I regularly follow about twenty or so value investors, including John Griffin of Blue Ridge Capital. I tend to focus on value investors who run a relatively concentrated portfolio and who invest in goog businesses, as opposed to net-nets, turnarounds, cigar butts, etc. I find it constructive to lay out their purchases in chart form to see how they enter and exit positions. It also gives me a perspective how they attempt to exploit Mr. Market and reinforces the patience required to wait for a fat pitch.
Recently, I’ve been writing a fair bit about insurance companies. Today, GuruFocus published an interview with Mason Hawkins and Sately Cates of Longleaf Partners Fund. Here is an exchange regarding Fairfax Financial.
Absent Prem Watsa’a speculations, Fairfax Financial Holdings’ performance would be greatly diminished. How does a value manager like you analyze an investment that is so dependent on the actions of one person?
[Hawkins:] First, unlike Berkshire Hathaway, where Mr. Buffett is virtually the sole investor, Fairfax has a very deep team of exceptionally talented analysts and investors, and they are anchored like almost no other investment group that we know of in Ben Graham’s margin-of-safety disciplines.
This team is housed in a company called Hamblin Watsa. It has an over-30-year record. It is led by Roger Lace, who is its president and head of equities. Brian Bradstreet oversees their fixed-income investing. Another leader is Chandran Ratnaswami who leads their international efforts. Sam Mitchell, who has had a terrific long-term record at another company, is part of the Hamblin Watsa group. Paul Rivett is their chief legal officer and also adds insight.
In Fairfax’s case, there is clearly a coordinated, cooperating, and collaborating investment team. They have executed like no other. Prem is part of that team, but by no means oversees the day-to-day execution of their investing efforts. Their record is nonpareil. In the last 15 years, they have grown book value per share at 16.4%, versus a 6.8% growth rate for the S&P 500. They have the number-one record in the insurance world of growing book value per share over that 15-year period. Over the last five years, Fairfax has grown book value at 22.5%, also number one among insurance companies. That was a period when the S&P had a 2.3% return. They far and away have exceeded their peers.
Turning to their long-term investment record, over the last 15 years their common stock investments have compounded at 17.2%, versus 6.8% for the S&P 500. Their bond record is equally superb. Their bonds have compounded over the last 15 years at 10.0% versus only 6.2% for the Bank of America Merrill Lynch US Corporate Index. Both bonds and stocks over the last 15 years have outperformed, and they have records in those two asset arenas unlike anyone we have studied, including those in the insurance world, hedge fund, and investment advisory world. They have a history of thinking independently, applying their appraisals, and using their discipline to say “no” unless something is exceptionally attractive from both a risk and a return standpoint.
Their hedging activities are misunderstood, and, to your question, they are not “speculations;” they are enabling them to lock in their investment performance and to protect their liabilities with their assets. Fairfax is a unique company, and they have evolved into one of the leading investment groups in the world, overlying a group of much-improved insurance companies. They have evolved with terrific management in the insurance companies that the holding company oversees.
Look at the team of talents that leads each of their insurance companies: Doug Libby at Crum and Forster, Mark Ram at Northbridge, and Nick Bentley running their runoff business called River Stone. You see well disciplined managers that understand that insuring risk has to be done at reasonable cost and against reasonable potential claim exposure. Dennis Gibbs is still a consultant of theirs, and he may be one of the most sagacious insurance minds there is.
Andy Bernard was just recently made president and COO of Fairfax Insurance Group. He previously ran OdysseyRe and created an exceptional company from virtually scratch. Now he oversees the various components of Fairfax’s worldwide and growing insurance group. As you probably know, they have nascent operations in many of the evolving world economies: India, China, the Middle East, and Eastern Europe. We believe that those early-day undertakings will pay great dividends as we go forward.
Fairfax is a combination of a superior investment team, with a lot of individuals who are very capable of running insurance companies and who have proven their worth and merit over a full cycle of insurance premium pricing. Prem has assembled a really unique group of operating and investing talent.
