Book presentation: Excess Returns: a comparative study of the methods of the world's greatest investors

Book Presentation:
Excess returns –
A comparative study of the methods
of the world’s greatest investors
Frederik Vanhaverbeke

Business literature
(best practices) Behavioral finance
Topics:
The investment philosophy;
Finding bargains;
Fundamental business analysis;
Valuation;
Common process mistakes;
How to buy and sell intelligently;
Risk versus return;
The intelligent investor
Books/articles/
interviews
about/by top
investors
Books stock
market behavior
Book Excess Returns

Overview
• Challenge to the Efficent Market Hypothesis
• The Investment Philosophy
• Effectiveness of sound investing
• The Investment Process
(*) Finding Bargains
(*) Due Diligence
(*) Common mistakes
• Buying and selling
(*) Stock types
(*) Market cycles
(*) Common mistakes
• Risk versus return
• The intelligent investor

The Efficient Market Hypothesis – are markets efficient ?
EMH claim: Market cannot be beaten as pricing
is always and totally efficient

1. Market beaters are random subjects who owe their “success” to luck
2. There is no systematic method to beat the market
The extreme efficient market theory is "bonkers". It was an intellectually consistent
theory that enabled them to do pretty mathematics. So I understand its seductiveness to
people with large mathematical gifts. It just had a difficulty in that the fundamental
assumption did not tie properly to reality. The efficient market theory is obviously
roughly right meaning that markets are quite efficient and it’s quite hard for anybody to
beat the market by significant margins as a stock picker by just being intelligent and
working in a disciplined way. The answer is that it’s pretty efficient and partly inefficient.
‐‐‐ Charlie Munger
The common view of top investors on EMH:

The Efficient Market Hypothesis –
Challenge 1: Momentum trading
Jesse Livermore (first decades of 1900s): spiritual father of momentum trading
Turtle traders
Richard Dennis: Other
1) 15 years (70s, 80s): $400 → $200 million
2) 1994 → 1998: 63% annually
William Eckhardt:
1978→ 1991: 60% annually
Turtle experiment
Annual compound
return
Number of years
(track record)
Tom Shanks 29.7% 22
Paul Rabar 25.5% 23
Liz Cheval 23.1% 21
H. Seidler 22.8% 23
Jerry Parker 22.2% 23
S. Abraham 21.7% 19
William O’Neil (CANSLIM):
40% annually over 25 years

The Efficient Market Hypothesis –
Challenge 2: Macro investing with George Soros and co.
George Soros:
1969 → 2009: 26.3% annually
George Soros + Jim Rogers:
1969 → 1980: Soros Fund x34 ↔ S&P 500: 47%
George Soros solo:
Outperformance continues
George Soros + Stanley Druckenmiller:
• Outperformance continues
• Druckenmiller = person who “broke the Bank of England” (not Soros)
• Druckenmiller (Duquesne Fund): 37% annually over 12 years
George Soros solo (with son):
Outperformance continues (e.g., return in 2008: +7%)
If markets are efficient, how can this string of outperformance be explained?

The Efficient Market Hypothesis – Challenge 3
Edward Thorp, Mathematics professor:
• Derived the Black‐and‐Scholes option pricing model a few years before
Black and Scholes but decided to keep it secret (to make money)
• 1969 → 1988: return Princeton Newton Partners: 19.1% annually
• Princeton Newton Partners: positive performance in 227 out of 230 months !!!
→ probability of this kind of consistency or beƩer  6.1E‐46
(number of atoms on earth  1E50)
Can this be explained by luck?

The Efficient Market Hypothesis – Challenge 4:
The Superinvestors of Graham‐and‐Doddsville and like minded
Annual compound
return
Number of years
(track record)
Benjamin Graham 21% 20
Walter Schloss 20% 49
Tom Knapp 20% 16
Bill Ruane 18% 14
Warren Buffet 22% 57
Pupils of Benjamin Graham
Annual compound
return
Number of years
(track record)
Joel Greenblatt 40% 20
Rick Guerin 33% 19
Eddie Lampert 29% 16
Charles Munger 20% 14
Prem Watsa 22% 28
Warren Buffet adepts
“Superinvestors of Graham‐and‐Doddsville”: Walter Schloss, Tom Knapp, Rick Guerin, Bill Ruane,
StanPerlmeter, Charles Munger: identified as exceptional investors by Buffett when they had no track
record!!!

