Warren Buffett, Sidecar Investing, and Common Misconceptions

Buffett does not give away any edge

Many people often quote Buffett when discussing investment strategies, yet they tend to misunderstand his advice. This is not a critique of Buffett—he is undoubtedly an exceptional investor, arguably the best. However, my point is that people often echo his advice without truly understanding it. I believe this is intentional and well known to Buffett, as he is highly competitive and would not willingly give away any competitive edge.

Tom Combs, who regularly meets with Buffett, revealed that Buffett applies three specific criteria when selecting investments: the price-earnings ratio should be less than 15, there should be a 90% confidence interval that the company will generate more profits in a five years, and a 50% confidence interval that earnings will grow by at least 7% annually. This is surprisingly specific and not what we usually hear from Buffett—advocating for economic moats, investing in good businesses, and his famous rules about not losing money (and remembering that rule)—which tends to be vague and not very useful, similar to saying "eat healthy and exercise more" when advising someone on how to lose weight. Again, I am not criticizing Buffett here; on the contrary, I highly respect how he does not give away anything.

Circle of (in)-competence

Let me give you another example and how I think people misunderstand what Buffett says. Consider the concept of the "circle of competence". I claim most people, including myself, have (measure by Buffett’s standards) a circle of competence that is equal to the empty set. It's just an illusion and in my experience very counterproductive if you talk yourself into believing that you really understand the business. After all, there is a reason why Warren Buffett likes highly predictable companies like Coke or banks. I guess there is not a single bank CEO in the US, probably in the world, who does not answer the phone when Buffett calls and asks questions. But even access to the CEO is not enough for him to be in his circle of competence. Despite Warren Buffett’s friendship with Bill Gates, who encouraged him to buy stocks in Microsoft, Buffett declined, stating it was outside his circle of competence. There you see how narrowly he defines his circle of competence. I believe there are few people who would have said that given the CEO is a good friend of yours who would happily answer all questions.

On the other hand, I also don’t view the circle of competence as too crucial. If you invest like Buffett and aim to hold investments ideally forever, then the circle of competence is very important, as are high returns on capital. However, on shorter time scales, other factors matter much more. And Buffett himself had a higher turnover earlier in his career, and his returns were much better. Of course, this is also due to his huge assets under management. He has mentioned many times that if he had only a small amount of money, he would invest in a completely different way, and I guess it would have little to do with the circle of competence.

The point I want to make is that recently, few innovative ideas have surfaced in the investment world, except for a notable concept introduced by Richard Zeckhauser, a former bridge world champion and Harvard University professor, who is also a friend of both Charlie Munger and Warren Buffett.

Sidecar Investing:

I have greatly simplified the excellent paper by Zeckhauser. This is intended more as an primer, and I hope that after reading this, you will return to the original paper, as it contains much more than what I've included here.

The World of Ignorance: Unknown and Unknowable (UU):

This is the domain where Bayesian decision-making is ineffective due to unknown states of the world. Bayesian decision-making works if the states of the world are known, but we might not be aware of the corresponding probabilities. This world is utter chaos. "Chaos," you say; "less competition," I say. Many individuals struggle to navigate the unknowable. When its presence is recognized, the usual reaction is avoidance.

Zeckhauser's Insights on Investments

Significant wealth is often generated in situations where capital alone is insufficient. Instead, complementary skills, knowledge, or expertise are essential. Think about drilling in an oil field. Just having money is not enough one should rather invest alongside someone who knows what he is doing.

Zeckhauser suggests that investments in scenarios that are unknown, unknowable, inaccessible to the general market, and involve a counterpart who is likely not better informed, tend to yield substantial expected excess returns.

The uniqueness of these unknown and unknowable situations tends to discourage most competitors, who are deterred by the absence of familiar references, thus providing a competitive advantage.

Speculation 1: UUU (Unknown, Unknowable, Unique) investments repel speculators, potentially leading to attractively low prices.

