Peter Lynch: “I Love Volatility”

There is this great short clip on YouTube with the legendary former mutual fund manager Peter Lynch (of Magellan Funds). In the video, Lynch declares his love for volatility and explains how he approached it: 

Volatility will occur. The markets will continue to have these ups and downs. I think that is a great opportunity, if people can understand what they own. If they don’t understand what they own mutual funds. And keep adding to it. Basically, corporate profits have grown about 8% per year, historically. So corporate profits double every nine year. The stock market ought to double every nine years.

The operative phrase here is “if people can understand what they own”. We can also invert what Lynch is saying in the video and ask ourselves what value we can provide by understanding the assets that have a volatile price?  

The Social Value of Active Investing

There’s a fantastic podcast interview with Micheal Mauboussin on the Invest with the Best Podcast, where he talks about the value that active investors bring to the market. Mauboussin says the following: 

Now, one of the things we’ve talked about quite a bit is, is there a role for indexing? And the answer is, absolutely yes. And I think for many people, that’s a very sensible solution. But that does not mean that the active management industry can go away. It’s not going to go away, because there are two things that it does that are still really important. One is price discovery, and again, indexing benefits from that positive externality, I think we can never lose that.” 

Essentially the fees paid to active management subsidize the indexing industry. And the other is liquidity. And even in these environments, we see that index people don’t trade that much. And so we need liquidity if you have it. I think those are public goods, those are vital, and those will continue to play a role. So the debate should be, what percent of the assets should be active versus passive?” 

By this logic, you could also posit that as an active investor the best way for you to add value is to find areas where you can add value by pricing the securities in question (research, know-how, etc), especially in securities where (or time when) liquidity is scarce.

How to Invest like Warren Buffett?

If you are asking yourself this question, you are asking yourself the wrong question. At the very least, I would propose you implement a minor tweak to it: How would Warren Buffett be investing if he were in your shoes? 

The thing is that the investing style of Warren Buffett has changed immensely over time. That’s just because he is extremely smart and extremely adaptable. And you wouldn’t want to mimic Buffett’s investments today, for the simple reason that he is severely disadvantaged compared to yourself. 

If Buffett were in your shoes, he most definitely wouldn’t be looking at Berkshire Hathaway for copycat ideas. You see, one of the things that is not talked enough about, when people are discussing Buffett is that he has been extremely adaptable. 

There are assets worth a total of $788 billion on the Berkshire Hathaway balance sheet. If the company would want to deploy 1% of its assets base to one investment, that investment would have to be valued at $7.8 billion. By comparison, the smallest company in the S&P 500 index has a market cap of $1.5 billion.

Therefore, if Buffett wants to make an investment that actually moves the needle today, his universe of available investment opportunities is actually tiny. 

The Buffett Partnership

So, how did Buffett invest early in his career, when he was a much smaller fish in a much bigger pond? This question brings you to the the Buffett Partnership, which Buffett managed from 1956 to 1969. When Buffett dissolved the Partnership in 1970, he kept his stake in Berkshire Hathaway, which the Partnership had had a controlling shareholder in. The rest is history, I guess.

First of all, during the Partnership years, Buffett invested in smaller, less liquid companies. Secondly, Buffett was a relatively concentrated investor, focusing on a few high conviction ideas. Nonetheless, this does not mean he didn’t try to diversify the Buffett Partnership Portfolio. The way he did it was not through quantity of exposure, but through the quality of exposure. 

By quality, I don’t mean that the stocks he chose were of higher quality than the stocks in the general market. But rather that he managed the stock portfolio by allocating its capital into three buckets that each had exposure to qualitatively different factors. 

The Three Arrows of Buffett’s Capital Allocation

His objective, as I understand it, was to be able to keep his options open and be flexible under different market conditions. For example, if the overall market went up, he would be able to allocate capital to the bucket of stocks that were not driven by the overall market, and vice versa if market sentiment was overly pessimistic. 

But you don’t have to take my word for it. Here is Buffett’s explanation of the three qualitative areas that he allocated capital to. The following is taken from the 1961 Buffet Partnership Letter Shareholders:


Our Method of Operation 

Our avenues of investment break down into three categories. These categories have different behavior characteristics, and the way our money is divided among them will have an important effect on our results, relative to the Dow in any given year. The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon availability factors. 

The first section consists of generally undervalued securities (hereinafter called “generals”) where we have nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself. Over the years, this has been our largest category of investment, and more money has been made here than in either of the other categories. We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen. 

Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential. Over the years our timing of purchases has been considerably better than our timing of sales. We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner. 

The generals tend to behave market-wise very much in sympathy with the Dow. Just because something is cheap does not mean it is not going to go down. During abrupt downward movements in the market, this segment may very well go down percentage-wise just as much as the Dow. Over a period of years, I believe the generals will outperform the Dow, and during sharply advancing years like 1961, this is the section of our portfolio that turns in the best results. It is, of course, also the most vulnerable in a declining market. 

Our second category consists of “work-outs.” These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs. An important source in recent years has been sell-outs by oil producers to major integrated oil companies. 

This category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout a year with a large portion of our portfolio in workouts, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year. Over the years, work-outs have provided our second largest category. At any given time, we may be in ten to fifteen of these; some just beginning and others in the late stage of their development.

I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior. Results, excluding the benefits derived from the use of borrowed money, usually fall in the 10% to 20% range. My self-imposed limit regarding borrowing is 25% of partnership net worth. Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs. 

The final category is “control” situations where we either control the company or take a very large position and attempt to influence policies of the company. Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it.

These situations, too, have relatively little in common with the behavior of the Dow. Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen. If it moves up before we have a substantial percentage of the company’s stock, we sell at higher levels and complete a successful general operation. We are presently acquiring stock in what may turn out to be control situations several years hence.

The Entrepreneur vs The Investor

In this speech by Peter Thiel, he says the following when talking about how to detect patterns when trying to recognizing entrepreneurs as a venture capitalist: 

“You always want to invest in the ones where they speak in definite future tense. You sometimes have to be careful they’re not totally crazy people, but that’s the sort of person you want to invest in. You do not want to invest in people who are talking too much about probabilities or risks or things like that because my experience has been that the people who think they’re involved in some sort of lottery ticket-like dynamic are already setting themselves up to already somehow get the probabilities wrong and invariably lose.”

“There is a similar version of this that I experience as an investor in these ventures. There’s always this very tricky question of the role of luck and chance in these things working. There certainly is this external truth perspective that there is a certain amount of luck that is built into the nature of the universe and you try to model it. You try to account for it. You try to get the probabilities right, as you assess these things. So, when people say that luck is involved, this is a statement about the deep nature of our universe.”

“And then there is this sort of internal truth version. Whenever we have thought that it is a matter of work. Psychologically I can say that this has often been a very bad sign. Where you say, “well, we don’t know if this is going to work. Maybe it works. Maybe it doesn’t. So, let’s just invest a slightly smaller amount for our lack of knowledge.”  And as a pattern, I would say, those are investments that have generally gone very badly wrong.”

“If I had to sort of explain why. When you think you are multiplying a small probability by a big payoff, you sort of psycho yourself into playing the lottery and you psych yourself into losing. Because you somehow are being sloppy and not doing that much work.” 

I think these thoughts do a great job of highlighting the inherent differences between entrepreneurs and investors. The entrepreneurs Peter looks for speak of the future through a deterministic mindset. They have a clear sense of the future and how they are going to shape it. Peter himself, on the other hand, as a venture capitalist does not invest his all his funds in one company. In his role he needs to have a more probabilistic mindset, even though he bets big once he has a high conviction on particular investments. 

The World According to…

The EntrepreneurThe Investor
Deterministic mindsetProbabilistic mindset
Risk is endogenic Risk is exogenic
AnalyticalStatistical
Concentration Diversification
High ConvictionRisk Management
Entrepreneurs vs Investors: Different Characteristics

If God was the Only Active Investor

In active investing the investor aims to outperform an index. In passive investing the investor aims to match or track the performance of an index. 

Now imagine if God was the only active investor in a theoretical market. 

God is all knowing, so he knows all the future cash flows of all the investments available in the market. Since he is the only active investor and all other investors mimic him, all the investments in the market will be priced based on their discounted future cash flows. As such, all the investments will have exactly the same expected return. 

There are two fundamental problems with this thought exercise:

  • If God knows the future cash flows, then he’s not taking any risk. If God isn’t taking any risk, what discount factor should God use? The rate of inflation? 
  • If God is the only active investor, then who is he buying from? If God is the only investor that sets prices and all other investors are trying to mimic his returns, then all the other investors would want to buy when God buys and sell when God sells. Does this mean that no orders will be matched?