The Efficient Market Hypothesis – Excess returns
(over S&P 500) of top investors

The Efficient Market Hypothesis – Excess returns
and the power of compounding
Warren Buffet, Jan 1957 – Jan 2013 (57 years): annual compound return = 22.29%
(= 12.4% annually above return of S&P 500 including dividends)

The Investment Philosophy –Market Philosophy
Success in the market starts with a sound market philosophy…
Effective market philosophy
• Explains drivers behind the market
• Explains how these drivers create inefficiencies
• Shows how one can take advantage of pricing inefficiencies
Effective market method
Practical and proprietary implementation of the philosophy
Common for all market
operators of same “school”
Different for each market
operator, dependent on:
• Personal preferences
• Fit with personality
There is nothing new on Wall Street or in stock speculation.
What has happened in the past will happen again and again and again.
This is because human nature does not change, and it is human emotion
that always gets in the way of human intelligence.
‐‐‐ Jesse Livermore
Market philosophies are timeless:

The Investment Philosophy – Examples
Investing versus momentum trading
INVESTING MOMENTUM TRADING
Drivers of stock
prices
• Cognitive biases: herding, extrapolation, asymmetric loss aversion, etc…
• Different market styles: investing, trading, speculating, etc…
• Different objectives among market operators (e.g., quick win vs. long term)
Basic premise Over long term stock prices revert to
their (true) intrinsic value
There is price momentum in stocks that
tends to persist over some time
Basic approach
• Determine intrinsic value of stocks
• Buy at discount to intrinsic value
• Sell when price reaches intrinsic value
• Closely track price action
• Buy (sell short) stocks with strong (weak)
price action
• Get out when trend reverses
Investing methods
Find stocks below intrinsic value
+
Buy/ sell intelligently
→ take cues from most success-ful
investors in the world
Focus of the book

The Investment Philosophy
BUY
Sell close to or above intrinsic value
SELL
Stock price (value)
Time
Intrinsic value
Stock price: quasi‐random
walk around intrinsic value
Buy when stock trades
at significant discount

The Investment Philosophy – remarks
It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately to
people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away,
I find that you can talk to him for years and show him records, and it doesn’t make any
difference. They just don’t seem able to grasp the concept, as simple as it is.
‐‐‐ Warren Buffet
Fully endorse investment philosophy (“fit with personal beliefs”)
Apply a method that fits their personality and preferences
Have the right psychological mindset (e.g., patience,
independence, emotional detachment, etc.)
Successful investors

The Investment Philosophy – consistency of outperformance, 1
Let’s first get a myth out of the world:
outperformance in every single year is not of this world !!!

Joel Greenblatt: one of the most impressive track
records in the hedge fund industry!!!
1995‐2005, Joel
Greenblatt on
his own: 30% a
year (20% better
than the
market)!!!
1985‐2005
Greenblatt: $1,000 → $840,000
S&P 500: $1,000 → $12,000

Even over multi‐year periods many top investors regularly underperform versus the market…
Their goal = outperformance over an entire (bull‐bear) cycle

Let’s look at Seth Klarman, one of the few hedge fund managers that
Buffett would entrust his money to…
In spite of long
period of under‐performance,
track record
over 26 years is
exceptional !!!

The Investment Philosophy – common sense on track records, 1
Investing = statistical process because stocks move along a quasi‐random walk
over which the investor has no control !!!!
Hence, for all those who are still not convinced, answer the following question:
In a game where
two dice throwers
must throw a
green surface,
does someone
who throws a dice
with 4 green and 2
red surfaces
always win from
someone with a
dice that has 3
green and 3 red
surfaces ?

→ Although the odds are
stacked in favor of the first
dice thrower (i.e., he
competes with an edge
versus the other player),
statistics says that only over
the long run (i.e., a sufficient
number of games) the first
dice thrower is (very likely)
to come out ahead.

