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Henry Paulson On The Brink

Earlier this week, Warren Buffett and Henry Paulson appeared in an informal 50-minute “conversation” that focused on Paulson and the events he writes about in his book, On the Brink: Inside the Race to Stop the Collapse of the Global Financial System

On the Brink gives an insider account of the events that unfolded in the biggest financial crisis that took place since the Great Depression.

…Continue reading » Henry Paulson On The Brink

Portfolio Turnover

If a parent company owns a subsidiary with excellent long-term economics, is it likely for the subsidiary to be sold regardless of price?

Not likely.

That is the same mindset that you, as a small investor, needs to adopt when you own a small piece of an excellent company. The worst advice you can possibly get from your broker is, “You can’t get broke taking a profit”.

$40 invested in Coke in 1919 will have grown to $3277 by the end of 1938. A fresh $40 invested at the end of 1938 would have grown to $25,000 by the end of 1993.

An investment lifetime is just too hard to make hundreds of smart decisions.

Risk – Buffett’s definition

Is it riskier to hold less stocks? Risk, as Warren Buffett defines, is “the possibility of loss or injury”.

A policy of portfolio concentration may even reduce the risk as the investor would have to think even harder about a business and its economic characteristics before he invests into it.

If you are a know-something investor who is able to understand business economics and find five to ten well-priced companies that possesses long-term competitive advantage, then diversification makes no sense for you.

It simply makes no sense as to why you would want to buy more of a company that is your 20th favorite, rather than buying more of your top choices.

The real risk that an investor must assess is whether his after-tax returns from an investment will give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.

While you can’t calculate it precisely, these are the factors (in his exact words) that Warrren Buffett tells us to consider:

1) The certainty with which the long-term economic characteristics of the business can be evaluated;

2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;

3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;

4) The purchase price of the business;

5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.

Risk – Academic definition

Academics like to define risk as the volatility of a stock or a portfolio of stocks compared to a large universe of stock. So, the higher the volatility (or beta), the riskier the stock.

Isn’t it absurb that if a stock suddenly suffers a massive drop in price, it’s volatility has increased and thus it has become riskier at a lower price?

The true investor welcomes volatility. In Chapter 8 of The Intelligent Investor, Benjamin Graham introduces us to Mr Market, a person who shows up every day to buy from you or sell to you.

Whatever the price of the day, you have the option of wanting or refusing to transact with Mr Market.

Now, if the prices are extremely volatile (or riskier as defined by the books), wouldn’t that offer you a chance for you to buy at irrationally low prices once in a while?

How can that be riskier for you when you are totally free to choose whether or not to transact every day?

Despite all these, you will be able to find companies with a very strong competitive moat (like Gillette or Coke) having a volatility that is similar to other run-of-the-mill companies who possess little or no competitive edge.

Equating beta or volatility with investment risks simply makes no sense. Rather, you should be looking at the business risks as given in the five factors mentioned above.

When Diversification is Appropriate

One example when wide diversification is appropriate is when you are doing arbitrage.

If a single arbitrage transaction poses significant risk, overall risk should be reduced by making other mutually independent transactions.

Just make sure that your gain, weighted for probabilities, considerably exceeds your weighted loss, and that you can commit to a number of similar but unrelated opportunities.

This is like a roulette operator who likes to see lots of action because it is favored by probabilities, but will not accept a single, huge bet.

Another example is when an investor does not understand the economics of specific businesses. In this case, he will be better off investing in a basket of stocks through an index fund.

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I was looking forward to the tea break at the end of the first session as I was feeling hungry. To my utmost surprise, there were no refreshments provided. Not even any finger food! The organisers must be trying to get their full ‘value’ for money…

What they had, however, was a booth selling some of Robert Miles products. There was a bundle of 3 books and 2 audio sets selling for a discounted price $200.

I find it wierd that they were only selling the bundle and not the individual products. Surely, there were people who only wanted to get 1 or 2 of the items but not all?

Back to the seminar. In the second session, we were told the character or traits that we should look for in the managers of the companies that we were going to invest in. 6 pillars of character are trust, respect, responsibility, fairness, caring and patriotism.

3 traits that Warren looks out for were integrity, intelligence and energy. And how does he do that? Simply by reading the annual reports of the company! By following the annual reports for many years, it is sometimes possible to tell whether what was stated in previous years have been acted upon.

This was followed by a presentation on the key managers of the various subsidiaries of Berkshire. This was quite a boring segment and I actually dozed off…

A common trait was that these people really had passion for their business. They were working even up to 80, 90 years old and retirement was simply not an option. If you liked what you were doing, why should you retire to sit at home doing something else?

In a nutshell, two quotes to always keep in mind:
Invest with people you like, admire and respect.
Sell when they are not managing the business for the benefits of shareholders.