Maxim A: For those with complementary skills, making a sidecar investment alongside someone adept in UU investments is beneficial, but one should ensure that the terms of investment are equal and that the rights are consistent.

Speculation 2: UU situations present lucrative investment opportunities, attributed to information asymmetries and the absence of competition.

• People have a strong aversion to betrayal, demanding higher odds when the potential loss can be attributed to human deception rather than an indifferent nature. Thus, in scenarios where betrayal is possible, potential payoffs are likely to be much higher than what rational decision-making would suggest.

Maxim B: In scenarios with ambiguous probabilities, it might be sufficient to gauge your knowledge relative to the opposing party's, possibly the market.

• In situations that are a mystery to both you and others, competition is scant. However, such scenarios come with the risk of retrospective criticism.

Additional Considerations

• We have this natural tendency to distrust the other guys information even when they're on our side, this makes sidecar investing difficult for most people. The moral here is that we are deeply inclined to trust our own information more than that of a counterpart, and I'm not well trained to know when this makes good sense, and when it inclines us to be a sucker.

• In the financial realm, understanding what one knows relative to others is vital. Although one might not have prophetic insights, it's possible to evaluate one's understanding in comparison to others.

This is a very condensed and simplified version of the original paper, but it should provide a glimpse of the content.

I'm not suggesting that it is the sole investment strategy one should use. Instead, I prefer to keep a broad range of options open and do not confine myself to any specific investment style. In fact, I hold both growth stocks and stocks categorized as deep value. Moreover, the analysis varies depending on what is most important - if one can’t figure the 2-3 variables out that will matter in the end then one should probably not invest. For some stocks, I delve deeply, reading hundreds of pages, communicating with management and competitors, visiting the companies, and conducting research for weeks or months before making a purchase. Conversely, using the sidecar investment strategy, I made a significant investment in under 20 minutes without reading a single page, based solely on one piece of confirmed information.

Example Huya:

Last year, I invested in $Huya using the sidecar investment strategy. This decision was primarily based on a single piece of information: Tencent, the majority stakeholder, purchased an additional 16% of Huya from Joyy at $5.70 per share. At the time I bought the stock was trading below $2.50 per share.

Let’s go through the sidecar investment strategy one by one and see how it ticks the boxes.

Speculation 1 and Maxim A:

The situation is unknown and unknowable. No one has clear insights into the actions of the Chinese government or the regulations affecting the esports market in which Huya operates. However, if any player has more information than others, it would be Tencent, as they are the majority shareholder of HUYA 0.00%↑ and maintain regular communication with the government.

Tencent possesses complementary skills that can enhance the operations of Huya, and we have the opportunity to invest alongside them for less than half of what they paid. They did not overpay, as their purchase price essentially covered just the net cash.

Speculation 2:

A Chinese tech company, subject to strict government regulations on games and gambling, was viewed as radioactive, facing virtually no competition. People feared betrayal by either the company or the government, which resulted in a lack of buyers and no competition; their actions were irrational. An additional advantage was that Chinese investors could not purchase Huya's shares, and people outside China were largely unaware of Huya's operations or its legitimacy. This positioned me in a very unique situation.

Maxim B:

I was not fully aware of the complete situation myself. However, I was confident that I was at least as informed as other investors outside of China. In fact, I believed I was in a better position because I knew Huya was a legitimate company and I was familiar with many people who use their services.

Additional considerations:

I trusted that Tencent knew what they were doing. Since they paid just the net cash price, it was clear that this was not an investment where they paid a strategic premium. Instead, it was advantageous for the seller JOYY 0.00%↑ , who could use the proceeds to repurchase their own undervalued shares.

Summary:

I was aware that I was paying less than half of what the best-informed player, Tencent, had paid. I knew they were not overpaying, they possessed the complementary skills needed to enhance operations (evidenced by their immediate replacement of the old management with their own team), and I was quite confident that I was at least as well informed as other investors.

If you are interested, the stock still trades below the price Tencent paid. They have repurchased a significant portion of the outstanding shares and will soon pay a 15% dividend.