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Coat-tailing and Bias


spartansaver
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Cloning is nothing new although it has a great poster child in Pabrai bringing it to the forefront of a lot of investment research lately. I was wondering though, how do you separate yourself from the bias of an investment idea from a professional such as him. If I am looking for an investment in Buffet's filings, I will automatically think it is a good idea even as I am researching it. How do you personally protect yourself from those biases? Is understanding that the bias is there enough, or for some is completely eliminating that bias by not cloning your own defense?

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The fact that an idea is good for Buffett does not mean it is a good idea for you.  Most likely you, Buffett, Combs and Weschler have different circles of competences.  So the first thing is understanding what makes an idea good---Buffett buying it isn't a reason, you understanding it is.  I also have two other defense mechanisms in place:

1. The position must be at least 7.5%.  This obviously gives me confidence that the idea is high conviction.  Of course, it doesn't mean that the idea will work but it gives me some piece of mind.

2.  Most important look at the price.  13f's are at least 45 days old.  And prices can change substantially over a short period of time.  If the average price for the quarter was $30 and now the stock is at $42 your upside has gone way done and your downside has gone way up. 

 

Hope this helps. 

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Cloning is nothing new although it has a great poster child in Pabrai bringing it to the forefront of a lot of investment research lately. I was wondering though, how do you separate yourself from the bias of an investment idea from a professional such as him. If I am looking for an investment in Buffet's filings, I will automatically think it is a good idea even as I am researching it. How do you personally protect yourself from those biases? Is understanding that the bias is there enough, or for some is completely eliminating that bias by not cloning your own defense?

 

That is a very interesting question.  Of all stocks in the universe, I think I would rather own a portfolio of only top investors' holdings, defined by their historical results, rather than a portfolio of all the stocks in the universe, excluding all top investor's holdings.  In other words, I would rather own the average of the best, rather than the average of what they chose not to buy.

 

The bias of being driven to top investors picks, I would guess, should improve your average results, not decrease your average return. The well-documented behavioral biases of being disconnected or distant from why you are buying the stock could potentially become a big issue.

 

It seems like the better you are behaviorally, the better the cloning strategy should work. But, if you don't have a solid understanding of the value of the business, how would you decide when to buy and sell? Valuation work and behavior are what produces great long-term results - top investors can lead us to the fish in a very large pond. Your skills will drive the rest.

 

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Cloning is nothing new although it has a great poster child in Pabrai bringing it to the forefront of a lot of investment research lately. I was wondering though, how do you separate yourself from the bias of an investment idea from a professional such as him. If I am looking for an investment in Buffet's filings, I will automatically think it is a good idea even as I am researching it. How do you personally protect yourself from those biases? Is understanding that the bias is there enough, or for some is completely eliminating that bias by not cloning your own defense?

 

Generally, when I'm cloning an idea, I don't do much research or try to conquer this bias. For me, the whole point of cloning is to benefit from the research of someone smarter than myself so I don't do it myself. This saves me a lot of time so I can focus the little free time I have on the few ideas that seem truly compelling to me. I guess I'm relying on this bias as the reason that I'm cloning.

 

I manage the risk of this "blind" investment in a few ways:

 

1) The sources have to be reputable sources with a good history AND the thesis has to be easily understood by me and easily fact checked.

2) I size the positions very small. I might have a 10% position in my own heavily researched ideas, but most cloned positions don't ever get larger than 3% for me.

3) I more readily harvest gains from cloned positions by selling percentages of the position on the way or selling calls against the position to help reduce the downside. 

4) Only about 25% of my total capital is available for cloning ideas. About 50% is used for my own researched ideas and the remaining 25% is more passively managed in a low-P/B portfolio.

 

Often times, these cloned IDs have something occur that draws my interest and I'll more research and determine I want a larger position now that I understand the risks/investment better. In these cases I mentally switch the bucket it is in and size accordingly. This actually happened recently with Fannie Mae and Fiat.

 

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1. It sounds like if they have a 7.5% position that would confirm the idea even more in your mind that it is a great investment. This would be counter-intuitive to protecting yourself from the bias.

2. Not to nitpick, but this also sounds like you are immediately justifying that it is a better investment because it has gone down since the original position. I know events can happen in that grey period, but taking that factor out it, still seems like a highly biased situation.

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1. It sounds like if they have a 7.5% position that would confirm the idea even more in your mind that it is a great investment. This would be counter-intuitive to protecting yourself from the bias.

2. Not to nitpick, but this also sounds like you are immediately justifying that it is a better investment because it has gone down since the original position. I know events can happen in that grey period, but taking that factor out it, still seems like a highly biased situation.

 

It's hard for me to reply without having a better grasp of your reasoning.  For me specifically, the 7.5% is a filter to dial down the number of ideas I look at.  I don't say to myself this idea is larger than a 7.5% therefore its great or its lower than 7.5% therefore it's bad.  The 7.5% limits the ideas I look at and also gives me some (but not too much) confidence that this is a meaningful position.  I would not say "immediately justifying," I would say it makes the idea more intriguing but this has nothing to do with whether or not the position would be cloned.  If I like an idea at $10, I should like it more at $8 if my reasoning/analysis is correct. The other thing I do (taken from Pabrai/Buffett) is I write between 5-7 bullet points regarding the reasoning behind purchasing a position.  This allows me to step away from the fact that I got an idea from Buffett, Einhorn or Klarman and simply judge the company on its own merits.

 

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I doubt there is any way you could completely kill this bias. To me, what is most important is that I never invest in something I don't understand because a "guru" owns it. As people say, the guru isn't going to tell you when to sell vs load up when something bad happens. I can't invest in things where I am unable to independently assess the value, because you need to be able to understand how value changes over time in response to new information.

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Guest Schwab711

I guess I'll be the downer :). As Klarman has mentioned before, there is a danger that you don't completely understand the reasoning/incentives of the expert you are cloning. For Baupost, stocks represent just 10%-15% of their portfolio and they often have debt/preferreds to go with their equity positions. If you were to clone him then you would likely take on substantially more risk then he does (not to mention the liquidity of his strategy vs your own liquidity). Also, for others like Buffett, taxes or ability to use excess earnings of other businesses (tax-free) to invest in a capital intensive business makes an investment more compelling for Berkshire then it may for yourself. Overall, I think cloning is generally a really bad idea outside of validation of your own research. Cloning as a strategy seems like a cover for greedy tendencies (investor wants higher returns without doing research so they clone instead of indexing). I think indexing is almost always a better option than investing a portion of your portfolio in purely cloned ideas.

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I guess I'll be the downer :). As Klarman has mentioned before, there is a danger that you don't completely understand the reasoning/incentives of the expert you are cloning. For Baupost, stocks represent just 10%-15% of their portfolio and they often have debt/preferreds to go with their equity positions. If you were to clone him then you would likely take on substantially more risk then he does (not to mention the liquidity of his strategy vs your own liquidity). Also, for others like Buffett, taxes or ability to use excess earnings of other businesses (tax-free) to invest in a capital intensive business makes an investment more compelling for Berkshire then it may for yourself. Overall, I think cloning is generally a really bad idea outside of validation of your own research. Cloning as a strategy seems like a cover for greedy tendencies (investor wants higher returns without doing research so they clone instead of indexing). I think indexing is almost always a better option than investing a portion of your portfolio in purely cloned ideas.

 

Schwab---you are talking about two guys who manage large sums of money.  Your line of reasoning (its a small percentage of all their holdings or they have a more compelling reason to invest probably wouldn't apply if you were cloning someone like Arlington or Brave Warrior would it?

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