Friday, April 06, 2007

Achieving excess returns

"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."- Warren Buffett on June 25, 1999 (Business Week)

Warren Buffett made the above comment in a 1999 issue of BussinessWeek. Mr. Buffett is a genius and is wired for allocating capital. Investors cannot expect to replicate this 50% per annum claim. However, investors still want exceptional market beating returns. How does one go about this? First, we must figure out what will not achieve these excess returns.
Value investors today advocate investing in undervalued large capitalization companies. While these companies are undervalued on a relative basis to the smaller capitalization companies they will not yield returns in excess of 50%. The field of large capitalization companies is a difficult area to have an edge over the competition, as a glut of analysts and information exists. The best businesses have limited competition and this clearly is not the case for an investor in the large cap arena.

Therefore, we eliminated one way to achieve 50% per annum returns – buying large capitalization equities. Maybe 50% returns can be achieved on these undervalued equities by using options or leveraging up your purchases. What else do we need to eliminate to attempt achieving 50% per annum returns? Excessive trading will eat up too much of our profits in taxes and commissions. However, one cannot buy and hold forever as Mr. Buffett has evolved to doing. This is a function of his enormous capital base.

Now that we have eliminated what not to do we must look for solutions on what remains. We will briefly look at three investors who have successfully achieved excess returns: Warren Buffett, Joel Greenblatt, and Mohnish Pabrai. These three have all maintained concentrated investment styles. All three favor large bets on a few securities, when the odds are heavily in their favor.

Buffett has stated multiple times that if he were running small sums of money he would purchase smaller capitalization companies due to less competition and wider discrepancies in their intrinsic value. Buffett purchased smaller obscure securities with scarce information in his early days, which is why he possessed a competitive edge. Warren Buffett was recently able to purchase twenty securities for his personal portfolio at under five times earnings from a specially prepared manual of South Korean stocks. A person looking to achieve excess returns would need look at obscure securities like Mr. Buffett’s South Korean investments. A good place to start would be The Walker’s Manual (, which contains unlisted securities.

Joel Greenblatt is another exemplar. He explains how he generated 50% gross returns per annum in his excellent book “You Can be a Stock Market Genius.” He did so by purchasing special situations i.e. spin-off’s, liquidations, recapitalizations, LEAPS, bankruptcy securities, stub stocks and warrants. Focusing on complex situations that are not readably understandable was Mr. Greenblatt’s bread and butter. Analysts generally have difficulty valuing companies when their standard excel spreadsheets do not spit out an answer. Mr. Greenblatt has been able to generate his excess returns by figuring out these complicated situations and heavily concentrating his bets.
Mohnish Pabraiis the final example. I highly recommend people read articles and interviews on how he has achieved annualized returns of 28.1% (for the PIF2 fund) since inception. Mr. Pabrai’s new book “The Dhandho Investor: The Low- Risk Value Method to High Returns” is being released April 6, 2007, which should help understand his investing framework further. Mr. Pabrai has achieved his results by focusing on small capitalization companies residing in distressed industries. He bets big when the odds are in his favor and the downside is minimal. As he succinctly puts it: “Heads; I win. Tails; I don’t lose much.” Mohnish generates his ideas from sources such as, Outstanding Investors Digest, as well as looking at other successful investor’s 13-F-HR’s (portfolio), which must be filed by managers with over $100 million in assets.

Personally, I prefer Warren’s and Pabral’s method – buying obscure low cap stocks or distressed stocks. If you had read my earlier post, you will noticed many small caps stocks would have returned you in excess of 50%.

For one to copy these all-star investor’s techniques is simple but not easy. It requires perseverance, patience, and discipline. An investor must look in many places and pass on many securities. It is hard work but I believe an investor with an average IQ, and a small capital base can roll up their sleeves and do the work to find these cheap obscure securities which will achieve excess returns. The problem with achieving larger returns is that it requires concentrated bets which create volatility in one’s portfolio. Most investors can not stomach the valleys of being down quite a bit in the short-term. However, over the long-haul these techniques have proved successful.

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