Thoughts on Intelligent Cloning

Mar 11, 2017 by Peter Coenen in  Diary

“Santa knocks on all our doors not once, but four times a year.” –Mohnish Pabrai

The idea of “Intelligent Cloning” is all about combining Ben Graham thinking on risk aversion with the Munger rule nr. 1 on how to become a successful investor. And to remind you. Mungers first rule is to carefully look at what the other great investors have done. The second rule is to pay close attention to cannibal companies (companies buying back huge amounts of stock) and the third rule is to focus on spinoffs.

If there is one investor out there that takes these simple Munger ideas very seriously it has to be Mohnish Pabrai. Recently he wrote an article in Forbes entitled “Beyond Buffett: How To Build Wealth Copying 9 Other Value Stock Pickers”, where he talks about “Shameless Cloning”. Actually he wrote it together with Fei Li and you can find the article on his wonderful website Chai with Pabrai.

Shameless Cloning. Isn’t that great. You know that there are some great investment minds out here. Don’t try to compete against these guys. Instead copy their best ideas and profit from them. I love it! Mohnish Pabrai is not just a great investor, he is a great communicator as well. I like the way he puts forward his ideas. Let me just quote from his article. Here it is:

“Santa knocks on all our doors not once, but four times a year. During his off­season, he reliably shows up bearing profitable gifts on February 14, May 15, August 14 and November 14. These are the deadlines for 13­F filings”.

Think about that. Four times a year you get probably the greatest stock picks on the planet on your doormat. For free! Mohnish describes a method to pick 5 stocks and rebalance the portfolio once every year. So, how did this 5­stock portfolio perform over the last 17+ years? It beats the S&P 500 by 10.7% annualized! That’s amazing!

A slightly different road

I toke a slightly different road. Not necessarily better, but different. First of all I am a long term investor and hold stocks as long as the company remains a good company. So I will avoid annual rebalancing. And secondly I make an extra effort and try to avoid the investing mistakes of these great value investors. Does anybody know how many mistakes great value investors make? It has been said that George Soros made money on fewer than 30% of his trades.

Now think about this for a moment. Suppose you run a concentrated portfolio of 10 stocks. And you joined the merry band of shameless cloners. So you picked for instance Valeant (Bill Ackman/Sequoia), SunEdison (David Einhorn), Horsehead Holdings (Mohnish Pabrai) and Royal Imtech (for many years the stock market darling of the Dutch stock exchange). These are all companies that went bankrupt or had to raise from the ashes. I mean, the result would have been devastating.

In comes Ben Graham. When investors make mistakes it is usually because they forget the inherent simplicity of the Ben Graham value investing system. I truly believe an investor can make better decisions by keeping things simple. So why not apply the Graham criteria for the defensive and enterprising investor to avoid mistakes? Now you might argue that these criteria are outdated and rightfully so. When Graham wrote them down he didn’t had access for instance to cashflow statements. Well. Then let’s rewrite them with the knowledge and insights we have right now.

What you want to do is to avoid the “too risky” investments. And to identify these I use 5 criteria. Very straight forward:

  • A “balanced” balance sheet. So you try to avoid too much debt, too much leverage and too much goodwill/intangibles.
  • Consistency in the per-share figures. I just don’t like companies that show a consistently growing earnings-per-share (which is good) in combination with a highly fluctuating operational cashflow per share.
  • Substantial free cash flow. As a company, if you don’t have free cash flow, you don’t have anything. Management could choose to reinvest in the business, buy other businesses, reduce debt loads, buy back stock, or pay out dividends.
  • Consistently high return on capital. You probably all know Joel Greenblatts Magic Formula. There are many ways to calculate ROC, so you have to figure out what suits you best and why.
  • Margin of safety. There is no such thing as a company that’s worth an infinite price. So you want a price that makes sense. I believe it was Chuck Akre who once said that he is willing to pay up to 20 times free cash flow for a high quality company. You might want to figure out what Warren Buffett paid for Precision Castparts.

By using this simple set of criteria you would have avoided Valeant, SunEdison, Horsehead Holdings and Royal Imtech. Instead you would have probably invested in John Deere (Team Berkshire) and Allison Transmission (Lou Simpson). As of recently team Berkshire sold John Deere. Probably not because it is a bad investment, but just to free up money to invest elsewhere. I will keep John Deere in my portfolio as long as the company remains a good company.

You might argue that team Buffett found better opportunities, so why not follow them for example into airlines. Well. That’s not who I am. If I find a low-risk solid-return opportunity I buy it and forget it. The same for Heineken. It’s not trading at an attractive price right now, but if the markets would go way down and I could buy Heineken below 55 euro, I buy it and forget it. And it makes life a lot easier, you know. If you continually keep hunting for “the best opportunity”, eventually that will drive you mad. In Value Investing your worst enemy is probably your own brain.

One final twist. Dependent on how many great value investors you want to follow you very well might end up with more than one investment opportunity. So which one to choose? You might want to use a simple Joel Greenblatt ranking system. So you rank e.g. 10 candidates by ROC. The highest gets 1 point and the lowest 10 points. And then you rank them by margin of safety. The highest gets 1 point and the lowest 10. You add the numbers and choose the lowest number.

