John Hempton, who runs a hedge fund and writes the blog called Bronte Capital, wrote a really interesting post over the weekend on investment philosophy. He basically calls out the majority of the professional money management community for cloning Buffett in word, but not in deed. His main point: many Buffett followers talk about the “punch card” approach to investing, but very few people actually implement this approach.
Here is Buffett explaining the Punch Card philosophy:
“I always tell students in business school they’d be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision, they used up one of their punches, because they aren’t going to get 20 great ideas in their lifetime. They’re going to get five or three or seven, and you can get rich off five or three or seven. But what you can’t get rich doing is trying to get one every day.”
It’s hard to describe how important and valuable this simple concept is. It’s one that I try to focus on, and try to get better at implementing each year.
But Hempton brings up a good point: lots of people talk about it, but very few people actually act this way. His reasoning for why people don’t follow such a sound approach is that it is hard to sell to clients. If you bought one stock every year or two, and you have a portfolio of say 7 or 8 stocks at a time, it may appear to clients (who see hardly any activity in their portfolios for months, sometimes years at a time) that you might not be working all that hard.
Trading activity has a way of making clients think that work is actually getting done. However, trading activity is almost always inversely correlated with investment performance. The client would be better off with the manager who charged his or her fee for selecting the punch card investments and then just sitting and waiting.
Bias Toward Activity
But human nature is difficult to overcome, and this type of an approach is difficult to implement. There are a few: Norbert Lou (who fittingly runs a fund named Punch Card) has built an outstanding track record of beating the market handily while making very few investments (his current portfolio consists of just three stocks and he makes very few new investments).
Hempton mentions that even Buffett’s two portfolio managers (Todd Combs and Ted Weschler) don’t follow a true punch card approach. I don’t know about Combs, but Hempton is wrong on Weschler I think, who is known for owning very concentrated positions in very few stocks and holding them for years (he compounded money at around 25% annually for 12 years in his fund before closing it to go work for Buffett, and the majority of his returns came from just a few positions that he held the entire life of the fund).
In fact, the majority of Weschler’s performance can be traced to two large investments that he owned throughout the life of his fund: DaVita and WR Grace. You could argue that those two investments were in large part responsible for his landing of a position at Berkshire. According to this article, he still holds a large personal stake in WR Grace (and what must be a massive personal deferred tax liability of something close to $100 million—he bought the stock for $2 in the early 2000’s).
So there are a few out there who walk the walk. But largely, I think Hempton is exactly right that most managers are biased toward activity. I also think many managers might not even consciously realize this bias. They intuitively want to convey to their clients that they are working hard, and one of the only ways to measure work progress (from the perspective of the client) is by looking at activity within the portfolio.
Some investment managers fear their clients think like this:
- Lots of activity: the manager must be busy looking at lots of ideas
- No change in the portfolio since last quarter: what has this guy been doing for three months? And why am I paying him?
Also, during a period of underwhelming performance, it can be difficult to stick with this approach. As Hempton says, these times can be extremely productive from a learning point of view:
But mostly I would have been just idle. So in the midst of underperformance a client might ask me what I did last year and I would say something like
a) I read 57 books
b) I read about 200 sets of financial accounts
c) I talked to about 70 management teams and
d) I visited Italy, the UK, Germany, France, Japan, the USA and Canada
This is such a great point. That type of workload will produce measurable results at some point in the future, but it won’t show up in this quarter’s statement that clients receive.
Just because there isn’t a lot (or any) activity in the portfolio doesn’t mean there isn’t a lot of activity going on in the research/learning department. I try and focus on getting better each day, regardless of whether I’m buying or selling anything. And in fact, the days I feel I’ve improved the most as an investor are usually the days where I am away from my computer screen deep in thought, reading something useful, or having productive conversations with someone that knows more about a particular business than I do.
Fortunately, I happen to have great clients who don’t expect activity from me, so I don’t feel any pressure to “come up with new ideas”. Instead, I can conduct my research efforts each and every day, and wait for opportunities. That said, I can improve on focusing more on my best ideas, and I try each year to get better at this.
The Concept Matters
Let me say that the concept is what is important here, not the actual number of punches. Buffett selected 20 as an example. Obviously, Buffett has made hundreds of investments over the years. He once said at an annual meeting that his partnership (from 1956-1969) made somewhere around 400 investments in various stocks. But he also said that the vast majority of those investments were small investments that didn’t have a significant net benefit to his returns. The vast majority of the money he made in his partnership was made from a handful of well-selected investments that he made a large portion of his portfolio (the famous example of course being American Express in the early 60’s, when he put 40% of his assets into that stock).
The key for Buffett was not his batting average, but his slugging percentage. He hit a lot of home runs in the stocks that he took big positions in. And even in the 70’s and 80’s when he was running a much larger portfolio, his best ideas made up a sizable portion of his portfolio. A quick glance at the equity portfolio from 1977 shows 24% of the assets in GEICO and another 18% in Washington Post. 2/3rds of his portfolio was concentrated in five stocks. By that point in his career, he was fully implementing the punch card approach, probably in large part because of his review of his partnership where he realized only a few big ideas were responsible for the entire performance record.
But again, there is no magic number that should be focused on. I think the concept is what is the key: there aren’t that many great investment ideas, and it’s crazy to think that you can find great ideas every day, week, month, or even year. Great ideas are rare, should be patiently waited on, and should be capitalized on when they come.
Easy to say, hard to do—especially when there is a built-in bias toward activity.
To Sum It Up
I really liked Hempton’s introspective review of his own investment philosophy, along with his honest observations. The strange thing is that he seems to imply that the punch card approach is the most sound, but yet he himself doesn’t practice it. This confounds me a bit. Either he hasn’t been able to shake the same bias he talks about (in his view it’s a very tough sell to clients), or maybe he thinks he can build a bigger business (more AUM) if he implements a more conventional long/short hedge fund strategy. I’m just completely guessing at his reasoning. Maybe I’m wrong and he doesn’t think the punch card approach is best.
But I think recognizing the “over-activity” bias is most of the battle—if you understand that you, as an investment manager, are going to be prone to activity and over-trading in an effort to justify your existence, then you at least have a chance to guard against it. It’s those who “don’t know that they don’t know” are the ones who don’t have a chance. Hempton clearly isn’t in the latter camp. He knows that he (like most humans) might be prone to this bias, so you’d think he would choose to guard against it and implement the better approach.
Either way, it was an interesting commentary, and one that I really agree with. Practicing a portfolio management strategy that involves very few (and very large) investments in high-quality companies at very infrequent junctures is a great approach, but one that can be viewed as unconventional, and thus difficult to practice in real life. I hope and plan to keep improving on this, one day at a time.
John Huber is the portfolio manager of Saber Capital Management, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.
John also writes about investing at the blog Base Hit Investing, and can be reached at firstname.lastname@example.org.