So, ditch a top investor who temporarily underperforms at your own peril!!
Common sense on track records
Investing = statistical process:
(*) Investor performance = quasi‐random walk versus market return (with other
expected return);
(*) Every year is like one throw of the dice; investor with edge will not win every year
but is very likely to come out ahead over sufficient number of years;
(*) Track records not easy to interpret, not even over multi‐year periods; those looking
exclusively at track records don’t count the number of green surfaces of the dice.
 Evaluation investment method indispensable in evaluation track record
(Buffet downplays importance of track records in his search for portfolio managers
of his investment float; focuses on personality, philosophy and process instead)

Why should the time required for a planet to circle the sun synchronize
precisely with the time required for business actions to pay off? While I
much prefer a five‐year test, I feel three years is an absolute minimum for
judging performance. It is a certainty that we will have years when the
partnership performance is poorer, perhaps substantially so, than the Dow.
If any three‐year or longer period produces poor results, we all should start
looking around for other places to have our money. An exception to the
latter statement would be three years covering a speculative explosion in a
bull market.

The Investment Chain ‐ Overview
Finding potential
bargains
BIASES “Investment Process”
Due Diligence
Qualitative analysis
Quantitative analysis
Valuation
Focus: stocks with
above‐average probability
of being undervalued
Ignore: stocks that are
unlikely to be bargains
Continuous follow‐up of existing positions
Buy/stay away/ hold/ sell/sell short
Preference
for wrong
types of
stocks
Biased
analysis
Irrational
trades
Succesfully
coping with biases
THE INTELLIGENT
INVESTOR
Superior process
& execution
PSYCHOLOGICAL

The Investment Process ‐ Finding Bargains ‐ 1
Huge stock universe + due diligence of single idea very time‐consuming
Top investors focus efforts on most promising ideas
What stocks
tend to be
undervalued?
What stocks
tend to be
overvalued?
Drivers of over/under valuation
Sentiment Cognitive biases
Information among investors about company
Number of investors looking at idea
Incentives to buy/sell
Select for
further scrutiny
Deselect
Tip‐offs
Well‐informed buyers/sellers
Well‐informed admirers
Choosing individual
stocks without any
idea of what you’re
looking for is like
running through a
dynamite factory with
a burning match. You
may live, but you’re
still an idiot.
‐‐‐ Joel Greenblatt

The Investment Process – Finding bargains ‐ 2
Stocks in the spotlight Ignored stocks
(dull, unfashionable, complex, small)
Positive sentiment stocks
(hot, widely admired, high‐growth)
Negative sentiment stocks
(despised, troubled, lousy industry)
People are always asking me where the outlook is good, but that’s the wrong question.
The right question is: Where is the outlook most miserable?
‐‐‐ John Templeton

The Investment Process – Finding bargains –
Jeffries’ Finest Moment
Jeffries, global investment bank; several nominations of "Best place to work“;
Excellent track record in its industry up until 2011
Leucadia merges
with Jeffries

The Investment Process – Finding bargains ‐ 2 ‐ examples
Companies with “buzz” around them are seldom good investments !!! – Belgium

The Investment Process – Finding bargains
IPOs Spin‐offs
Example, Belgian spin‐off out of Omega Pharma:
The new issue market is
ruled by controlling
stockholders and
corporations who can
usually select the timing
of offerings.
Understandably, these
sellers are not going to
offer any bargains.
Any time you read about
a spinoff being
accomplished through a
rights offering, stop
whatever you’re doing
and take a look.
‐‐‐ Joel Greenblatt

The Investment Process – Finding bargains ‐ Summary
Odds stacked against undervaluation

Don’t waste your time on these!!!
(does not exclude that there can be
an ocassional winner here)
Above‐average probability of undervaluation

Take a closer look (don’t buy blindly!!)
Hot
stocks
Ignored
stocks
IPOs
Special situation
stocks
Stocks
hitting
new lows
Hated
stocks
Greenblatt’s
magic formula
stocks
Stocks added to
an index
Stocks removed
from index
Underappreciated
beneficiaries of
new trends
Post‐bankruptcy
stocks
Stocks of
pioneering
businesses
Businesses without
earnings track
record
Insider
buying
Not necessarily good short ideas (see next slide)!!!

