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10 insights from one of the greatest hedge fund managers

Larissa Fernand  |  04 Dec 2017Text size  Decrease  Increase  |  
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Barton Biggs had an interesting start to his financial career. His father instilled a tradition whereby each of his three sons, on turning 18, would be presented with a portfolio of about 15 stocks worth roughly $150,000. They were encouraged to ask questions and learn more about the stocks.

After graduating from college, completing a stint with the US Marines, playing semi-professional soccer, and teaching English in an upmarket school, he approached his father and told him he wanted to be an investor.

His father told him to read Benjamin Graham's classic Security Analysis from cover to cover and they would then resume the conversation. He did as was told.

His father gave him another task. Read the book again. He wanted his son to have a deep grounding in value investing and come to terms with the fact that investing was hard, grinding work.

Biggs learnt that. He attended business school, went to work as an analyst with a brokerage, set up his own hedge fund--one of the first hedge funds in the US (Fairfield Partners), joined Morgan Stanley as partner and managing director, and on quitting set up another hedge fund (Traxis Partners) at the age of 70.

He was one of the most innovative and successful investment managers on Wall Street, and the first "global investment strategist," being one of the first to invest in emerging markets.

In a very engaging book called Hedgehogging, he writes candidly about the characters he encountered in his investment career. Intertwined with all those experiences are some amazing lessons learnt. Here, we put together 10 investing insights revealed in his writing.

1) Don't hold on blindly to a stock

As a value investor and believer in the inherent efficacy of fundamental analysis, he disdained momentum investing--buying strength and selling weakness. But he was always respectful of the knowledge of the market.

If a position went against him by 10 per cent, he conceded that maybe somebody has understood something he has missed. That would lead him (or rather his team) to conduct an extensive and systematic review of the fundamentals with both internal and external resources.

After the review, if nothing has changed except the price of the stock, they bought more. If they lacked that conviction, they would sell at least half of the position.

2) Be a disciplined reader

A compulsive reader, his interests went beyond just business and financial subject matter.

Investing, he believed, is about glimpsing, however dimly, the ebb and flow of human events. That drove him to read history. He also believed it is very much about resisting the tides of emotion, which is where the novels and poetry came in.

However, it's not just reading, but reading smart. Hence, he cautioned against getting overwhelmed with all the research reports and the flooded inbox.

The investor must dominate their own intellectual intake environment and not let the outside world control them. Internet and e-mail can be brilliant, time-saving inventions, but also huge distractions.

3) All good investors have cold spells

The hard reality in the investment business is that you are only as good as your most recent performance.

It's a numbers game. Fame and glory are transitory events. Clients' loyalty, salespeople's admiration, and management's love are all fickle, so don't get cocky.

Smooth investment sailing inevitably is followed by vicious storms. And at the bottom of a performance cycle, it's a hard, unforgiving business.

All this is perpetuated by the fact that senior business management in most firms don't understand that investment performance is cyclical.

4) Love art for itself, not as an investment

Whether a particular piece of art is a good investment is far more a matter of fashion than the valuation of equities. The bear markets in art have been silent but brutal.

Within the long-wave secular cycle, there are also sector cycles driven by fad and fashion where the price changes are even wilder. Amateur collecting can be a loser's game if you misjudge future fashions in taste.

Art of exceptional quality probably does have fairly immediate liquidity, but this is not true of run-of-the-mill pictures. Biggs recommended buying a picture because you love looking at it, not as a diversifier or as an investment.

5) Identifying growth stocks is extremely difficult

Growth stock believers argue that you want to own stock in companies whose earnings and dividends are consistently increasing. What you pay for the shares of these companies is important, but not as crucial as correctly identifying true growth companies.

By definition, these companies tend to have excellent management, proprietary positions in businesses that are not particularly cyclically sensitive, and be highly profitable.

Ideally, growth investors want to hold shares in great businesses and sell only when the business itself falters, not because the share price has risen.

Academics have proved that if you had perfect foresight and bought shares of the companies with the fastest earnings growth, regardless of valuations, over the long term you would outperform the market by an immense amount.

The problem is that no one has perfect foresight. We are generally all overconfident and overoptimistic about our skill in picking growth companies.

