. Often these businesses are run by inexperienced managers and have little advantage over their competitors. Thus, the business risks you assume are big ones, although most investors think a cheap valuation makes up for it. Sometimes, but not always.
Take for an example Dempster Mill Mftg – a well known Buffett investment way back when. If you think through the situation, there was a good probability that the investment was not a wise one. It took heroic efforts by a new manager to keep Dempster from going under, and even then, it was not an absolute home run. Yet, most Buffetteers admire these types of investments Warren used to make.
But what was Warren’s largest partnership investment? American Express, a well known company then and now, not a micro-cap dishwasher manufacturer. He also had a successful investment in Disney, and one in GEICO, again two companies that were well known. What was probably his best stock investment at Berkshire? The Washington Post, not exactly “unknown.”
Yet we’re told that he made all of his great returns back then because he could look small. Well, as with everything in life, the answer is yes and no. I think there is a great myth that you need to look where no-one else is looking and be creative in the investment process. That you should get points for creativity or something. But the very same people propagating this myth are students of Charlie Munger, who once wrote to Wesco shareholders that “We try to profit more from always remembering the obvious then grasping the esoteric.”
Let’s talk about a few more of Warren’s home runs. Petrochina, one of the largest companies on the planet. Freddie Mac, one of the largest companies on the planet. Coca-Cola, the most well-known brand on the planet. BYD, one of China’s most well-known and well-respected companies. These are investments where, for the first 5-10 years, he made 25%+ compound annual returns. Who are these people not getting rich by consistently generating 25% compound returns? Where is this stock market where 25% annual returns don’t generate “alpha”? Why do small investors need to run around looking at micro-caps?
Let’s also look at some other legendary investors. What sort of returns did they achieve and what were they buying? Lou Simpson – 20%+ type returns buying very well known companies. Rick Guerin – 25% type returns investing in a pretty broad range of securities small and large. Ruane, Cunniff – 15% over 40 years investing in large stocks. Eddie Lampert at ESL – you would probably know of almost every company he ever invested in – 30% CAGR for a 15-20 year period. Glenn Greenberg at Chieftain – did 25% for about 20 years, again you’d probably recognize almost every stock he owned.
These guys are legends, they’re all rich, and they invested in a huge range of securities.
Who do we know of that was investing in small securities that no one has heard of? Here’s two: Schloss and Graham. Did either of them do 50% compounded? Hell no. They’re hall-of-famers with 15-20% returns. Do I need to bring up Charlie’s returns? What has he bought over time?
So I dispute this notion that investors are somehow doing themselves a disservice by sticking with companies they know well and that others know well. Well-known companies are often just as mispriced as small ones. “To a man with a hammer, everything looks like a nail,” says Munger. Yet the Buffetteers seem to only admire one tool for finding cheap stocks (size constraints), when myopia, ignorance, and a host of other biases are just as powerful in creating misvalued securities.
To wrap this up a little, I’m not saying there aren’t lots of small mispriced stocks. Buffett did very well with them, and there are probably others doing great, too. But recognize two things: 1. Huge CAGR’s are really, really hard. 2. You can do extremely well investing in larger companies, great companies, and well-known companies, without a lot of the risks of investing in broken-down nags. This is well proven.
So if you rationally evaluate Fairfax and come to the conclusion that you’re going to get 15-20%+ CAGR (eminently reasonable given the fact that they are a relatively small player in a gigantic global insurance market and are run by one of the smarter investment teams on the planet), don’t worry about how much “alpha” you’re not generating by looking elsewhere. Was it a mistake to invest in Berkshire when it had a billion dollar market cap and was well known? I repeat, there are no points for creativity. Don’t forget it takes a unique cast of mind to just sit on some great companies and compound at high rates with no taxes, professional investor or not.
I’m probably not going to convert anyone who believes strongly that they have to be looking in the dirty alleys for cheap stocks, but if you’re on the fence, hopefully this is food for thought.
Here’s a link to the thread if you want to read more.
My own opinion is that there is no reason to limit yourself to certain investments based on market capitalization, just like it doesn’t make sense to make a false distinction between value and growth. You can get rich investing in either. For example, today large caps offer unusually strong risk-adjusted returns.
In investing, what really matters is how much cash you get back and when for the cash you invest and how certain you are of the outcome. I do think it’s fairly obvious that Buffett would be more active in small and micro caps if he were investing far less money, although not to the exclusion of investing in large caps. He would simply have greater options.