Bill Miller: Lessons From The Legendary Value Investor

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Bill Miller is a melting pot of value investing icons There’s no better description than from Janet Lowe (emphasis mine):

“Like the purist Graham, Miller ignores the fickle moods of the infamous Mr. Market. Like value icon Buffett, Miller looks for franchise value. This is one of the characteristics he likes about Like John Burr Williams, Miller is willing to forecast when he runs the numbers. At the same time, he believes that numbers aren’t enough to tell you everything you need to know before dialing up your brokerage firm and placing an order to buy a stock. Like Charlie Munger, Miller looks for investment ideas everywhere.”

A combination of Ben Graham, Warren Buffett, John Williams, and Charlie Munger makes for one hell of an investor.

In 2019 Bill Miller turned in one of the best performances in hedge fund history. His fund, Miller Value Partners, generated a 119.50% return. That’s not a typo. This, of course, crushed any benchmark by orders of magnitude. It’s easy to get caught up in recent data, but it wasn’t too long ago Miller’s fund saw declines of over 70% in an 18-month span. Talk about a wild ride.

But at the end of the day, Bill Miller will go down as one of the greatest value investors to have ever live. Bill doesn’t call himself a value investor. And it’s perhaps for that reason why he’s so successful. After all, Bill is the only investor to beat the S&P 500 fifteen consecutive years.

Over the course of this piece, we’ll dive into Bill’s strategy, how he looks at new ideas. His thoughts on margin of safety and intrinsic business value.

The amount of content written, produced and recorded on Miller is astounding. The goal of this piece is to strip everything down. Curate the first principle ideas that make Miller one of value investing’s sharpest practitioners. Then, provide ideas on how to use such ideas in our own process.

There’s three things that distinguish Miller as one of the greatest:

    1. Laser focus on free cash flow
    2. Disregard for Investing Labels
    3. Buying at low expectation inflection points and holding on

Before we can discuss what makes Miller one of the best, we should understand the basics of his investment approach.

Miller’s Investment Process

Bill lays out his approach on his website, which you can find here. The process boils down to five principles:

    1. Valuation
    2. Time Arbitrage
    3. Contrarian
    4. Nontraditional
    5. Flexibility

Some of these things aren’t specific to Miller’s style. Valuation is standard across the board. But remember, Miller doesn’t refer to himself as a value investor. This is why the last two principles make sense (from Miller’s site, emphasis mine):

Nontraditional:Intellectual curiosity, adaptive thinking and creativity are important parts of our investment process. Our team stays current with numerous nontraditional resources, such as academic and literary journals in the sciences. We have also been involved in the Santa Fe Institute for more than 20 years and recently became involved with the London Mathematical Laboratory. Incorporating nontraditional inputs into our research and process allows us to view businesses and situations from perspectives that others may not.

Flexibility –Constraints almost always, by definition, impede solutions to optimization problems. Our strategies are characterized by their unconstrained formats, and each attempts to maximize the long-term risk-adjusted returns for our investors through its primary objective.”

We’ll touch on these in more detail later. Let’s pivot to the foundation of Miller’s investment philosophy: ruthless focus on free cash flow.

It’s Free Cash Flow That Matters

Miller succinctly articulates his views on valuation in a 2016 interview with John Rotoni of Motley Fool (emphasis mine):

The value of any investment is the present value of future free cash flows, so that is ultimately of the most importance to us. It’s important to note that growth does not always create value. A company can grow, but if it doesn’t earn above the cost of capital, that growth destroys value. In order for growth to create value, a company must earn returns above its cost of capital.”

Miller later remarks that free cash flow yield is the most useful metric in determining valuation, saying (emphasis mine):

We try to understand the intrinsic value of any business, which is the present value of the future free cash flows. While we use all of the traditional accounting based-valuation metrics, such as ratios of price to earnings, cash flow, free cash flow, book value, private market values, etc, we go well beyond that by trying to assess the long-term free cash flow potential of the business by analyzing such things as its long-term economic model, the quality of the assets, management, and capital allocation record. We also consider a variety of scenarios. Empirically, free cash flow yield is the most useful metric. If a company is earning above its cost of capital, free cash flow yield plus growth is a good rough proxy for expected annual return.”

According to Miller, a company’s free cash flow yield plus growth provides a guidepost for a stock’s expected return. This makes intuitive sense. A company with positive free cash flow and a beaten-down share price would have a high free cash flow yield (FCF/Market Cap). Because the stock’s down so far, it’s expected annual returns (should the company maintain positive FCF) would be its cash flow yield plus any additional business growth.

What would this look like in your investment process? A quick screen of companies that return at least 6% free cash flow yield. It’s a large list depending on other variables, but it’s a Miller-esque starting point.

At the end of the day, Miller’s goal is simple: Find companies whose free cash flow yield can beat the market’s hurdle of 6%-8% and hold on as long as you’re right.

But that’s not the only reason Miller’s reaped significant profits.

Label Adherence Doesn’t Provide Excess Returns

One of Bill Miller’s greatest qualities is his refusal to conform to investing labels. Many Miller critics try and poke holes in Miller’s success. Saying things like, “he’s not a real value investor.” It’s these types of comments that make true value investors cringe.

Miller doesn’t care if a company trades at 10x P/E or 100x P/E. At the end of the day all he cares about is the future cash flows of the business — and if he can buy those future cash flows for less than they’ll be worth. He lays it out in the book “The Man Who Beats The S&P” saying (emphasis mine):

“Our definition of value comes directly from the finance textbooks, which define value for any investment as the present value of the future free cash flows of that investment. You will not find value defined in terms of low P/E [price-to-earnings] or low price–to–cash flow in the finance literature. What you find is that practicing investors use those metrics as a proxy for potential bargain-priced stocks. Sometimes they are and sometimes they aren’t.”

Here’s the important part of this quote: “Sometimes they are and sometimes they aren’t.” Metrics like P/E and P/FCF should be guideposts for further research, not the end-all-be-all of investment decision-making.

All this goes back to GAAP accounting standards. In his interview on The Investors Podcast. Miller discusses this notion of GAAP accounting. Spoiler, he’s not a GAAP purist (emphasis mine):

“If you earn above your cost of capital then growth equals value creation. We did a regression of over 200 variables to see what was correlated with AMZN’s stock price. And it was gross profit dollars. Makes perfect sense because gross profits after COGs, because all that went to investments where the company would earn well above the cost of capital over the long term. Uses example/comparison of John Malone in the cable biz. The guy never reported a profit over 30yrs but you made 900x your money if you invested with him because he created a lot of value but that doesn’t show up in normal GAAP accounting.”

This is why Miller’s comfortable investing in software/technology companies. Old-school value investors focused on net income, Miller focused on the cash flow.

Where do we see such non-GAAP centric ideas today? Software-as-a-Service is a big one. But it goes beyond the SaaS circle. Any business that invests capital today to grow tomorrow won’t look good under GAAP accounting. Short-term profits are exchanged for long-term shareholder value creation. At whose expense? Mr. Market’s short-term bias.

Such companies won’t appear in traditional value investing screens. That’s why it’s important to use metrics like P/E and P/FCF as guides, not absolutes. A perfect example of the dangers of relying on pure quantitative metrics is newspapers. Here’s Miller’s explanation on why buying cheap stocks doesn’t always work (emphasis mine):

“[Value traps happen’] when you get down toward the lower end of these valuations, value people find them attractive. The trap comes in when there’s a secular change, where the fundamental economics of the business are changing or the industry is changing, and the market is slowly incorporating that into the stock price. So that would be the case over the last several years with newspapers. They are a good example of where historical valuation metrics aren’t working.”

An investor focused on sticking to MorningStar’s definition of value wouldn’t be able to invest in technology or software companies. They’d invest in low P/B newspaper-type stocks. Value traps. Miller doesn’t care about labels. He cares about the future cash flows of a business. As it should be. I’ll leave this section with this quote from Miller:

“‘Growth’ and ‘value’ are labels that people use to try to categorize things. If you look at Morningstar’s investment-style grid, we have migrated through the whole spectrum. Yet this fund has invested the same way for 15 years.”

Buy Low (Expectations) and Hold On (For A Long Time)

The final characteristic of Miller’s success is his ability to buy companies at points of low expectations. Maybe it’s one of those Baader-Meinhof phenomenons, but after reading Expectations Investing by Michael Moubouisson I can’t help but see this idea everywhere.

The concept is simple. You buy stocks when the share price implies low expectations of future business performance. If you’re thinking about a reverse DCF, you’re pretty much there. The goal is to use Mr. Market’s price as information about expectations. Does the current stock price imply high or low expectations? What would the company need to do over the next three, five or seven years to justify the current price?

In Miller’s case, he’s looking for low expectation situations (emphasis mine):

The major commonality among our biggest winners is a starting point of low expectations. A stock’s performance depends on fundamentals relative to expectations. For big winners, the gap between how a company actually performs and how it’s expected to perform is the widest. Our biggest winners tend to be companies that continue to compound value over many years as well, like Amazon.”

Low expectations is Miller’s starting point. By being patient, he’s able to take advantage of such low expectation points. When he sees an idea, he buys knowing it’ll continue to drop:

“Lowest average cost wins. It’s rare for us to pay up for anything, and it’s common for us that if the stock goes lower after we buy it — and it always does — we will buy more of it. If we’re not buying more of it, then we’ll be selling it, because it doesn’t make any sense to hold onto a declining position without putting more money into it or changing the weighting in the portfolio.”

If he’s right, he makes a killing. If he’s wrong, his winners make up for the losers. One of Miller’s analysts, Mark Niemann explains this concept (emphasis mine):

“If Miller is investing in four companies, three of them might go to zero. But if the fourth went to 6 times its current price, Miller could end up with a 50 percent return, or a total return on his portfolio that would beat the market. In fact, an analysis of Miller’s portfolio performance would show that he sometimes has a lower frequency of correct picks than other managers do, although his return remains high.

The above scenario can only happen if you do two things:

    1. Buy stocks at points of very low expectations
    2. Hold on longer than others

Not only does Miller buy at low expectation prices, he generally holds positions for over five years. Portfolio turnover averages around 20%, much lower than the 100% turnover average for most managers.

Why is this important?

Two words: Time arbitrage.

If you can look out further than other investors, you can create an edge. As Joel Greenblatt says (about Miller):

Legg Mason’s Bill Miller calls it time arbitrage. That means looking further out than anybody else does. All of these companies have short-term problems, and potentially some of them have long-term problems. But everyone knows what the problems are.

Markets are discounting machines. The short-term is already embedded in the price of the stock. In other words, the only advantage you have as an investor is an ability to look far enough into the future and see a different outcome than the one Mr. Market’s expecting. One way or another it comes back to expectations, as Miller explains:

“The securities we typically analyze are those that reflect the behavioral anomalies arising from largely emotional reactions to events. In the broadest sense, those securities reflect low expectations of future value creation, usually arising from either macroeconomic or microeconomic events or fears. Our research efforts are oriented toward determining whether a large gap exists between those low embedded expectations and the likely intrinsic value of the security. The ideal security is one that exhibits what Sir John Templeton referred to as “the point of maximum pessimism.”

It Boils Down To Three Advantages

Miller’s ability to compound capital is nothing short of spectacular. From the valleys of 70% drawdowns to the peaks of 119.50% annual gains. Miller’s investment style stands the test of time and is one we value investors can learn a great deal from.

As we’ve discussed, Miller’s success boils down to three things:

    1. Ruthless focus on free cash flow
    2. Disregard for investing labels
    3. Buying at low expectations and holding for a long time

Miller consolidates these ideas into three factors: time arbitrage, knowing your competitive edge, and intellectual curiosity.

Are you willing to look further out than most investors? Do you know your edge in the markets? Are you curious about all types of businesses?

If you answered yes to each of those questions, you’re thinking like a value investing legend.

Teachings From Commodities Corp (CC)

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Today I wanted to share a little nugget with you guys and gals that I pulled from our internal library that’s available to members of our Collective.

It’s about Commodities Corp. The training grounds for many of the best traders alive today. Inside, you’ll find some back story on CC along with a host of documents on market theory and practical trading tips that CC published internally and which you almost certainly haven’t seen before. There’s some great stuff in here, so enjoy…

For those of you not familiar with Commodities Corporation, I suggest giving this Fortune article from 1981 a quick read and then pick up a copy of Mallaby’s book More Money Than God, which does a good job detailing the story of this unique outfit, as well as that of many other early pioneers in the hedge fund industry.

CC was a trading operation founded by Helmut Weymar and Amos Hostetter during 1977 in Princeton, N.J. The firm was established to raise money which it would then use to trade in the commodities market and hopefully profit.

In many ways, CC was one of the very first hedge funds. Its story is so incredibly impressive not just because of the unbelievable returns the fund produced (which were astronomical) but even more so because of the long list of legendary traders who came out of it. The CC alumni list reads like a 20th-century trader hall of fame inductee roll. Some of these names include:

Anyways, the other day I was going down the internet rabbit hole and came across some pretty unbelievable finds.

The first one is a short (43 page) internal booklet prepared by another trader named Morry Markovitz at CC that summarizes Hostetter’s teachings and approach to trading. The booklet is titled Amos Hostetter; A Successful Speculators Approach to Commodities Trading. You can find the pdf link here.

The booklet is jam-packed with timeless trading wisdom from one of the greats. Paul Samuelson, Nobel Prize-winning economist and early backer of CC said Hostetter was “the most remarkable investor I know, he made money in commodities 50 years straight.” That’s tall praise coming from a man who was also one of the first investors in a young Buffett.

I suggest you read the booklet in full, but I’m going to share with you one of my favorite takeaways from the piece, which is fantastic in its simplicity and truth. If you were to follow this advice on every trade I guarantee you would see a significant amount of improvement.

To follow are the screenshots of Hostetter’s section on “questions to ask before entering and exiting a trade”:


Now here’s the second trading nugget I found in the far-nether regions of the dark web. This one written by an unknown. I don’t think he ever gives his name, but apparently he worked at a broker that filled orders for traders at CC and may have even worked at CC itself for a time.

This one is a 10-page document titled Commodity Corporation: The Michael Marcus Tape. It’s apparently a compilation of some of Marcus’ trading notes along with the author’s commentary; including some of his stories about working with Marcus. The PDF link is here.

For those of you not familiar with Marcus, he was profiled in Schwager’s original Hedge Fund Market Wizards. He’s a legendary commodities trader who is said to have turned his initial $30,000 investment into over $80 million in under 20 years — not bad. He also got his start at CC and is part of the most famous mentor/trader lineage which started with Hostetter, who trained Seykota, who taught Marcus, and who then taught Kovner. Talk about having a mentor advantage — that’s just unfair. And who knows, Hostetter could’ve trained under Livermore and Baruch for all we know.

Again, read the entire document. It’s short and well worth your time. Here are some of my favorite takeaways from the piece (bolding is mine):

Comm. Corp was essentially a trading university where traders learned to trade and perfect their skills. In the course of their employment, the traders were asked to prepare their trading philosophy which was archived. Commodities Corporation also made traders do write-ups when they lost money or “got knocked out-of-the-box.” These “knocked out-of-the-box” papers focused on how they failed and how they were going to correct their problems. All of these were archived and available to read or watch. In my opinion, these were an invaluable resource for all traders to learn from. I just wish they were now available on a website. I will discuss some of these in a later post.    

I think the “knocked out-of-the-box” papers are a great idea and “hot damn!” what I’d give to be able to go through those.

Somebody has to know where those docs are and side note: it’s really strange that a more in-depth book hasn’t been written about CC. I have Schwager’s number — I used to call him years and years ago under the guise that I was writing an interview style book and wanted to learn tips on how to give a proper interview, but I’d just end up pestering him for trading stories (he was cool about it) — I should phone him up and see if he knows anything… But I digress… here’s another one.

Trading has two types of capital that must be managed – financial capital and mental capital. In this case, losing a lot or being unsure of your system drains you of your mental capital. You don’t want to do that. Losing either your financial or mental capital will knock you out of business. So protect both equally well.

So true. Both are equally important and you have to protect one to protect the other. And finally:

Comm. Corp. taught me to see the signal, like the signal, follow the signal. If you follow your system /methodology then over time your edge will kick-in and you’ll end up ahead.

“See the signal, like the signal, follow the signal” was an oft used phrase amongst traders at CC, as well as “ride your winners and sell your losers” which was coined by Hostetter. Simple, yet powerful. There’s also some great stuff in there on adding at “danger points”, something we refer to as inflection points and a good discussion on the importance of developing market feel. Take 10 minutes and read through it.

Lastly, here’s a document (for you more wonkish types) that summarizes and advances Weymar’s original Ph.D. dissertation on forecasting cocoa prices (the theory was the primary reason for CC being created). Here’s the link. I used to have Weymar’s original dissertation, but I seemed to have misplaced it — but this is close enough.

If getting into the weeds of this stuff is your type of thing then I highly recommend you come and check out our Collective (it’s a risk-free highly asymmetric opportunity).

