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Circle Of Competence Issue #17

What are you reading this week? Drop me a line or tweet @competence_co. Have a great week!

HIGHLIGHTED INVESTOR - SETH KLARMAN (BAUPOST)

This week, I thought I'd write a few thoughts on one of my favorite investors of all time, Seth Klarman. Klarman graduated with an economics degree from Cornell, and a few years later graduated with his MBA from Harvard Business School. While at Harvard, he met Professor William Poorvu and with a few partners, they seeded the Baupost Group with $27 million, allowing Klarman to run the money early on.

Although Klarman is known as reclusive and eschews the press, his investment philosophy is not as much a secret, because many investors carefully observe his filings and investment decisions. As I wrote in Issue #16 last week, his style is very similar to Michael Burry in the sense that he goes into any industry, any type of security (real estate, equities, debt, derivatives) at any time. He often prefers to buy what people are forced to sell - for example, he raised significant outside money in 2008 to begin buying distressed debt securities that were being liquidated due to margin calls and forced selling by other hedge funds. He tends to hold a decent percentage in cash when solid investment opportunities are scarce. In addition to higher cash balances when valuations are high, he uses index puts (derivatives betting on market declines) to hedge his portfolio against large systematic market declines. In fact, he only returned negative single digits in the financial crisis while other funds and the broader markets were down 30, 40, 50% due to his hedging and large cash balances prior to the real estate bubble collapse. He has been described as a Benjamin Graham deep value style investor due to buying securities that are distressed and fundamentally unwanted in nature.

To illustrate his idiosyncratic style relative to the rest of Wall Street, one can easily check out his equity holdings in his recent SEC 13F filing. As I look down the list of his holdings, I notice several trends:

- the top 10 holdings account for 76% of his equity holdings (very high concentration).

- Of $29 Billion in assets under management, only $10 billion was allocated to equities, representing ~34% of assets. That is a telling sign in a world where many funds (either by mandate or by choice) are fully invested in equities.

- They invest in stocks with: activists involved (LNG, the activist is Icahn), potential buyouts in the future (TWX buyout which is closing, FOX being pursued as I write this), dirt cheap stocks on a multiple basis (AGN cheap on free cash flow multiple), and convertible debt (Tesla and Theravance Biopharma convertible debt).

DEPARTMENT OF GENERAL FINANCE

As always, Howard Marks' latest Memo to clients was a gem. I encourage ALL investors who are interested in index investing vs. active management as well as artificial intelligence applied to financial markets to read this thoughtfully written piece. My favorite quotes below:

"Further, quantitative investing's emphasis on profiting from short-term dislocations leaves a lot more to be mined. So much of investing these days considers only the short run that I think there's great scope for superior active investors to make value-additive decisions concerning the long run. I have no reason to believe computers can make these in a superior way.

The greatest investors aren't necessarily better than others at arithmetic, accounting or finance; their main advantage is that they see merit in qualitative attributes and/or in the long run that average investors miss. And if computers miss them too, I doubt the best few percent of investors will be retired anytime soon."

Along with:

"Computers, artificial intelligence and big data will help investors know more and make better quantitative decisions. But until computers have creativity, taste, discernment and judgment, I think there'll be a role for investors with alpha."

I tend to agree with Marks here when he says that:

"Computers can do an unmatched job dealing with the things that can be counted: things that are quantitative and objective. But many other things - qualitative, subjective things - count for a great deal, and I doubt computers can do what the very best investors do..."

I really enjoyed reading this article on the CFA Institute Blog about Robert Wilson's hedge fund, Wilson & Associates as well as his lessons on shorting stocks. While shorting a stock can allow you to collect cash up front to increase your long exposure (amount of stock that you buy and hold, not sell short) as well as hedge your portfolio when the markets decline rapidly, what this article truly makes clear is the risk in shorting stocks. Wilson details his most costly short trade where he shorts a stock at $15, only to have it rocket to $190/share in three months! Talk about huge losses... and yet despite this large loss, he still managed to return 30% annually over about a decade for his clients. Even though his thesis would be proven correct about the stock later, he was simply too early for it to matter. As the article aptly states "Being too early is indistinguishable from being wrong."

Great article by Ensemble Capital on how safe, 'moat-y' stocks became overcrowded and overvalued back in 2016. Great article emphasizing the lesson: Any asset can be a good (bad) investment if bought for a good (bad) price.

Jim O'Shaughnessy shares some of his most costly mistakes on his blog that are well worth the read.

Is there any wonder that these European youngsters turn to populist promises when their current situation is so hopeless?

