CHAPTER 1
Identify as a Capital Allocator: Put Your Capital Where It Is Treated Best

Man the living creature, the creating individual, is always more important than any established style or system.

-Bruce Lee

The stock market is a curious place because everyone participating in it is loosely interested in the same thing-making money. Still, there is no uniform path to achieving this rather uniform goal. You may be only a few clicks away from purchasing the popular book The Warren Buffett Way,1 but only one man has ever truly followed the path of Warren Buffett. In investing, it is hard enough to succeed as an original; as a copycat, it is virtually impossible. Each of us must carve out a personal way to investment success, even if you are a professional investor.

That said, great investors like Warren Buffett, Peter Keefe, and Howard Marks have much to teach us, and we have much to gain by learning from them. One of the masters' key teachings is as important as it is simple: A share of stock represents a share in the ownership of a business. A stock exchange simply provides a convenient means of exchanging your ownership for cash. Without an exchange, your ownership of a business would not change. The ability to sell your stake would be negatively affected, but you would still be able to do it, just as you can sell your car or house if you decide to do so.

Unfortunately, when we start investing, we are inevitably bombarded with distractions that make it easy to forget the essence of stock ownership. These titillations include the ticker tape on CNBC, the seemingly omniscient talking heads, the polished corporate press releases, stock price charts that are consolidating or breaking out, analyst estimates being beaten, and stock prices hitting new highs. It feels a little like living in the world of Curious George, the lovable monkey for whom it is "easy to forget" the well-intentioned advice of his friend. My son loved Curious George stories, because as surely as George gets into trouble, he finds a way out of trouble. The latter doesn't always hold true for investors in the stock market.

Passive Versus Active Investing

I still remember the day I had saved the princely sum of $100,000. I had worked as a research analyst for a San Francisco investment bank for a couple of years and had managed to put aside what I considered to be an amount that made me a free man. Freedom, I reasoned, was possible only if one did not have to work to survive; otherwise, one was forced into a form of servitude that involved trading time for food and shelter. With the money saved, I could quit my job, move to a place like Thailand, and live on interest income. While I wisely chose not to exercise my freedom option, I still had to find something to do with the money.

I dismissed an investment in mutual funds because I was familiar with findings that the vast majority of funds underperformed the market indices on an after-fee basis.2 I also became aware of the oft-neglected but crucial fact that investors tended to add capital to funds after a period of good performance and withdraw capital after a period of bad performance. This caused investors' actual results to lag significantly behind the funds' reported results. Fund prospectuses show time-weighted returns, but investors in those funds reap the typically lower capital-weighted returns. A classic example of this phenomenon is the Munder NetNet Fund, an internet fund that lost investors billions of dollars from 1997 through 2002. Despite the losses, the fund reported a positive compounded annual return of 2.15 percent for the period. The reason? The fund managed little money when it was doing well in the late 1990s. Then, just as billions in new capital poured in, the fund embarked on a debilitating three-year losing streak.3 Although I had felt immune to the temptation to buy after a strong run in the market and to sell after a sharp decline, I thought this temptation would be easier to resist if I knew exactly what I owned and why I owned it. Owning shares in a mutual fund meant trusting the fund manager to pick the right investments. Trust tends to erode after a period of losses.

Mutual funds and lower-cost index funds should not be entirely dismissed, however, as they offer an acceptable alternative for those wanting to delegate investment decision-making to someone else. Value mutual funds such as Bruce Berkowitz's Fairholme Fund or Mason Hawkins's Longleaf Funds, or Europe-based UCITS funds4 such as Terry Smith's Fundsmith Equity Fund, are legitimate choices for many individual investors. High-net-worth investors and institutions enjoy the additional option of investing in hedge funds, but few of those funds deserve their typically steep management and performance fees. Warren Buffett critiqued the hedge fund fee structure in his 2006 letter to shareholders: "It's a lopsided system whereby 2 percent of your principal is paid each year to the manager even if he accomplishes nothing-or, for that matter, loses you a bundle-and, additionally, 20 percent of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10 percent in a year will keep 3.6 percentage points-two points off the top plus 20 percent of the residual eight points-leaving only 6.4 percentage points for his investors."5

A small minority of value-oriented hedge fund managers have chosen to side with Buffett on the fee issue, offering investors a structure similar to that of the limited partnerships Buffett managed in the 1960s. Buffett charged no management fee and a performance fee only on returns in excess of an annual hurdle rate. The pioneers in this small but growing movement include Guy Spier of Zurich, Switzerland-based Aquamarine Capital Management, and Mohnish Pabrai of Irvine, California-based Pabrai Investment Funds. These types of funds bestow a decisive advantage, ceteris paribus, on long-term investors. Table 1.1 shows the advantages of an investor-friendly fee structure.

TABLE 1.1 Effect of Fees on the Future Wealth of a Hedge Fund Investor

TYPICAL HEDGE FUND FEE STRUCTURE: "2 AND 20" BUFFETT PARTNERSHIP-STYLE FEE STRUCTURE MANAGEMENT FEE: 2% MANAGEMENT FEE: 0% PERFORMANCE FEE: 20% PERFORMANCE FEE: 20% ANNUAL HURDLE RATE: 0% ANNUAL HURDLE RATE: 6% Assumed gross return 5.0% 10.0% 5.0% 10.0% Resulting net return 2.4% 6.4% 5.0% 9.2% Gross value of $1 million . after 10?years $1,628,895 $2,593,742 $1,628,895 $2,593,742 . after 20?years 2,653,298 6,727,500 2,653,298 6,727,500 . after 30?years 4,321,942 17,449,402 4,321,942 17,449,402 Net value of $1 million . after 10?years $1,267,651 $1,859,586 $1,628,895 $2,411,162 . after 20?years 1,606,938 3,458,060 2,653,298 5,813,702 . after 30?years 2,037,036 6,430,561 4,321,942 14,017,777 Value lost due to fees . after 10?years $361,244 $734,156 $0 $182,580 . after 20?years 1,046,360 3,269,440 0 913,798 . after 30?years 2,284,906 11,018,842 0 3,431,625

I also considered investing my savings in one of a handful of public companies that operate as low-cost yet high-quality investment vehicles. Berkshire Hathaway pays Warren Buffett an annual salary of $100,000 for arguably the finest capital allocation skills in the world. Buffett receives no bonus, no stock options, and no restricted stock, let alone hedge-fund-style performance fees.6 It certainly seems like investors considering an investment in a highly prized hedge fund should first convince themselves that their prospective fund manager can beat Buffett. Doing this on a pre-fee basis is hard enough; on an after-fee basis, the odds diminish considerably. Of course, buying a share of...