My teammates (Tyler, Chris, Brandon) and I started Macro Ops (MO) with the aim of creating the trading community and research service we always wanted, but which didn’t exist.

Our goal is to build a virtual Commodities Corp. We want a place where traders from all over the world can come together and share ideas, theories, trade approaches, knowledge and so on. A place where those who are committed to mastery and possess a deep respect for the game, can push each other to grow and improve — where iron can sharpen iron. The Collective contains the highest quality trading education, research, and discussion, all of which combine to create spontaneous developmental feedback loops leading to rapid evolution.

This is what we’ve done with The Macro Ops Collective. We’ve created a CC advantage for traders.

Similar to Bridgewater, the Collective is like an “intellectual Navy Seals” for those wanting to reach a deeper understanding of the markets and how to play them. Just click below to find out more.

Special Announcement: The Macro Ops Collective Now Open.

Winter enrollment for the Macro Ops Collective is now open. This enrollment period will end on January 19th at 11:59PM. If you’re interested in joining our community make sure to sign up by this Sunday!

Click here to enroll in the Macro Ops Collective

Every purchase comes with a 60-day money back guarantee no questions asked. That means you have a full two months to immerse yourself in our community, read through our research, see how we trade, and go through a huge library of educational material before committing your money. If the material isn’t a good fit, just send us an email and we will promptly return your funds in full.

Enrollment in the Collective will not open again for another 3-months and we will be raising our prices by 46% this next go around. So if you’re at all interested make sure to take advantage of this opportunity and check it out. Looking forward to seeing you in there.

The Greatest Value Investor You’ve Never Heard Of


“We can have no finer role model. First and foremost, he was a value investor — a member of that eccentric tribe that believes it’s better to underpay than to overpay.”

Those words by James Grant were in reference to one of the greatest value investors the world has ever seen. It’s not who you think it is. And no, you couldn’t guess him given fifty chances. This investor remains off the beaten path, absent from many investors’ Mt. Rushmore of allocators.

The investor is Floyd Odlum.

Buried somewhere in the junk drawer of investing lore, Odlum’s story remains unknown. A quick Google search reveals his Wikipedia and IMDB pages. Yet in typical deep-value fashion, the last link on the page revealed Odlum’s investing story.

The Holy Financier’s blog post was that last link. The blog proved an excellent springboard for a deeper investigation into Odlum’s early life, initial career and his path to market fortunes. Although Odlum (pictured on the right) and Ben Graham never met, their investment philosophies are one in the same.

We’ll journey through his upbringing, his days as a struggling lawyer and his initial attempt at market speculation. Then we’ll see how Odlum turned $39,000 into $700,000 in two years.

Life Before The Markets

Floyd Bostwick Odlum was born on March 30, 1892 in Union City, Michigan. When Floyd was 16, his father — a Methodist minister — moved the family to Colorado. Floyd stayed close to home, studying law at the University of Colorado. He received his degree in 1914. Floyd bounced around in his first few years after college. After marrying his first wife, Hortense in 1915, Odlum accepted a job as an attorney for the Utah Power and Light company in Salt Lake City, UT.

Three years later, he found himself off the ski slopes and in the throes of New York City. Between 1917 and 1918, Odlum worked for the Simpson, Thatcher and Bartlett law firm, as well as the Electric Bond and Share Company. He settled down with Electric Bond and Share Company long enough to gain the role of vice president.

Dipping His Toes in Speculation

With a decent income from his job as a law clerk, Odlum started trading in the stock market. He initially saw the market as a rich, fertile ground for speculative profits. Far from his cemented legacy as a deep value investor. Yet like most beginning speculators, Odlum too paid his fair share of market tuition.

After losing all his $40,000 starting capital, Odlum retreated from the markets. One newspaper revealed it, “took [Odlum] a while to pay back that sum”. Yet It was this early $40K loss that turned Odlum from speculator to investor. From tape reader to business analysis. Lawyer to Wall Street Legend.

Soon enough, Odlum would be back. The starting capital would be the same. The approach, anything but similar.

The United States Company

Odlum wasn’t just a great investor. He also had a knack for choosing the most generic partnership names, such as his first “The United States Company”. The partnership, formed in 1923, was a couple’s affair. Odlum, George Howard and their wives seeded the partnership with $39,000 ($573K adj. for inflation).

What followed over the next two years was nothing short of incredible. According to Odlum’s biography, The United States Company grew 17x from 1923 – 1925. What started as a small partnership amongst friends turned into a $660,000 behemoth ($9.47M adjusted for inflation).

Odlum’s two-year CAGR is mind-numbing. If that wasn’t impressive enough, he generated these returns while working full-time as a law clerk!

How did he generate such outsized returns?

Well, he was a deep value investor. He searched for fifty-cent dollars and  scoured every corner of the market. According to documents from the Eisenhower Library, Odlum preferred two kinds of investments:

    1. Utility stocks
    2. Special situations

He defined a special situation as “an investment […] involving not only primary financial sponsorship, but usually also responsibility for [the] management of the enterprise.” The former lawyer wasn’t interested in flipping a business for a quick buck, either.

Embedded in Odlum’s strategy was the determination to see a special situation through until success, “[We will] stay with the investment until the essentials of the job have been done, and then move on [to] another special situation”.

Between 1925 – 1928, Odlum steadily grew the partnership. By investing in utilities and special situations, The United States Company AUM grew to $6M (over $88M adjusted for inflation). It was around this time that Odlum began sensing euphoria in the market. He smelled a top and he decided it was time for him to act.

The Formation of Atlas Corporation

In 1929, he rolled his original partnership into a new vehicle, The Atlas Corporation. Wary of a market top, Odlum sold half his assets. He stayed in cash and issued $9M worth of Atlas Corporation securities. With $14M in cash, Floyd sat on his hands. Waiting for the next market crash, which shortly followed.

Odlum was prepared and took full advantage once fear had fully gripped the market and there was blood in the streets… His subsequent operations were chronicled in an old newspaper article (courtesy of NeckarCap on Twitter):

After the crash, Odlum, looking around quietly with more ready money than almost anybody in Wall Street except [a] few of the big banks, noticed that the trend in trusts had reversed.”

Odlum’s 1929 Strategy: Sit. Wait. Attack.

Along with his traditional investments, Odlum dabbled in a number of other industries, including:

    • Mining
    • Oil and gas
    • Motion picture production and distribution
    • Aircraft and airlines
    • Department stores
    • Manufacturing
    • Broadway stage productions
    • Hotels and buildings

But his bread and butter during the Depression was buying investment trusts. His strategy was simple. He found investment trusts that had fallen so much their stock prices were trading less than the value of their marketable securities. A good example of this in today’s markets is Manning & Napier (note: I do not hold shares).

He discovered he could buy these trusts, liquidate their assets, and reap large profits for his stakeholders. He was buying dollar bills for $0.60 and he milked this strategy for all it’s worth. He ended up buying and merging investment trust twenty-two times. The newspaper article profiled these dealings:

“He figured out that by buying all the outstanding shares of a particular trust, he was really buying cash or its equivalent at sixty cents on the dollar.”

When he didn’t have the cash to buy the trusts, he sold shares in his own company, Atlas, to fund the purchases. After exchanging his stock for the trust’s stock, Odlum would merge or dissolved the existing trust, keeping the cash and assets within Atlas Corp.

This strategy helped grow his assets to $150M ($2.2B adjusted for inflation).

Between 1929 and 1935, Odlum invested (and controlled) many diverse businesses. He owned Greyhound Bus, a little motion picture studio named Paramount, Hilton Hotels, three women’s apparel companies, uranium mines, a bank, an office building, and an oil company.

Taking It All In

Odlum started with $40,000 and lost it all speculating in the market. He then pooled together another $39,000 to form his first partnership. That original $39,000 grew to $150M in controlled assets. All that during a span of just twelve years.

The math is incredible. Odlum grew assets 384,515% in a bit over a decade. That’s a 32,042% CAGR for asset growth.

And his early partnership returns are just as impressive. Odlum grew assets from $39,000 to $6M between 1923 – 1929. That’s a cumulative 15,284% return. In other words, Odlum compounded capital at an annual rate of 2,547%.

Life After Markets: A Love of Aviation

Odlum’s life was unique. His extracurriculars sprinkled with high-profile relationships, a pioneer wife and bountiful philanthropy. After his divorce in 1935, Odlum married Jacqueline Cochran. Cochran (pictured below) was a pioneer in the field of women’s aviation. And while Amelia Earnhart garners most aviation lore, Cochran’s track record is nothing to scoff at. Some of her achievements include:

    • Flying solo on the ninth day of flying lessons
    • First woman to complete the Bendix race, a cross-country race from LA to Ohio
    • Set flight duration record in 1937 flying from NY to Miami, FL
    • First woman to make a blind landing (1939)
    • Broke 2,000km international speed record (1940)

The list goes on. At the time of her death, Cochran held more speed, distance and altitude records than any living pilot.

Odlum played a key role in women’s aviation and space flight. He financed a majority of his wife and Earnhart’s flights. He also pumped millions into the US missile development program because, “I think the money could have been spent better otherwise. But it’s too early to tote up the value of its products. My wife thinks the moon shots were terrific.

Health and Retirement

Odlum battled rheumatoid arthritis most of his adult life. The pain got so bad he had to stop working. Yet even in retirement, Odlum conducted business. One section in Odlum’s obituary shines light on his relationship with business:

“He often [took[ telephone calls on a rubberized receiver while floating in his Olympic-sized swimming pool.”

Odlum entertained (and housed) some of America’s most prolific leaders and talents. He dined with General James Doolittle, Bob Hope, Gloria Swanson, Walt Disney, Nelson Rockefeller and Howard Hughs.

But of all these guests, none were more famous than President Dwight D. Eisenhower. He and Eisenhower shared a close relationship. So close, in fact, that Odlum carved out a piece of land for Eisenhower to live during the winters. Eisenhower’s small piece of property on the Odlum Estate was known as Eisenhower Cottage.

Bringing It Back To Investments: Three Takeaways

I want to finish this essay with three takeaways from Floyd Odlum’s investing career:

    1. You don’t need to be 100% invested 24/7
    2. Boring is beautiful
    3. Be a dumpster diver (with standards)

1. You Don’t Have To Be 100% Invested 24/7

Odlum wasn’t a market timer. He was a deep value investor. When value ideas dried up, Odlum went to cash. He didn’t force investments or lower his underwriting standards. He simply sat in cash.

Jesse Livermore, a man whose made (and lost) millions in the markets, praises sitting on cash. Seth Klarman is known for his 40% cash balances during periods of market froth.

If you want to beat the markets you must do things differently. Passive investors are 100% invested, but they’re not worried about beating the market.

2. Boring is Beautiful

The United States Company invested in utility stocks and special situations. These are boring corners of the market. Yet it’s these areas that catapulted Odlum’s returns into the stratosphere. How can we apply this ‘boring is beautiful’ philosophy?

In today’s tech-driven market, many investors forget about the boring, slow-growing cash producers. These companies are toll road operators, electrical component producers, road builders. Boring businesses with not-so-boring returns.

3. Be a Dumpster Diver (with Standards)

The stocks Odlum bought were the ones others hated. These companies traded around 52-week and all-time lows. You wouldn’t find anyone talking about these stocks at cocktail parties. Yet they offered outsized returns simply because nobody bothered to look at the (potential) hidden value. Be a dumpster diver with standards. You’ll find many companies trading around all-time lows that aren’t as bad as Mr. Market thinks.

Sources Used:

Lessons From 24 Years of Operating: Bowl America, Inc. (BWL.A)

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Bowling isn’t a sexy business. In fact, it’s sort of a dying business. Drive by any bowling alley and you’ll find flickering lights and half-filled parking lots. Physical bowling has been replaced by handheld entertainment. Virtual copycat. One might reasonably assume that owning a bowling operator would make for a poor investment.

Yet, what if I told you one of the best public owner-operators ran a bowling business? And what if I told you this same owner-operator never experienced an operating loss in 55 years?

Enter, Leslie H. Goldberg.

Goldberg took over the bowling business from his father after World War II. Luckily for us, he’s left behind over 20 years of shareholder letters. I dug through each one going back to 1995.

The amount of knowledge gained from reading this “simple” bowling operator is astounding. I found gems of wisdom that echoed Buffett’s earlier writings. There are lessons on operating during a war cycle, adapting to changing consumer habits and more.

Goldberg sounds like the brain-child of Warren Buffett and Joel Greenblatt.

As the Internet overdoses on high-profile Silicon-Valley investor letters. It forgets about the little guys. The small, family-owned operators grinding it out year after year. It’s time to give owners like Goldberg their time in the sun.

We have 24 shareholder letters going back to 1995. I want to take you through each one. I’ll highlight a few key insights and apply those lessons to investing in today’s world.

Along with this breakdown, I’ll add some of my own thoughts on the practical application of some of Goldberg’s ideas. Think of it as a reverse-engineered interview. Throughout each letter, I talk to Goldberg, flesh out his concepts and wonder what he’s thinking next.

Bold quotes are my own personal emphasis.

You can find all Goldberg letters here.

Strap on your bowling shoes, it’s time to dive in!

Letters from 1995 – 1999

1995: Switching Costs & Leisure Time

1. “People adjust their recreation activities to accommodate changes in their schedules. They [consumers] do not increase their total recreation expenditures as more options become available; rather they reorder their priorities. They change their total recreation expenditures as their expectations of their earnings change, except in the case of gambling, which often diverts money from other activities.”

The meat of this quote involves the phrase “rather they reorder their priorities”. This is an important distinction. More choices aren’t correlated with increased spending on recreation. Instead, we rank which activities we actually want to do.

This reminds me of the Paradox of Choice theory coined by psychologist Barry Schwartz. The Paradox of Choice states that humans become more anxious with more options. It sounds counter-intuitive, but think about when you order at Chipotle. If Chipotle added five more meat and cheese options, would you feel more enthused? Or would you feel more stress as people behind you wait on you to make a decision?

Goldberg knew this back in 1995, almost 10 years before Schwartz released his famous book. Goldberg also knew bowling would face a tougher time with each incremental new activity.

2. “We will also face the problem that many of our customers will reorder their priorities because of actions beyond our control. In Maryland, for all practical purposes, you can no longer smoke in a bowling center. We have already seen a dramatic decline in league bowling in the centers [affected], as smokers find the restriction limits their enjoyment of the game, and there has been no increase in ‘non-smoking’ traffic.”

This quote about smoking restrictions struck me as ingenious. Marketing guru Rory Sutherland chatted about this concept in a Ted Talk.

Rory jokes (and I’m paraphrasing), “When you’re at a party and you stand off in the corner looking out of a window, alone, you’re a bit of a loser. However, put that same man in the corner, alone, looking out of a window — but this time have him hold a cigarette. Now he’s a fucking philosopher.”

Bowling (like video games and concerts) is more a platform for social interaction and community than a utility good. In other words, people don’t pay for bowling for the actual act of bowling. Rather they pay for the venue and the platform to engage in community with friends. Similar to how video games have shifted from experience to community-based interactions.

It reminds me of Alex Danco’s theory on video games.

3. “Male and female bowlers skills overlap to such an extent that leagues can be organized without regard to gender. Almost anyone can be taught to bowl. And over 95% of adults do not currently bowl in a league. That’s a great potential for a great game whose importance to the community is being recognized anew.”

Goldberg hints at the low barriers to entry for a sport like bowling. Bowling is unique in that its a sport that any able-bodied person can pick up. Most times with ease.

Another unique aspect of bowling is the lack of gender difference in skill level. Other sports (basketball and football) have clear differences in skill level between genders.

1996: Capital Allocation & Forecasting

1. “The number of times that companies with enormous financial resources and stables of previously successful executives ‘get it wrong’ when it comes to predicting the public taste is a measure of the difficulty of the task.

Forecasting is hard with quantitative measurements. Forecasting human emotions, tastes and preferences is damn near impossible. It’s difficult to know what the consumer wants. Why? Most times the consumer herself doesn’t even know what she wants.

2. “This uncertainty about recreation spending led Bowl America to develop its approach to the allocation of our resources.”

3. “People often react to a strong balance sheet the way they do to an insurance premium for a catastrophe that didn’t happen. In our case, we paid little for our security and flexibility for expansion and modernization because of the earnings received over the years from the investment of our reserves.”

Goldberg begins fleshing out his capital allocation theories in his 1996 letter. He prefers a strong balance sheet with loads of cash and no debt. He views a cash-loaded balance sheet as an insurance vehicle.

We’ve seen this before from a man in Omaha, NE. A strong balance sheet protects a business during a major downturn in the business cycle. Yet Goldberg reminds investors that the cash generates returns. So it’s not completely idle.

4. “Our focus remains on building a profitable company from which the owners receive continuing income. We have never viewed Bowl America as a trading vehicle and those of you who have read these reports will know that we distinguish between profiting from a business and profiting from trading paper.”

