On 4 Feb, Seth Alexander, President of MIT Investment Management Company and his Global Investment team member, Joel Cohen delivered a wonderful lecture to my students and ex-students at MDI. It was a privilege to host them at MDI.
A few days before the lecture, I had asked my students to read:
- This excellent interview of Seth, Joel and their colleague Nate Chesley conducted by the Manual of Ideas in December 2014; and
- MITIMCO’s investment brochure.
If you haven’t read these documents, I urge you to read them carefully.
The presentation delivered be Seth and Joel at MDI can be downloaded from here which I have uploaded with permission.
While the entire presentation was quite instructive, I got the maximum out of slide 8 on top down risk framework. While Seth and Joel were talking about top-down risk framework in the context of managing an endowment, in my view, there’s an important lesson which is equally applicable for building much smaller portfolios using the principles of value investing.
Essentially, Seth stated that at MITIMCO, they buy “bottoms up” but worry “top down” while constructing portfolios.
Most value investors are bottom-up stock pickers anyway. But having a top-down risk management framework while constructing portfolios is a different skill which is worth acquiring.
What are the type of things one should worry about while constructing portfolios? Well, to my mind, there are many things and just one of them is to do with the type of value investing one is following. In risk arbitrage, for example, you need lots of diversification while investing in high quality businesses with long runways you need a lot less diversification. But you still need diversification. How much is sufficient diversification? There’s is no right answer to this question in my view, and many other questions related to top down risk framework. Any constraints imposed by the portfolio manager will be necessarily arbitrary. The key point Seth made on this was that having an arbitrary constraint is better than having no constraint.
What are the other things one must worry about while constructing portfolios? An excellent answer to that question lies buried deep inside Warren Buffett’s 2001 letter, in which he wrote a wonderful essay titled “Principles of Insurance Underwriting.” Here’s that essay in which I have bolded the relevant part for our purposes.
Principles of Insurance Underwriting
When property/casualty companies are judged by their cost of float, very few stack up as satisfactory businesses. And interestingly unlike the situation prevailing in many other industries neither size nor brand name determines an insurer’s profitability. Indeed, many of the biggest and best-known companies regularly deliver mediocre results. What counts in this business is underwriting discipline. The winners are those that unfailingly stick to three key principles:
- They accept only those risks that they are able to properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors including remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions.
- They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly-unrelated risks.
- They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn’t work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so.
* * * * * *
Good insurance underwriters as well as value investors must worry top down about risk aggregation and they must “ceaselessly search for possible correlation among seemingly-unrelated risks.”
Seth’s remarks on MITIMCO’s top down risk framework should be read with Buffett’s principles of insurance underwriting. There is a very important lesson for value investors in there and that important lesson is this: Buy bottoms up, worry top down.