Over the weekend I came across some excellent investing counsel from hedge fund titan Ray Dalio in the book The Global-Investor Book of Investing Rules by Philip Jenks and Stephen Eckett. Although not known as a “value investor” in the classic sense of the phrase, Dalio’s approach is solidly grounded in value investing principles. Per Wikipedia, “Ray Dalio is an American businessman and hedge fund manager who in 1975 founded Bridgewater Associates which manages approximately $80 billion in assets. As of 2007, his net worth was estimated at $4.0 billion.”
Here is a quote from the The Global-Investor Book of Investing Rules.
There are some general principles that most winners of this game employ that losers neglect. If you want to win any game, you must know what the principles of the game are, and then work to develop the required skills – e.g. counting the cards and calculating odds for poker. What I describe here is my approach to playing the game, which is a mix of these general principles and my own twists on them. For me, the following are required.
1. A deep understanding of the fundamentals so that pricing inefficiencies can be identified.
Adding value (getting a return greater than that available from passive investing) requires one to see how markets are mispriced, and this requires an understanding of how they should be priced. This is required to be a winner over time. It is the equivalent of being able to count cards and calculate the odds of a winning hand in poker – it is the fundamental assessment that allows you to discern a good bet from a bad one.
Some people say that understanding the fundamentals isn’t required and that one can play and win the game by playing it technically. If by technical they mean an approach that is devoid of understanding fundamental cause-effect relationships – like trend following – then I believe that they are wrong. Sometimes markets trend, and sometimes they chop, and they do so for reams. So, without an understanding of these reasons, one will be blindly betting that markets trend more than they chop. Do markets trend more than they chop? This is one of thus cosmic questions that can’t be definitely answered, and certainly not without an understanding of the fundamentals that determine marks behavior.
There is no escaping the need to have a deep understanding of the fundamentals so that one can sensibly assess what is cheap and what is expensive. In playing poker, I would rather place my bet based on my ability to count the cards and calculate odds than on the likelihood of hot streak continuing (e.g. betting that I will do well because I won the last few hands).
Adding value is a zero-sum game – for me to add value I must be a better player than my opponents. The markets are extremely competitive. That means that my understanding must be very deep, which requires focus. I have rarely seen investors that win over time who trade a lot of different markets. The winners I know discuss their markets with the same depth that specialists in other professions (e.g. physicians, scientists, etc.) discuss the subjects of their focus [emphasis added].
In addition, successful market players have the capacity to think conceptually and independently. Equipped with knowledge and perspective, they can justifiably have the confidence to stand apart from the crowd, which is essential for being able to buy low and sell high.
3. Perspective without data-mining.
Many years ago I did a lot of discretionary trading based on the flow of information I was seeing at the time. I wrote down the criteria I used to make each trade so that I could reflect on the trade later. I learned that if I specified the criteria clearly I could see how these criteria would have worked in the past, and in different countries, which gave me perspective. That perspective was invaluable.
In many cases I learned that the criteria wouldn’t have worked in the past and I could see why. In other cases I learned how well my decision rule worked so that I would not abandon it when it lost (all rules lose sometime) or put too much on it because it has recently been hot and I thought it was better than it really was. As a result, I developed a good sense of what I could expect from my criteria.
I learned that I could program the computer to scan the world for opportunities, according to these criteria. And I learned a lot more. I learned to be especially wary about data mining – to not go looking for what would have worked in the past, which will lead me to have an incorrect perspective. [Greg Speicher’s note: “If past history was all there was to the game, the richest people would be librarians. – Warren Buffett] Having a sound fundamental basis for making a trade, and an excellent perspective concerning what to expect from that trade, are the building blocks that have to be combined into a strategy.
Knowing how to identify good bets is only the first step. Knowing how to balance these bets – how much to place to on each based on their different expected returns, risks and correlations – is at least as important. This requires an understanding of probabilities, statistics, and money management principles. It requires the ability to simulate how this strategy would have worked in the past and to stress test its performance under varying conditions.
