Mark Yusko is the Founder, CEO and Chief Investment Officer of Morgan Creek Capital Management. Morgan Creek has over $3 Billion in Assets Under Management.
Prior to forming Morgan Creek, Yusko was President, Chief Investment Officer and Founder of UNC Management Company, the Endowment investment office for the University of North Carolina at Chapel Hill, from 1998 to 2004.
Yusko recently sent out his 2nd Quarter Market Review and Outlook to his clients. Part of his review what his letter to investors which includes an amazing overview of what it takes to invest like Seth Klarman.
It’s a must read for all value investors.
Following is an excerpt from Yusko’s letter to investors:
Klarman on Mindset
Zig Ziglar, a famous author and motivational speaker (Born to Win), says that “your attitude, not your aptitude, determines your altitude.” In essence your mindset determines your success. Klarman would agree and he speaks and writes extensively on the importance of a Value mindset to an accomplished investor.
He believes one of the challenges we face is that “Investing is the intersection of economics and psychology. The analysis is actually the easy part. The economics, the valuation of the business isn’t that hard. The psychology, how much do you buy, do you buy it at this price, do you wait for a lower price, what do you do when it looks like the world might end, those things are harder. Those you learn from experience and by having the right psychological makeup.”
Again, we hear that a significant component of Value investing (the actual analysis) isn’t hard, but having to manage the psychological component is very challenging indeed.
Having the right mindset, the right “psychological makeup” is the key to success. The good news is that achieving that mindset is possible, the bad news is it requires a lot of experience (read overcoming mistakes). As Klarman revealed above, the three of the key psychological characteristics that great investors share are Discipline, Patience and Judgment, but also Persistence (to always seek to improve) and Resilience (the ability to shrug off failure and begin anew).
All that said, “to be a Value investor requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.”
The number one psychological characteristic of Value investors is Risk Aversion, full stop. All of the behavioral research shows that the pain of loss exceeds the thrill of gain by a 2:1 ratio and that should imply that just about anyone could be a Value investor.
Alas, we know from the DALBAR Study that individual investors are anti-Value investors over time, meaning that they repeatedly buy the most expensive assets and sell the cheapest assets leading their portfolios to underperform dramatically.
Over the past twenty years, buying and holding stocks (100%) would have delivered 8%, buying and holding bonds (100%) would have yielded 6.5%, a 60/40 Stocks/Bonds portfolio rebalanced annually would have yielded 7.4%. Yet the average investor in mutual funds achieved only 3.4% (a stunningly bad resulting from constant performance chasing).
As a point of comparison, the average Endowment (following a model with Value roots) returned 9% and the top ten Endowments returned 12% over the same period.
Klarman’s response to this phenomenon is, “while no one wishes to incur losses, you couldn’t prove it from an examination of the behavior of most investors. The speculative urge that lies within most of us is strong; the prospect of a free lunch can be compelling, especially when others have already seemingly partaken.”
That “speculative urge” is a psychological characteristic in all of us that we must fight in order to reach our full potential as great investors. B.F. Skinner did a great deal of work on trying to discern why human beings seemed hard-wired to want to speculate (gamble), and found that the behavior was linked to a concept called “sporadic reinforcement.”
In essence, by winning only occasionally, the desire to participate in that activity actually increases. Capital markets are incredible sources of sporadic reinforcement as odds are skewed against you (not to different than Vegas), but only slightly worse than 50/50 so that you win often enough to keep playing (and eventually lose a great deal as the DALBAR data shows).
Worse yet is the feature that somewhere somebody won big in the markets. This knowledge of available opportunity makes the desire to speculate even greater. Klarman summarized this sensation perfectly. Said another way, there is nothing so damaging to your net worth that seeing a friend get rich.
When others have good fortune, we want it too, and we will speculate in order to make it happen. Taking this point further, “it can be hard to concentrate on potential losses while others are greedily reaching for gains and your broker is on the phone offering shares in the latest “hot” initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome.”
Something to keep in mind next time you are offered a “great deal.” If I was George Soros and someone from a brokerage firm called me with a “hot” IPO, I would probably take it (he pays enough commissions to warrant getting the best deals), but by the time I get that call (let’s just say my commission ledger is ever slightly smaller), the best way to avoid a loss is to pass.
