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Buffett And Munger – Secrets To Success That Are Not Talked About Enough

Summary Warren and Charlie Borrow with Pride. To be very successful you have to be intelligently different. Disciplined flexibility is a key advantage. Growing up in Nebraska it is no surprise that I was heavily influenced by Warren Buffett, Charlie Munger, and Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ). There is a lot to learn from the dynamic duo and there is a significant amount of material discussing their words of wisdom. However, there are a few things I have learned from them that are not as widely discussed as I think they should be or can be seen through a different lens. Borrow with Pride Years ago I used to follow an international telecom company called Millicom International. One of their common sayings was “Borrow with Pride” as they wanted employees to learn from and borrow ideas from one another. I had been borrowing with pride for many years before hearing this, but had never put it into those words. Now I have borrowed their saying as a motto in my life and am proud to Borrow with Price. Of course, Warren and Charlie figured this out years ago. It is widely known that Warren started off by borrowing many of the ideas of Benjamin Graham, then learned from Philip Fisher, and of course from Charlie Munger. For that matter, Charlie Munger’s lattice framework is based on borrowing (learning) ideas and concepts from others. Between Charlie and Warren there really have been few original ideas, but they have borrowed ideas from many people. Even looking at many of the companies Berkshire has purchased, both private and public companies, the ideas came from somebody else. For example, Lubrizol was David Sokol’s idea. The idea of borrowing with pride is really taking another angle on what we already know about Warren and Charlie. The reason why I look at it from this angle is because I know quite a number of very smart people that do not like to borrow ideas from others; they have to be original. At a firm I worked for one associate disliked the idea that I followed certain investors and looked into their holdings. He thought we should be original and find our own ideas through other means. There is nothing wrong with finding ideas that are original, but there is nothing wrong with borrowing either. What I think he missed is that the vast majority of frameworks we use are borrowed and the skills we have are learned from others. There is no shame in borrowing ideas from other smart people. Both Warren and Charlie have made a lot of money from borrowed ideas. Different, but Intelligent “If past history was all there was to the game, the richest people would be librarians.” – Warren Buffett To be extremely successful in investing you have to do something that is both different from the majority of investors, yet intelligent. While most of the ideas behind Berkshire Hathaway are borrowed they way they applied the concepts is original in many ways. This is a huge reason why they were and are successful. For centuries people had been investing insurance float, but Buffett and Munger used it differently. By being disciplined with the float they not only were able to obtain cheap leverage, which had a multiplier effect on their investment returns, but were actually paid to borrow money. The conglomerate structure has been around for centuries as well and Buffett and Munger both learned a lot from Henry Singleton who started Teledyne. However, Berkshire is different than Teledyne and was built to be an enduring company while Teledyne was eventually sold . Of course, if you do something different and it is not done intelligently than more likely than not it will be a failure, unless you get lucky. From Buffett and Munger I have learned to both borrow ideas/concepts and try to apply them in a different yet intelligent way. Apply it to yourself Let’s face it, you are not Warren Buffett or Charlie Munger and neither am I. If you try to completely imitate them you will find that you do not have the skills and attributes they do. However, each investor has their own talents and skills. Buffett and Munger talk about circle of competence and that should apply to both the types of companies you understand as well as the skills that you have. You need to know yourself, what skills you have, and strengths you can improve on to become a better investor. You don’t have to know everything as Warren said , “You only have to do a very few things right in your life so long as you don’t do too many things wrong.” Neither Warren or Charlie tried to be Benjamin Graham, Philip Fisher, or Henry Singleton but they did learn a lot from each of these men. What I have learned from Warren and Charlie is not to try to be them, but to learn from them and apply what I learn to myself. Flexible, Disciplined, Opportunistic Often people discuss the fact that Warren Buffett has changed his stripes over time from being more of a Graham net-net investor to a Fisher quality with growth investor. However, I see Buffett differently as I think he is quite flexible. After the financial crisis he invested in Bank of America Preferred Stock and Warrants. I wouldn’t call Bank of America a high-quality growth company. There was also the controversial derivative investments that have worked out well. In the book “Of Permanent Value” by Andrew Kilpatrick he mentions Buffett and Munger buying silver. When Berkshire Hathaway purchases 100% of a company you can bet that they think the company is a high-quality company. However, some of their partial investments have not been. Buffett and Munger are opportunistic; if they see an opportunity they will jump on it. Yet, they are disciplined in that they only invest in ideas they understand and expect to generate strong returns on. What I learned from Buffett and Munger is to be flexible to all the types of investments that I understand, but to be disciplined in my approach and wait for opportunities.

