Never Lose Money (in the Aggregate)

In a 1985 appearance on Adam Smith’s Money World: How to Pick Stocks & Get Rich, the great Warren Buffett said something that has subsequently become immortalized within value investment circles. The comment is often quoted as follows:

“Rule number one [in investing]: Never lose money. Rule number two: Never forget rule one.”

We believe that this is one of Buffett’s most misunderstood quotes, and one that (ironically) has likely cost investors a lot of money.

A close look at Buffett’s career reveals several decisions that seem inconsistent with the quote. On occasion, he has knowingly made investments with a real probability of impairment when the potential payoff was very large and the odds were stacked in his favor. Two examples that have worked incredibly well are (1) his 1976 distressed purchase of GEICO shares at $2 per share and (2) his BYD investment. GEICO in 1976 was in serious trouble and could have gone bankrupt. BYD was different, it was more comparable to a venture capital investment in a cash-burning company, not yet the powerful automotive manufacturer it is today.

These investments (along with others) seem to be at odds with the quote at the beginning of this letter. But of course, they are not. That’s because Buffett’s quote doesn’t end there. The real comment goes like this.

“The first rule of investment is don’t lose, and the second rule of investment is don’t forget the second rule… I mean if you buy things for far below what they are worth, and you buy a group [our emphasis] of them, you basically don’t lose money.” (source)

At Zorea, we have yet to see a riskless equity investment. But there is such a thing as a low-risk/high-return portfolio of equities[1].

In our view, the way to achieve this portfolio is through a combination of security selection and portfolio management:

Security selection: (1) invest only when the potential upside is multiples of the potential downside, creating a strongly positive payoff skew; and (2) require that the probability-weighted upside substantially exceed the probability-weighted downside.

Portfolio management: The greater the potential downside and the wider the range of outcomes, the smaller the position should be. No single investment should be capable of materially impairing the portfolio. If the facts change materially for the worse, we should reduce or exit the position as quickly as practicable.

We believe that this, done correctly, gets to the essence of Buffett’s quote.

Why investors confuse security-level risk with portfolio-level risk

This misunderstanding, in our view, stems from the natural discomfort human beings have with being wrong. It affects both professional and individual investors. Indeed, the more accomplished someone is outside of investing, the harder it can be to overcome this discomfort. In most fields, losses are viewed as failures, so it is natural for people to carry that mindset into investing.

We have read hundreds of investment pitches from investors with a wide array of experience. Of the few that make a sincere effort to understand an investment’s risks, we have never read a pitch where the author assigns a probability of 40% or more to a bad outcome. However, we have yet to find a portfolio manager that is wrong less than 40% of the time.

The cost of that confusion

In our opinion, most investors chronically and materially misjudge the risks of individual investments. That misjudgment creates cognitive biases and unintended risk-taking, culminating in what we consider one of an investor’s worst enemies: overconfidence.

Overconfidence is particularly dangerous because it affects not only how an investor assesses an opportunity at the outset, but also how that investor interprets new information over time. Evidence supporting the original thesis is readily accepted, while negative developments are too often minimized, rationalized, or dismissed as temporary. As the facts change, the thesis gradually changes with them, but the investor fails to recalibrate because acknowledging the change would require acknowledging a mistake. This “thesis drift” can leave an investor defending an investment materially different from the one originally underwritten. Combined with excessive position sizing and an unwillingness to sell, an ordinary analytical mistake can become a material impairment of capital.

This misjudgment presents another challenge to those who are not careful with it. Truly compelling risk-reward opportunities with a high probability of success are rare. Investors must accept that uncertainty cannot be eliminated at the position level. Requiring near-certainty from every investment would reduce the investable universe to almost nothing. As statistics teach us, the smaller the sample size, the greater the role of luck; as the sample grows, outcomes tend to move closer to their expected result. Too few attempts therefore leave portfolio outcomes disproportionately dependent on luck.

To help illustrate the point, consider a simplified example. Assume an investor finds a security with a 95% probability of tripling and a 5% probability of declining by 20%. This is about as attractive a combination of upside and downside protection as one could reasonably imagine – which helps explain why the investor finds only one such opportunity. If the investor places 100% of the portfolio in that security, there is a 5% probability that the portfolio will decline by 20%.

Now assume that another investor can construct an equally weighted portfolio of 15 positions[2], each with a 70% probability of doubling and a 30% probability of declining by 50%. Although each individual position has a materially worse risk-reward profile than the first example, the probability that the portfolio will decline by at least 20% is materially lower at less than one basis point, or <0.01%.

While luck is an inevitable part of investing, more shots on goal dissipate some of that noise.

Attractive risk-reward propositions are already rare. This is why we believe unlevered portfolios with materially more than 20 investments will generally struggle to outperform. Imposing an unrealistic requirement for near-certainty would reduce the opportunity set even further.

Some real-world evidence

Here are two examples that help illustrate the difference between individual negative outcomes and portfolio-level outcomes.

To the best of our knowledge, Renaissance Technologies’ Medallion Fund has produced the best long-term investment track record in history. From 1988 through 2021, Medallion reportedly generated gross annualized returns of 62% – not a typo (source). Empirically, it does not appear that those returns came with a high level of portfolio-level impairment risk: during that 33-year period, the fund had only one mildly negative year. Yet Medallion’s reported hit rate – the percentage of trades that made money – was only 50.75%. In other words, its hit rate was unremarkable, yet its portfolio-level results were extraordinary, with no multi-year period of impairment.

