The Game

A summary of my investment philosophy

What’s the overall goal?

To borrow from Buffett, rule #1 is don’t get yourself kicked out of the game (i.e. permanently losing a large portion of your bankroll).

And rule #2 is often remind yourself of rule #1.

The overall goal for me is to compound money as fast as possible while taking sufficiently low risk of permanent blow-up. Note that there are many different strategies to accomplish this goal. Many people tend to focus on one, but I think it is to my advantage to use as many strategies as I can master / use appropriately.

As a side note, Buffett is an example of someone who has mastered and used many strategies over time. Specifically Buffett’s strategies (among others) include

  • Merger arbitrage
  • Physical arbitrage (e.g. the cocoa exchange he did)
  • Distressed debt investing
  • Buying (e.g. BAC preferred stock) and selling (e.g. the long-dated out-of-the-money put options) derivatives

People tend to misunderstand this about him and think that what he does is buy businesses and hold them forever — that’s (primarily) what he does today, given the constraints he has (e.g. the size of his bankroll) as well as his preferences (he doesn’t want to optimize returns at the expense of dealing with people he likes, doesn’t want to spend all or even most of his time on investing, doesn’t want to risk his reputation even a little, etc.).

Note that several of the below strategies are not really associated with stock market investors. That’s fine with me — any reliable way to earn high returns with minimal blow-up risk is attractive to me.

What are strategies?

Given that the first thing (and second thing) to do here is to not permanently lose large amounts of my bankroll, when considering any strategy, it’s most important to understand how that strategy successfully avoids permanent loss of large amounts of the bankroll.

Let’s start with a couple strategies that I know of but am not currently good at / interested in:

  • Short-term arbitrage: e.g. Renaissance Capital, Newport Partners
  • Agreeing with the market’s general rules on valuation but being better than the market at analysis: e.g. David Einhorn, many long-short funds

The main strategies I currently know and feel comfortable using are below:

  • Owning a piece of a business where the business is growing owner wealth at high rates with not too much valuation risk in the medium term — I’ll call this “compounding”
  • Putting cash out where you quickly and with low risk get your cash back and then have an option on the future of a business (of any quality) — I’ll call this “BlueLine” in honor of Platinum Equity’s use of this strategy in their investment in BlueLine Rentals
  • Very, very mispriced bets — I’ll call this “Cornwall” in honor of Cornwall Capital’s strategy as told in The Big Short and Hedge Fund Market Wizards

“Compounding”

Start with the downside: the way to avoid losing money here is to be very confident about the long-term prospects of the business and about management’s ability to at least not lose you money / defraud you / cheat you.

In broad strokes, there are four types of businesses where your downside is protected:

  1. Winning an open game
  2. Stable position in a closed / semi-closed game
  3. Financial returns
  4. Low-cost in a reliable demand commodity

1. Winning an open game

By open game, I mean an industry with few barriers to entry (which also means it is typically fragmented with a changing cast of competitors). Open games include

  • Retail
  • Restaurants
  • Money management
  • Banks
  • Insurance
  • Airlines
  • Grocery

Downside protection here comes if you are clearly winning for some reasons that is not unsustainable. In general, companies in these open games are either winning or losing — there’s no in between.

2. Stable position in a closed / semi-closed game

By closed / semi-closed game, I mean an industry where there are barriers to entry which effectively make the industry have monopoly / oligopoly characteristics. Unlike open games, there aren’t typically winners and losers in a closed / semi-closed game — it’s more like everyone is winning (broadcast TV stations in the past) or everyone is losing (broadcast TV stations now and into the future), with only small differences between the competitors’ competitive positions

Examples of this include

  • Software
  • Many subscription-based things
  • TV channels (at least in the past)
  • Cable distributors
  • Aggregates companies

The downside protection here comes from the characteristics of the industry.

3. Financial returns

By financial returns, I am referring to businesses where everyone in the industry generally earns a “financial” return, i.e. a return on capital invested that is in the roughly 8% to 20% range. Compared to other industries, there is a very tight range of returns here, because money can very easily come into (when returns are at the higher end of the range) and out of (when returns are at the lower end of the range) the industry, which keeps returns in that relatively narrow range.

Examples of this include

  • Real estate
  • Hotels
  • Pipelines
  • Banks
  • Insurers

Downside protection here comes because the assets are money-like, so they will tend towards a roughly money-like return over time.

4. Low-cost in a reliable demand commodity

This category refers to having a low-cost competitive position as a producer of a commodity that has enduring demand.

Examples of this include

  • Saudi Arabia, with oil
  • Compass Minerals, with salt
  • The boran mine Charlie Munger refers to in Damn Right!

Downside protection here comes because the market price is set at to earn the marginal producer marginal returns, so if your costs are well below the marginal producer’s, you should do better than them.

Other forms of downside with a “compounder”

Even if a “compounder” fits one of the above models, there are other forms of downside to be aware of.

These include

  • Fraud
  • Losing competitively
  • Having cyclical profits that are hard to estimate
  • Management that wastes money / steals it
  • Too much leverage for the type of business it is (and given its relative position)

My policy is that if any of the above are not highly likely to be in your favor, move on to the next one.