The Investment Process –What do top investors short?
Shorting is not for the faint of heart + stock selection requires a very specific approach…
Poor fundamentals
 Management issues: dishonesty, greed,
exuberance, rubberstamping of boards
 Poor financials: weak balance sheet, low ROE
and low ROIC, poor cash flow generation
 Flawed business model
 Growth saturation
 Weak industry
Good stock characteristics
 Overinflated price
 High float
 Popular among professionals
 Middle-sized short interest
Triggers
 Insider sales
 Resignation key people
 Change in auditors
 Late filings
 Rumors that something is wrong
Do not short stocks with good stock
characteristics that are
fundamentally OK
Avoid technology
stocks
Avoid beaten-down
stocks
Good Short
candidates

The Investment Process – Finding bargains in emerging
markets
Compelling valuations
+
+
Attractive country
Primary beneficiaries of
emergence of the country
Economic reforms, hands‐off
government, infrastructure,
savings mentality, etc.
Successful investing
in emerging markets
Financials, consumer products,
media, excellently‐run players,
etc.

The Investment Process –
How Top Investors analyze businesses
In evaluating people you look for three
qualities: integrity, intelligence, and
energy. If you don’t have the first, the
other two will kill you.
Quantitative
analysis
Income statement
 Earnings track record
 Dividend history
 Profit margins
 ROIC, ROE
Cash flows
 Operating cash flow
 Free cash flow
Balance sheet
 Liquidity
 Solvency
 Z-score, H-score
Qualitative business analysis
Industry
 Barriers to entry
 Competitive pressure
 Threat substitutes
 Capital intensity
 Rate of change
Business model
 Simplicity ↔ complexity
 Track record: scalability,
profitability, market share
Competitive position
 Power versus customers,
suppliers, internal
competitors
 Pillars: culture, HR,
structure, processes,
marketing, R&D, innovation,
operations
Control over destiny
 Government interference
 Dependence on R&D,
fashion or critical decisions
 Operational/financial
leverage
 Diversification of customer
base and geography
 Impact weather or economy
Growth
 Decent growth prospects
 Track record
 Growth management
 Risk of growth saturation?
Management
Personality
 Integrity
 Modesty
 Non-complacency
 Independence
Experience & skill
 Track record
 Capital allocation: tight
ship, focus on
opportunities, little
leverage, no empire
building
 Strategy: unique + based
on core competencies
Values
 Promotion values
 Consistently enforced
 Management = example
Ownership & allegiance
 Insider holdings
 Long tenures
 Fair compensation
 Long-term thinking
 Focus on company not on
personal cult
Energy and passion
 Love for the job
 Fascination for industry
 Motivated by challenge
and contents
Board of directors
 Skills, savvy, experience
 Skin in the game
 Devotion to their duties
 Independence: willingness to
challenge CEO, small board,
low compensation, no family
ties,…
Insider sales?
Earnings management?
Late filings?
Resignation key people?
Auditor turnover?
Footnotes?
Due diligence characterized by:
• Independence
•Thoroughness (“going the extra mile”)
• Scuttlebutt
• Looking at subtle things that other
investors overlook
• Skipping businesses that are too
complex
• Critical view on leverage
• Focus on one’s circle of competence

The Investment Process – How Top Investors value businesses
Multiples –balance sheet:
 P/BV: capital-intensive, no economic goodwill
 P/Liquidation value: decline/near bankrupt
 P/Replacement value: stable, low-growth
DCF
Multiples –income statement+balance
Multiples –income statement:
 P/E (trailing + normalized)
 P/FCF: for mature companies
 P/S: companies without or with unstable earnings
sheet:EV/EBIT(DA), EV/S, EV/FCF
Sum-of-the-parts Value on a deal basis
(with discount)
Graham and Dodd
 EPV: business with moat
 Full growth value: franchise
with substantial growth
Conservatism
(margin of safety)
KISS
(simple models)
Comparison with Triangulation
peers/historical valuation
Quality at fair price Skepticism
Restrict number
of parameters
Preference for balance
sheet multiples
Normalize + use
trailing values
Be skeptical of
moats and growth
Avoid DCF
when possible
As long as you are
consistent in how you
value businesses, your
degree of inaccuracy, if it is
replicated through
consistency, will lead to a
great model for relative
valuations. So if your
valuation model is not
sophisticated, does not
take into account six
dozens variables, well, as
long as you are applying it
the same way to every
company and you are
looking at a lot of different
companies, you will have a
useful model for relative
valuation which can lead
to very superior investment
returns.
‐‐‐ Charlie Munger

