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Thought Piece

Sustaining Compounding

  • Rule #1: Never Lose Money. – Warren Buffett

The power of compounding only becomes evident over time. At its exponential inflection, compounding becomes a juggernaut for wealth – or really any – creation. It is instructive to look at those who have compounded wealth and knowledge successfully over time to draw lessons, and perhaps the sine qua non of successful long-term compounding is Warren Buffett. One of Buffett’s maxims is to never lose money, and it pervades his long-standing ability to compound. In our opinion, Buffett steers his capital allocation decisions with 'never lose money' in mind. That framework is based on an assessment of a company's value, durability, and brand, all of which drive his enduring ability to compound.

  • Price is what you pay, value is what you get.

Starting with value, the environment for valuation oscillates over time, and in studying Buffett, it is instructive to see how his cash stockpile has been an arbiter of the value climate. For example, he liquidated his investment partnerships towards the end of the go-go 1960s due to a lack of opportunities that met his hurdle. Prior to the 1987 Black Monday crash, Berkshire Hathaway had trimmed almost all of its non-core equity exposure (save for the ‘permanent three’: Cap Cities, Geico, and Washington Post). Its insurance/reinsurance arms have periodically stepped away from underwriting as premiums did not reflect their probabilistic assessment of risk (and others proceeded to reap the whirlwind, so to speak). Currently in our COVID environment, Berkshire Hathaway is sitting on record cash. Judging by these calamitous periods over decades, Buffett is clearly conscious of valuation as a means of protecting his portfolio. This was indelably seared into his investing ethos through his time with Ben Graham.

  • The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.

Moving beyond his net net value roots, durability is emblematic of the franchises he has held successfully over time. Moaty businesses, as Charlie Munger would put it. Whether it was Nebraska Furniture Mart, Geico, or The Washington Post, he was looking for advantaged businesses that can stand the test of time. Durability is often synergistic with brand, as brand can protect a franchise such as Coca-Cola from identical discount competitors and subsequent profit mean reversion.

Brand and durability help protect capital impairment (and thus promote compounding). Every business faces inevitable hardship or economic calamity, and the two can be instrumental in finding one’s way to the other side. Buffett learned about this during his tempestuous investment in Salomon Brothers, or perhaps more recently with Kraft Heinz. A clear recognition of brand durability paired with a margin of safety with regard to price paid renders favorable initial conditions for compounding to flourish.

Left Tails

  • All I want to know is where I’m going to die so I don’t go there. – Charlie Munger

Avoiding permanent capital loss is the name of the game for long-term compounding. Another way to think about that end goal is cutting off as many future left tail scenarios as possible. This is a helpful mental model because pursuing active outperformance (not simply compounding at the market rate) incurs a wider distribution of outcomes; fatter-tails. The right-tails are what creates Buffetts and the left-tails are what embody Icaruses.

How do we define left-tail scenarios? Going back to permanent capital loss, they fall into a few amorphous categories: unlimited liability payout, mark-down, bankruptcy, expropriation, governance, and rapid obsolescence. Is the secret to long-term compounding simply avoiding these? Well, not exactly. Instead of a binary formula, we think a probabilistic framework is more appropriate. The key is to measure the true economic exposure to these risks and thus better assess one’s aggregate risk/reward. More succinctly, embed it within one's portfolio construction.

For example, you can invest in potential zeros within an aggregate portfolio, so long as it is diversified and the right-tail potential outweights the left-tail calamity (VC approach). Similarly, you can short (and thus have ‘unlimited liability’ risk) as long as that risk never metastizies into a portfolio-level margin call (e.g., MF Global). You can look at bankruptcy situations if there is tangible recoverable value (e.g., prudent distressed investing), you can invest in 'squishy' governance situations if you can roughly handicap the risk (e.g., founder-led dual share class structures).

Governance Left Tails

To make this more tangible and personal, we were recently faced with a left tail scenario in our unconstrained strategy: the governance risk associated with Chinese ADRs. This is something we have greater liberty to detail in our investor quarterly letter, but speaking generally, these exposures represented a confluence of left-tails: "shareholder" rights associated with VIEs, changes in regulatory posture within China (potentially leading to significant mark-down), and a real difficulty (from our vantage) to appropriately discount such risks and thus tame them with portfolio construction.

We made the decision in Feb 2021 to intervene in our systematic process, curtailing some (but not all) Chinese ADR exposure from matriculating into the portfolio. This wasn’t a manual override but rather a reformulation of our algorithms, interrogating the sources of data which upranked such positions. This examination revealed significant biases associated with the strength of signals underlying our ADR exposures. We worked to remedy this by systematically addressing those biases, culminating in a process improvement implemented three months later. This raised the hurdle for these types of exposures to matriculate into our portfolios, and unsurprisingly, our China ADR exposure vanished.

These aren’t decisions we take lightly. We believe in disciplined, long-term underwriting over compulsive reaction. However, this risk factor simply did not align properly with our need to protect our portfolios from left-tail scenarios. In hindsight, we aren't patting ourselves on the back and touting our prescience. We do not know how this eruption of Chinese regulatory angst will play out in the coming weeks, months, and years (what really counts). We do contend that the increasing likelihood of that tail-risk became apparent to the sober observer for some months now. We followed a simple common sense approach to examining and then mitigating it.

Returning to one last Buffett maxim, the market provides an infinite number of pitches, and we as investors enjoy the advantage of simply avoid the ones that don’t meet our criteria. For us, that criteria starts with avoiding permanent capital loss because our goal is to be around for a long time. How else will compounding work its magic?


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