After downside, then upside

Once downside is covered in the above ways with a “compounder,” then it’s on to upside.

To do very well for you as the owner over time, the business has to be compounding your wealth at high rates. There are a number of ways to do this that I can think of

1. Winning in an open game, and then take a lot of share

  • GEICO
  • MTB
  • SAVE (and many other low-cost airlines around the world like Lion Air in Indonesia, Wizz Air in Eastern Europe, etc.)
  • Aldi

2. A closed / semi-closed game where you are surfing a wave of fast growth

  • MSFT (in the 80’s and 90’s)
  • KO (in the 80’s and 90’s)
  • Amazon Web Services
  • Cable channels (until recently)

3. A closed / semi-closed game where you are rolling up a fragmented industry and running each asset better than most

  • Capital Cities
  • 3G (first with InBev, then with Heinz)
  • Constellation Software
  • John Malone

4. A financial returns asset that is very low-priced

  • Zell with real estate
  • Kinder with pipelines

5. A low-cost producer in a reliable demand commodity with a long growth runway

  • Saudi Arabia
  • Chilean lithium mines

“BlueLine”

For background on why I call this “BlueLine,” see here: https://www.pehub.com/2014/02/blueline-to-pay-platinum-shareholders-dividend-shortly-after-1-1-bln-sale/# and here: http://www.reuters.com/article/platinum-pik-highyield-idUSL5N0LH4Q020140214.

Here’s what happened, according to the articles:

  1. Platinum bought BlueLine for $1.1B with Platinum putting in $201M in equity (with the rest of the price being funded by debt, presumably) — the deal closed 2/3/14.
  2. A week or two later, BlueLine issues an additional $250M of debt, which allowed Platinum to return itself its original investment, after which it was still left owning all the equity.
  3. To recap, Platinum put up $201M at risk for a week or two, and in exchange got all the equity of BlueLine.

Back to the general concept: downside protection comes here from the high likelihood of very quickly getting most or all of your original investment out, and then having an option on the remaining equity value in the business. A key point here is that I’m not just looking for a situation where my equity investment COULD be returned to me — I want a situation where the money WILL be.

Some examples of this, which is relatively rare in public markets, include

  • Victoria Carpets — for more details, see here: http://www.telegraph.co.uk/finance/12143637/Questor-share-tip-Victoria-carpets-remarkable-turnaround.html
  • CEQP — in early 2016 the equity was trading for around $8 and you could buy 10/16 $7.50 puts for around $2, with quarterly dividends of $1.375 (which the company implied it would not lower before it made improvements to its capital structure); in effect, you could pay $10 for the right to sell at $7.50 and receive two quarters of $1.375 dividends (or lower dividends if the company announced, as it did subsequently, positive news on its capital structure)
  • Aurelius — this is a German company that itself looks to buy businesses (often loss-making or otherwise in need of restructuring) for essentially nothing

“Cornwall”

Here I am looking for very mispriced bets. There is no individual downside protection here, unlike with “compounders” or “BlueLine” situations. In fact many of these mispriced bets will go to zero.

With these, safety comes from what sports bettors use — diversification.

Note that these are just bets (typically options bets), and given the math of bets, the only way to get extreme mispricings is to bet on things where the implied probability is low. E.g. even if a bet has 60% implied probability but is in reality a 90% proposition, the EV (1.5x) isn’t that appealing. But if the implied probability is say 2% but the actual likelihood is 20%, then that’s interesting.

Situations I’ve seen where options can get very mispriced are

1. Financial company with questions of fraud / blow-up

  • Admiral Group, in late 2011
  • JPM, after the London Whale losses
  • AFSI
  • ETFC, in 2013 with questions about their mortgage book
  • COF, as told in The Big Short

2. Lawsuit / regulatory issue with fear of a huge penalty

  • COF, as told in The Big Short
  • LOCK recently
  • MA in regulatory uncertainty in aftermath of financial crisis
  • HLF, after Ackman presentation

3. Unclear accounting, particularly where investments look like expenses but management is good / trustworthy

  • AMZN
  • VPRT
  • Regus

4. Companies going parabolic

  • TSLA in 2013
  • LGF with Hunger Games
  • Nintendo with Pokemon Go

5. Change in the way that something is valued, with related re-rating

  • NFLX (DVD rental business –> better version of HBO)
  • FB (mobile is a threat –> mobile is an opportunity)
  • GOOG (same as FB)

One helpful (but not absolutely necessary) characteristic that makes an above situation appealing is to have good management showing confidence through buybacks.

One additional risk with these types of situations is that I don’t want to just gamble — I want to focus only on situations where I have some pre-existing reason to think that the outlier positive case has a decent chance of coming true.

Conclusion

I’m always looking for situations that fall into any of the above buckets, so if you know of a situation that falls into one of the above buckets, please let me know!

Disclaimer

The above is just the author’s personal opinion and may contain errors. It is also not investment advice, and it is not a recommendation regarding any securities mentioned.

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