Monday, May 4, 2009

Cigar-Buffett Investing

After spending an entire weekend immersed in and inundated by Warren Buffett idolatry, I began to reflect further on the kind of investor I would like to be in the future. When you are in Omaha it is easy to get caught up in the Buffett adulation and forget that A) he is just a man and B) it does not make much sense for most value investors to invest like The Oracle does now. While his words and opinions on stocks will likely continue to move markets, the truth remains that the sheer size of Berkshire (BRK) precludes Buffett from getting involved with potentially lucrative investment opportunities. There is no question that the "Buffett Premium" is still alive and well as evidenced by the price to tangible book multiple that Wells Fargo trades at compared to its rivals and the 17%+ the stock is up today after Buffett talked about it on numerous occasions at this year's annual meeting. However, for the average retail or professional investor, piggy-backing on BRK stocks makes less sense than it ever has.

Specifically, with $58B in cash at his disposal, if a deal does not include the word "billions" the Oracle is both unlikely and unable to participate, regardless of the potential return. To make an impact on BRK's overall returns, the company must be able to invest a substantial sum of money. This means that BRK is nowhere near as nimble as other investors because the size of the stakes that BRK has recently taken make the investments much less liquid. Because the buying or selling of shares has the potential to move the market price significantly, BRK is basically locked into a long-term buy and hold strategy that will likely limit the company's ability to move in and out of stocks as better opportunities emerge. As a result, in the future it is more and more likely that Buffett's returns will be more fixed income-like and/or basically track those of the major indexes.

It is true that recently Buffett has had access to deals (with GE and GS for example) that others have not. But these investments have had relatively capped upsides (aside from the warrants he received) based on the fixed coupon and callability of these securities. At the annual meeting Buffett readily admitted that there is no way BRK will replicate its past returns and at this point he would be satisfied to beat the S&P 500 by a few percentage points each year (my detailed notes on this event should be out in the next day or so).

So, if we are not going to be able to outperform the S&P by a sizable margin by piggy-backing on the Oracle's stock picks, does that make him less relevant? Hardly. As individual investors we have the ability to invest like Buffett did in his partnership days and before BRK is what it is today. His lessons, like those of Ben Graham, are timeless. What he can teach us about value investing, specifically when it comes to identifying companies with great management and durable competitive advantages will continue to be relevant.

My own personal view is that a prudent portfolio absolutely contains a number of "Buffett Stocks." Now, what do I mean by that? Simply these are well-known businesses with large moats and pricing power that cannot be taken away easily. These are unlikely to be high fliers, meaning that they cannot be expected to double or triple within a short time period. But, between dividends, stock buybacks and consistent organic growth these companies ideally will provide consistent low double digit returns and will likely prove to be more defensive in an economic downturn due to their unwavering customer base and value proposition. I suspect that if I ever am lucky enough to manage other people's money that my portfolio will include many "Buffett Stocks." These will be the "pretty" part of my portfolio.

Now to the ugly part. By far my favorite investor is Seth Klarman of The Baupost Group. The eloquent way he articulates his value investing philosophies resonates with me like nothing else. If you go through the list of my favorite investment quotes of all time, you will find a disproportionate number of absolutely golden nuggets of wisdom from Klarman. The only "problem" that some investors have with Klarman is that he invests in "ugly" stocks; the kind of stocks my first hedge fund boss would categorize as having "hair on them." These companies are often unloved, unfollowed, distressed, tricky to assess, beaten down and may even have declining fundamentals that eventually will precipitate the death of the company. Klarman loves these companies because the risk-reward ratio is often very attractive and they can provide what are known as market agnostic returns. In other words, because of the unique circumstances facing these companies, their returns may not be tied at all to the general direction of the market.

Investing in "Klarman Stocks" is similar to what Buffett called cigar-butt investing (as described above he does not invest this way anymore). The idea is to find a company that has a little juice left in it and accept those returns with very low risk, similar to taking the last few puffs from a discarded cigar butt. The interesting thing about these companies is that the circumstances they find themselves in often present the opportunity for fantastic returns if the problems can be resolved. These are the potential two and three baggers in which the worst case scenario provides acceptable returns as a result of being bought with a sufficient margin of safety.

While the substantial research and digging, as well as contrarianism, certainly appeal to me, I'm not sure I want to spend my entire investing career looking for only "Klarman Stocks." Every once in a while it is nice to find a company that can be bought cheaply because the market is underestimating the fundamental strengths as opposed to overestimating the fundamental weaknesses. In other words, sometimes I want to buy a great company at a fair price and other times want to buy fair (or even bad) companies at a great price.

In conclusion, my goal as I build and hone my portfolio building and stock picking skills is to use what I have learned from both Buffett and Klarman to distinguish myself from other investors. I think the combination of potentially defensive and market agnostic stocks would lead to outsized returns in good years but even more importantly would protect capital extremely well in lean years. To that end I have even created a name for this style of investing: cigar-Buffett investing.