Now let’s go back to Mohnish. He beats the the S&P 500 with 10.7% annualized over the last 17+ years. That’s like indexing on steroids and you can probably boost returns even further by using the above set of criteria. But you have to be very rational and unemotional to successfully implement a long-term cloning strategy. And most people unfortunately are impulsive and irrational. The average investor is probably too restless and the smart investor too smart to just follow a simple strategy. For most of us investing periodically in a low cost index fund probably remains the best low-risk solid-return proposition on the planet.

Mohnish and Fei end the article with the hope we will join the merry band of shameless cloners. Well. Just count me in.

Happy Santa Claus!

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Disclosure: This article and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. Further, The Value Firm® makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss. Positions held by The Value Firm BV may be inconsistent with views mentioned herein. The Value Firm BV accepts no liability for any errors or omissions in the given content.

Howard Marks to Keynote Latticework 2016 in New York City Next Week

Sep 08, 2016

Howard MarksHoward Marks, Co-Chairman of Oaktree Capital Management, is not only one of the world’s greatest investors but has also been one of the most generous in terms of sharing his knowledge and experience with the value investing community. As we look forward to learning once again from Howard Marks at Latticework 2016 next Wednesday, I’d like to reflect on the following insight, one of many, shared by Howard Marks at a past ValueConferences event:

“To me, the most important single question at a point in time with regard to strategy, I’m not talking about tactics, I’m not talking about what’s going to go up tomorrow, I’m not talking about eternity, but for the middle term, let’s say three to five years, the most important thing at a given point in time is how you’re balancing offense and defense… we want to have a lot of offense when prices are low, psychology is depressed and the outlook is bad to most people but we don’t think it’s so bad. And we want to have defense when prices are high, psychology is buoyant and everybody sees a brilliant future, and we don’t think the future may live up.”

What is offense and defense in investing? On page 145 of The Most Important Thing, Howard Marks defines offense as “the adoption of aggressive tactics and elevated risk in the pursuit of above-average gains” And what’s defense? “Rather than doing the right thing, the defensive investor’s main emphasis is on not doing the wrong thing.” While on the surface there might not seem much difference in doing the right thing and avoiding doing the wrong thing, Howard Marks goes on to say that there is a big difference in the mindset needed for one or the other:

“While defense may sound like little more than trying to avoid bad outcomes, it’s not as negative or non-aspirational as that. Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance.”

So where do we stand today? In 2013, Howard Marks unequivocally stated “we’re in the middle.” The implication being that investors ought to balance offense and defense as that is what successful investors do in the middle. Roughly three years later, we wonder what Howard Mark’s assessment is of the current investment climate.

We are delighted that William Green, acclaimed author of The Great Minds of Investing, has agreed to moderate the Q&A session with Howard Marks.

Howard Marks: Be Aware of the Temperature of the Market

Howard Marks is a keynote instructor at Latticework 2016.

William Green on Howard Marks and the Role of Luck in Investing

Feb 19, 2016

I sat down for a wide-ranging interview with William Green, former Time editor and author of The Great Minds of Investing, in New York a couple weeks ago. William also worked closely with Guy Spier on Guy’s The Education of a Value Investor.

In our conversation, we touched on many aspects of what makes great investors different. We spoke at length about the lessons of Guy’s book. William also shared his insights into some of the investors profiled in The Great Minds of Investing.

Here is William on the role of luck in Howard Marks’ career success:

Riots Force Cancellation of Value Investing Dinner in New Delhi

Feb 20, 2016

Gurgaon riots

The cancellation of a dinner scheduled to take place in Gurgaon (New Delhi) serves as a stark reminder of the volatile political situation in many parts of the world. Imagine scheduling a dinner with a dozen fellow value investors in a Western city, only to have to cancel because the army was called in to put down a riot, resulting in the loss of human life. Surreal.

Yet, in countries like India, such a scenario is still not only a possibility but a reality. Writes Sourabh Soni, organizer of the value investor dinner in New Delhi:

…we are cancelling this event for tonight due to unavoidable­ circumstanc­es (riots on the way from Chandigarh to New Delhi). I will publish the meetup for next weekend. Sorry for [the] inconvenien­ce caused due to this cancellatio­n. Regards, Sourabh

Sourabh followed up with the following message to me:

I have to cancel today’s dinner at New Delhi, because of riots… All buses and trains got cancelled. Army was deployed to calm down the situation, I think people got killed also. It is [a] protest against [the] reservation system. I will reorganize it next Saturday.

The #valueinvestors Meetup group has grown to hundreds of value investors in just a few months, and meetups are being organized by members all around the world. The MIT Investment Management Company recently hosted a dinner for a dozen fellow value investors in Mumbai.

In our zeal to meet fellow investors, learn, and share, we often forget just how fragile the world really is. This makes our engagement and our community even more important: We try to provide a space for learning and personal growth, no matter where you reside or what regime you live under. We believe that each human being has the capacity for greatness, and we are proud to contribute in a very small way to uplifting individuals, even if their own governments have failed them.

The world is unlikely to become less volatile and less dangerous any time soon.

We will keep uniting people around a positive mission of lifelong learning, personal growth, friendship, and respect.

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