by Amit Kumar
Q: So you never really convinced Société Générale about value investing?
I never managed to convince them. I performed well from 1979 to 1996; however, the board of directors never understood my style and always remained suspicious. While my value strategy worked, they always expected it to stop working at some point. Jeremy Grantham says that most of [the] “sell” side only has a six- to twelve-month view of a business. But, to look at the business with six- to twelve-month period in mind is a completely different approach than looking at it over five years.
Q: Would you consider your investment style closer to Ben Graham or Warren Buffett? Can you also describe your approach to value investing and the reason behind your emphasis the importance of balance sheet?
I started with [a] Ben Graham approach because I was working alone and Graham’s approach was more quantitative than qualitative, [and] hence easier. We eventually moved closer to [a] Buffett approach as we began to hire analysts in the [19]90s. Today, with the exception of Japan and micro-cap stocks, there are really no Ben Graham type stocks to find. There are no hostile takeovers in Japan, so the Japanese companies are under no pressure to allocate their capital wisely. Ben Graham did speak about high-quality businesses, but Buffett and Munger actually focused more closely on high-quality businesses. Graham’s approach is less time consuming and easier if you know the numbers and if you are careful to read footnotes.
When everyone and their brethren were buying Enron, someone at our firm asked, “Why don’t we own Enron?” We looked at Enron and one of my analysts found that one of their footnotes was incomprehensible. When we called the Enron CEO [chief financial officer] and his lieutenants, they were evasive in explaining the footnote. We threw the Enron investor material in the trash and moved on because we were not satisfied with that one footnote. You can understand the significance of balance sheet in the case of Enron.
A friend of mine once said accounting reflects the mind of the people. For example, German firms tend to point out every risk associated with their business—risks which are sometimes hard to imagine. I had always wondered why the U.S. has not privatized JFK and LaGuardia airports while the U.K. has privatized its airports. We checked the accounting assumptions for runway depreciation for the private airports. British airports depreciated their runways over a hundred years while Copenhagen depreciated their runways over thirty years. When you make the comparison, you can see two ends of the spectrum: too aggressive versus too conservative accounting.
I do not like companies with low effective tax rates (except for countries like Hong Kong with natural low tax rates), because either the companies are trying to cheat the tax authorities or they have fancy accounting and the companies are not making much money. Their earnings quality will often turn out to be poor.
The Buffett approach implies the exercise of judgment in addition to looking at accounting, which admittedly, every now and then, can also lead to erroneous judgment. I helped someone teach a value investing course at Columbia and I told the students that I don’t want a forty-five page paper on a stock. We don’t need to know everything about the company, but instead we want to know the major strengths and weaknesses of the company. This can easily be summarized and produced in a four- to five-page paper. Yes, you run the risk of missing something important, but that is how you can build upon exercising your judgment. We will not blame you in that case. I mean, I have been wrong in many cases.
Q: Can you talk about an example of your approach to analyze the strengths and weaknesses of a business?
About twenty years ago, someone mentioned to me that David Swenson had started buying timberland. I said, let me look at timberland, which was a great business in my view. Weyerhaeuser had acquired most of the timberlands a hundred years ago for $1 per acre while the prevailing prices were $3,000–$4,000 per acre. So, the balance sheet values were misleading and you needed to make adjustments to both assets and liabilities. In those days, engineers who liked shiny and expensive paper machines ran paper and pulp companies. As a result, the tremendous cash flow generated by timber business was dissipated in processing timber into pulp and paper. Over a full business cycle, the investment returns were mediocre at best. David Swensen was not buying the stocks. Instead, he bought the physical timberlands. We decided to wait on buying the stocks as well.
Plum Creek and Rayonier were among the companies that divested most of the wood processing businesses within a radius of fifteen miles from Seattle. Pope Resources was spun off from Pope and Talbot. Interestingly, three to five years later in the [19]80s, Pope and Talbot went bankrupt. They could no longer generate cash through the timber business to subsidize the processing businesses. So, there was only one thing to know in this case: the quality of timber business and that processing business is highly cyclical and capital intensive.
Q: So, which business qualities/characteristics do you find to work more in the realm of Buffett’s style of investing?
Buffett likes businesses with sustainable competitive advantages. For example, he likes the brick business because you cannot transport bricks too far because then they will lose their competitive edge. Quarries are similar businesses—no one wants a quarry in their backyard. Some of quarries have a life of 75–100 years. Most of these businesses have sustainable local competitive advantages.
Sometimes, the firm’s management is the differentiator. For instance, let me talk about Sodexo, a French catering business with 300,000 people. There were only three worldwide companies. Compass in Britain and Aramark in [the United States] were the other companies. Someone once told me, “Retail is detail.” There was plenty of detail in Sodexo to look at. Their voucher business within catering was very profitable. After the Second World War, Sodexo was one of the growth companies on the Paris exchange. However, the founder never got along with investors because he didn’t like what the portfolio managers and analysts wanted him to do with his business in the short term. He was focused on the long term and he said that, though he was mortal, if he took care of his business, it would outlive him. Their British subsidiary was not doing well and portfolio managers used to point to Compass, which had higher return on equity. It later turned out that Compass had been using creative accounting to cover up.