If I took out the words “Bowl America”, you would think this were Joel Greenblatt. Goldberg makes it clear to investors that BWL.A is in it for the long-term. Families depend on the income from this small company.

That’s also why I love diving into small and micro-caps. These are businesses that feed families in a more direct way than larger firms.

1997: Operational Improvements & Marketing Ideas

1. “One such effort that shows promise is glow-in-the-dark bowling. We now have 12 centers in operation or scheduled for equipment. In addition to higher revenues, we’re seeing increased traffic from young adults, a group we had not been regularly reaching.”

One way to spur youth involvement is to create something new. Something like glow-in-the-dark bowling. It works because it’s a visually drastic change, but isn’t a major capital expense.

Yet it shifts how young people view the activity. It goes from being an “old person’s game” into the hip, cool thing to do on a Friday night.

Goldberg reached the younger population by offering another marketing incentive: good grade rewards.

2. “We also worked closely with local school systems to reward academic achievements. Students were offered a free bowling game at a Bowl America center for every ‘A’ on their final report cards.”

Although simple in practice, this marketing technique is genius. Incentivizing students with free bowling games does two things. First, it creates an image that Bowl America wants students to succeed. This increases people’s affinity for the company.

Second, the company knows that these students can’t drive. This means for every one free game of bowling a student receives, their parent(s) pay for an equal game. Moreover, if the student has siblings, they will most likely bring them along for a game.

This is a perfect example of Rory Sutherland’s “1+1=3”.

3. “This conversion [owning amusement games vs. third-party operators], installation of glow-in-the-dark, our expansion at Dranesville, and the closing of two unprofitable centers created extra expense in the last quarter of 1997, but has improved profitability at the start of fiscal 1998.

If there’s one sign that management’s focused on the long-term, it’s this: creating short-term expenses for longer-term increased profitability. Short-term operators wouldn’t close down stores, add glow-in-the-dark capabilities and buy-out third party concession operators. At least not all in one year.

Yet Goldberg’s able to look beyond the next quarter or next year. He’s setting his business up for success five, ten, even twenty years from now.

1998: Thinking about Revenues & Working Staff

1. “League bowlers provide the steady base to support our operations by showing up every week. The casual or non-organized bowlers provide a less predictable but increasingly important contribution to our earnings.

This is a great way to think about the bowling business. You have two customers you’re trying to reach. One is the league bowler. This is your “fanatic”. They’ll show up every week, pay their dues and bowl for hours.

The next customer is the casual fan. The one that shows up with a date or a couple buddies. They don’t normally bowl, but given the rainy weather outside, they decide to shake things up.

Goldberg knows he has to focus on the fanatic bowlers. These bowlers keep the lights on. But the real money at the end of the year comes from the casual bowlers. These, while infrequent, have the potential to increase returns ten-fold. These are your casual bowlers.

2. “But two of our best performing centers could not accommodate much of the new equipment, and still significantly improved their results, mostly by working harder at giving good service.

We see in the 1998 letter a focus on customer service. Later he remarks, “More and more, when observing our staff solve a problem, I find myself wishing I had thought of their response.” Great leaders commend their employees.

3. “But there is little we can do about the weather. Continuing to adapt to the shift to casual bowling while not discouraging the heaviest users, our league bowlers, remains our biggest challenge. Our biggest asset in managing the process remains our capable and experienced staff.

What I like about this quote is Goldberg’s focus on what he can control, and his disregard for what he can’t control. He mentions earlier in the letter that “weather does not recognize a fiscal calendar.”

This quote doubles as the business model for Bowl America. A succinct, one sentence model.

1999: Stock Buybacks and Customer Retention

1. “When a bowling center is filled with leagues, potential open play customers become discouraged and may not even try to bowl. This provides a shrinking pool of replacement bowlers for existing leagues. It is only when league play has contracted enough that people feel they can drop into a bowling center on a weeknight and get a lane that we can begin to build back our customer base.

2. “Our challenge is to make sure that those customers enjoy themselves enough to participate regularly and to talk about the fun they had to their friends, neighbors and fellow workers.”

Repeat customers are the lifeblood of any company. The casual fan needs to enjoy herself enough to come back. Goldberg knows that if he can convince each customer to revisit the bowling center at least twice, he’s won their business.

Goldberg even mentions an analysis of a competing recreation center that went bankrupt. When reviewing the insolvent firm, the analyst noted, “[the business] needed only to get customers to come back a second time to survive.”

Goldberg trained his staff to get customers to come back 35 times a year. Talk about margin of safety.

3. “It is superior customer service that has made Bowl America the bowling centers for people who love to bowl.”

4. “Also, the greater the number of recreation events a person tries, the greater the bargain bowling seems. Therefore, we should get the advantage of better pricing to support all of our locations.”

Goldberg’s business has two things going for it:

1. excellent customer service

2. substitution effects.

Goldberg mentions many times the level of customer service. He attributes much of each center’s success to the employees that work everyday. This reminds me a lot of Jeff Bezos’ obsession with the customer.

Goldberg also benefits from substitution effects.

How does substitution effect work in Bowl America’s favor? Comparatively, bowling is a lower-cost option for fun. It’s one of the few date ideas that won’t wring you out of $50. So, with every new form of recreation a person tries, bowling will likely appear the cheapest option.

Letters from 2000 – 2004

2000: What Makes a Strong Financial Position

1. “I am enclosing the press release from our nine-month earnings report, which shows that we have completed our eleventh consecutive year-to-year quarterly profit improvement.”

2. “Bowl America has increased its dividend for 28 consecutive years and twice in the last twelve months.”

The year 2000 marked 11 straight quarterly profit improvements. The company also increased its dividend for the 28th straight year. Credit that to Goldberg’s fiscal responsibility and fortress-like balance sheet.

3. “Bowl America has no debt. In addition, we have substantial reserves to adapt to changes in public taste, both now and in the future. Casino operators (among other masters of statistics) are quick to tell you that you have to have the cash to outlast a bad run so that you can capitalize on the good run that inevitably follows.”

No debt, large cash reserves and an optimistic outlook. That seems to be the recipe for Goldberg’s financial success. During the time of this letter, many bowling operations closed shop due to debt. Goldberg’s avoidance of debt is so strong it’s as if he’s scared of it.

4. “Timing the market is beyond me. But a dividend that increases faster than prices provides real income in any market and downside protection in a poor market. It gives us a chance to share our success four times a year, something I hope we can do for many years in the future.”

Goldberg reiterates the benefits of real income BWL.A produces for its shareholders. Why do I keep going back to this saying? Because the purpose of this business is to generate income for shareholders.

Goldberg doesn’t mention capital gains or trading profits. He mentions real income. It’s this distinction that infects his letters with a sense of true ownership.

2001: Simple Business Models & Ownership in Business

1. “Bowling is easy to understand, simple to learn and allows people of various skill levels to compete with each other. Add to that Bowl America’s policies of locating sites near our customers, moderate pricing and emphasizing friendly service and you have a foundation for earnings longevity.

There’s nothing confusing about what Bowl America wants to do. They want to bring bowling to where the people are. At an affordable price. With excellent service. Prioritizing the customer.

2. “Bowl America is one of the leading companies in providing its owners with these annual [dividend] increases. At the end of 2000, according to Mergent’s Dividend Achievers, only 73 companies of the 10,000 they surveyed had longer consecutive dividend increase records.

This is an impressive feat for any company. Let alone a micro-cap stock. Once again we see a focus on ownership and being owners of BWL.A, not owners of paper.

3. “However, we were able to use the money we might have used for a new location to buy in more of our stock, increasing each shareholder’s stake in the remaining bowling centers. The combination of reduced shares outstanding, the strength of our balance sheet and the relatively higher valuation granted by the market to dividend-paying stocks combined to enable us to reach an all-time high for Bowl America stock.

Goldberg again portrays his knowledge of capital allocation philosophy. He understood that higher returns were possible if he bought back stock. This is also the first time he mentions BWL.A’s stock price. And as we’ll see he’s quick to note why he mentioned it.

4. “That [share price increase] often gives rise to a temptation to sell one’s interest in a successful company in order to find another more successful company … We prefer to continue to emphasize the benefits of ownership of a business as opposed to ownership of stock certificates.

Read that again and tell me it doesn’t sound exactly like the doctrine Joel Greenblatt preaches. Goldberg is a value investor through and through. He knows that share prices are blips on a screen and not a reflection of the true underlying value of a business.

2002: Thoughts on The Double Tax of Dividends

1. “I have always held that our objective should be to help our shareholders prosper through their ownership of Bowl America … Dividends have the benefit of being paid in cash, not accounting fantasy. The disadvantage is that they are subject to double taxation.

Double taxation.

My biggest gripe when it comes to dividends. The first tax is the tax on operating earnings of the company. Then, if a company issues a dividend, the shareholders pay income tax on that dividend. Ouch.

This is why I prefer buybacks. When companies buy back stock, they don’t inflict the double taxation rule. Yet at the same time increase the value of each shareholder’s stock.

2003: Opportunity Cost and Board Dependence

1. “The current panacea is control of companies by “independent” directors. I favor “dependent” control of boards … My preference is, however, related to the fact that the “dependent” directors will be more likely to share in any loss caused by their decision making. If a director shares with other owners the risk of loss from the collapse of the enterprise, he or she is more likely to focus on the company’s survival.

I’ve never understood “independent” board members. If you think about it, board members should have a vested interest in the future success of a company. It never made sense to have a board of directors, paid for showing up four times a year, without skin in the game.

Goldberg nails the reason why. A dependent board, one with skin in the game, must think long-term if they want to reap financial success.

2004: Longevity, Building New Stores and Short-Term Thinking

1. “For the first time in ten years, we are building a new bowling center from scratch … It will add to our standing as the best and oldest continually operating bowling company in the Richmond [VA] area.”

After failing to find bowling centers to buy, Goldberg took matters into his own hands. The company had the cash on hand to build the bowling center without debt. Even with building a new facility, the company kept its promise of dividend increases. Good for 32 consecutive years.

2. “Location in any retail business is important, but we have always felt that longevity flows from great customer service and great customer service flows from people who enjoy what they do. I have always been pleased that so many of our employees are bowling enthusiasts.”

Goldberg’s recipe is simple: Focus on the customer. Make sure they have the best experience possible. Word-of-mouth experiences are binary. You either had such a great time that you must tell others. Or you had such a bad time that you need to let others know so they avoid your experience.

3. “Another group shares the need for price increases, but has an even shorter horizon. These are the so-called money managers, whether they be mutual funds, pension funds or insurance companies that are threatened with investor defection if they didn’t ‘match market performance.’

Letters from 2005 – 2009

2005: The Changing Consumer

1. “As our business shifts from the committed week-after-week bowler to what we call the casual bowler, it will become even more important to vary our entertainment, communication and control capabilities.”

We see the beginnings of a tectonic shift in their core business model. A few letters back, Goldberg referred to his league bowlers as the earnings driver. Casual bowlers, in contrast, provided hefty (albeit lumpy) returns.

Instead of burying his head in the sand and sticking to the “old way” of doing things, Goldberg adapted.

2. “League bowling is not dead. Only this week I heard a report that sociologists have discovered that many of the declining neighborhood institutions are showing turnarounds. The reason given is the growth in the immigrant population, which is looking to community groups as a way to participate with their neighbors.

Goldberg believes in the league bowler, but not as his main source of revenue. Yet the most important piece of this quote revolves around the community group. With each incremental advance in technology we lose that shared, human connection.

This is why companies such as Nextdoor and Discord are Silicon successes. These businesses thrive on creating a sense of community within a neighborhood. In the case of Nextdoor, a community as small as your zip code.

2006: The Pitfalls of Earnings & Not Selling Shares

1. “Also, some of our best business is done in locations that have been actively used for almost 50 years. This year, some of the oldest buildings required expensive and unpredicted repairs. These buildings, however, are well located for future growth.”

Businesses aren’t linear entities. They’re living, breathing, volatile organisms. Thus, earnings should not grow in a linear fashion over the long-term. If they do, it might be a sign of earnings manipulation. But I digress …

2. “We have long argued that shareholders are best served if they can share in their companies’ success without having to sell their stock.”

Here we see Goldberg (again) push the doctrine of thinking of stocks as pieces of businesses.

3. “Future success won’t simply flow from bricks and mortar. It will be determined by the skills of our people and customs we have developed over the years.”

Goldberg emphasizes the importance of his employees whenever he gets the chance. That’s a sign of a great leader. That’s a sign of someone you want to work with.

2007: Bowling People, Not Stock People

1. “Three hundred thousand shares of the new Bowl America stock were sold to the public at $2.00 [at founding]. In addition to the current fiscal year being a birthday for the bowling center, it will also mark the year in which the cumulative dividends on that single $2.00 share will exceed $100.00. Those original investors who were smart enough not to sell their original shares now have 11.3 shares of Bowl America stock.

This is a testament to the power of compounding. Investors received 11.3 shares for every one share owned — all through dividends. Granted that was over the course of 50 years, but that’s the point. You bought and you held it. You participated in the business rather than traded its shares.

Goldberg made no mistake about what he wanted the company to be: A conservative enterprise that generates income for shareholders.

2. “We were bowling people, not stock market people, and our objective was to create a secure, profitable bowling company to generate income for our families’ futures. We, therefore, valued survival of the company as our top priority. We proudly reported paying off each mortgage.

Now contrast this approach with today’s public companies. We live in a time where money is cheap, revenue growth is the gauge of success and fiscal responsibility is low.

How much better would public companies be, micro-caps in particular, if they ran their businesses like Goldberg? A business that focused on preservation of capital. An obsession with its employees and its customers. Would we see such pessimism permeate through the micro-cap space if that happened?

2008: Strong Balance Sheets & Business Reform Ideas

1. “As of today, we own 17 of our 19 bowling centers. None has a mortgage. In fact, we have no long-term debt. Our payrolls and trade bills are current … We, therefore, expect that we have deep protection for our ability to finance our center operations and to support possible expansion. Further, unless there is a runaway panic, we believe that our healthy balance sheet would enable us to borrow if a promising option became available.”

And so we’ve arrived. The Great Financial Crisis. Yet before reading the 2008 letter, one would assume that the company would survive — and even thrive.

Emphasizing a strong balance sheet, little to no debt and a focus on creating value pays off. It’s obvious in times like the GFC.

Businesses with great balance sheets and zero debt relish opportunities like 2008. During recessions, responsible businesses can scoop up competitors for pennies on the dollar.

Goldberg reminds shareholders of this idea, saying, “I hope you will take comfort as we work through the problems and opportunities of the near term, that we share common objectives.”

2009: Bad Politics and Long Term Capital Management

1. “I was recently asked if I could recall a scarier time for business … ‘How about December 7, 1941?’

If that doesn’t put things into perspective for shareholders I don’t know what will. Think bigger (and farther out) than the last few quarters.

Letters from 2010 – 2014

2010:  Matching Expenses and Long-Term Investing

1. “We have, therefore, devoted our efforts during the past year to bringing our expenditures as closely in line as possible to our traffic, continuing to promote the business and providing a service that, when economic conditions change, will enable us to accommodate the upswing in our business.”

2010 marked BWL.A’s first league bowling season under Virginia’s “no indoor smoking” policy. We saw the negative effects of a smoking ban in earlier letters.

Why do people have such a hard time quitting the devil stick? There’s the nicotine, yes. But is that it? I stumbled upon an article from Psychology Today (written by Romeo Vitelli, Ph.D) addressing this very issue.

The article reveals that, “Not only did study participants describe themselves as being friendlier, more extroverted, and less socially anxious after ingesting nicotine, but nicotine use helped improve awareness of social and facial cues compared to participants who had abstained from nicotine use for 24 hours or longer.”

Now it’s clear why a smoking ban hits bowling sales. Bowling was the outlet, the catalyst for social smoking.

2. “Perhaps someday people will view stock purchases as an opportunity to own part of a business and not simply a piece of paper. We will continue to run this company as though we represent people who prefer the former.”

I love this. There’s nothing to add.

2011: Skin in The Game & Operating Leverage

1. “As you may have noted over the years our Board shares the risks and rewards of ownership of Bowl America with all of you. Our ladder has been designed to protect as well as possible every owner of the Company.”

Goldberg’s 2011 letter brings back the notion that Board members should have skin in the game. That they should own a part of the business they’re running. While such a common sense idea, it amazes me how few boards install this philosophy.

2. “Debt can create the risk of bankruptcy. We have no debt. It has been over 20 years since we paid off our last mortgage. Rent in a troubled economy can be as dangerous as debt.

Many investors underestimate the cost of obligations. We see this especially in retail businesses. Why is that? Under GAAP accounting, operating leases count as an operating expense. This makes sense at first glance. You need the building/space to do normal business activities.

Yet valuation guru Aswath Damodaran disagrees. He suggests, in his 2009 whitepaper, that operating leases should count as a financing expense. According to Damodaran, leaving leases as an operating expense, “results in a skewed estimate of profitability, leverage and value.”