The Investment Process – Common Process mistakes ‐1
1. Incoherent investment approach
• Investing  trading
(e.g., Buffet: “stop losses is like buying a house for $1 million and telling your
broker to sell when he/she gets a bid for $800,000.”)
• Investing  speculation based on hunches/rumours
2. Lack of independence: markets are quite efficient so one must do one’s own thorough
due diligence (what most others know is already in the stock price)
What is already known and published by others has already been acted upon.
3. Biased analysis:
Assume you are always the last to know.
• Mindless extrapolation of stock price performance/financial results
• Cherry‐picking of information about companies
• Sympathy and home bias: e.g., Kirk Kerkorian invested in GM right before its
bankruptcy due to his passion for cars.
• Illusion of familiarity: e.g., people invest substantial amounts in stock of employer
even though they don’t know its financials well.
‐‐‐ Charles Kirk

The Investment Process – Common Process mistakes ‐2
4. Focus on wrong factors: economy (too challenging for most investors), short‐term
“catalysts” (or lack thereof), etc.
Charlie and I continue to believe that short‐term market forecasts are poison
and should be kept locked up in a safe place, away from children and also
from grown‐ups who behave in the market like children.
5. Price instead of value:
• Anchoring to purchase price as measure of cheap/expensive
• Price action as element in fair value analysis
6. No attention to quality‐price tradeoff: buying cheap “crap” & overpaying for quality

Buying/Holding/Selling – Advice of top investors on how to
trade different stock types
AVOID TRADE
ACTIVELY
BUY‐AND‐HOLD BUY‐AND‐WAIT
Emerging
businesses
X ‐ ‐ ‐
Fast growers Undisciplined
with leverage
‐ Buy late and
sell early
‐
Stalwarts ‐ Buy cheap and sell
after 50% return
Decent market‐beating
returns
‐
Slow growers X ‐ ‐ Special situations
& turnarounds
Cyclicals Most investors X ‐ ‐
Turnarounds ‐ ‐ After turnaround if
business great
X
Asset plays ‐ ‐ After asset realization if
business great
X
Special
situations
‐ ‐ After special situation
priced in if business
great
X
Most top investors focus on limited number of stock types and avoid others
(determined by personality and style)

Textbook case of a turnaround – Thomas Cook
Distress,
high uncertainty
Hopeful signs
Peter Lynch:
• Wait when uncertainty
too high
• Pounce when “hopeful
signs” line up
Source share prices: Yahoo finance

Will Blackberry be Prem Watsa’s turnaround story of then next few years?

Buying/Holding/Selling – General approach of top investors
Buying
• High selectivity
• Patience
• Gradual buying
• Average down
Selling
• Thesis invalidated
• Business not well understood
• Price reaches fair value
• Replace with better bargain (dangerous!)
• Gradual selling
Short selling
• Are you up to the task?
• Proper risk management: stop losses & limit sizes
• High selectivity

Buying/Holding/Selling – General approach of top investors
Example, International Coal (Prem Watsa)

Buying/Holding/Selling – Market cycles ‐Depression
Brutal market action of the Dow Jones between 1929 and 1932:

Buying/Holding/Selling – Market cycles ‐Depression
Only one in hundred survived the debacle of 1929‐1932 if one was not bearish
in 1925.
‐‐‐Benjamin Graham

Buying/Holding/Selling – Market cycles ‐2008‐2009
Portrait of a smart and disciplined investor – PremWatsa
Watsa – not a a one hit wonder:
(*) Annual compound growth in book value per share 1986‐2005: 28%
(*) Successfully navigated market bubbles (Japan, technology crisis) prior to 2005

In 2007, a major U.S. bank CEO famously said ‘as long as the music is playing you have to get up
and dance.’ After the Lehman bankruptcy in 2008, this same bank needed $45 billion from the U.S.
government to continue in business. Expensive dance! We prefer to wait for the music to stop and
not depend on the kindness of strangers to be in business.
‐‐‐PremWatsa
Portrait of a smart and disciplined investor – PremWatsa – a detailed look