Surfing The Market Waves: The Nested Pullback

Patterns are important in trading; you might even say that trading is basically a game of recognizing the right patterns and doing the right thing when they happen. Most of you who have read my blog or my book, or have seen the research I write every day, know that I focus heavily on trading pullbacks in most market environments – pullbacks in trends, after breakouts, before breakouts, at the end of trends, at turning points in trends – even a simple pattern offers many ways to trade the market’s action. One of the more useful variations of the pullback theme is something I have called a “nested pullback.” As always, terminology can be confusing, so it’s important to realize that the “nested” part of the term means that the nested pullback is a smaller structure that is “nested” within the larger pullback’s drive to resolution. It is not nested within the larger pullback itself, but, rather, within the thrust that happens when the bigger pullback begins to turn into another trend leg. Another way to think about it is that it is a pause: the bigger pullback starts to go into another trend leg, and that move stalls into a small consolidation which is the nested pullback. (I wrote a longer post about a year ago here .) Take a look at this recent example in natural gas futures: Nested pullback in natural gas. Identifying the bigger pullback was easy if you were able to let go of preconceptions, concerns about sentiment/COT data, and other nonsense that always encourages us to fade trends. So many times, the right thing to do is to simply align ourselves with the dominant group in the market until the market makes it clear that something has changed. The market is in a downtrend so we want to short bear flags – that sentence is the essence of one pretty successful trading plan. The nested pullback provided additional confirmation. We obviously would prefer if every trade would move immediately and cleanly to its target, but things don’t often work like that. It’s more common for a move to stall or pause, but we can then often find additional information in the character of that pause. In this case, the nested pullback showed that there was a good probability that this market would break lower. (For instance, a pause that had a lot of sharp rallies would be more likely to suggest that factors were beginning to align against the trade.) This is a good pattern to add to your toolkit because it can do at least three things for you: 1) it gives you some insight into how to manage the trade and how to tighten stops, 2) it can provide a secondary entry if you miss the initial spot to get into the trade, and 3) it can be a good spot to add, if you do that within your trading plan. Spend some time looking for this pattern and see if it can enhance the way you view market trends. I’m very suspicious of “after the fact” analysis, and you should be too. Anyone can find any pattern on an old chart, but this is another example that we identified in real time: I signaled the initial short to my research clients and identified the nested pullback as it was developing. We took partial profits into the decline, and are still short for today’s meltdown. Obviously, not every trade works like this, but this is a clean example of the pattern, and a good example to commit to memory.