What does he mean by that?

Damodaran argues that operating leases look, smell and feel like regular debt. The type of debt you would see on a balance sheet. It makes sense. Leases meet all the requirements of debt:

    • length agreements
    • contract terms
    • specified payments
    • use of building as collateral if payment is not received.

Yet for some reason, these payments don’t receive capital expense status.

This designation results in higher than actual operating income, returns on equity and lower debt to equity ratios. All these things matter when valuing a business.

Goldberg drives this point home later in the letter, saying, “We own the land and buildings at 17 of our 19 bowling centers. In addition to the security that provides, the cost savings when compared with rent are significant.”

2012: Hoarding Cash & Staying Profitable

1. “We are not pleased with our results but we are pleased that we have done better than many companies in keeping the doors open and employment levels high and in operating profitability during every year of this downturn.

Staying profitable during the Great Financial Crisis is applause-worthy on its own. Doing so in a recreation dominant business? Even more impressive.

Bowling, like most recreational activities, isn’t an inelastic good. We engage in recreation in tandem to our level of leisure time and discretionary income.

There wasn’t much of either between 2007-2009.

2. “We are probably the oldest firm in the bowling business which has the operation of bowling centers as its primary activity. Over the years our interaction with you, with our customers, and with our employees has convinced us that all prefer a more predictable outcome to an adventure.

Goldberg wants to be the tortoise, not the hare. In a business where the board, the employees and the CEO owns most of the company’s stock, this makes sense.

There’s a skewed preference among value investors around distribution of returns. Most value investors prefer a lumpy, but excess return. Meanwhile, Goldberg prefers a steady, predictable income stream. After all, this business feeds his family, and his employees’ families.

2013: Employee Ownership & Inflation Benefits

1. “Survival of the employer is the cornerstone of employee security. But benefits must be personal for employees to commit to a career. Our full-time employees, without cost to them, participate in our stock ownership plan which now owns 7% of Bowl America stock.”

Employee stock ownership makes sense. You want your employees to care about the long-term future of the business. What better way to inject that sense of long-term thinking than via direct ownership?

Investors relish large, C-suite level ownership. But it’s employee ownership that matters more. The reason for this hypothesis lies in scuttle-butt research. When managers engage in scuttle-but, where do they find the most valuable information?

It lies inside the trenches.

Erik Forsblom and Ludwig Smedberg dove deeper in their whitepaper, Stock-based Compensation and Shareholder Value. Their results were, well, predictable.

Companies with more generous (or presence of) employee stock ownership programs generated almost double the return over the five-year period. The study also found that the use of warrants resulted in even higher shareholder return.

This isn’t to say that employee stock programs were the sole reason for excess return. The companies that offered such programs could be better companies in general. But it is something to think about.

2014: Digging Out From Recession & Social Capital

1. “Our results continue to disappoint despite the fact that this was the 51st consecutive year of profitable operations … You have perhaps noticed in the news the pattern is the same for golf rounds played, movie attendance and even some football stadiums. People simply have more choice for recreation and for shrinking budgets.”

We first saw this instance of Paradox of Choice in Goldberg’s 1995 letter. A decade later, it resurfaces. It shows how challenging it was for businesses to get back to Square 1 after the GFC.

BWL.A’s stock recovered in swift motion — less than three years — but the underlying business failed to grow. Imagine how difficult things would’ve been if they had excessive leverage.

Goldberg ends the 2014 letter giving his elevator pitch for bowling:

2. “Bowling is the most gender-neutral major popular pastime. Bowling is safer and more age inclusive than almost any sport. Our game is economical (the price of a game actually declined in the last year). Bowling is an important contributor to social capital.

Social capital. The term first coined by Robert Putnam in his book Bowling Alone (imagine that). In Putnam’s words, social capital “refers to features of social organization such as networks, norms, and social trust that facilitate coordination and cooperation for mutual benefit.”

Goldberg runs with the idea. Each Bowl America building is the hub for social capital. People come in, bowl, and grow their social capital. That social capital then spreads throughout their community. The community grows closer together, prompting more group-level engagement. These groups then choose to bowl together … And the beat goes on.

Letters from 2015 – 2018

2015: Light at The End of The Tunnel

1. “If you acquired one of the original shares at $2.00 and still held today, you would have 11.4 shares and would have received dividends of $164. The market value of those 11-plus shares roughly equals the dividends received, suggesting a balanced return as rewards of our ownership.

Ben Graham liked to say that in the short-term, markets are voting machines. It doesn’t matter the fundamentals of a business or strong financial position. In the short-term, anything’s possible.

That’s the beauty of an auction-driven market. We can take advantage of these mechanisms.

Yet in the long-run, Graham believed markets become weighing machines. In contrast to voting machines, weighing machines balance price and value. In this time-frame, fundamentals do matter. Strong balance sheets matter. Exceptional (and aligned) management matters. Over time, the market will get it right.

But not on your time.

2. “Overbuilding in the industry in the early ‘60s required the founders to guarantee additional borrowing to save the company. From that experience the directors decided that it would be wise to own property rather than lease locations so that if business turned down again it would not be faced with closing good locations or paying inflated rents.”

The rise of Amazon reveals a crucial error in most brick-and-mortar business models. Death via operating lease. We discussed operating leases a few pages back, but it’s worth bringing up again. Why? Because operating leases are value destructive in times of slow-down.

A lease is a fixed cost. Whether a company generates ample or pitiful sales, the lease must get paid. Goldberg mentions one way to ease the lease overhead: buy the building.

But what if you can’t do that? How can brick-and-mortar operators protect their solvency when forced to lease? Here’s two ideas:

Idea #1: Figure out a “worst-case” scenario for profitability, earnings and revenues. If you can still make your lease payment in a worst-case scenario, sign the agreement.

Idea #2: Downsize, downsize, downsize.

In this scenario, less is more. Everybody wants the larger house. Yet nobody wants the added responsibility of owning a larger house.

Therein lies the key: unit margins. The higher the margin, the more sensible it is to expand. The lower the margin, the riskier it is to expand.

2016: Nothing New Under The Sun (and Profitability Factors)

1. “It would seem that the old pattern of consumer preferences changing is in fact accelerating … However the particular impact of in-home entertainment is not new. Our predecessor company went into business two months before World War II. We were exposed to behavioral changes brought about by new TV technology. VCRs, DVDs, high definition, cable, 3-D and, of course, streaming TV. Each of these events had an impact that was noticeable on the bowling business and from each of them Bowl America recovered.

Ecclesiastes recognized this thousands of years ago. There is nothing new under the sun. The reason for this is simple, yet important. Technology changes and improves quicker than ever before. Meanwhile, our human brain — evolutionarily speaking — remain in the hunter-gatherer stage of development.

There’s an element of genius in Goldberg’s decision not to change bowling as quickly as technology. Throughout each technological change, Goldberg’s business remained profitable. In fact, 2016 marked the 53rd consecutive year of profitability. Wars, recessions, massive inflation, you name it. The company adapted.

Goldberg offers two reasons for the company’s enduring success:

    • Incentivized and aligned employees
    • No mortgages

Goldberg reminds shareholders of these two factors. His letters sound like a broken record. But then again, so does 53 consecutive years of profitability.

2. “We think two factors have helped us. Most important is our view that an enlightened policy towards our employees has produced an experienced staff able to deal with the changing bowling customer … Over 700 Bowl America employees are owners of the stock … [Bowl America] has no mortgages. This stability is a key to the development of long-term employment opportunities.

2017: Buying Assets For Pennies on The Dollar

54 consecutive years of profitability. I’m beginning to wonder if they even have red pens in their corporate office. In this letter, Goldberg looks back on what he thinks the most pivotal year in the company’s history: 1974.

During that year, the company won a lawsuit, received a hefty cash payment and invested in a new center. This center, located in Richmond, VA remains one of their best-performing assets. It also marked the shift from leasing to owning property.

Meanwhile, the bowling business in Japan crumbled …

1. “Many high-quality bowling lanes and pin setting equipment were for sale [in Japan]. We began to buy and store [the equipment] for future use. Our skilled employees handled much of the installation and maintenance of this equipment themselves, developing skills which continue to benefit us.”

Goldberg is, in fact, a deep value investor. He bought good quality Japanese bowling equipment for pennies on the dollar. And he bought from forced sellers.

2. “Once our original investment in the new centers was paid off, we had a cost basis that could not be duplicated. In addition, when we made a mistake we were able to sell the resulting real estate at a profit.

Two things jumped out at me:

    • Bowl America’s competitive advantage — its moat — comes from buying great equipment at cheap prices.
    • Goldberg builds in a margin of safety into each new center.

One decision changed BWL.A’s trajectory forever. Those Japanese assets provided the company a low cost-basis. So low, in fact, competitors couldn’t achieve similar margins and remain profitable. In turn, the low cost-basis offers a low hurdle should Goldberg sell the bowling center.

Heads I win, tails I don’t lose much.

2018: Have Your Cake & Eat It Too

Here we are, Goldberg’s most recent letter. We’ve journeyed over two decades to this point. We’ve seen the dot-com bubble, the Great Financial Crisis and advancing technology.

Yet despite the above factors, one thing remains unchanged: profitability. 2018 marked the 55th consecutive year of profitability. An incredible feat of any company, let alone a consumer behavior-driven, micro-cap business.

Goldberg book-ends these 24 years the same way he started them. By focusing on employees, customers and no debt. He’s owned BWL.A stock for 60 years and hasn’t sold a share. He’s got skin in the game and longevity.

1. “Every full time employee of Bowl America has a piece of the same cake. The Company’s non-contributory stock ownership plan holds 391,000 shares, with employees fully vested after 6 years of plan service.”

Many BWL.A directors sport 30, 40 even 50 year tenures with the company. The most common cause of employee turnover seems to be death. Goldberg hints at why that’s the case, saying, “We are of the opinion that this plan has contributed to the feeling of security held by our employees.”

Skin in the game throughout all levels of employment.

2. “Ours is a service business and attitude is important in providing service. In addition, the experience of our staff guarantees competence to our customers who are rarely faced with ‘that’s not my job’ when asking for assistance.”

Bowl America is the Chick-Fil-A of bowling centers. Excellent customer service is a large competitive advantage. It’s also one of the hardest to achieve. Top-notch customer service requires employees to buy-in to the company’s long-term vision.

Not only that, employees must enjoy working for the company. Reward your employees and they’ll reward the business.

Concluding Thoughts

Leslie Goldberg is an incredible operator. Unfortunately he passed away on October 14th, 2019. Yet he left behind an incredible legacy. 55 consecutive years of profitability is a feat few business owners can tout.

I hope these letters and Goldberg’s thoughts  inspire you to think about durability in business. About investing through economic cycles and the power of long-term ownership.

We now live in a world where it costs nothing to buy or sell securities. The barrier to entry for short-term minded traders has never been lower.

Where will the advantage be over the next 24 years? It will rest in the hands of those willing to look beyond the next quarter or year. The advantage goes to the one with a long-term mindset. The mind-set of an owner. One that views stocks as ownership in actual businesses. Not pieces of paper or blips on a Bloomberg screen.

Think like an owner. Think like Leslie.

“Good service, happy customers and a fun game is the way to bake a great cake.” – Leslie H. Goldberg

The Evolution of Political Regimes

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Plato, using Socrates as his mouthpiece, wrote the following condemnation of Athenian democracy in his Republic:

[The citizens] contemptuously rejected temperance as unmanliness… Insolence they term breeding, and anarchy liberty, and waste magnificence, and impudence courage… The father gets accustomed to descend to the level of his sons and to fear them, and the son to be on a level with his father, having no shame or fear of his parents… The teacher fears and flatters his scholars, and the scholars despise their masters and tutors… The old do not like to be thought morose and authoritative, and therefore they imitate the young… Nor must I forget to tell of the liberty and equality of the two sexes in relation to each other… The citizens chafe impatiently at the least touch of authority, and at length…. They cease to care even for the laws, written or unwritten… And this is the fair and glorious beginning out of which springs dictatorship… The excessive increase of anything causes a reaction in the opposite direction;… dictatorship naturally arises out of democracy, and the most aggravated form of tyranny and slavery out of the most extreme form of liberty.

Plato reduced the evolution of political regimes to a sequence of monarchy, aristocracy, democracy, and dictatorship. In the excerpt above he’s commenting on the fraying democracy in Athens that was driven by a widening gap between the rich and poor… sound familiar?

The wealth disparity drove the poor to try and enlarge their cut of the pie through legislation, taxation, and revolution. The rich banded together to protect themselves and their money. This division fractured Athenian society and opened the door for Philip of Macedon to invade and conquer Greece.

Greeks had grown so despondent with their political system that many actually welcomed his conquest. Greek democracy transitioned to dictatorship.

Nearly 300 years later we saw a similar sequence play out in Rome. The Roman Republic created enormous amounts of wealth through its vast control and exploitation of foreign lands. The new aristocrats curried favor with the leaders on Palatine Hill through bribes and political support. Over time, the government began to work for the special interest of the few.

In response, the commoners supported Julius Caesar who seized power and established a popular dictatorship. He was then stabbed in the back (literally) by the aristocrats and replaced by another dictator, Gaius Octavius. Democracy became a dictatorship which then became a monarchy.

Political regimes like much of nature seem to oscillate between extremes (democracy and autocracy), where each extreme sets the conditions for the inevitable transition towards the other. How a nation’s wealth is divided amongst its people is one of the biggest drivers of this constant pendulum.

In Will and Ariel Durant’s The Lessons of History they write that “inequality is not only natural and inborn, it grows with the complexity of civilization. Hereditary inequalities breed social and artificial inequalities: every invention or discovery is made or seized by the exceptional individual, and makes the strong stronger, the weak relatively weaker.”

This fact keeps the political system in oscillation between extremes. Where — again quoting both Durants—  “…freedom and equality are sworn and everlasting enemies, and when one prevails the other dies. Leave men free, and their natural inequalities will multiply almost geometrically, as in England and America in the nineteenth century under laissez-faire. To check the growth of inequality, liberty must be sacrificed, as in Russia after 1917. Even when repressed, inequality grows; only the man who is below the average in economic ability desires equality; those who are conscious of superior ability desire freedom; and in the end superior ability has its way.”

When economic prosperity is relegated to a few, society’s desire for political freedom becomes merely a conciliatory afterthought. This arises not so much through the wealthy’s direct exploitation of the poor but rather due to the increasing complexity of the economy and government. This complexity puts an additional premium upon one’s superior ability to navigate it, which further amplifies the concentration of wealth and political power.

Running under all of this is the Bridgewater style long-term debt cycle. The wealthy are the creditors that hold the assets, the poor the debtors who suffer under the liabilities. The larger the balance sheet grows, the more complex the economy and the more enriched the wealthy and the more financially strangled the masses become. Until of course, a natural limit is hit… equality pushes back at freedom… and democracy inches towards autocracy.

The Durant’s note that when “our economy of freedom fails to distribute wealth as ably as it has created it, the road to dictatorship will be open to any man who can persuasively promise security to all; and a martial government, under whatever charming phrases, will engulf the democratic world.”

The interesting political events of late (ie, Brexit, Trump, the rise of nationalist parties in Europe etc) are not causes but rather effects of the debt cycle and the natural evolution of the political sequence as described by Plato some 2,400 years ago.

That is not to say we are going to see a shift to dictatorship or anything of the kind in the near future (we aren’t)… nor am I saying that is what Trump in any way represents (he doesn’t). Rather, I’m talking about the large tidal forces at work; the historical cogs that are turning and driving the current rise in populist sentiment and which will play out for many years to come.

We are witnessing the battle between two opposing forces of political and economic nature unfold. Neither is good or bad, they both simply are. Each is embedded in the evolution of our natural system where equilibrium is merely a concept and constant change a reality.

It is with that understanding that we must judge and assess things to come. Taken in this context, the current insanity of the world begins to make a lot more sense.

The course we are on now is not a sustainable one.

I fear the rise in populist politics is only just beginning. Let’s hope we don’t swing too far back in the other direction…

Arlington Value Investor Letters: Five Invaluable Lessons On Value Investing

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There aren’t many investors compounding capital at double digits over the course of decades and those that do are already well known (i.e., that guy from Omaha). However, in a small office above a taco shop, there’s a man running a hedge fund called Arlington Value who has demonstrated the advantage in simplicity, long-term thinking, and the power of compounding.

Arlington Value doesn’t have a large team of analysts. They don’t run advanced machine-learning algorithms or exploit esoteric satellite data and there’s not a single distinguished diploma on their walls.

Yet, Arlington Value has returned 18.36% CAGR over 11.5 years and its main fund, AVM Ranger Fund, has returned a mind-boggling 37.9% return since 2008. The man behind these numbers is Allan Mecham.