Sometimes, companies in the U.S. and U.K. follow accounting practices that observe the letter of the law but betray the spirit of law. In contrast, in continental Europe (i.e., France and Germany), it is not as easy to betray the spirit of law because according to the law, everything that is not specifically authorized is forbidden. Before Compass admitted to loose accounting, the financial community turned against Sodexo and its stock fell. We bought some Sodexo stock at this point because we believed the management was focused on the long term.
The founder also could see that we were long-term investors. Chuck, one of our analysts who later left to start IVA [International Value Advisors], used to cover the company. He got along well with the founder. He was invited by Sodexo to come to their New Jersey headquarters to speak to its U.S. executives about our investment approach because they believed that our approach to long-term investing was in line with that of their own.
Q: When do you decide to sell a stock?
We made mistakes with Swissair in [the 1990s] that would indirectly answer your question on when to sell the stock. I looked at Swissair from Ben Graham standpoint but I misread the impact of leverage. When you look at things from a Graham perspective you have to be extremely careful about leverage. For example, if you estimate the value of assets to be 100 and debt is 70, the equity is worth 30. If you are wrong by 10 percent on the asset value (which is not difficult) and the value turns out to be 90, the equity is now worth only 20. The value of equity is now 33 percent lower. As the saying goes, asset values are contingent but debt is forever.
From a high-quality standpoint, we found that Swissair had all sorts of good subsidiaries—hotels and an extremely profitable business in Turkey. Their nickname was “flying bank�
�� because they were a cash machine with no leverage. They had a young fleet and very good reputation for service. Originally, from a deep value standpoint, Swissair was depreciating the fleet quickly.
They made a mistake that I did not realize immediately. They hired a consultant as their CEO [chief executive officer]. He began to make big plans to make Swissair a global airline by acquiring Belgian Airlines, which turned out to be a fiasco. I was very slow to react to this news. One should be quick to sell if things turn sour or one is worried that the business model appears to be changing for the worse. Sometimes, such a change to business model can result from outside forces. For example, some American newspapers started failing with the advent of the internet. This was not necessarily because of the complete failings of their management, but rather because they did not charge for newspaper online quickly enough.
So after some time, I realized that [the] Swissair CEO was not doing good things for the business. In such a case, one should be quick to sell the stock, acknowledge the mistake to avoid a permanent loss of capital, and move on to something else. Conversely, one should be very slow to sell if the company appears to have [a] competitive advantage.
Q: There is a group of ardent Buffett followers who do not believe in selling the stock. What are your views on that?
Several weeks back, Bruce Greenwald pointed out to me that Buffett never sells. There are two reasons: firstly, Buffett makes few mistakes. He once acquired a shoe business and was quick to get out because it did not work and he got out of some oil stocks as well. Secondly, if you think you are holding on to a business with strong moat around it and it trades close to, or slightly above, its intrinsic value, you have to come up with another business with a real moat to replace your original investment. Now, the problem becomes graver when the stock becomes very overvalued. Buffett himself acknowledged that he should have sold some Coca-Cola in 1997, when Coke stock seemed vastly overvalued.
If the business begins to deteriorate and stock is modestly overvalued, the stock can fall a lot very quickly. You have to be quick to determine if the weakness is temporary or not. Marty Whitman says if the weakness is temporary, then the losses are temporary and unrealized as well. Now, only time can tell whether you can call it temporary unrealized losses or permanent loss of capital. I personally have tried to be slow in selling unusual businesses from [a] quality standpoint. With the exception of Swissair, I am quick to sell businesses where I think the business model has changed for the worse.
Q: As a value investor, you do not believe in short selling. Can you talk about some of behavioral reasons that prevent value investors from engaging in short selling?
Some mutual funds that specify in their prospectus that they short sell can do so, but we do not engage in short selling. You gave the perfect answer earlier in this chapter when you quote Charlie Munger that he doesn’t trade agony for money. Buffett says the loss can be unlimited and even if a company turns out to be a fraud, it can take a long time for the market to discover the fraud. Short selling can be a very painful experience. Instead, increasing cash allocation is a good alternative to short selling for value investors.
Most mutual funds say they have to be fully invested, unlike our funds. They fear to antagonize their intermediaries, financial planners, and brokers who will tell them that they are not paid to hold cash. This is nonsense. Their prospectuses might say they have to be a 100 percent in cash but there may not necessarily be a regulatory compulsion to stay fully invested. In our case, we have 1 million shareholders. The idea that the investor is not paying the manager to hold cash is erroneous. Investors pay shareholder advisory fees and give money to portfolio managers in order to do good work over the long term. If I have enough investment ideas, then I will keep only a modest amount of cash for redemption. However, if I don’t have enough ideas, I will keep more cash. Some might argue that I should increase the position size of the stocks I own. But that would not make sense if the stock has moved up and I am not trying to time the market. In general, cash is an important tool for the value investors.