5. Substantial resources.
The days that an astute individual trader equipped with little more that his wits, being able to be a substantial winner at this game are over. Now, world class teams consisting of conceptual thinkers supported by specialists and advanced technology set the standard of play. While technology has radically advanced the average level of play, in markets as in warfare, it has served to widen the gap between the resource-rich and the resource-constrained players.
Ray Dalio’s Principles – Here’s a brief expert of how he learned his craft [my emphasis added]:
2) I came up with the best independent opinions I could muster to get what I wanted. For example, when I wanted to make money in the markets, I knew that I had to learn about companies to assess the attractiveness of their stocks. At the time, Fortune magazine had a little tear-out coupon that you could mail in to get the annual reports of any companies on the Fortune 500, for free. So I ordered all the annual reports and worked my way through the most interesting ones and formed opinions about which companies were exciting.
3) I stress-tested my opinions by having the smartest people I could find challenge them so I could find out where I was wrong. I never cared much about others’ conclusions–only for the reasoning that led to these conclusions. That reasoning had to make sense to me. Through this process, I improved my chances of being right, and I learned a lot from a lot of great people.
4) I remained wary about being overconfident and I figured out how to effectively deal with my not knowing. I dealt with my not knowing by either continuing to gather information until I reached the point that I could be confident or by eliminating my exposure to the risks of not knowing.
Recession? No, It’s a D-process, and It Will Be Long – 2009 Barron’s interview
Inside the world’s biggest hedge fund – Fortune, March 19, 2009
Books from the Fortune article:
Essays on the Great Depression by Ben Bernanke
The Great Crash of 1929 by John Kenneth Galbraith
Dalio’s recent appearance on CNBC
FPA is out with their Q4 2010 letter and, as usual, it is worth carefully reading. Steve Romick is a great investor with a fabulous record. I have great admiration for his disciplined and thoughtful investing process.
Here is his thesis on Wal-Mart.
Wal-Mart (WMT) seems anomalous in a world where stocks have rebounded so dramatically from the stock market’s 2009 bottom. Wal-Mart’s stock averaged $48.59 in February 2009 (We are using the average in the month its price hit bottom, as it seems more relevant since it is only the rare circumstance and good fortune that allows one to accumulate a position on the day the market decides to price a stock at a low). At that price, it traded at a TTM and Forward P/E of 14.5 and 13.0x, respectively. Wal-Mart closed 2010 at $53.93 per share – more dear in price but cheaper in valuation – trading at a lower TTM and Forward P/E of 13.3 and 12.1x, respectively.
With more than 8,000 stores in 15 countries, in excess of 2 million employees, and more than 200 million customers each week, most everyone has heard of Wal-Mart. And yet, it seems relatively ignored by investors – a big change from a decade ago, when the market deemed its growth expansive enough to justify it trading ~40x earnings (both trailing forward). Investors may be disappointed in its stock price over the last decade, but we don’t feel there’s much to complain about as far as its revenues and earnings growth go. Revenues grew at a 9.4% rate, while earnings per share compounded at 11.5%.
So where does that leave us, and how do you make money in a company that already has revenues exceeding $400 billion and a market capitalization approaching $200 billion? We now feel that Wal-Mart has grown its way (via earnings) into its stock price. We view Wal-Mart as an infinite duration bond with a rising coupon – a “bond-like equity.” We believe Wal-Mart can grow at an acceptable rate well into the future and that the company will pay a fair dividend, as well as opportunistically repurchase shares, which should provide a high single-digit to low double-digit total return over time – not bad in the context of low single-digit interest rates.
We do not know if the above scenario will play out as exhibited, but we take comfort in the following:
- Revenues have grown 5%, 8% and 9% in the last 3, 5, and 10 years, respectively. More than 25% of Wal-Mart’s sales come from overseas, and we expect foreign economies to continue to grow better than our own. After dividends and share repurchases, we expect there to be additional free cash flow that will be used to drive the top line.