Protect Your Portfolio Against Risks

Uncertainty in the market is increasing, which means that investors want to insure themselves against risks. Hedging is one way to protect a portfolio against losses. Hedging with options is a popular method that has a lot of shortcomings. A market-neutral portfolio is a hedging method in which the distinguishing feature is the lack of correlation with the market. A market-neutral portfolio enables investors to make a profit when the market takes a nosedive, but this method has to be used carefully. It’s not uncommon to hear that there is a bubble forming in the market. The more a market grows, the more participants start to voice such concerns and the more convincing their arguments sound. However, aside from bubbles such as the dotcom crash in 2000 or the crisis of 2008, there are other situations that impact investors negatively. The slowdown of the Chinese economy, the crisis in Greece and the expectation of increases in interest rates are all factors of uncertainty that put pressure on the market this year. The increase in uncertainty on the market means that a lot of investors want to insure themselves against risks and retain profits made during years of rapid growth. The simplest way to protect yourself against risks is to have a cash position. This position is the least affected by risks and allows investors to take advantage of the opportunities that may present themselves if the market crashes. For example, the recent Flash Crash allowed market participants to purchase stocks of great companies at low prices. Nonetheless, cash positions have one major disadvantage – during periods of market growth, they significantly limit potential returns. Hedging is another way to insure a portfolio against risks. A hedge is a position in an instrument that serves to decrease potential losses on a position in another instrument. Hedging with options is one of the most popular ways to hedge. Options can be used to create all sorts of different hedging strategies. Let’s look at a few basic examples. Protective puts . One of the simplest hedging strategies – the purchase of put options with a strike price at the level of tolerable losses. Let’s look at a scenario in which an investor purchases a stock for $100 and in which the amount he/she is willing to lose is 15%. After purchasing a put option with a strike price of $85, the investor will ensure that the most he or she will lose is 15%. The investor is paying a premium when he/she buys put options – essentially paying for insurance against risk. Collar . The premium an investor must pay to purchase a put option can be quite large. The system of hedging a portfolio with a collar allows to decrease these risk insurance costs. In this strategy, the investor simultaneously purchases a protective put and sells an out-of-the-money call option. By selling the call option, the investor receives a premium that can cover part of the expenses for purchasing the put option. In some cases, the premium received from the sale of a call option can be higher than the premium spent for the purchase of the put option. Thus, the investor essentially gets paid for hedging their position. However, in selling the call option, the investor limits potential income from the long position. This is why the collar strategy only makes sense if the investor expects the price of stocks they purchase to not exceed the strike price of call options they sell. In spite of the popularity of these strategies, hedging with options has a number of serious disadvantages. First, the options market is too difficult to navigate for many individual investors, which is why they prefer to not trade instruments they don’t understand. Second, liquid options don’t exist for all securities, or premiums on the options can be very high. Options strategies described above help to limit losses of the portfolio. But smarter way of hedging is reducing the exposures of the portfolio to different kinds of risk. A better hedge is one that would not only cut down on potential losses, but would eliminate a portfolio’s correlation with the market and other risk factors such as sector specifics (this is relevant, for example, for the Energy sector, which dropped significantly when oil prices fell). A market-neutral portfolio is one such hedging strategy. The idea behind a market-neutral portfolio is that the investor takes a long position on a number of instruments in the portfolio, and shorts the rest. In this way, if the portfolio is put together correctly, there is an opportunity to make profits regardless of how the market behaves. The most popular example of a market-neutral portfolio strategy is pair trading, which is when an investor takes long position in one stock and shorts another (with different weights) in case of widening of spread between their prices. The expectation is that the spread will eventually be become narrower. Pair trading is quite simple in theory, but difficult to carry out in practice. In order to be implemented successfully, investors have to find the right pairs to pair trade. It is best to have more than one pair so that a potential loss on one would be covered by profits from the others. Moreover, it is necessary to determine the weights on long and short positions in each pair, since the securities can have different beta coefficients against the market. Pair trading opportunities do not come up systemically, which is why an investor has to constantly monitor pairs – not a good strategy for those who prefer to only trade occasionally. There has to be a stop-loss for each pair, since the difference between each pair may never diminish, but rather continue to increase in the future. Finally, broker commissions for short positions may make opening a short position on a security in a potential pair impossible. A much simpler implementation of the market-neutral portfolio strategy is as follows. The investor longs stocks and shorts index futures (with adjustment for the beta of the long part of the portfolio against the index). This portfolio would have a correlation with market that is close to zero because of the short part. Profits will depend on how much better than the market the long stocks perform on a risk-adjusted basis. In other words, this portfolio will allow the investor to extract the alpha of securities in the long position. With the development of ETFs, constructing such portfolios has become a lot easier. Instead of shorting futures (the price of E-mini futures does not allow investors to use them to hedge small portfolios), inverse ETFs can be used – ProShares Short S&P 500 ETF (NYSEARCA: SH ), for example. Moreover, sector risks can be hedged by using sector ETFs as hedges. An investor could profit on recent biotech plunge by hedging portfolio of best biotech stocks with iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ). An important advantage of this portfolio is the fact that it does not require a large number of trades. All the investor has to do is occasionally correct the size of the position in the hedge to make sure that it doesn’t differ too much from the long position (with respect to the beta). Here is an example of a backtesting of implementation market-neutral portfolio strategy. We conduct backtesting, starting on 01/01/2008. The backtesting period’s start date was set to 01/01/2008 to include periods of both market decline and market growth. We apply simple screening to choose stocks for the portfolio. On the first step of the screening we limit the universe of 500 US companies with the largest market cap to 100 with the lowest 1-year volatility. On the second step we pick top 20 stocks by dividend yield from 100 stocks that have been chosen on previous step. This portfolio presumably should generate excess return against the market on a risk-adjusted basis. In order to make portfolio “market neutral” we should add hedge to the portfolio. As a hedge we would use short position in SPY. The proportion of assets allocated in hedge should be equal to beta of the portfolio against hedge. Then beta of the hedged portfolio would be equal to zero. In other words, hedged portfolio would be market-neutral portfolio. We would rebalance this portfolio quarterly. Rebalancing is necessary because: It insures that stocks in the portfolio match our screening criteria; It helps to adjust allocation of assets in long and short parts of the portfolio, so that the beta of hedged portfolio would be zero. Beta of the portfolio is recalculated on each rebalancing date. (click to enlarge) At the selected interval, the portfolio has an Annualized Return that is comparable to S&P 500 (NYSEARCA: SPY ). The Maximum Drawdown is much lower, while the Sharpe Ratio is higher. Of course, hedging a portfolio like this is not free. In this case, the price is that a neutral portfolio will show moderate returns during market boom periods. Investing always involves risk: the market is volatile, and this volatility is influenced by both fundamental factors and by noise. Forecasting a market drop is almost impossible, which is why it makes sense to hedge portfolios during periods of uncertainty in order to avoid significant losses. A market-neutral portfolio is a type of hedging that allows investors to limit losses and make profits in any market conditions, since the profitability of such portfolios does not depend on market shifts. But during market booms, such portfolios will be less profitable than regular ones. This is why investors with moderate risk tolerance can employ this hedging strategy periodically, when uncertainty is high.