Q: What do you think about the role of a short seller in the stock market?
They have a very legitimate role in the stock market as long as they don’t propagate rumors. Many value investors are reluctant to accept short sellers as part of the stock market. I believe that some short sellers have been good at identifying fraud and they should be complimented for that. The fact that short sellers exist and they can practice their art successfully keeps some people—especially management—on their guard. As long as short sellers behave within the confines of the law, they are very valuable to the stock market.
Q: You have relied on changing cash allocation in the portfolio to shield from downturns. Is keeping cash a way for a long-only value investor to express a short opinion?
In more than 50 years of my investing career, I have seen only one incidence in the late [19]80s where I could barely own one stock in an entire geography (i.e., Japan). I had looked at forty-five stocks and I could not own more than one because the entire market was a joke. In 1988, I sold my last Japanese stock and the stock market moved another 30 percent. Briefly, the Tokyo stock market was the largest stock market in the world. We were bearish and we kept cash.
Financial brokers will call me and say it is one thing to be underweight [in] Japanese markets, but it is preposterous to not own anything in the second largest stock market in the world. I would tell them that I owned nothing because I have not been able to find a single stock that I would like to own. They would point out stocks trading at 45× P/E stocks that were trading at discount to the stock market that was trading at 60× P/E. I would chuckle. It was not until the 1990s that I saw a similar situation in the U.S. markets. However, there was a clear divide between new economy and old economy stocks. In this situation, we had plenty of choices in the U.S. old economy stocks.
Q: Bob Rodriguez of First Pacific Advisors had a similar style as yours. For long-value investors, is there another way to be short?
Yes. They can also buy cheap credit default swap (CDS)-like instruments, as Seth Klarman has done in the past from the standpoint of portfolio insurance. But Seth can do things similar to hedge funds that ordinary mutual funds cannot. I don’t think we can buy CDS because it is a derivative. We do not participate in derivatives.
Seth Klarman can also buy out of the money “call and put” options. When I was at the wedding of Jim Grant’s daughter, Seth and I were at the same table. He told me that he has two advantages over other funds. One, he was a value investor, and two, his investors think along the same line as him. He doesn’t worry about redemption. He started out with family offices and his funds remained closed to outside investors most of the time. When he would reopen, he would selectively decide his investors. He could easily say no to a fund from a funds investor who may have a short-term orientation. In my next life, I would probably like to run a closed-end fund.
Q: How important is it for value investors to pay attention to overall macroeconomic conditions and market levels? Have you paid attention to the macro in the past?
Value investors are normally bottom-up investors and do not believe as much in paying attention to the macro. I am familiar with [the] Austrian school of economics, where they talk about credit boom and bust. Every boom is followed by [a] bust, just like the night follows the day. I like the emphasis they place on credit cycles because credit booms end badly, and I like their analysis of the 1920s. There is a famous anecdote about a professor at an Austrian school, who had just got engaged and also got an offer at a large bank. His fiancée wanted him to take the offer and quit professorship for the money. He replied that the last place he wanted to join is a bank. Indeed, the bank went kaput in 1930.
In the late [19]80s, with the appearance of leveraged buyouts (LBO), I asked myself if this was the beginning of a credit boom. Rupert Murdoch of News Corp was very much in debt and so was Sam Zell. They only escaped because the credit boom reappeared. A
lan Greenspan, when he flooded liquidity in the market in 1987, caused problems to disappear quickly. With his success with the 1987 problem related to portfolio insurance, Greenspan became motivated to flood liquidity in response to any, and every, other problem as well.
In the case of News Corp, it is important to understand that banks cannot easily force people into bankruptcy and they also don’t like to force bankruptcies. News Corp had issued bonds in all sorts of currencies. Swiss banks were desirous to compete with Wall Street funds and they had also issued papers for News Corp in these currencies. When the investment banks were reluctant to distribute, Swiss Banks had stuffed their own clients with these bonds. The problem was that these bonds were now trading at sixty-five cents on a dollar. They didn’t want to mark the discount, especially right after the bonds were issued at par.
We bought these junk bonds in 1990 because these bonds provided equity-type returns. If the company doesn’t go bankrupt until the bond goes par, you can make a lot of money—almost an equity-type double-digit return for holding bonds. In the case of bonds, the company either needs to have cash flow to service their debt or needs to have assets in excess of the debt. News Corp had a temporary cash flow problem but they had asset protection. A corporation, if it can avoid bankruptcy, will avoid the bankruptcy at any cost because bankruptcy is an acceptance of failure. In contrast to corporate bonds, sovereign bonds entail the risk of not only a sovereign country’s ability to service the debt but also its willingness to service the debt.
I started worrying about [a] credit boom in 1980s, which interrupted briefly before resuming again at the beginning of the century. It accelerated in real estate and the music didn’t stop until the last guy with no assets, no income, and no cash flow was able to get credit with no money down. My worry about the credit boom motivated me to raise cash levels and buy gold during the 2008 financial crisis, and we declined 21 percent when most value investors had declined by over 40 percent or worse.