Arlington Value Investor Letters: Five Invaluable Lessons On Value InvestingAlex
Mr. Bean here.
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!
- 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.
- 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.
- 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.
- 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.
- 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.
Article by Mr. Bean, Macro Ops