Always remember Neuberger’s three rules, “Don’t lose money. Don’t lose money. Don’t forget the first two rules.” “If you are predisposed to be patient, disciplined and psychologically appreciate the idea of buying bargains, then you’re likely to be good at it. If you have a need for action, if you want to be involved in the new and exciting technological breakthroughs of our time, that’s great, but you’re not a value investor, and you shouldn’t be one.”
A psychological appreciation of bargains is such a powerful idea.
Bargains are gifts that may be infrequent, but they are valuable. If you have a need for more frequent activity and excitement, Klarman says it very clearly that you don’t have the mindset to be a Value investor. There are obviously other styles of investment, and all he is saying is that if you don’t have the right temperament, you should find the strategy that works best for you.
If you have the natural propensities Klarman has described for us thus far, the rules of engagement are very simple.
“To a value investor, investments come in three varieties: undervalued at one price, fairly valued at another price, and overvalued at still some higher price. The goal is to buy the first, avoid the second, and sell the third.” It is not enough to seek fairly valued assets you must restrict yourself to ones that are on sale and avoid speculation in the frothy part of the market.
Furthermore, if the assets you own reach a price higher than your ascribed intrinsic value, you must sell. Ben Graham said “Price is what you pay, Value is what you get,” and Klarman expounds on this relationship in saying, “value in relation to price, not price alone, must determine your investment decisions. If you look to Mr. Market as a creator of investment opportunities (where price departs from underlying value), you have the makings of a value investor. If you insist on looking to Mr. Market for investment guidance however, you are probably best advised to hire someone else to manage your money.”
I am here again reminded of Burbank’s distrust of price. A related that and important point is that “investors frequently benefit from making decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy into situations at prices so low they offer a margin of safety despite the incomplete information.”
Markets move fast today and the ability to gather every last piece of information to build the perfect DCF model to create an estimate of intrinsic value is challenging.
Sometimes the bargain is so good and the margin of safety is so high that it pays to move quickly, even in the absence of perfect information. It is better to be approximately right, rather than precisely wrong. So you think you have the psychological makeup and mindset to be a Value investor?
There is a simple test to find out. “Here’s how to know if you have the makeup to be a Value investor. How would you handle the following situation? You own a great business (like P&G) in your portfolio and the stock price goes down by half. Do you like it better? Do you reinvest dividends? Do you take cash out of savings to buy more? If you have the confidence to do that then you’re an investor. If you don’t, you’re a speculator, and you shouldn’t be in the stock market in the first place.”
Let’s walk through this one a bit. Is Klarman saying you can only be a good investor if are willing to double down on my losses? Didn’t Paul Tudor Jones say “Losers Average Losers?”
These questions are valid, but Jones was speaking to a different arena. In the world of trading the quality of the company is not the essential characteristic of the asset. Rather, the important judgment is on the prospective collective actions of other traders in the short-term.
Inherent to these explanations is the difference between trading and investing, which is a line that can be blurred in common speech or even in the naming of firms. Klarman is talking about investing, and importantly, investing only in assets purchased with a margin of safety.
Thus, if Mr. Market marks down such an asset, by definition, your margin of safety has grown, and you are compelled to buy more. The keys here are diligence in the determination of the true value of the business and then remaining steadfast in your discipline.
“Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands. By having confidence in their own analysis and judgment, they respond to market forces not with blind emotion but with calculated reason.”
My boss at my first investment firm believed in this concept so wholeheartedly that he had coffee mugs made with “Invest Without Emotion” emblazoned on them. Ben Graham said the same thing (and Buffett is credited with it all the time) “Be greedy when others are fearful and fearful when others are greedy”.
Klarman puts a modern spin on the wisdom, saying “successful investors, for example, demonstrate caution in frothy markets and steadfast conviction in panicky ones.” Continuing to reiterate how this mindset defines how well an investor will fare over time, saying “indeed, the very way an investor views the market, and its price fluctuations, is a key factor in his or her ultimate investment success or failure.”
Taking it back to some of the Philosophy above, we know that the crowd is always wrong over the long-term, so being able to step away from the pack at the inflection points is one of the most critical determinants of investment success.
I talk about #Edge all the time on Twitter (@markyusko if you are new to the game), and I have tweeted an abundant collection of psychological characteristics and character traits that define how successful people (those with Edge) live their lives.
As I have touched on previously in this letter, I find Conviction to be the biggest Edge (particularly in panicky markets), but Klarman has a different view. “The single greatest edge an investor can have is a long-term orientation.” I have created my own Catch-22 here.