This quote says it all:

"An RBS spokesman said: 'Since 2014 the number of customers using our branches across the UK has fallen by 40% and mobile transactions have increased by 73% over the same period.'"

Although I'm not a gamer, this is a trend that many investors have been paying attention to - the gaming explosion of the 21st century. Most recently, this has taken the form of the gaming world's obsession with Fortnite, however over the last decade, the momentum of this trend has been steadily building.

It seems the tax reform has certainly helped the bottom lines of many companies, because every percentage point reduction in tax rates from their previous effective rate drops straight to the bottom line. But analysts are not as bullish for earnings going forward.

This is the definition of a crowded trade - there was a LOT of money betting that the deal would eventually close and that now stand to profit handsomely from this bet. In fact, this week's highlighted investor, Seth Klarman, had a position in Time Warner worth ~$750M as of his last 13F SEC filing.

Interesting set of economic charts showing some effects of the recent tax cuts.

DEPARTMENT OF REAL ESTATE

It is interesting how in student housing, demand drives what type of supply is built, whereas in other industries, oftentimes the features of the product drive demand. I have been reading recently about the potential bubble forming in higher education debt markets and can't help but wonder what happens to a lot of the newest student housing supply if marginal demand tapers or begins to decline because of the increasing costs of higher ed.

Two great articles that pair together nicely. The message is clear - rising housing demand and lower supply are driving prices higher nationwide.

Interesting article on the incredible growth of the Nashville metropolitan area and the potential problems forming.

DEPARTMENT OF STARTUPS AND TECHNOLOGY

In addition to posting interesting articles on startups and technology, this week I wanted to take a moment to thank Azeem Azhar for inspiring me to read, learn, write, and share my thoughts on finance and investing. Although Circle Of Competence focuses on studying financial markets, investment philosophy, companies, and investors, I shamelessly copied Azeem's format (Department of...) and weekly long-form posts because of how much I enjoyed his newsletter, The Exponential View. If you are interested in new technology, trends in society, and how startups are pushing boundaries in all areas of life, I would suggest you head over to the link above and subscribe - you won't be disappointed!

This is the logical end of automation - a warehouse that literally employees no workers for actual work, but rather for servicing the true workers... the robots.

Is Google starting to compete with Amazon? This should be good...

DEPARTMENT OF PODCASTS

I enjoy podcasts as way to learn from the best of the best, and this week I wanted to share the list that I regularly listen to on a weekly basis. I have listened to other shows, but have found that these are my favorites over time. If you have additions you'd like to recommend, please tweet to @competence_co or message me directly!

In this episode, Preston and Stig go in depth on 5 of the best questions asked at the Berkshire Hathaway Annual Shareholders Meeting. Highly recommend this for those who didn't catch the live stream of the annual meeting!

This episode is less about real estate investing and more about the habits of the most successful people - personal development mixed with real estate, if you will. I HIGHLY recommend listening closely to the Miracle Morning portion (most of the podcast), because this is a powerful technique for achieving consistent gains and goals in your life. I decided that I would begin applying the SAVERS technique each morning after listening to this episode and doing more research on Hal and David's morning routines. Wonderful episode!

Really intriguing episode where Barry Ritholtz interviews Dr. Raife Giovinazzo from Fuller & Thaler Asset Management on behavioral and cognitive mistakes investors tend to make... and how they use this research to profit from these biases.

This episode with Jocko Willink discusses the work "Concerning Military Affairs" by Flavius Vegetius Renatus. This piece of historical writing covers the Roman Empire at the pinnacle of its power and puts forth some powerful lessons that are broadly applicable in business and life. Here are some that I found especially powerful:

1. Discipline is everything. When it begins to slip, the end is near (talking about Roman Empire, but this can be generalized to anything - a company, a family, a marriage, etc.).

2. Practice is the core essence of any skill. Whatever your goals are, practice is the only thing that will get you there.

3. Discipline trumps skill. Hard work outperforms talent. Small numbers of well trained troops (employees, etc.) can take down a larger, undisciplined, and comfortable army (company, etc.).

DEPARTMENT OF LETTERS

This week, at the SandRidge Annual Meeting, Icahn won 5 of the 8 board seats, effectively gaining control of the company after waging a proxy fight with the company beginning earlier this year. It seems likely that he will push for asset sales to realize value for shareholders, because, after all, he is a fund manager, not an oil & gas executive. This will continue to be a story I follow.

What are you reading this week? Drop me a line or tweet @competence_co. Have a great week!

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