I spent all of last weekend pouring over his letters (s/o to Focused Compounding for the post) and there is plenty of nuggets to share. I’ve gone ahead and whittled down Mecham’s insights into five recurring lessons from his letters (spanning from 2008 – 2017) that are worth reviewing. Let’s get started!

1. Less (Not More) Information is Better — Avoid Noise

“I disagree with the notion that more information is always better.” – 2008 Letter

This may sound tongue-in-cheek as you’re reading this from an “information source” on investing, but bear with me. Mecham is old school. He reads print newspapers and avoids the sensationalist financial news media found on TV and the internet. Warren Buffett, Walter Schloss and countless other value investors follow similar practices (i.e., Buffett doesn’t have a computer in his office).

We know successful investors practice the art of “less is more”, but why exactly do they do it? What’s the edge?

The edge is found in clear thinking and an uncluttered mind. Our brains only have so much decision making power capacity each day. Disposing that energy into numerous outlets — reading too many blogs, following too many investors, watching Mad Money — reduces our brain’s capacity to make full-powered decisions on important questions. Mecham addresses these issues in his 2010 annual letter, saying (emphasis mine),

The steady surge of information coupled with short-term performance pressures can push rational long-term investing to the brink of extinction. The easy access to information, and the snack-bar nature of consuming it, suggests that disciplining one’s temperament rivals the need for energy and action.

The less information you consume the more time you have to ponder the few critical bits that really matter.

2. Selling Great Businesses Is Almost Always a Mistake

“Selling is difficult, and my track record suggests it’s usually a mistake.” – 2010 Letter

In a perfect world, we find businesses we love with management teams that know how to allocate capital well, and then we sit. Unfortunately, a small fraction of public companies meet that criteria, and even then, it’s tremendously difficult to sit and hold. In his 2010 Letter, Mecham addressed the issue of selling, saying (emphasis mine):

My view on selling is akin to the old sports adage, ‘the best defense is a good offense’; the best sell discipline is a stingy buy discipline — which couples proper analysis with a bargain price.

Mecham highlights his disdain for selling via his example of selling Autozone in 2010 — sale he admits was a mistake.

At the time, Autozone (AZO) comprised 18% of the Fund’s portfolio (something we’ll touch on later). Mecham sold at an average price of $155.67/share. Had Mecham held his shares till year end he would’ve seen share prices climb to $272.59/share (that’s good for a 75% increase in price). Hindsight is 20/20, so it’s not the share price increase I want to highlight, but Mecham’s post-mortem analysis on AZO:

We’ve followed and owned AZO for years and admire the intrinsic qualities of the business — a leading market position, durable and counter-cyclical characteristics, strong growth prospects, and an impressive managerial record of capital allocation.

Mecham sold a business with all of these characterisitcs (albeit for another great business in BRKB) and regretted doing so. Hold on to great businesses.

3. Inactivity Is The Key To Success — Learn To Do Nothing

We favor infrequent action (and commentary), patiently waiting for exceptional opportunities. – 2010 Letter

Takeaway #3 is a corollary to the cousin above as you cannot have one without the other.

If you don’t have an ability to be patient, do nothing and wait for opportunities, you’ll never be able to hold on to great businesses. In order to achieve the powerful effects of compounding, inactivity isn’t a preferred skill, it’s a must-have.

Although value investors talk about the necessity for long periods of inactivity, the reasons for doing so are not always clear. Mecham (like most successful value managers) buys only at deeply discounted prices — normally expressed during bouts of extreme pessimism. In his 2014 Letter, Mecham discusses his important practice of sitting on his hands (emphasis mine):

Our office feels more like an abandoned library with a couple of bums loitering around. We have yet to be swayed by the virtues of analyst teams and investment meetings. We’re old school. We mostly just sit around reading, thinking, and waiting. A quip by Stanley Druckenmiller describes our process best: ‘I like to be very patient and then when I see something, go a little bit crazy.

Not only does frequent activity result in reduced performance, but it also translates into higher costs of doing business (i.e., commissions and taxes). But why is inactivity so hard? =Two major reasons come to mind: job security and measurement barometer.

There’s an aura of legitimacy around seeing someone (or a group of people) frantically engaged in work. If you’re paying someone to do a job, your mind will more likely be at ease seeing that person at work. This plays into the first reason why it’s so hard to stay inactive: job security. Most money managers are closet indexers. In other words, they hug the index as close as possible to keep clients’ assets flowing in. And if you put yourself in the shoes of the average money manager — this makes sense. It’s a much easier conversation to have with a client if their assets move in line with the index (going up or down). It’s a much harder talk to have when the market is going up and your portfolio is stagnant (or God forbid down) during the same time frame.

Along with this crutch of job security, most managers — whether through their own blight or from their clients — measure themselves on too short of a time frame. For example, if clients expect you to outperform quarterly or monthly, how will the manager base his/her decisions on investments? Quarterly or monthly measurements leads to overtrading, selling too soon and getting into riskier positions to chase incrementally higher returns over a short time frame. This third takeaway is best surmised with the following quote from Phil Carret:

Turnover usually indicates a failure of judgement. It’s extremely difficult to figure out when to sell anything.

4. Focus On The Long Term — Play For Keeps

Our ideas and policies are all structured with one goal in mind: to cultivate a culture that encourages rational decision making that ultimately leads to solid risk-adjusted returns. – 2012 Letter

If there’s one takeaway that was mentioned the most throughout Mecham’s letters, it was Number 4. Playing for keeps.

Mecham routinely stresses the importance of an owner-like mindset and its impact on long-term investing success. Not only does an owner-like mindset change the time frame as an investor, it forces you to change what you care about when looking at businesses. Focusing on long-term investing (i.e., holding businesses for decades not decimal seconds) leads to a natural decline in the level of importance you place on quarterly results (earnings “beats”), short-term headwinds and temporary compressions in earnings and margins. When you think long-term, all of that doesn’t really matter. More than that, if you keep thinking like this, you’ll start to question why others even ask for quarterly guidance.

Mecham makes this crystal clear when he discusses the long-term mind-set in his 2014 letter, writing (emphasis mine):

First and foremost, we adopt the mentality of a business owner buying for keeps. To us this means thinking about staying power, competitive threats, economics, and  comparing price to value … We don’t think quarterly “beats” are germane to intrinsic value.

In other words, changing the time frame in which you think about investments leads you to spend most of your time thinking about the above items instead of the quarterly metrics that everybody else is so focused on. Mecham drives this point home a couple pages later, claiming:

I believe the biggest difference (and our main advantage) between Arlington and the average fund is our ability to implement a framework of analyzing businesses like long-term owners.

5. Concentration (Not Diversification) Is Vital To Outperformance

The result is a concentrated portfolio that tends to be more volatile than the indices — a situation that’s not well tolerated by lay people and Wall Street alike. – 2010 Letter

The fifth and final takeaway is (arguably) the most important for investors looking to outperform the market over the long-term.

Concentration of assets is as counter-consensus as it gets within the investing community. As I’ve mentioned before, most money managers hug the index, investing in 30, 40 or 100 stocks. This is the recipe for average, something Allan recognized early on in his Fund’s existence.

Mecham keeps a concentrated portfolio of around 12 – 15 businesses. He isn’t afraid to allocate a large percentage of his Fund’s capital to a few select names. For example, we saw earlier where Mecham allocated 18% of his funds to Autozone. Even 18% pales in comparison to Mechem’s largest investment during the course of his letters. In 2011, Mecham made Berkshire Hathaway a 50% position in his Fund. That’s a five zero % position. In fact, Mecham went so far as to go on margin to purchase more shares of Berkshire Hathaway (1.5% margin cost) — leveraging up in his largest Fund position. Most run-of-the-mill managers would be on career suicide watch after a move like that. But, like Mecham illustrates, it made logical sense (emphasis mine):

Conventional fund management holds dogmatic disdain for highly concentrated positions. Needless to say, we hold a different view. To us, as a BRK owner, the contempt for concentration is acutely illogical as BRK provides ample diversity, with exposure to disparate businesses, sectors, and asset allocations.

This logic falls in line with Buffett’s old adage of adequate diversification in which he describes owning a few local businesses in your town as proper diversification. If you own a few of the best operations in town, wouldn’t that be considered properly diversified? Of course. Somehow when venturing into financial markets that same philosophy flies out the window. A portfolio of 10 – 15 strenuously researched companies bought at bargain-bin prices is as low of a risk investment strategy as they come. Mecham stresses this to his LP’s when he pens (emphasis mine):

While our focused portfolio is sometimes criticized by the financial mainstream, we think the judgements lack substance. We are a risk-averse fund looking for low-risk layup-type investments while other funds are akin to a run-and-gun offense that routinely takes a smattering of low-percentage shots.

If you want to beat the market over the long-term, you need to make concentrated bets in companies you believe will earn higher returns on their capital than the general market. Couple these concentrated bets with a long-term time horizon and steadfast determination to do nothing and you’re almost on your way to cloning Allan Mecham.

Here’s the link to all of Arlington Value’s Letters via Focused Compounding.

Lessons From A Trading Great: Linda Bradford Raschke

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I realize that I’m only human, and that I’ll always make mistakes. I just try to make them less frequently, recognize them faster, and correct them immediately!

We can thank Linda Bradford Raschke for that important bit of trading wisdom.  

Only the very best can battle the markets over the long-haul and still come out on top. Linda Bradford Raschke is one of these traders. She’s been at the game for over three decades and still manages to clean up. You probably know the name. She was featured in Schwager’s The New Market Wizards book (hers was the best chapter in your author’s opinion).

If you haven’t already I highly recommend you go and check out her latest book Trading Sardines. It’s a fantastic read, full of humor and valuable trading wisdom from a decorated veteran of the game.

Linda’s traded from all sides of the business; as a market maker in the open outcry pits, as an individual trader for her own account, as well as a fund manager for institutional investors. She’s literally done it all.

In this piece, we’re going to explore Linda’s methods, habits, and practices. We’ll breakdown how she approaches markets and the tools she’s used to make a consistent killing over the years. Let’s jump in!

Linda’s Trading Program

Linda segments her trading between four different strategies (she calls them profit centers). Each profit center has a different approach to the market so that she can diversify her revenue streams. Not all of them bring home the bacon each year, but she counts on at least one of them to make her nut for the year.

LBR Profit Center 1 — S&P Day Trading

S&P day trading is Linda’s bread and butter. 95% of this trading is in the E-mini S&P 500 futures contract as opposed to the other stock index futures like the Rut, DOW and NASDAQ. This was her original program and still to this day, her most consistent producer.

She stresses that successful day trading in the S&Ps requires contextual awareness. Do the odds favor a low to high day or a high to low day? Is it likely a trend day or a consolidation day? Getting this context right makes the trading day much easier.

Linda likes to fade the noisy fluctuations of the S&Ps as the market awaits a big economic report or FOMC release. On light volume days she likes to fade the tests of the intraday range.

But her biggest money maker is on high volume high vol trend days. Once Linda has the market by the tail she presses hard and rides her position into the close. There’s more on her big bet philosophy in the ensuing sections. Her “secret sauce” (like many of the other wizards) is knowing when to size up and “go for the jugular.”

LBR Profit Center 2 — Swing Trading

Her second profit center involves swing trading on the major futures contracts with a 1-3 day holding period. Losers get cut quickly.

For these swing trades, Linda generates entry signals based on 2-period ROCs and other momentum readings. Even with all the fancy computer equipment available, Linda still chooses to manually write down the indicator reading and closing prices for the 24+ futures markets that she tracks. Writing the data down every day helps keep her in tune with the market in a way that just following things on a screen can’t.

LBR Profit Center 3 — Daily and Weekly Classical Charting Trades

The third trading strategy generates profits using classical charting patterns with Peter Brandt style execution. Like Peter, her entry signals are discretionary but she does her best to quantify her process and patterns via ATRs, pivot points, and swing highs and lows.

To manage these trades she likes to use a trailing stop to see how much the market will give. If momentum begins to move against her, she will override the trailing stop and exit the market at the close.

She finds that her best trades come from daily swings turning up or down (false breakouts) rather than the breakouts of chart formations.

Over the course of her career, Linda has noticed that a particular market will give roughly 14-20 reasonable swings per year. Her goal is to just capture one great swing a month. If she does this then she’ll usually have a great year — provided she pulls back her aggressiveness when the market enters a period of low volume churn.

LBR Profit Center 4 — The Everything Else Bucket (Special Situations)

Linda dips into this bucket during severe market dislocations. One of her favorite trades is to fade sentiment extremes with an option structure that allows her to take the other side of consensus fear/greed while keeping her risk capped. For bullish bets she prefers the long call spread, and for bearish bets she deploys the long put spread. This keeps her risk tightly defined in the incredibly volatile market conditions that accompany extremes in sentiment.

She’ll also take seasonality trades under this bucket. Seasonality trades are generated from patterns in the commodity markets. Check out this website for more info on commodity seasonality.

The defining characteristic of this bucket is that the opportunities are rare. And because of that they are not easily modeled.

Rare opportunities usually mean fatter edges because they can’t as easily be arbitraged away by a professional quant firm that uses immense computing power to search for patterns in reams of market data.

That’s the skinny on Linda’s trading setups. But setups are only a small part of what makes a trader of Linda’s caliber. In Trading Sardines she explains how successful trading requires much more than finding a good chart pattern. It’s about having a sound process, robust research methods, solid position sizing, good market reads and a healthy lifestyle away from the trading screen.

A Strong Trading Process

In trading, a good process leads to good profits.

Linda refers to her trading as a business. She uses terms like profit centers and costs. That’s a great way to frame it because one must approach trading with the same seriousness and discipline as one would running a business.

Successful businesses keep meticulous records so they know what’s working and what isn’t. Based on this feedback the leader will adjust fire and calibrate the process appropriately.

Linda does the same for her trading.

She monitors each of her four profit centers on a quarterly basis. Her performance will come from different programs each quarter depending on market conditions. If she finds that one profit center is consistently underperforming she’ll tweak her approach until it starts producing again.

One indicator she likes to look at is trade frequency. If trade frequency for one of her programs comes in way higher or way lower than normal she knows there’s likely an execution error going on. This usually means she’s overtrading, not getting rid of losers quickly enough, or trading while sleep deprived.

We follow a similar protocol here at Macro Ops. Each quarter we review our results and segment them by market and trade strategy type. We discard what’s not working and keep what does.

Another thing all successful businesses have in place is a crisis management plan. Linda has hers for trading. If an execution error occurs she immediately corrects course, no questions asked.

Linda talks about a time where she came into the open incredibly bullish on the S&P E-minis. But instead of going long she accidentally put on a large short. Instead of monkeying around and trying to find the perfect exit to limit her losses, she immediately cut the trade and went long.

“Correct mistakes immediately” has saved Linda millions of dollars over her trading career.

On Models and System Building

Linda has her four core profit centers that work for her — but that doesn’t mean she stops refining her old edges and at the same time searching for new ones.

She is constantly scrutinizing and scouring around for new and improved approaches — the markets force you to continuously adapt or die.

Linda’s not a 100% mechanical trader but she tries to systematize as much as possible to take some mental burden off of herself so she can focus on the tape. Here’s her explaining this in Trading Sardines.

I was never a systems trader though I try to stay systematic. It is hard for me to give up the control I get with tape reading. I don’t want to give up control, period. I would like to believe my experience gives me an edge. But some people will only be able to make money following a system.

She also mentions that if you do use a system it has to be your system. This is in line with what we preach here at Macro Ops. You can’t succeed long-term blindly following somebody else’s approach. Here’s Linda again (emphasis mine).

The problem is, it’s hard to muster the necessary confidence in a system unless you develop it yourself. Systems, even ones that make 100 trades a month, can go through brutal drawdown periods. And if the system isn’t your baby, you’ll abandon it with a loss instead of adhering to it long enough to recover a drawdown.

To vet system ideas Linda is a fan of manual backtesting.

My best work came from testing by hand. I could see where a signal worked and why. I could also look at the conditions where signals failed. When testing with a computer, too much data gets lumped together. This often cancels things out and it is easy to miss the subtle nuances that lead to learning. I’ve learned more by notating signals on charts, studying when signals don’t work, looking for secondary or confirming signs, and recording seas of data by hand. There is no way I could have created my numerous nuanced tactics by backtesting and doing computer runs.

This is exactly how our resident systems trader at Macro Ops, Chris D. does his research.

He’s all about manual backtests so he can develop a feel for the signal and the underlying market. You also see ways to subtly improve things that a computer can’t catch.

Even though Linda is a discretionary trader she likes to build her trade ideas from the base of a model. Here’s why:

Most professional traders know things intuitively from experience. However, we are all subject to different cognitive biases. Models help us keep an open mind and guard against biases. They differ from mechanical systems but are an integral part of the trading process.

It’s possible to trade within the confines of a model or a framework but still allow enough flexibility so your trading is not 100% systematic. Using a model or framework to define trade ideas coupled with manual execution gives you the best of both worlds. The model keeps you from overtrading and the manual execution allows you to make adjustments depending on market conditions.

