The Rules Part XXVII and Seeming Cheapness vs Margin of Safety

The market takes action against firms that carry positions bigger than their funding base can handle.  Temporarily, things may look good as the position is established, because the price rises as the position shifts from being a marginal part of the market to a structural part of the market.  After that happens, valuation-motivated sellers appear to offer more at those prices.  The price falls, leading to one of two actions: selling into a falling market (recognizing a true loss), or buying more at the “cheap” prices, exacerbating the illiquidity of the position.

When an asset management firm is growing, it has the wind at its back.  As assets flow in, they buy more of their favored ideas, pushing their prices up, sometimes above where the equilibrium prices should be.

As Ben Graham said, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”  The short-term proclivities of investors usually have no effect on the long run value of companies.  Rather, their productivity drives their long-term value.

There have been two issues with asset managers following a “value” discipline that have “flamed out” during the current crisis.  One, they attracted hot money from those who chase trends during the times where lending policies were easier, and the markets were booming.  And often, they invested in financials that looked cheap, but took too much credit risk.  Second, they invested in companies that were seemingly cheap, rather than those with a margin of safety.

My poster child this time is Fairholme Fund.  Now, I’ve never talked with Bruce Berkowitz; don’t know the guy at all.  Every time I read something by him or see a video with him, I think, “Bright guy.”  But when I look at what he owns, I often think, “Huh. These are the stocks you own if you are really bullish on financial conditions.”

Yesterday, I saw a statistic that said that his fund was we eat dollar-weighted returns . Only the happy few that bought and held get time-weighted returns.  And, give Fairholme credit on two points (though I suspect it will look worse when the annual report comes out):

• A 9.9% return from inception to 5/31/2011 is hot stuff, and,
• A 6.0% dollar-weighted return is very good as well.  Only losing 3.9% to mutual fund shareholder behavior is not great, but I’ve seen worse.

This is the problem of buying the “hot fund.”  Once a fund becomes the “Ya gotta own this fund” fund, future returns on capital employed get worse because:

• It gets harder to deploy increasingly large amounts of capital, and certainly not as well as in the past.
• Management attention gets divided, because of the desire to start new funds, and the complexity of running a larger organization.
• When relative underperformance does come, it is really hard to right the ship, because assets leave when you can least handle them doing so.  The manager has to think: “Which of my positions that I think are cheap will I liquidate, and what will happen to market prices when it is discovered that I, one of the major holders, is selling?”

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That is a tough box to be in, and I sympathize with any manager that finds himself stuck there.  It can be a negative self-reinforcing cycle for some time.  My one bit of advice would be: focus on margin of safety.  If you do, eventually the withdrawals will moderate, and then you can work to rebuild.

Written By: David Merkel