If I give up my conviction that Conviction is the greatest Edge and agree with Klarman on long-term orientation, then do I lack conviction? Allow me digress for now in the comfort of the notion that, if two people always agree, one is unnecessary.
I concede that investors who embrace a long time horizon have a gargantuan advantage over more short-term oriented investors. The data shows (rather conclusively) an extraordinary positive correlation between the time horizon of investors and their performance (Endowments crush individual investors over 3:1 over past twenty years).
Speaking again to the inherent nature of the value mindset Klarman emphasizes that “a value strategy is of little use to the impatient investor since it usually takes time to pay off.” The challenge of having a long time horizon is waiting to see investments to fruition. In the instantaneous world we live in today, having patience is all the more challenging.
One of the biggest changes I have witnessed in investing over the three decades I have been involved in the endeavor is the incredible shrinkage of time horizons. Investors, as well as Boards and fund managers, can have very little patience in a world of 24/7 media coverage and instantaneous access to online information.
One of the other problems that the constant barrage of information creates is the mirage that everything that is urgent is really important (it isn’t). One of the best ways to deal with this issue is to disengage and focus on longer-term information sources.
Klarman says it very clearly, “I don’t have a Bloomberg on my desk. I don’t care.” One of my favorite lines in investing is that “if you want to be a good investor talk to everyone, if you want to be a great investor, talk to no one.”
Independent thinking is the best way to achieve outstanding returns and disengaging from the daily noise and focusing on the long-term signal is what makes Value investors great. One of the last areas of a Value mindset that is critical is the ability to balance the Conviction to take a position with the continual willingness (and discipline) to reevaluate your position, seek disconfirming evidence and constantly challenge your assumptions to make sure your original thesis (and analysis) is still sound.
Klarman says “successful investors must temper the arrogance of taking a stand with a large dose of humility, accepting that despite their efforts and care, they may in fact be wrong.” A true Value investor takes a position that is materially different from the consensus and in that very act there is an element of arrogance in the belief that you have better information, better insight, superior analytical skill or some other edge worthy of taking that contrarian position.
The fact always remains that no matter how diligent your research, no matter how thorough your analysis and no matter how strong your Conviction, you could be wrong. For most people the fear of being wrong restricts them from taking an unpopular or controversial stand. Perhaps this is why there are so few truly intrepid Value investors.
Stated simply, “the only way for investors to significantly outperform is to periodically stand far apart from the crowd, something few are willing, or able, to do.” Michael Steinhardt called it a “Variant Perception.” He defined VP as a view that is materially different from the consensus, that you believe has an above average probability of being correct.
According to Steinhardt, they made all their big returns when they took a Variant Perception that turned out to be right. For many, the fear of standing out negatively overrides their desire to stand out positively. However one of the more important and amazing facts of investing is that you do not have to always be right. If your resistance to variance has reached a level of portfolio paralysis remember that even the Legends of this business were wrong only slightly less than they were right.
In a dynamic world, things change and as often as not you will have to change your original thesis in order to maximize returns. Klarman chimes in here too, “In investing it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it.”
The second part of this quote is the most important. You have to do something about the change, you have to take action, sell something you are long, or cover something you are short. Lord Keynes famously quipped when confronted by someone in the audience during one of his speeches that he had said something different the week before, “When the facts change, I change my mind. What do you do, sir?”
Informed action is an #Edge. One addition here is that good investors do the first order change (sell what they own or cover what they are short), but great investors reverse their positions (go short what they were long, go long what they were short). Alas, even the greats can falter here.
Sebastian Mallaby tells a great story in his book More Money Than God of a phone call between a young Stan Druckenmiller and George Soros. After nimbly switching a much smaller portfolio from long to short, Druckenmiller received a call from a broker telling him that a seller was dumping huge amounts of shares.
Knowing his friend’s long position, Druckenmiller called Soros to share the news but was met with uncharacteristic, almost tired. Only that weekend when reading Barron’s did Druckenmiller learn that his future boss was the elephant unloading shares.
Having a Value mindset is another difficult proposition disguised by simple descriptions. Perhaps the most important attribute of a Value mindset is having the ability to do nothing when there is nothing to do.
To read Yusko’s full 2nd Quarter Market Review and Outlook, including his letter to investors, you can find it here.
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