In Lee Freeman-Shor’s The Art of Execution, the author analyzes the investment records of 45 managers between June 2006 and October 2013. Freeman-Shor’s employer had allocated capital to these managers and therefore had visibility into the 1,866 investments they made. The most successful group – a group he labeled the “Connoisseurs” – had a lower hit rate than the other managers, losing money on 60% of their investments. How, then, did they outperform? When they lost money, they generally lost little and were quick to sell when the facts indicated that they were wrong. Conversely, when they made money, they made a great deal.

These are only two examples, but they illustrate a pattern found among many successful investors: hit rate matters less than the relationship between gains and losses.

The long-term fundamental investor’s advantage

Thinking about risk at the portfolio level while recognizing that uncertainty cannot be eliminated at the position level provides a structural advantage to long-term fundamental investors such as ourselves. We make investments with the expectation of holding them for many years – typically five or more – and generally seek opportunities capable of returning multiples of our capital. Position-level downside, by contrast, is limited to the capital deliberately allocated. If we assess probabilities reasonably well, size positions appropriately and act promptly when an investment thesis is impaired, we believe we can generate satisfactory portfolio-level returns while maintaining a low probability of permanent impairment.

Applying this framework to Zorea, we believe our portfolio consists of high-quality, defensible businesses that create tremendous value for their customers. We purchased these businesses at prices that, in our judgment, offer asymmetric risk-reward profiles. Where the range of potential outcomes is wider, we have sized the position more conservatively. We also monitor our investments closely and seek to reduce our exposure when business fundamentals or the investment thesis deteriorate.

We would not go as far as Buffett and say that if “you buy a group of them, you basically don’t lose money.” Investing never offers that degree of certainty. But we believe our combination of security selection, disciplined position sizing and ongoing risk monitoring gives us a low probability of permanent portfolio impairment. That is why we are comfortable having a meaningful portion of our own net worth invested alongside our clients.

Thank you for your trust,

Simon Bennaim

---

[1] We define risk as the probability of capital impairment over a multi-year period.

[2] Assuming their outcomes are independent.

---

Disclaimer and disclosures

The information in this presentation was prepared by Zorea Capital LP (“Zorea”). It has been obtained from public sources believed to be reliable. Zorea makes no representation as to the accuracy or completeness of such information. Opinions, estimates, and projections in this presentation constitute the current judgment of Zorea and are subject to change without notice.

Any investment in any strategy, including the strategy described herein, involves a high degree of risk. The description of the approach of Zorea Capital LP (“Zorea”) and the targeted characteristics of our strategies and investments is based on current expectations and opinions and should not be considered definitive or a guarantee that the approaches, strategies, and your investment portfolio will, in fact, possess these characteristics. In addition, the description of our risk management strategies is based on current expectations and should not be considered definitive or a guarantee that such strategies will reduce all risk. These descriptions are based on information available as of the date of preparation of this presentation, and the description may change over time. Past performance of any strategy we employ is not necessarily indicative of future results. There is the possibility of loss, including loss of principal.

Any projections, forecasts, or estimates contained in this presentation are necessarily speculative in nature and are based upon certain assumptions. It can be expected that some or all of such assumptions will not materialize or will vary significantly from actual results. Accordingly, any projections are only estimates and actual results will differ and may vary substantially from the projections or estimates shown. This presentation is not intended as a recommendation to purchase or sell any commodity or security.

Performance information in this document reflects the actual performance of the account established by Zorea’s Chief Investment Officer as of May 1, 2024. Reported net performance is net of all actual trading and other account expenses, reinvestment of all income, as well as Zorea’s fees. Zorea’s fees, as presented here, are composed of our standard fee schedule for non-Qualified Clients, consisting of a 1.8% management fee. Our Qualified Clients may elect from other fee schedules we offer. Qualified Clients who elect a different fee schedule may pay higher (or lower) fees and therefore realize lower (or higher) net returns depending on the portfolio’s performance. The specific fee charged to a client will be identified in the client’s advisory agreement.

Because this account was established prior to Zorea becoming a registered investment advisor, this means the performance results are ‘hypothetical’. Different types of investments involve varying degrees of risk and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio.

Index information is included for illustrative purposes only, as it is not possible to directly invest in an index.  Indices are unmanaged, hypothetical vehicles that serve as market indicators.  Index performance does not include the deduction of fees or transaction costs which otherwise reduce performance of an actual portfolio.

Broader market events will generally have some corresponding impact on our results and the client portfolios managed in accordance with our strategy. For example, if US equity markets rise overall, that will frequently help the performance of portfolios with exposure to US equities, while declines in the overall US equity markets will frequently hurt the performance of portfolios with exposure to US equities. Similarly, increases or decreases in interest rates will have an inverse relationship on bond market prices (higher interest rates generally result in lower bond prices, and vice versa) and also some corresponding impact on the returns of   fixed income investments. No investment approach can guarantee a positive return or prevent loss.

Performance results shown are not a guarantee of future results and are not a guarantee or prediction of how any client portfolio will perform.

The information contained in this presentation is provided for informational purposes only, is not complete, and does not contain certain material information about our strategy, including important disclosures relating to the risks, fees, and expenses.  The information in this presentation does not take into account the particular investment objective or financial or other circumstances of any individual investor.

This presentation is strictly confidential and may not be reproduced or redistributed in whole or in part nor may its contents be disclosed to any other person without the express consent of Zorea and/or its managing partner.

Zorea Capital LP is a registered investment adviser domiciled in the state of New Jersey. We may not transact business in states where we are not appropriately registered, excluded, or exempt from registration. Individual responses to persons that involve either the effecting of transactions in securities or the rendering of personalized investment advice for compensation, will not be made without registration or exemption.