Growth companies have a high propensity to fall from grace, in other words, to stop being growth companies. By the time you can clearly identify a stock as a growth stock, it usually will already be valued accordingly. Therefore, you end up buying the expensive stocks of good companies.

6) Fall in love with people, children, and dogs, but not stocks

Growth investors are inclined to fall in love with their growth companies that have treated them well. Remember that you are buying stocks, not companies, and don't fall in love.

Value investors don't fall in love with their stocks. When the prices of the shares of the ugly companies they own go up, become expensive, and sell well above their intrinsic value, they sell and go searching for cheapness elsewhere.

Growth stock investors have portfolios filled with companies with great, growth franchises they can be proud of. Value investors have portfolios stuffed with the cheap shares of companies that are doing badly, and have hair and dirt all over them.

7) Alpha investing is a zero-sum game

The institutional investment world runs on the beloved alpha. This is understandable, but can be counterproductive. The pressure for short-term performance versus a benchmark can easily disorient the investment brain of a portfolio manager.

What should matter is capital enhancement in bull markets and capital preservation in bears; in other words absolute, not relative, returns.

In this sense, professional alpha investing is not a winner's game but a zero-sum game, because for every winner there has to be a loser.

Biggs explained that the right way to look at relative performance is relative to the dimensions of the gain. In other words, if the index was up 10 per cent and the portfolio 5 per cent, there is negative alpha of 500 basis points. That is a big deal!

The relative underperformance to the benchmark is 50 per cent (-5 per cent of alpha is 50 per cent of 10 per cent). But if the index is up 56 per cent and the portfolio is up 51 per cent, that's a relative underperformance of only a little more than 9 per cent and a minor event.

Demanding performance versus a benchmark and focusing on short-term results are the two great banes of investing. The more you want performance and push for it, the more difficult it is to get. The more confident you are, the better you play; a relaxed, obsessive investor is best.

8) The bliss of starting fresh

Sometimes he suggested to his partners that they each go home, reflect as though they had nothing but cash, and come in just as they did on that Sunday before they started with a fresh portfolio and a new exposure position.

He believed that it is a great discipline to pretend that you just got the money and have to build a new portfolio--unencumbered with stale positions, where the story has deteriorated and is too cheap to sell.

There are unrecognised, subconscious, emotional hang-ups that block a portfolio manager from impartial, cold-blooded investment actions like selling. The baggage (what they already own) gets in the way of excellence. There are positions one believes in but the market has not discovered them yet. It's hard to give up on such a position.

There is a bias against switching, because you can be wrong twice. By the same token, it's hard to sell winners because of what they have done for you and because you hope they have more to deliver.

The investment decision-making process should be completely intellectual and rational, not emotional, because they are just pieces of paper. The stock does not know you own it.

There is no reward for being a faithful holder. It is those holds that are too cheap to see but not attractive enough to buy that make a portfolio stale and retard performance.

9) Public money floods in and flows out at exactly the wrong times

The big flood of public money comes in after, instead of before, the fund does well. Then the fund redeems after it has done poorly and usually just before it's about to do well again.

Billions of dollars poured into tech funds in 1999 and 2000 when the Nasdaq was pushing towards 5,000. Around 80 per cent of all the public money that was invested in mutual funds at the height of the bubble in the spring of 2000 went into tech funds.

Over the next three years, as the Nasdaq sank to 1,000, investors lost 60 per cent to 80 per cent of their money. Redemptions were heavy in 2002 and 2003 just before the Nasdaq doubled again.

The public never learns

10) Finding meaning in all the noise and babble

The intellectual problem an investor must wrestle with is the constant barrage of noise and babble. Noise is extraneous, short-term information that is random and basically irrelevant to investment decision making. Babble is the chatter and opinions of the well-meaning, attractive and numerous talking heads.

The investor's task is to distil this overwhelming mass of information and opinion into knowledge and then to extract investment meaning from it. Meaning presumably leads to wisdom, which should translate into performance.

Noise and babble can be very hazardous to your investment health. One of Nassim Taleb's major themes in Fooled by Randomness is that the wise man listens for meaning but the fool gets only the noise.

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Larissa Fernand is website editor for Morningstar.in, where this article initially appeared.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is the editor of the Morningstar India website.

© 2019 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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