- Operating margins are unusually stable, ranging between 5.6% and 6.1% over the past decade. Wal-Mart has exhibited tremendous margin stability, in part due to their stated goal of delivering cost savings to their customers in the form of lower prices. By not taking price into margin, we expect they will be able to pass through price increases in an inflationary environment – an advantage vis-à-vis competitors that keep efficiencies for themselves. We also note that extremely high inflation would hurt unit sales.
- Shares outstanding have declined by an average 2.2% per year since 2001 and have accelerated in recent years. In the first nine months of 2010, shares outstanding declined by 5.4%.
- The dividend payout ratio has increased in each of the last 10 years, from 17% in 2001 to 29% today.
- Incremental returns on capital have been quite good as management proudly exhibited in the company’s most recent 10-Q. Return on investment for the trailing twelve month period, adjusted to include rent, increased from 18.4% to 18.6%, and return on assets increased from 8.2% to 8.8%.
Regaled Stanford Business School in California long has been seen as a bastion of “efficient markets” thinking. Indeed, two finance professors, Bill Sharpe and Myron Scholes, have won Nobel prizes—a record for business schools—advocating that markets are efficient, that stock prices accurately reflect all information. But another Stanford faculty member, Professor Jack McDonald teaches that markets are not always efficient, that discrepancies can occur, allowing a serious student of fundamental investing to buy a dollar for 50 cents.
“Jack is lonely at Stanford,” both Buffett and Charles Munger have said of McDonald. He is the only professor at Stanford teaching fundamental investing, value investing, offering a bottom-up, company-oriented approach.
Using such texts as Benjamin Graham’s The Intelligent Investor, Phil Fisher’s Common Stocks and Uncommon Profits and Charles MacKay’s Extraordinary Popular Delusions, McDonald believes that gaps of value can be ferreted out. Those willing to do the homework of examining the intrinsic value, the real worth, of an enterprise and comparing it to its market price, may be able to capture the gap in value.
For the past 36 years—sort of like the Cal Ripken of baseball—McDonald has taught investment and finance classes, with a little help from his friends.
Buffett, Munger and Phil Fisher, who have all spoken to McDonald’s class over the years, say that while the market may be largely efficient, it is not always efficient. Buffett teaches one class every two years, Munger has spoken occasionally and Fisher gave his last talk to McDonald’s class in 2000.
Michael Price is a legendary investor and someone I try to learn from whenever I get the chance. I mean, this is one the guys that taught Seth Klarman how to invest capital. A few years ago, Michael Price gave a speech to Bruce Greenwald’s Value Investing course at Columbia Business School. While I do not have the transcript directly in front of me, his words can be summarized as follows: “Read proxies and bankruptcy disclosure statements because they tell you what rational buyers are paying for businesses.”
Now this is not theoretical data – i.e. this stock should trade at 6x or 9x – this is a real buyer, with real capital at risk, deploying that capital to buy a certain asset or company. And that information holds value and is very rarely discussed or even analyzed by the sell side.
For those that are interested on Bloomberg, you can make a macro to type in NSE “PREM14 A”, and assign that macro to a button and have all the proxies filed at the tip on your hand. For disclosure statements, the process gets a little trickier – you have to monitor the docket to determine when the disclosure statement actually gets filed.
Better Than Small
Sizing Up Small Caps
By Rhonda Brammer
Barron’s – August 13, 2001
When, after two decades at D.L. Babson, where he had managed the highly regarded microcap Enterprise Fund, Peter Schliemann in 1999 decided to strike out on his own, he obviously needed a name for his fledgling firm. Finally, after no little mulling, he came up with — are you ready? — Rutabaga Capital Management. That’s right — as in the humble yellow-rooted vegetable, eaten by people and livestock alike, sometimes called a Swedish or Russian turnip.
“Well, it’s catchier than Schliemann & Associates,” quips the 56-year-old money manager.