In Trading Sardines, Linda gives us some advice on how to start the modeling process. For her, it starts by asking some simple questions.

A modeling process starts out by asking simple questions. For example, what happens if you enter on a breakout of the first 15-minute bar after the opening? What is the distribution of how many ticks you can get in the next 15-minute bar? What happens if you enter on a breakout of the 15-minute bar going into the last hour and exit at MOC (market on close)? Is there a distribution pattern showing the most common time for highs and lows? The permutations are endless.

Once you discover the answers to these questions through backtesting and market research you can start to develop a real trading edge that will act as the foundation for your own profit center. Linda makes her models world-class by incorporating new information into each of her trades. This is a form of Bayesian inference — another concept we hound on again and again here at Macro Ops. Here’s Linda (emphasis mine):

Another essential step is to layer on top of our multiple model tree a form of Bayesian process. Start with the prior models and probabilities and then continuously update them as new information unfolds. One data point at a time. To go one step further, we can even weigh these new pieces of information. And as the volume of information increases exponentially, you see how easy it is to fall down a rabbit hole.

In regards to model building Linda offers up some wisdom on how to design exit criteria. She’s a fan of time-based exits.

Much of my modeling uses time-based exits. Exits on the close or the next day’s close, Exit after one hour. Exit when Europe closes. Time-based exits are not dependent on the range or volatility condition, and they are robust.

Instead of exiting based on a predetermined price target, time exits allow you to realize the full strength of the signal. Here’s more on her exit philosophy from her interview in New Market Wizards.

I’m also a firm believer in predicting price direction, but not magnitude. I don’t set price targets. I get out when the market action tells me it’s time to get out, rather than based on any consideration of how far the price has gone. You have to be willing to take what the market gives you. If it doesn’t give you very much, you can’t hesitate to get out with a small profit.

On Position Sizing and the Big Bet

At Macro Ops we’re huge proponents of the Big Bet and there’s a reason for that. All of the trading greats talk about how “going for the jugular” when the stars align with your approach to the markets.

Linda says the same thing in different words (emphasis mine).

When traders think about money management, they think about stops and trade management. But a big part of the equation is knowing when to go all in, increase the leverage and press your trading to the hilt. Load the boat. These opportunities have an increase in volume and volatility. There is no point in actively trading in a dull market. Let the market tip its hand and come to life first. And then if you are fortunate to be in the groove and know you’ve got a tiger by the tail, milk it for all it is worth. This is where the real money is made.

It’s possible to simply “get by” in trading by having an okay edge and proper risk control. But if you want to achieve market wizard status you have to know when to up size and bet big.

Linda’s first ever 7-figure day in the market came from utilizing the big bet strategy on the S&P E-mini contract (emphasis mine).

There is no more glorious feeling in the world than capturing a huge trend day. My first seven-digit day came from a short position in the S&Ps. The market was overbought, the sentiment readings showed too much bullishness, the 2-period rate of change was poised to flip down and my models lined up like a rare planetary alignment.

I had come into the day with a short side bias. When the market started selling off the opening, I added in a big way and held until the close.

I want to stress her planetary alignment comment here. Because this moment is similar to what Druck talks about when he says to go for the “whole hog” or when Warren Buffett mentions “swinging hard at the fat pitch.”

All market opportunities are not created equal which is why position size must vary depending on the expected value of the trade: EV = (Probability of Winning) x (Amount Won if Correct) – (Probability of Losing) x (Amount Lost If Wrong)

When trading a diverse set of markets like Linda it’s paramount to standardize the dollar risk of each contract so each trade risks a similar dollar amount. By not standardizing the risk between markets, the most volatile market will dominate the p&l.

Linda uses the average dollar daily range for each contract she trades in order to get all of her positions sized correctly.

Each quarter, we calculated the average daily dollar range per market. If gold had a 20-dollar average daily range over the previous 30 days, this translated into a $2,000 average daily dollar range. If the S&P e-minis had a 14-point average daily range, this is a $700 average daily dollar range. Gold sizing might be 4 contracts per million. If we had $100 million of AUM, it mean that 1 unit of gold equaled 400 contracts. In the S&P e-minis, 1 unit might be 10 contracts per million or 1000 contracts.

This is otherwise known as volatility-weighted position sizing. This ensures a trader risks similar amounts on each trade. Lower volatility instruments will need more contracts and higher volatility instruments mean fewer contracts. By sizing this way, fluctuations in highly volatile markets will equal the fluctuations in quieter markets.

In markets, there’s a time to play aggressive offense (and place the big bet), and then there’s a time to play aggressive defense. When positions move against you, Linda suggests to taking off size until you can think clearly again.

Whenever you have your back up against the wall, you have to get smaller. Reduce your size to the level where you can start trading again, because in these types of situations when there is uncertainty or unprecedented volatility, there is lots of money to be made. But you can’t do it if you are frozen or stressed, so figure out the level where you can function and trade freely again.

Taking size off when things go south will preserve mental capital and allow you to get ready to pile on again when general conditions favor your bias.

On Market Dynamics

It’s not the actual news that’s important — it’s the market’s reaction to that news that is most important to a trader.

Linda talks about this concept and gives guidance on how to best trade news driven moves.

If positive economic news is released and the market sells off on that news, this could also be perceived as an aberration. It is a divergence from what would normally be expected. But this, too, is the market’s way of imparting powerful information. In this case, it may be that there are no buyers left, or that the news has been long discounted.

Trade in the direction of the aberration. The market is never too high to buy or too low to sell.

Trading mastery requires a thorough understanding of the boom/bust process that plays out over and over again in public markets. Linda has studied the underlying dynamics of the boom/bust process to give her the confidence to trade bubbles when they are about to pop (emphasis mine).

There was a study done on price behavior when the field of behavioral finance was just coming on the scene. It simulated trading with groups of individuals who were not traders. The price of the market would always rise first. It kept inching higher until everyone had bid and there was nobody left to buy. At that point, it broke sharply with no support underneath.

To this day, this is one of the main reasons markets sell off—there is nobody left to buy.

That’s why at Macro Ops we are such huge fans of sentiment indicators. Sentiment indicators tell us when there is “no one left to buy.” Periods of extreme optimism set the stage for gut-wrenching selloffs. Linda exploits this same edge in her profit center 4 through the use of call spreads or put spreads.

On The Trifecta Approach: Combining Fundamentals and Technicals

The best traders in the game pull data and information from numerous sources to construct a trading thesis. Linda uses the “Marcus Trifecta” approach in her trading by first finding fundamental market imbalances and then entering the market via technical analysis cues.

She made tons of money trading the yen using this multi-faceted approach. Here’s an excerpt from Trading Sardines which describes the trade in more detail (emphasis mine).

The “carry trade” was a popular strategy from 2002-2007. Investors borrowed money in yen where interest rates were low and invested it in higher-yielding currencies. It was a crowded trade, meaning too many people were in this same position. What was going to happen when people needed to unwind?

I trade by technicals since I have not yet had much luck using fundamentals. But I am aware when there is a market imbalance implying a crowded trade. The yen was a ripe situation. It has left a bear trap or false downside breakout on the weekly charts. I tried twice to put on a position, both times unsuccessful. The third time I knew I got it right. It was our signal to load up. I don’t mind trying a few times if there is a basis for a position but the timing is off. The real key is to make it pay and use maximum leverage when the trade starts working. I told Judd to keep buying yen, and the ensuing rally made our year. The yen went straight up for the next five years as global interest rates came crashing down.

On Trading Lifestyle

Grinding an initial capital stake into millions of dollars takes time. Fortunes aren’t made overnight in the trading business. The big money is made by finishing the marathon, not the sprint.

Linda makes this clear and lays out many lifestyle strategies that maximize your chances of making a  real fortune from trading the markets.

She used the following three things over her long career to keep her mind and body fresh and ready to battle the markets day in and day out.

  • Gratitude practice
  • Physical fitness
  • Time off

The markets are volatile beasts which mean they will send your emotional brain into a whirlwind. In order to combat the push/pull of these emotions, Linda uses a gratitude practice to keep her grounded when things go wrong.

Gratitude is a key ingredient of success. It means that even when bad things are happening, you always have something to focus on. Just like pilots have a gauge to make sure they can still tell which way is up, gratitude keeps me from ever feeling upside down. When you are trading the markets, you have to have a separate source of happiness —- to know that there are still wonderful things all around, most of which do not require money. It is easier to take risks when you remove your personal happiness and well-being from the equation.

Gratitude leads to optimism, and a positive attitude is 90% of the game.

Linda was extremely active in the gym and even competed as a bodybuilder! The discipline required for her to compete in bodybuilding carried over into her trading program.

Trading and physical training have a lot in common. Every successful training routine requires the following:

  • A sound methodology
  • Consistent execution of that methodology through the use of daily rituals
  • Records of progress
  • Positive thinking and optimism

These are the exact same things needed to succeed in the trading grind! So if you aren’t already, get in the gym!

Finally, Linda recommends taking time away from the trading screens to refresh and recharge. A hobby helps to relieve stress. For her, this was horseback riding.

LBR has the whole package of a legendary trader — a burning desire to win, emotional fortitude to withstand the ups and downs of a trading career and the ability to “go for the jugular” when the market required it.

I want to end this piece with her advice on how to find success as a new trader (emphasis mine).

Understand that learning the markets can take years. Immerse yourself in the world of trading and give up everything else. Get as close to other successful traders as you can. Consider working for one for free. Start by finding a niche and specializing. Pick one market or pattern and leam it inside out before expanding your focus.

Finally, remember that a trader is someone who does his own work, has his own game plan, and makes his own decisions. Only by acting and thinking independently can a trader hope to know when a trade isn’t working out. If you ever find yourself tempted to seek out someone else’s opinion on a trade, that’s usually a sure sign that you should get out of your position.

Well said Linda… Now time to get to work!

If you liked this article, you will love Lessons From The Trading Greats Volume 1 which has more insight from the world’s best traders. Click here for a free copy!

The Chandler Brothers: The Greatest Investors You’ve Never Heard of

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Two secretive brothers from New Zealand have perhaps THE best long-term track record in the investing world. Starting in 1986, the two turned $10 million of family money into over $5 billion just 20-years later. That’s an astounding 36% CAGR.

Compare that with Buffett (19% over 50yrs), Klarman (20% over 34yrs), Lynch (29% over 13yrs),  Soros and Druckenmiller both around (30% over 30yrs).

Yet, hardly anybody has ever heard of these guys. I live and breathe markets and I just came across them for the first time this year.

This is by design.

The two brothers have gone to great lengths over the years to maintain a low profile and keep their faces out of the news. It wasn’t until 2006 that they chose to give their first and only substantial interview. It was with Institutional Investor (link here), and they only agreed to the interview so they could counteract bad press they were receiving from Korean media over a failed activist push by the two to upseat management at a Korean Chaebol.

They were amongst the first investors to plunge into emerging markets like Russia, Brazil, and the Czech Republic. They are sons of a WWII veteran who ran a beekeeping business with Edmund Hillary (yes, that Edmund Hillary), before starting what became New Zealand’s most upscale department store.


They are the Chandler brothers: Richard and Christopher. They ran the Sovereign Global Fund for 20-years (the two have since split off to manage their own money with Legatum and Clermont Capital).

To follow is a profile of the brothers along with some of the secrets they’ve shared in how they look at and invest in markets — also, some commentary and case studies of their investments by me. (All quotes are from the Institutional Investor interview unless otherwise noted).

First, some quick background on the brothers and their unusual origin story (emphasis by me).

The Chandler’s investing background is anything but conventional. The brothers grew up in Matangi, a rural town outside the provincial city of Hamilton in the dairy farming country of New Zealand’s north island. Their Chicago-born grandfather had emigrated to New Zealand in the early 1900s, gone into advertising and married his secretary. He died of an allergic reaction when his third son, Robert, was just one year old.

Although he never knew his father, Robert was profoundly marked by the American success literature he had left behind, notably the books of Orison Swett Marden, an early-20th-century American journalist and author who inspired such proponents of “positive thinking” as Dale Carnegie and Norman Vincent Peale. Robert’s sons were deeply influenced by this worldview as well. We are great believers in the idea of having audacious goals, breaking out and doing something out of the ordinary,” says Richard. “It’s helped us turn what most people consider a mere profession into a vocation and, beyond that, an art, where we frequently put ourselves in harm’s way.”

In 1972, Robert and his wife Marija, started a department store called the Chandler House which quickly became a booming business. This is where the two brothers, Richard and Christopher, began learning the skills of business and investing.

Richard and Marija employed their two sons at the store when not away at boarding school. The two worked sales and helped their father balance the books on the weekend. They also accompanied their mother on buying trips where they learned the key principles on how to buy right (more on this below).

Richard referred to his mother as “the most brilliant business person I’ve ever met who taught us many of the key principles we follow as investors”. Two of these key principles were, “Never buy something unless you know to whom you can sell it” and “Buy as much as possible in a narrow range of hot items.” Richard said his mother “was able to identify the best opportunities and be the master of narrow and deep and that, with stocks, we do the same thing. We back our beliefs to the hilt.

The two brothers were essentially getting an MBA when they were only kids. This undoubtedly helped shaped them into the two market masters they are today.

After college, Richard and Christopher took over the family business and rapidly expanded its size. And in 1986 they sold it for $10m which they then used to launch their fund Sovereign Global. Richard remarked on the decision to the sell the family business that, “Basically, we said, ‘Let’s do something that we love to do, not just something that we are good at.” That something they loved, was investing…  

The fund’s first investment serves as a perfect example of the style that would typify the brother’s approach. And that’s contrarian to the extreme and highly concentrated. Narrow and deep just like their mother taught them.

The two poured nearly the entire family fortune into just four Hong Kong office buildings in 1987.

That year the property market in Hong Kong was in dire straights. Real estate prices were down roughly 70% from their 81’ peaks. Britain’s lease on the territory was due to lapse in the coming decade and according to Richard, “The feeling was that China was going to take over Hong Kong, so most investors said, ‘Who cares?”.

The sentiment at the time was that the island was uninvestable. Here’s a few Newspaper headlines from the year.

This pervasive negative sentiment and over extrapolation of recent trends is what drew the two brothers to the place.

They objectively studied the fundamentals and came away with a variant perception. Richard remarked on the time that, “We had read the treaty, and it promised the status quo for 50 years, and we believed it. Even more important, rents were rising, and rental yields exceeded interest rates by 5 percentage points, which guaranteed that any investment would more than pay for its financing costs.”

The brothers leveraged up and paid $27.6 million for D’Aguilar Place, a 22-story building. They then renovated the place which allowed them to triple rents over just three years, which gave them the cash to acquire more buildings.

Low and behold, Hong Kong didn’t immediately become a communist despot as many feared. The property market recovered and the brothers sold their buildings for $110m, pocketing over $40m after paying off creditors; quadrupling their fund’s NAV in just over four years time.

The brothers also invested in Hong Kong stock index futures during this time which they viewed as another way to play the recovery in the property market, as the Hang Seng was mostly made up of real estate companies. But in the middle of the the crash of 87’ their stop losses were hit and the brother’s were forced to close out the position. The following week markets crashed around the world and the brother’s narrowly escaped a major loss.

Richard said they learned from this experience that “if you get lucky once, don’t press your luck.” It also gave the brothers an aversion to using leverage. Being unlevered “enabled the Chandlers to take a long-term view of risky markets, their key competitive advantage at a time when many investors, particularly highly leveraged hedge funds, invest with a short-term horizon.” A long-view is a critical part of their philosophy, as Richard notes the brothers “like investments where the risk is time, not price.”

With their recent winnings in Hong Kong the brothers went looking in emerging markets. Richard recalled that “The fax machine was becoming very popular” and “we felt that value was moving from real estate to communications. So we researched it and found that Telebras was the cheapest telecom company in the world.”

It was here that they ran into some analysis problems which led to them developing a unique valuation method which they would use again and again throughout their careers.

At the time, Brazil’s hyperinflation had rendered earnings and P/E ratios absolutely meaningless. So they had to turn to “creative metrics — in this case, market capitalization per access line. Telebras, the nation telephone monopoly, was trading at about $200 per line, compared with $2,000 for Mexico’s Teléfono de México and an average cost of $1,600 for installing a line in Brazil. The brothers bet that the government of then president Fernando Collor de Mello would liberalize the economy and open the country up to foreign investment.”

This practice of using unique metrics to compare and discern value is an important piece of what Richard calls “the ‘delta quadrant’ — transition economies or distressed sectors where information is not easily available and standard metrics don’t apply.”

After obtaining government permission to invest in Brazilian equities (Sovereign was one of the first foreign investors in the country) the brothers put $30m —  roughly 75% of their fund — into Telebras shares in 1991 and a smaller amount into Electrobras, an electric utility.

This was an even more contrarian bet than Hong Kong was. Not only was sentiment in the dumps in Brazil (news clipping from 91’ below) but foreign investors weren’t even looking at opportunities there. The Chandler brothers were walking their own path.

