[2/19/12] On a fall day in 2010, half a dozen wealthy investors and portfolio managers converged on an office in midtown Manhattan. These were serious Wall Street moneymen; in aggregate, they handled more than a billion dollars. They had access to the most exclusive hedge funds and investment partnerships and often rubbed shoulders with the elite of New York, Greenwich and Palm Beach.
But on this day, they had turned out to meet an unknown college dropout from Utah -- and to find out how he was knocking them all into a cocked hat.
The unknown, Allan Mecham, had been posting mind-bogglingly high returns for a decade at a tiny private-investment fund called Arlington Value Management, and the Wall Streeters were considering jumping on board.
Over a 12-year stretch, through the end of 2011, Mecham, now a mere 34 years old, has earned an astounding cumulative return of more than 400 percent by investing in the stock of U.S. companies -- many of them larger ones like Philip Morris, AutoZone and PepsiCo. That investment performance leaves the stock market indexes and most mutual funds trailing far in the dust. Of the thousands of mutual funds in America, only a smattering of stock-oriented funds have done better, according to Lipper. Arlington, which is structured like a hedge fund, has put most firms in that category deep in the shade as well. It even managed to turn a profit during the crash of 2008, when Standard & Poor's 500-stock index fell nearly 40 percent. And Mecham has done this mostly while sitting in an armchair, in an office above a taco shop, in downtown Salt Lake City.
His investment approach will be familiar to anyone who has been even a casual follower of Buffett. Mecham looks for businesses with great long-term prospects, great management, strong cash flow and big defensive "moats," or barriers to entry for potential competitors. And he stresses the importance of sitting still and doing nothing. "Activity is the enemy of returns," says Mecham. "If I find two new ideas a year, that's phenomenal."
[3/23/12] Mecham, whose stellar returns were highlighted in the March edition of Smart Money, tells his investors that last year he levered up the fund and has invested half the money in Warren Buffett's Berkshire Hathaway.
"Able to borrow at around 1.5%, we levered (Berkshire) into a 50%+ position," he wrote in his annual letter to shareholders. "Though not advocates of leverage, we believe the low cost and modest amount, combined with [Berkshire's] iron-clad safety and cheap price, makes our action sensible."
There is some method to the madness. Mecham, a long-term Buffett disciple, argues that Berkshire Hathaway stock, on its own, "provides ample diversity, with exposure to disparate businesses (more than 70), sectors, and asset allocations." Berkshire's assets include a ton of cash-generative businesses, a book of blue-chip public stocks valued at more than $75 billion, and nearly $40 billion in cash, he says.
Short-term gains are irrelevant, but Mecham built up the huge Berkshire Hathaway position before the announcement, last September, that Berkshire would start buying back stock.
Since then stock has zoomed about 16%, from around $105,000 to $122,000.
[12/27/14] This weekend I came across a link to an excellent Manual of Ideas interview with Allan Mecham that I've read before, but I decided to read through it again. There are a few key points that Mecham brings up that I think are really worth repeating, so I thought I’d highlight them here.
Understand what you are buying
The first is the concept of understanding a business like an owner.
Mecham said something interesting when asked how he generates ideas:
“Mainly by reading a lot. I don’t have a scientific model to generate ideas. I’m weary of most screens. The one screen I’ve done in the past was by market cap, then I started alphabetically… Over the past 13+ years, I’ve built up a base of companies that I understand well and would like to own at the right price. We tend to stay within this small circle of companies, owning the same names multiple times. It’s rare for us to buy a company we haven’t researched and followed for a number of years—we like to stick to what we know.”
Speaking of unforced errors, Mecham references the importance of reducing them when answering a question on mistakes investors tend to make:
“Patience, discipline, and intellectual honest are the main factors in my opinion. Most investors are their own worst enemies—buying and selling too often, ignorning the boundaries of their mental horsepower. I think if investors adopted an ethos of not fooling themselves, and focused on reducing unforced errors as opposed to hitting the next home run, returns would improve dramatically. This is where the individual investor has a huge advantage over the professional; most fund managers don’t have the leeway to patiently wait for the exceptional opportunity.”
Beware the Lottery Ticket Investments
The concept of focusing on the downside brings me to a tangential topic that I'd like to briefly talk about, and that is the allure of the “lottery ticket” investment. This is the type of investment that has long odds of paying off but could result in a huge payday if it works. For example, let’s say investment has a 40% chance of making 5 times your money, and a 60% chance of going to 0. In theory, this investment has a high expected value, and should be taken (if you could make this investment 10 times, 4 times out of 10 you’ll make 5 times your money, which far more than compensates for the 6 times your investment went to 0). In other words, if you bet $1 on a situation like this 10 times, you’d end up with $20 on a $10 total investment.
One thing I’ve observed over time is that market participants tend to overestimate the probability of the favorable outcome. It’s very easy to do this for a number of reasons: one, we are generally optimistic beings. Two, we naturally want to find a situation with high expected value like the one described above.
I think in general, it’s much better to simply focus on simple situations that you understand very well—good businesses at bargain prices—and patiently keep building out your circle of competence while waiting for the proverbial fat pitch. Home runs will help increase long term returns, but they don’t need to come from swinging at really difficult pitches that are outside the strike zone.
Is this the next Warren Buffett?
*** [1/6/15] The 400% Man