As an aside: Does this look like “déjà vu all over again” ? – PremWatsa
As they say, it is better
to be wrong, wrong,
wrong and then right
than the other way
around!
‐‐Prem Watsa
Observations:
• Economic growth since 2009 far below historical average in USA and Europe
• Inflation steadily came down over past few years in Europe and USA; Europe close to deflation
• Stock prices in USA at historically high valuations (in Shiller PE terms)

Buying/Holding/Selling – Market cycles – 1970s
Stocks go nowhere; sentiment drifts down; inflation high (so real returns even
negative); valuations move from expensive to extremely cheap

How did the Superinvestors of Graham‐and‐Doddsville fare over the period ?

Ignore the
sentiment of the
moment
How
did they
do it?
Focus on bargains
(cheap stocks)
Stay away from
hot Nifty‐Fifty
stocks
Build cash in
frothy markets
Get cash to work
in bear markets
An investor should put
money to work amidst
the throes of a bear
market, appreciating
that things will likely
get worse before they
get better.
‐‐Seth Klarman
Example, Warren Buffet:
• 1969: could find no bargains in the market and therefore wound down his
investment partnership (kept only one deep‐value stock: textile company
Berkshire Hathaway)
• 1974: around market bottom: “I feel like an oversexed man in a whorehouse”

Buying/Holding/Selling – Market cycles – bubbly 90s

Would you entrust your money to these underperformers ???
Top investors refuse to participate in market folly and actually protect themselves against collapse:
• Buffet: refuses to invest in technology stocks
• Seth Klarman: hedges portfolio + moves into cheap small caps

Seth Klarman, one of the most respected hedge fund managers of our time…
Seth Klarman, Dec. 1999:
Occasionally we are asked
whether it would make sense
to modify our investment
strategy to perform better in
today's financial climate. Our
answer, as you might guess,
is: No! It would be easy for us
to capitulate to the runaway
bull market in growth and
technology stocks. And
foolhardy. And irresponsible.
And unconscionable. It is
always easiest to run with the
herd; at times, it can take a
deep reservoir of courage and
conviction to stand apart
from it. Yet distancing
yourself from the crowd is an
essential component of long‐term
investment success.

Well, you better would…
Top investors roar back with a vengeance and actually have positive performance
throughout the collapse of the Nasdaq and S&P 500 !!!

Buying/Holding/Selling – Dealing with market cycles
→ They are NOT afraid to underperform a few years and reap the profits aŌerwards
Top investors don’t try to time the market, often anticipate market turns years in advance…
Indicators for market turns: market sentiment + valuations

Common Buying and Selling mistakes‐ some examples
Common practices
among investors
Top Investors
Constantly trying to
anticipate the moves of the
market
Far more money has been lost by investors preparing for corrections
or trying to anticipate corrections than has been lost in the
corrections themselves.
‐‐‐Peter Lynch
Constantly trading in an
attempt to take advantage
of the market’s movements
Inactivity strikes us as intelligent behavior.
‐‐‐Warren Buffet
Nobody has gone broke
taking a profit.
Can you imagine a CEO using this phrase to urge his board to sell a
star subsidiary?
Selling winners and hanging
on to losing stocks
Selling winning stocks and hanging on to losing stocks is like cutting
the flowers and watering the weeds.
Buying and selling based on
emotion.
While enthusiasm may be necessary for great accomplishments
elsewhere on Wall Street it almost invariably leads to disaster.
‐Benjamin Graham
The economy as a first
consideration
The way you lose money in the stock market is to start off with an
economic picture. All these great heavy‐thinking deals kill you.