Once Collor de Mello began cutting the budget deficit and opening the market to foreigners, Brazilian equities tripled. But soon “Collor de Mello was… caught in a massive kickback scheme and was impeached that April. Stocks swooned, falling 60 percent over the next eight months. Most foreign investors fled the market, but the Chandlers sat tight.”

Richard recalls the selloff saying, “As far as we were concerned, the shock was external to the fundamentals of the company… Telebras had simply gone from extremely undervalued to outrageously undervalued.”

By 93’ the market recovered and the Chandlers sold out of their position later that year. The brothers more than 5x’d their initial investment in under 3-years, boosting their fund to more than $150m. Richard said the experience of riding out the volatility helped them “build our emotional muscles, helping us to make it through major market falls and grind through the trying times without losing our equilibrium.”

The brothers continued their run of highly concentrated and extremely contrarian investing with forays into Eastern Europe, South Korea, and Russia. Always going into markets and investing in assets that no one else would touch.

Another great example of their approach is their big bet on Japanese banks in the early 2000s. Institutional Investor writes that “In November 2002, with Japan slipping back into recession after a decade of stagnation and with stocks at 20-year lows — the Nikkei 225 index was more than 78 percent below its 1989 peak — the country’s banks were wallowing in bad debt.” It was under this backdrop that the Chandlers began loading up on shares in the sector.

The two bought a $570m stake in UFJ Holdings, “which had posted a staggering loss of $9.3 billion in its latest year. The pair went on to buy more than 3 percent of Mizuho Financial Group as well as stakes in Sumitomo Mitsui Banking Corp and Mitsubishi Tokyo Financial Group… Altogether they spent about $1 billion on their spree.”

“The banks were priced for a total wipeout of equity holders,” says Sovereign’s broker at the time at Nikko Citigroup, John Nicholis. “We were advising our clients to stay away from the sector.

Here’s a few headlines from the time showing the negative consensus of the time.

Like in Brazil, the brothers had to be creative in the metrics they used to value the banks since they didn’t have any “earnings on which to base multiples, and uncertainty about the extent of bad loans made it difficult to forecast a turnaround.”

So instead, the team looked at “market capitalization as a percentage of assets; on this daily basis they determined that UFJ and other megabanks traded at about 3 percent, compared with 15 percent for Citigroup at the time. The Chandlers concluded that Japan would have to nationalize the banks or reflate the economy with low interest rates, and bet — correctly, as it turns out — on the latter scenario.”

After riding out a near 50% decline from when they began building their position the Chandler brothers rode the stock all the way back up to new multi-year highs. They were still sitting in the stock in 2006 (when the II interview was conducted).

In talking about their big win in Japan, Richard said that, “Most fund managers are focused on what can go wrong rather than on what can go right and were too afraid to make that call. We were not.

Talk about having courage in your convictions. These guys must have to push around a wheelbarrow to haul their giant cojones around.

Richard helps shed light on how he and his brother are so effectively greedy when others are fearful in sharing one of his favorite sayings from Investor Philip Carret, who said it is essential “to seek facts diligently, advice never.” Richard explains: “Money managers have to account for their actions to their shareholders, which means they have an undue fear of underperformance. We invest only our own money. Our investment decisions are driven by optimism, not fear.

Once they establish the conviction they then have the optimism and courage to buy in size. II writes:

The brothers also prize scale, believing that the way to achieve outsize returns is to make a few big bets — Sovereign usually holds fewer than ten stocks — rather than manage a diverse portfolio. The Chandlers favor large-cap stocks in big countries. “If you are invested in big companies in big countries, that means there is a ready audience of benchmark-following investors who must buy the asset,” says Richard. “By buying big — going narrow and deep, as opposed to diversifying — you maximize your success.

Sovereign usually holds fewer than ten equity positions at any one time. Though it typically holds its larger positions for two to five years, the firm regularly trades in and out of some stocks to test the waters and take advantage of price movements.

It’s very important to note that this isn’t dumb blind conviction. You’re not a smart contrarian by just buying a hated falling asset. The crowd could be correct and the underlying could be worth much less than what it’s selling for.

The Chandlers lived and breathed business from the time they were children. Richard had a degree in accounting and a masters in Commercial studies. After college he worked for a big accounting firm where a coworker recounted his “incredible intellectual capacity and enormous, almost unbelievable thirst for knowledge. He used every project we work on as an experience to learn a new business model.”

These two know businesses. They know what’s important and the things to look for in valuing them. They know how to correctly assess a prospects margin of safety in relation to its upside.

Richard said, “Our talent is to understand the long-term potential of a business” and “the market gives you the opportunity to arbitrage what the emotional investor will pay or sell at versus the fundamental value of a company, but you’ve got to pull the trigger promptly without hesitating… We’ve disciplined ourselves mentally and prepared ourselves in terms of information, as well as relationships with brokers, to do that.”

Lessons From the Chandler Brothers

To make these types of long-term outsize returns, you have to go NARROW and DEEP.

That means putting large portions of your portfolio into just a few high conviction trades, the veritable fat pitches, when they come along.

We call this Fat-Tail Exploitation Theory, or FET for short. And it flys in the face of all the conventional wisdom that espouses the wonders of diversification. Druckenmiller talked about the importance of FET when he said the following:

The first thing I heard when I got in the business, from my mentor, was bulls make money, bears make money, and pigs get slaughtered.

I’m here to tell you I was a pig.

And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

And Barton Briggs touched on it in his book Hedgehogging when writing about his friend and macro fund manager, Tim.

To get really big long-term returns, you have to be a pig and ride your winners… When he lacks conviction, he reduces his leverage and takes off his bets. He describes this as “staying close to shore… When I asked him how he got his investment ideas, at first he was at a loss. Then, after thinking about it, he said that the trick was to accumulate over time a knowledge base. Then, out of the blue, some event or new piece of information triggers a thought process, and suddenly you have discovered an investment opportunity. You can’t force it. You have to be patient and wait for the light to go on. If it doesn’t go on, “Stay close to shore.”

A reason why FET is key to delivering outsized returns is because of the underlying power laws that are embedded in markets. Pareto’s law of 80/20, or in markets it’s more like 90/10 or 95/5 even, which means that 90% of your returns will come from 10% or fewer of your trades.

Just take a look at the profile of Sovereign’s returns. Over a 15-year period just five investments generated 90% of their returns (chart via II).

There are two keys to this.

One is that you can’t force it and you have to really really know your stuff or else you’re assuming blind risk and opening yourself up to financial ruin. The Chandler brothers understand businesses inside and out. They could cut through the fluff in laser like fashion and get to the meat of the issue when evaluating companies.

Second is time. Fat pitches like these don’t come around often. The Chandlers would go years in between big investments without risking any substantial amount of money. Michelangelo once said that, “Genius is infinite patience” well the corollary to that in investing is that infinite patience is success.

Joel Greenblatt said this about the need for patience and taking a big picture view of things:

Legg Mason’s Bill Miller calls it time arbitrage. That means looking further out than anybody else does. All of these companies have short-term problems, and potentially some of them have long-term problems. But everyone knows what the problems are.

Next there is contrarianism.

The Chandler brothers made it a point to set up shop in Dubai and Singapore, far away from the financial centers of the world in New York and London. They did this because they didn’t want to fall victim to the powerful pull of groupthink and herd mentality.

Being able to look at the same situation as the market and form a variant perception lies at the heart of how they uncover highly asymmetric trades. A good way to develop a variant perception is to take a page from the Palindrome, George Soros, who said:

The generally accepted view is that markets are always right — that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite view. I believe the market prices are always wrong in the sense that they present a biased view of the future.

As humans we all have the tendency to get wrapped up in the hysteria and be seduced by compelling narratives, especially when the components of fear or greed are present. But it’s in these situations where the narrative has driven the market to extrapolate trends ad infinitum, driving prices to ridiculous levels, that create the environment where amazingly asymmetric bets exist.

You need to step back, objectively sift through the data yourself, and develop a big picture view of things. This is what Templeton referred to as “the point of maximum pessimism” which Bill Miller explains here:

The securities we typically analyze are those that reflect the behavioral anomalies arising from largely emotional reactions to events. In the broadest sense, those securities reflect low expectations of future value creation, usually arising from either macroeconomic or microeconomic events or fears. Our research efforts are oriented toward determining whether a large gap exists between those low embedded expectations and the likely intrinsic value of the security. The ideal security is one that exhibits what Sir John Templeton referred to as “the point of maximum pessimism.”

And lastly, you need to be creative and think out of the box in order to form a variant perception and see a future different from the one in which the crowd is pricing in.

The Chandler brothers used “creative metrics” and the point is that it’s not rocket science. But it does mean you need to do the thinking, do the work, and come to your own conclusions. Great opportunities aren’t found in a simple screen or low P/E. They exist BECAUSE they are difficult to find, to comprehend, to value. Greenblatt says it like this:

Explain the big picture. Your predecessors (MBAs) failed over a long period of time. It has nothing to do about their ability to do a spreadsheet. It has more to do with the big picture. I focus on the big picture. Think of the logic, not just the formula.

Narrow and Deep. Contrarian. And think of the logic, not just the formula…



My Notes on the Druckenmiller Real Vision Interview

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Alex here.

The Druckenmiller Real Vision interview is well worth the watch if you have a subscription and 90 minutes to spare. And if you don’t, you’re in luck because I’m sharing with you my notes along with some of my thoughts on what the GOAT said.

Let’s begin…

The start of the interview was by far my favorite part and really blew me away.

Stanley Druckenmiller opened the conversation by looking straight into the screen and then spoke some words I’ll never forget. He said, “Alex Barrow, I am your real biological father…” My jaw dropped even though this was something I’ve always kind of suspected. I mean, just look at the photo of me and my dog below. The resemblance is pretty uncanny. It’s nice to finally know the truth for certain.

Now that I’m done showing off my photoshopping skills, let’s get to the real stuff.

13D founder, Kiril Sokoloff, leads the interview and he and Druck discuss a wide range of topics including his views on the current macro environment, the diminishing signal of price action due to the rise of algorithmic trading, central bank policy, and then my favorite which was his thoughts on trade and portfolio management.

Here’s Druck talking about the difficulty he’s been having in this low rate environment, and how he’s made the vast majority of his money in bear markets (with emphasis by me).

Yeah, well, since free money was instituted, I have really struggled. I haven’t had any down years since I started the family office, but thank you for quoting the 30-year record. I don’t even know how I did that when I look back and I look at today. But I probably made about 70% of my money during that time in currencies and bonds, and that’s been pretty much squished and become a very challenging area, both of them, as a profit center.

So while I started in equities, and that was my bread and butter on my first three or four years in the business, I evolved in other areas. And it’s a little bit of back to the future, the last eight or nine years, where I’ve had to refocus on the equity market. And I also have bear-itis, because I made– my highest absolute returns were all in bear markets. I think my average return in bear markets was well over 50%. So I’ve had a bearish bias, and I’ve been way too cautious the last, say, five or six years. And this year is no exception.

It’s no secret the central bank suppressed rate environment has hurt practitioners of old school macro, such as Druck and PTJ. When these guys began their careers they could park their money in 2-year rates and capture high single to double-digit rates.

Not only did this jack up their returns but higher interest rates and inflation caused more volatility and action in markets. And exploiting volatility is the lifeblood of old school macro traders. Like Druck said, he made his highest returns during bear markets.

The last decade of extremely low-interest rates and dovish Fed policy has suppressed volatility, leading to smoother trend paths. This has led to more capital flowing into passive indexing and less to active managers, which in itself helps to extend the trend of less volatile markets; at least to a point.

Eventually, this low rate regime will reverse. We’ll see higher inflation and a secular rise in interest rates. In fact, this is one my highest conviction ideas for the next secular cycle. The massive debt and unfunded obligations in developed markets, along with the secular rise in populism, nearly ensures that we’ll see profligate government spending and competitive devaluations in the decade ahead.

So we’ll see the rise of volatility and an environment conducive to old school macro once again!

Here’s Druck discussing the major macro thematics he’s been tracking this year.

I came into the year with a very, very challenging puzzle, which is rates are too low worldwide.

You have negative real rates. And yet you have balance sheets being expanded by central banks, at the time, of a trillion dollars a year, which I knew by the end of this year was going to go to zero because the US was obviously going to go from printing money and QE to letting $50 billion a month, starting actually this month, runoff on the balance sheet. I figured Europe, which is doing $30 billion euros a month, would go to zero.

So the question to me was, if you go from $1 trillion in central bank buying a year to zero, and you get that rate of change all happening within a 12-month period, does that not matter if global rates are still what I would call inappropriate for the circumstances? And those circumstances you have outlined perfectly. You pretty much have had robust global growth, with massive fiscal stimulus in the United States, where the unemployment rate is below 4. If you came down from Mars, you would probably guess the Fed funds rate would be 4 or 5/ and you have a president screaming because it’s at 175.

I, maybe because I have a bearish bias, kind of had this scenario that the first half would be fine, but then by July, August, you’d start to discount the shrinking of the balance sheet. I just didn’t see how that rate of change would not be a challenge for equities, other than PEs, and that’s because margins are at an all-time record. We’re at the top of the valuation on any measures you look, except against interest rates. And at least for two or three months, I’ve been dead wrong.

So that was sort of the overwhelming macro view. Interestingly, some of the things that tend to happen early in a monetary tightening are responding to the QE shrinkage. And that’s obviously, as you’ve cited, emerging markets.

We talked about this obvious market mispricing in our latest MIR, The Kuhn Cycle (Revisited). The old narrative of low rates for longer had become extremely entrenched. And this narrative consensus has created a certain amount of data blindness, as is typical with popular and enduring narratives. This data blindness has led to a large mispricing of interest rates, particularly in developed markets.

Where things get interesting is all the corollaries that stem from a low rate narrative like this. Think of the billions of dollars that have poured into private equity over the last decade. The current PE model is predicated on the assumption of interest rates staying low, which is needed for their businesses’ long-term funding needs and justification for their sky-high valuations etc…

A really interesting section of the interview is when Druck talks about the diminishing signaling value in price action. He says:

The other thing that happened two or three months ago, mysteriously, my retail and staple shorts, that have just been fantastic relative to my tech longs, just have had this miraculous recovery. And I’ve also struggled mightily– and this is really concerning to me. It’s about the most trouble I’ve been about my future as a money manager maybe ever is what you mentioned– the canceling of price signals.

But it’s not just the central banks. If it was just the central banks, I could deal with that. But one of my strengths over the years was having deep respect for the markets and using the markets to predict the economy, and particularly using internal groups within the market to make predictions. And I think I was always open-minded enough and had enough humility that if those signals challenged my opinion, I went back to the drawing board and made sure things weren’t changing.

There are some great nuggets in here. I’ve long thought that one of the most important skill sets of a great trader — and something Druck has in spades — is to be extremely flexible mentally; never marrying oneself to a viewpoint or thesis and continuously testing hypotheses against the price action of the market.

Market Wizard Bruce Kovner said he owed much of his success to this, saying:

One of the jobs of a good trader is to imagine alternative scenarios. I try to form many different mental pictures of what the world should be like and wait for one of them to be confirmed. You keep trying them on one at a time. Inevitably, most of these pictures will turn out to be wrong — that is, only a few elements of the picture may prove correct. But then, all of a sudden, you will find that in one picture, nine out of ten elements click. That scenario then becomes your image of the world reality.

And Livermore noted the importance of flexibility when he wrote, “As I said before, a man does not have to marry one side of the market till death do them part.”

Now compare this to the “Fintwit experts” who have peddled a doom and gloom outlook for the last 7 years without ever taking a step back to maybe rejigger the models they use to view the world, which have been so consistently wrong.

Anyways, Druck then goes on to lay out the cause behind the diminishing power of price signals.

These algos have taken all the rhythm out of the market and have become extremely confusing to me. And when you take away price action versus news from someone who’s used price action news as their major disciplinary tool for 35 years, it’s tough, and it’s become very tough. I don’t know where this is all going. If it continues, I’m not going to return to 30% a year any time soon, not that I think I might not anyway, but one can always dream when the free money ends, we’ll go back to a normal macro trading environment.

The challenge for me is these groups that used to send me signals, it doesn’t mean anything anymore. I gave one example this year. So the pharmaceuticals, which you would think are the most predictable earning streams out there– so there shouldn’t be a lot of movement one way or the other– from January to May, they were massive underperformers. In the old days, I’d look at that relative strength and I’ll go, this group is a disaster. OK. Trump’s making some noises about drug price in the background.

But they clearly had chart patterns and relative patterns that suggest this group’s a real problem. They were the worst group of any I follow from January to May, and with no change in news and with no change in Trump’s narrative, and, if anything, an acceleration in the US economy, which should put them more toward the back of the bus than the front of the bus because they don’t need a strong economy.

