It has been quite a while. In these 2 long years, I went from working for a fund to start my own advisory firm along with an excellent investor and most of the time has been spent understanding businesses and reading annual reports. Few years back, I thought of starting a series of articles called “Octavo Pansophy“, but a dramatic turn of events in my professional life (Change of Career Path) and personal life ( I got married !!!) led to a delay in its inception.
Nowadays, Indian stock indices are in a magnificent run-up. There is an air of optimism and too much of it is reflected in the prices of the securities. Though after a lot of reading of investment books, the incremental benefit diminishes a lot, but times like these (bull markets) are generally great times to sit and re-read, revisit, reflect and learn from the people who have gone through many cycles in past and managed to maintain excellent returns. There are lot of great investors besides our most frequently media covered and popular names on street. I thought of reading about few of them and I found that some are interviewed in a collection by Kirk Kazanjian in his book, ‘Value investing with the masters’. Even though I was not very pleased with the depth of interviews the kind one find in those of Jack Schwager’s Market Wizards , still one can always find the nuggets of wisdom in the words of these investors.
One such investor interviewed in the book is James Gipson. I will frame this post in easy takeaway points rather than long chit chats. Also I have added few comments on my thoughts on the same. The bold content are the snippets from the interview and the remaining text is my addition. Any misquote here is my mistake.
James Gipson (Pacific Financial Research)
Style of Investing
No surprises here, Gipson started his career by practising the tenets of Value investing and still do the same, but he is quick to point out that Value investing is not about buying statistically cheap bargains. Growth is one component of Value and Value investing doesn’t automatically mean never buying quality growth companies.
I agree with his approach and practice it myself. We all are aware that Buffett shifted from Graham’s statistical type bargain finding to good quality companies which are available at reasonable price and for which earnings can be predicted with a reasonable amount of certainty. In most of the filters I use (except for the one where I am specifically looking for Deep value stocks which are mostly assets play), I include the growth parameter and the estimate of intrinsic value calculation includes growth as a component.
Portfolio Construction
In the initial phases of his career, he was more focused on tactical allocation and avoiding the loser’s game.
In 1981, when oil stocks were hot, he avoided them completely. He bought bonds instead. By late 1981, 70% portfolio was in bonds when the long term treasuries were at around 15% yields. No one was buying it then but as per Gipson, It was a no-brainer call.
Entering the crash of 1987, 40% of the portfolio was in zero coupon bonds. Tactical asset allocation worked well for them during that time but such opportunities are not much present now. He also completely avoided any exposure to dot com stocks.
Going against the consensus have been preached and practised by most value investors. The flip side is that some investors take it too literally and will bet against every consensus decision. This is what Howard marks explains in his book “The most important thing”,
Finally, it’s not enough to bet against the crowd. Given the difficulties associated with contrarianism just mentioned, the potentially profitable recognition of divergences from consensus thinking must be based on reason and analysis. You must do things not just because they’re the opposite of what the crowd is doing, but because you know why the crowd is wrong. Only then will you be able to hold firmly to your views and perhaps buy more as your positions take on the appearance of mistakes and as losses accrue rather than gains.
This, for me, is the key to contrarian investing and it takes guts and loads of research to follow this. If there is flaw in the reasoning of the crowd and with all intellectual and emotional integrity, one is confident of the same, it makes sense to bet big on it.
I found this interview of Gipson in NY times in 1998 where he talks about the same.
Concentration v/s diversification
He believes in the power of concentrated portfolio. He says,
“Your best ideas one through 20 are whole lot more likely to do well than your worst ideas 101, through 120. It makes sense to concentrate.”
Risk Management
Since he is more concentrated, the interviewer was concerned on the risk involved and as per Gipson, Risk management is their starting point of analysis.
We start thinking by preventing losses.
He also says,
We’ve put in a structural framework. If you like a stock, there’s a tendency to talk only to people who share your positive view. We, on the other hand, look at what can go wrong.
The risk management approach similar to what Gipson is prescribing here has been prescribed by many successful investors. The way I see it, we don’t mitigate risk by a lot of diversification. It has been proved statistically also, that diversification beyond 13-15 stocks doesn’t really reduce your risk. But beyond the statistical point, a proper approach to risk mitigation is two fold.
- The price at which you are buying a business
- The quality of business you are buying.
As simple as these two points may appear to be, I believe that both of these points requires a very thorough understanding of the business. And if one spends enough time on the understanding part, the mitigation of risk is achieved by paying sensible values and not by diversifying.
At this point, I would also advise the readers to go through this post by a very smart investor, Abhinav Mansinghka. He also gave a presentation during the Flame Conference held every year in Pune. Even though his main topic of discussion is capital allocation, he explained this point well in his post and blog. His blog, manufactured luck, is highly recommended.
On the other point which Gipson mentioned, it’s a very commonly noticeable occurrence for investors to have discussions with other investors who are bullish on the same stocks. This leads to what behavioral psychologists refer to confirmation bias. I wrote about it sometime back in this post. The ideal approach, obviously, is the reverse of it. When bullish on a stock, it’s imperative to talk to people who are negative on the same. In my recent work on housing finance companies while following this approach, I got enormous benefit and a big jolt to my initial thesis after discussing it with an investor who holds an opposite point of view.
What to buy
Gipson has the following recommendations for the investors who like to invest in the concentrated manner.
- Buy what you understand: As per Gipson, understanding of a business means how a company works and what its prospects are likely to be. He stress on this point a lot and mentions,
Not only large numbers of investors but even corporate managers have a misconception about how to predictably understandable their companies are.
- Buy what is a good business: Good businesses are the one that has a competitive advantage, generates superior returns on capital or on equity and generates cash apart from accounting numbers.
- Buy what is available at a sizeable discount: In his case, he practices buying at 30% discount to intrinsic value and keep on adding if it falls below. He believes in building good valuation models to value the company as a private buyer would value that business. They make special purpose valuation models for that.
As mentioned above, the points mentioned are very similar to what all great investors have been emphasizing and the trick is to master these things over a period of time. Valuing a business as a “private buyer would value it” is a comprehensive task and is often ignored (especially when the stocks run as fast as they are moving currently) but that, I feel, is the essence of investing. For the uninitiated on competitive advantage, I will suggest the readers to go through Prof. Greenwald’s book, Competition Demystified. If time permits, I will write my learning from that book. I feel it’s an under-rated book but highly recommended. I also recommend a series written by a dear friend, Soham, under the name, Competition Sutra. He does some excellent work on making case studies for people to learn the concepts easily.
Key characteristics of great investors
As per Gipson, Patience is a virtue most investors lack. He believes the pursuit of getting rich quick leads mostly to inferior returns.
Patience is a virtue that is easy to preach and more difficult to practice… Periods of superior performances come in unpredictable lumps. This is one thing that frustrates people who are trying to get rich quick or making long term judgements about the deployment of capital based on short term performances.”
“From a psychological standpoint, many people have “avoiding criticism” as their major goal in life. One way to avoid criticism is to do what everyone else is doing. The real essence of what you are asking comes down to character. Do you have the patience to persist in doing what you believe is rational thing, even though you are not being rewarded for it, infact you‘re being criticized for it.
I would like to end this post with one question which Gipson suggests and I feel a lot of people should ask themselves especially in the given euphoria in stock markets.
Before buying any stock, ask yourself, “How much could you lose by owning it?”…