Risk versus return
Top investors deride academic view on risk, have unconventional view on risk:
(*) volatility = opportunity to buy cheap
(*) diversification = protection against ignorance
(*) risk = lack of knowledge
To invest successfully, you need not understand beta, efficient markets, modern
portfolio theory, option pricing or emerging markets. You may, in fact, be better off
knowing nothing of these. Graham & Dodd investors, needless to say, do not discuss
beta, the capital asset pricing model, or covariance in returns among securities.
These are not subjects of any interest to them. In fact, most of them would have
difficulty defining those terms. The investors simply focus on two variables: price
and value.
Do not trust financial market risk models. Reality is always too complex to be
accurately modeled. Attention to risk must be a 24/7/365 obsession, with people –
not computers – assessing and reassessing the risk environment in real time. Despite
the predilection of some analysts to model the financial markets using sophisticated
mathematics, the markets are governed by behavioral science, not physical science.
‐‐‐Seth Klarman

Risk versus return – Basic tenets of top investors
The ten commandments of intelligent risk management
1) Do not participate in market folly – not even under the pressure of clients
2) Be patient and tolerant of temporary underperformance
3) Have the courage to accumulate cash when you can’t find bargains
4) Have the courage to get cash to work when the market is in a tailspin
5) Always insist on a margin of safety (i.e., buy cheap and sell when something is dear)
6) Know what you hold (very) well
7) First look at a stock’s downside (e.g., balance sheet); the upside will take care of itself
8) Always be prepared for the unexpected (e.g., black swans)
9) Use leverage sparingly (if at all)
10) Always remember “If something is too good to be true, it probably isn’t.”
For people who do not adhere to these tenets:
(*) diversification makes sense
(*) volatility = risk
(*) don’t ever think that you are investing !!!!

Risk versus return
Top investors exhibit excellent risk‐return ratios

Risk versus return – top investors protect against the downside
Limited number of down years + usually outperform when S&P 500 negative

Risk versus return – deviations from benchmark
Although they use the S&P 500 as a yardstick, they only compare themselves with
that benchmark over several years (and take large annual deviations in their stride)

Risk versus return – deviations from benchmark
Let’s see how Buffett did versus the S&P 500 over his career:
Definitely no benchmark hugging here …

Risk versus return ‐ concentration
Example:
Warren Buffet said in 2009 that if he would have been allowed by regulators he would
have seriously considered to go “all in” on Wells Fargo (a company he knows extremely well)
in the depth of the credit crisis…
We agree with Mae
West: “Too much of
good thing can be
wonderful.”
It is unwise to spread one’s
funds over too many
different securities. Time
and energy are required to
come to a sound judgment
of an investment and to
keep abreast of the forces
that may change the value
of a security.
‐‐‐Bernard Baruch
Not the first time:
• 1951: bulk of Buffet’s
portfolio in GEICO
• 1964: 40% of Buffet’s
portfolio in American
Express

The intelligent investor
Are smart people automatically intelligent investors ?
Newton: probably the
greatest genius that ever
lived…
Newton lost a time‐adjusted $3 million in the South Sea bubble; After this traumatizing
experience, he forbade anyone to speak the words “South Sea” in his presence…

The Intelligent Investor
What does it take to be a successful investor ?
Investor Intelligence
Passion
+
Right Attitude
+
Hard work
+
Right mental setup
Intellectual Intelligence
A winning combination: Warren Buffet
Without Investor
Intelligence
Newton
(IQ)
Let me emphasize that it does not
take a genius or even superior talent
to be successful as a value analyst.
What it needs first is, reasonable
intelligence; second, sound principles
of operation; third, and most
important, firmness of character.
‐‐‐ Benjamin Graham
I have heard many men talk intelligently, even brilliantly, about something – only to see them proven
powerless when it comes to acting on what they believe. Investors must act in time.
‐‐‐ Bernard Baruch

The intelligent investor ‐ Example
Edward Thorpe, 1991: review of the Maddoff hedge fund for client
His findings:
• Returns inconsistent with trading strategy
• Suspicious:
(*) Trade confirmation statements: friend of Madoff
(*) Information technology: brother of Madoff; Edward not alllowed to visit premises
• Ghost option trades:
(*) Many options didn’t trade on transaction dates
(*) Option prices on statements impossible (different from actual trade prices)
• Madoff’s organization could not be identified as counterparty to purported trades
Edward Thorpe exposed the Ponzi scheme 18 years before its self‐destruction by going the
extra mile…
→ Advises client to get out (doesn’t bother to inform the SEC as they showed little interest in
fraud cases at that time)

Book presentation: Excess Returns: a comparative study of the methods of the world's greatest investors

Book presentation: Excess Returns: a comparative study of the methods of the world's greatest investors

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