They have now been about the best group from May until now. And I could give you 15 other examples. And that’s the kind of stuff that didn’t used to happen. And that’s the major challenge of the algos for me, not what you’re talking about.

Well, I’ll just, again, tell you why it’s so challenging for me. A lot of my style is you build a thesis, hopefully one that no one else has built; you sort of put some positions on; and then when the thesis starts to evolve, and people get on and you see the momentum start to change in your favor, then you really go for it. You pile into the trade. It’s what my former partner George Soros was so good at. We call it– if you follow baseball, it’s a slugging percentage, as opposed to batting average.

Well, a lot of these algos apparently are based on standard deviation models. So just when you would think you’re supposed to pile on and lift off, their models must tell them, because you’re three standard deviations from where you’re supposed to be, they come in with these massive programs that go against the beginning of the trend. And if you really believe in yourself, it’s an opportunity. But if you’re a guy that uses price signals and price action versus news, it makes you question your scenario.

So they all have many, many different schemes they use, and different factors that go in. And if there’s one thing I’ve learned, currencies probably being the most obvious, every 15 or 20 years, there is regime change. So currency is traded on current account until Reagan came in and then they traded on interest differentials. And about five years, 10 years ago, they started trading on risk-on, risk-off. And a lot of these algos are built on historical models. And I think a lot of their factors are inappropriate because they’re missing– they’re in an old regime as opposed to a new regime, and the world keeps changing. But they’re very disruptive if price action versus news is a big part of your process, like it is for me.

If you’ve been trading for any significant amount of time then you’ve certainly noticed the change in market action and tone due to the rise of algorithmic trading over the last decade. There’s often little rhyme or reason behind large inter-market moves anymore. Moves can simply happen because, as Druck said, algos that run on standard deviation models determine one sector has advanced too much relative to another, so the computers start buying one and sell another.

What we can do as traders now is to evolve and adapt. Work to understand what the popular models are that drive these algos so we can understand when they’re likely to buy and sell.

Also, I love his line about how he works to build a thesis and a position when he says:

A lot of my style is you build a thesis. Hopefully, one that no one else has built; you sort of put some positions on; and then when the thesis starts to evolve, and people get on and you see the momentum start to change in your favor, then you really go for it. You pile into the trade.

This a great lesson in trade management and how to build into a position using the market as a signal.

Druck also talked about Google (one of our largest positions) and reveals how he looks at some of the tech stocks that are popularly thought of as “overvalued” by the market.

I guess, let’s just take Google, OK, which is the new bad boy, and they’re really a bad boy because they didn’t show up at the hearing. They had an empty chair because they only wanted to send their lawyer.

But it’s 20 times earnings. It’s probably 15 times earnings after cash, but let’s just say it’s 20 times. Let’s forget all that other stuff. And they’re under earning in all these areas, and losing money they could turn it off. And then I look at Campbell’s Soup and this stuff selling at 20 times earnings.

And they’re the leaders in AI– unquestioned leaders in AI. There’s no one close. They look like they’re the leaders in driverless car. And then they just have this unbelievable search machine. And one gets emotional when they own stocks, when they keep hearing about how horrible they are for consumers.

I wish everyone that says that would have to use a Yahoo search engine. I’m 65, and I’m not too clever, and every once in a while, I hit the wrong button and my PC moves me into Yahoo. And Jerry Yang’s a close friend so I hate to say this, but these things are so bad.

And to hear the woman from Denmark say that the proof that Google is a monopoly and that iPhones don’t compete with Android is that everyone uses the Google search engine is just nonsense. You’re one click away from any other search engine.

I just I wish that woman would have to use a non-Google search engine for a year– just, OK, fine, you hate Google? Don’t use their product, because it’s a wonderful product. But clearly, they are monopolies. Clearly, there should be some regulation. But at 20 times earnings and a lot of bright prospects, I can’t make myself sell them yet.

Kiril then asks Druck about portfolio construction and how he builds positions, which was one of my favorite parts of the interview.

Kiril: When you worked with Soros for 12 years, one of the things that you said you learned was to focus on capital preservation and taking a really big bet, and that many money managers make all their money on two or three ideas and they have 40 stocks or 40 assets in their portfolio.

And it’s that concentration that has worked. Maybe you could go into that a bit more, how that works, how many of those concentrated bets did work, when you decided to get out if it didn’t work, do you add when the momentum goes up assuming the algos don’t interfere with it?

Druck: As the disclaimer, if you’re going to make a bet like that, it has to be in a very liquid market, even better if it’s a liquid market that trades 24 hours a day. So most of those bets, for me, invariably would end up being in the bond and currency markets because I could change my mind. But I’ve seen guys like Buffett and Carl Icahn do it in the equity markets. I’ve just never had the trust in my own analytical ability to go in an illiquid instrument, which in equity is if you’re going to bet that kind of size on– you just have to be right.

But to answer your question, I’ll get a thesis. And I don’t really– I like to buy not in the zero inning and maybe not in the first inning, but no later than the second inning. And I don’t really want to pile on in the third or fourth or fifth inning.

But even against the dollar, it’s not all-in right away. Normally, I’ll wait for– I’ll go in with, say, a third of a position and then wait for price confirmation. And when I get that, when I get a technical signal, I go.

I had another very close experience with the success of the Deutschmark, which was the euro. I can’t remember– I think it was 2014 when the thing was at 140, and they went to negative interest rates. It was very clear they were going to trash that currency, and the whole world was long the euro. And it would go on for years. I’d like to say I did it all at 139, and I did a whole lot, but I got a lot more brave when it went through to 135. And that’s a more normal pattern for me.

We write a lot about the importance of concentrating your bets due to the natural power law distribution of returns (here’s a link).

This part of the interview was great because it shows how Druck uses a confluence of factors to leg into a trade. He says he develops a theory then waits for the market to begin to validate that theory and he puts a small (usually ⅓ position on). He then waits for further market confirmation that he’s correct (he calls this point the second inning) at which time he piles in and goes for the jugular.

The chart below illustrates perfectly his short EURUSD trade.

Here’s Druck talking about the 2000 tech bubble and what made him turn bearish.

Then there would be this strange case of 2000, which is kind of my favorite, and involves some kind of luck. I had quit Quantum, and Duquesne was down 15%. And I had given up on the year and I went away for four months, and I didn’t see a financial newspaper. I didn’t see anything.

So I come back, and to my astonishment, the NASDAQ has rallied back almost to the high, but some other things have happened– the price of oil is going up, the dollar is going way up, and interest rates were going up— since I was on my sabbatical. And I knew that, normally, this particular cocktail had always been negative for earnings in the US economy. So I then went about calling 50 of my clients– they stayed with me during my sabbatical– who are all small businessmen. I didn’t really have institutional clients. I had all these little businessmen. And every one of them said their business was terrible.

So I’m thinking, this is interesting. And the two-year is yielding 6.04, not that I would remember, and Fed funds were 6 and 1/2. So I start buying very large positions in two and five-year US treasuries. Then, I explained my thesis to Ed Hyman, and I thought that was the end of it. And three days later, he’s run regression analysis– with the dollar interest rates and oil, what happens to S&P earnings? And it spit out, a year later, S&P earnings should be down 25%, and the street had them up 18.

So I keep buying these treasuries, and Greenspan keeps giving these hawkish speeches, and they have a bias to tighten. And I’m almost getting angry. And every time, he gives a speech, I keep buying more and more and more. And that turned out to be one of the best bets I ever made. And again, there was no price movement, I just had such a fundamental belief. So sometimes it’s price, sometimes it’s just such a belief in the fundamentals.

Higher oil, higher dollar, and higher interest rates is likely to eventually lead to a negative earnings surprise for us as well; though that’s probably at least a few quarters if not further away.

Kiril then asks Druck about how he manages a drawdown. What he does emotionally and practically to stage a comeback.

Kiril: One of the great things I understand you do is when you’ve had a down year, normally a fund manager would want to get aggressive to win it back. And what you’ve told me you do, you take a lot of little bets that won’t hurt you until you get back to breakeven. It makes a tremendous amount of sense. Maybe you could just explore that a little bit with me.

Druck: Yeah, one of the lucky things was the way my industry prices is you price– at the end of the year, you take a percentage of whatever profit you made for that year. So at the end of the year, psychologically and financially, you reset to zero. Last year’s profits are yesterday’s news.

So I would always be a crazy person when I was down end of the year, but I know, because I like to gamble, that in Las Vegas, 90% of the people that go there lose. And the odds are only 33 to 32 against you in most of the big games, so how can 90% lose? It’s because they want to go home and brag that they won money. So when they’re winning and they’re hot, they’re very, very cautious. And when they’re cold and losing money, they’re betting big because they want to go home and tell their wife or their friends they made money, which is completely irrational.

And this is important, because I don’t think anyone has ever said it before. One of my most important jobs as a money manager was to understand whether I was hot or cold. Life goes in streaks. And like a hitter in baseball, sometimes a money manager is seeing the ball, and sometimes they’re not. And if you’re managing money, you must know whether you’re cold or hot. And in my opinion, when you’re cold, you should be trying for bunts. You shouldn’t be swinging for the fences. You’ve got to get back into a rhythm.

So that’s pretty much how I operated. If I was down, I had not earned the right to play big. And the little bets you’re talking about were simply on to tell me, had I re-established the rhythm and was I starting to make hits again? The example I gave you of the Treasury bet in 2000 is a total violation of that, which shows you how much conviction I had. So this dominates my thinking, but if a once-in-a-lifetime opportunity comes along, you can’t sit there and go, oh well, I have not earned the right.

Now, I will also say that was after a four-month break. My mind was fresh. My mind was clean. And I will go to my grave believing if I hadn’t taken that sabbatical, I would have never seen that in September, and I would have never made that bet. It’s because I had been freed up and I didn’t need to be hitting singles because I came back, and it was clear, and I was fresh, and so it was like the beginning of the season. So I wasn’t hitting bad yet. I had flushed that all out. But it is really, really important if you’re a money manager to know when you’re seeing the ball. It’s a huge function of success or failure. Huge.

This is perhaps the most important section of the interview. So much of being a great trader is learning to arbitrage time and I mean that in a number of different ways.

First, it means to analyze things on a longer timescale, to be able to pull back and look at the bigger picture, the broader trends, and not get hung up on a missed earnings or the latest news cycle. And secondly, it’s to have enough experience to be able to trust your process to the point that you know returns will eventually come to you if you just stick to your game. This form of time arbitrage means that you’re focusing on having a good return record over a 3, 5, and 10 year time period and you won’t go full-tilt if you’re down for a quarter.

Capital preservation always comes first and a strict adherence to a solid process produces good outcomes over the long pull.

That’s it for my notes. I tried to include all the sections that I thought were worth sharing though I’m sure I missed some stuff. Watch the interview yourself if you can. Here’s a snapshot of Quantum Funds returns; Druck took over in 88’.



The Psychology Behind Managing A 20 Bagger…

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What do you do with a massively profitable trade that has grown to become a large percentage of your total portfolio value?

This question has been circulating in the Macro Ops Collective chat room the last few weeks because one of our deep out of the money (DOTM) calls took off in a big way. Back in the summer we bought call options on AMD struck at 28 for $0.40. Those calls traded as high as $8.50 in the month of September — a 2000% gain.

Managing large winners like this is difficult… really difficult. The reason being is that there’s no universally correct answer.

Managing losing trades is pretty straight forward. You define the risk before you enter and once the asset hits your stop, you exit. Easy peasy.

Winners are a whole other animal. Now you’re faced with the question of: Do I let my winner keep running and risk giving some or all of my profits back or do I take profits now foregoing more upside but putting cash in hand? This is literally one of the toughest questions in trading and something we at MO are constantly stewing on.

A winning DOTM option magnifies this conflict because of how volatile they become once they go in the money. A DOTM option can easily lose 30-50% of its value in a day if the stock pulls back after an extended run.

Another difficulty with a profitable DOTM option is that as it becomes more in the money, the reward-to-risk payout structure shifts from a highly convex one to being more linear.

When a stock crosses the strike of a DOTM call the options have usually already appreciated by 10x-20x. At this point, the forward reward-to-risk drastically changes. Instead of risking 1 unit to make 10 or 20, you’re now risking 10-20 units of unrealized profit for a potential gain of another 10-20. So instead of a 10:1 reward-to-risk in your favor, it becomes a 1:1 proposition.

After mulling this over for awhile with the other members of the Macro Ops Collective we think the profit taking decision comes down to these two things.

  1. The size of the unrealized profit relative to your net worth
  2. Your portfolio performance optimization strategy

You may think a DOTM call option will go on to appreciate from a 20 to a 40 bagger. But, what’s really important is whether you have the psychological makeup that will allow you to actually hold through the inevitable volatility and realize that second tranche of gains.

Your ability to hold through the volatility without tapping out is dependent on the size of the position relative to your net worth. This is also why managing large winners is so difficult. Since everyone has their own unique risk tolerances, there’s no “one size fits all” advice.

Picture these two scenarios:

Scenario 1: Bob puts $10,000 in a DOTM call that turns into $200,000. He has a net worth of $500,000.

Scenario 2: Jane puts $10,000 in a DOTM call that turns into $200,000. She has a net worth of $5 million…

Which of these two traders will have an easier time pressing and holding their winner?

Obviously, Jane will, because Bob’s going to feel it right in the gut if he gives back half those gains (20% of his net worth) to the market. It will bother Jane too, but will be much less mentally trying.

The larger the position is relative to your net worth the more mentally taxing it is to hold onto.

It’s painful to watch large paper gains swing up and down by double digit amounts on a weekly basis — which is exactly what can happen if you hold onto a DOTM call option that has 20x’d but still has many months until expiration.

Only a small fraction of traders have the stomach for holding onto large winners like these that have become a large percentage of their total portfolio values. Operator Darrin pointed this out during our conversations in the Comm Center. He correctly states that this ability is partially hereditary.

I’ve been lucky to know some real traders w/ what I’d call “Market Wizard DNA”. One, just made an additional 2mm dollars on LULU overnight (post earnings). I only bring this up because I think this insight can offer clarity for new traders/investors…

This trader was in a drawdown for 6-months that was > -30%. He held conviction in this trade (long gamma, long dated) for almost a year. It was his largest holding. He analyzed the fundies, the vol term structure etc…

At the point in which the trade started to yield some strong profits, he held on. We are talking .03 delta —>.50 delta kind of profits. Yet, he continued to hold on. The moral of the story is that 95% of humans do not have the ability to actually execute at this level.

I meet so many smart quantitative analysts and traders, yet I know that almost none of them have the behavioral edge necessary to reap the benefits of triple digits even four digit returns—and that’s perfectly ok!

I say all of this to remind retail traders that it’s ok to be average. It’s ok if a 20% return on 100k is the best you can do. The financial media have done everyone a disservice. They omit the part of the Big Short where they held losing options for YEARS before getting rich.

I can only speak for my own experience, but the biggest difference between the market wizards and everyone else is probably DNA. They have an ability to take risks on large sums of money that the average person could never imagine. That’s a major edge…probably the biggest edge available.

Having the wherewithal to endure large account swings is not for most of us which is why the correct answer for the majority of traders is to take profits when faced with massive unrealized gains.

Now let’s talk about portfolio performance optimization. This comes into play if the winner is small enough so that it’s not an emotional burden. For example, if a trader put 25 basis points (bps) into a DOTM option that goes on to 20x, that is still only a 5% account appreciation. At this position size the trader can think with his prefrontal cortex instead of his dumb lizard brain (limbic system).

Different traders need to optimize for different things. Some people just want to straight up maximize returns. Others need to prioritize consistent performance, especially those who are managing other people’s money or looking to raise funds.

Traders and investors who need their account balance to help pay for things outside of the market are also operating in a shorter timeframe and generally would rather have consistency and smoothness of returns rather than higher but much more volatile ones.

Taking profits sooner on large winners will pull performance forward in time, reduce account volatility and create a smoother equity curve. But it also sacrifices long-term return potential in the process…

Traders with true long-term capital and the psychological fortitude to ride out massive profit volatility should hold and press large winning trades because that will compound capital at the highest rate in the long run.

The biggest mistake we see with traders who decide to hold their winners is that they are optimizing for the long run even though they aren’t managing true long-term capital. Most people underestimate what it takes to apply a disciplined process day in and day out for a decade. And a decade is the bare minimum we would consider long-term.

If you want to see how we ended up managing our 20x winner on AMD you’re in luck because Tyler will be talking about it in our free DOTM webinar this Thursday, October 4th at 9PM EST.

Click this link to sign up for the Macro Ops DOTM special event!

Tyler will be presenting all the specifics of our DOTM option strategy and how we used it to produce a 2000% gainer on AMD. He’ll also be discussing our year-to-date performance for the DOTM plays, the winners and the losers. You don’t want to miss this.

If you have any interest in our DOTM option strategy that has produced 2000% returns, sign up now at the link below!

Click this link to sign up for the Macro Ops DOTM special event!