Schliemann, whose Enterprise Fund was ranked No. 1 by Lipper in the microcap category for the 10-year stretch just before he left, says he got the idea for the name from a woman at Morningstar who had described his investment strategy at Babson as “unearthing rutabagas.” All along, Schliemann has shown an affinity for unloved, largely unfollowed companies, typically in rather run-of-the-mill businesses and not infrequently going through a rough patch.
“If you asked 10 analysts what they look for in an investment,” he observes, “at least eight of them will say a company with good profit margins. Well, we look for just the opposite.”
A big believer in the regression to the mean, Schliemann searches out small companies whose margins have temporarily deteriorated for reasons he thinks he has a handle on. And while he wants to see a catalyst for improvement, he’s willing to wait two or three years for the full turnaround. He prefers companies with a dominant niche and a good balance sheet — though he will buy leveraged outfits if they have ample cash flow to service and pay down debt.
Schliemann runs $285 million for institutions — $60 million in microcaps (companies with market caps of less than $200 million) and the balance in small-caps (with market caps of less than $1.5 billion). And while the small-cap portfolio has handily outperformed the Russell 2000 — up an annualized 8.9% since June 1999 versus 4.1% for the Russell — it’s the microcap fund that has truly sparkled. Since September 1999, it’s up 26.1% annually, compared with 8.4% for the Russell. So far this year, through July 31, Schliemann’s microcap picks have gained a sizzling 40.4%.
But don’t think for moment Schliemann is a wild and crazy guy. Because of his value bent, the beta of his funds — one measure of volatility — is roughly half that of the overall market, with the microcap portfolio being even less volatile than his small-cap holdings.
I learned about Praetorian Capital at the excellent blog Distressed Debt Investing. Praetorian is run by Harris Kupperman. His investment strategy is outstanding and worth studying closely. Here it is:
For a number of years I have followed Canadian value investor Francois Rochon who runs Giverny Capital. Rochon focuses on great businesses with durable competitive advantages. He looks for companies that are growing their earnings twice as fast as the S&P 500, which over the longterm he expects will lead to market-beating performance. $100,000 invested with Giverny on July 1st, 1993 would have grown to $984,096 vs. $342,349 if invested in the S&P 500.
In Giverny Capital’s 2009 Annual Letter to Partners, Rochon reflected on the lessons he has learned from the financial crisis, noting that some of these were already known.
Everything that cannot rise forever will someday stop. This certainly occurred with the speculation on derivative products, technology stocks in 2000, American residential real estate in 2005, Dubai real estate earlier this year, biotech companies in the early 1990s and with the price of oil in more recent years. These are just a few recent examples!
It is the nature of things that with every economic cycle, some businesses disappear while new ones are born. This reminds us of the cycle of life here on Earth.
Companies that went bankrupt all had faced a common pitfall: too much debt. The companies that withstand crises are most often the ones with solid balance sheets and with leadership that is prudent, trustworthy and devoted. Isn’t this perfectly logical?
Warren Buffett once said that investors should not be in the market if they are not willing to accept a temporary drop of 50% in the values of their portfolios. I always mention to our partners that that this was likely to happen once in their life as an investor—I knew it would happen but I didn’t know “when”.
Many investors who were on margin at the beginning of 2009 were forced to sell at the worst possible time. An investor who uses margin to invest can do well for 30 years and then lose everything in a single day of irrational market movements.
The irrationality of short-term market fluctuations makes derivative products extremely volatile (options, swaps, etc.) When many people try to sell these instruments at the same time, derivative products can become worthless overnight. When this is combined with leverage (debt), you end up with an explosive cocktail.
The good news is that the market, as Ben Graham wrote 60 years ago, ultimately renders an accurate assessment of the intrinsic value of companies over the long term. To remain calm and rational in the face of wild fluctuations in stock prices is, beyond the shadow of a doubt, the most significant quality an investor can have or try to have.
At the end of the day, in order to build wealth, there is a simple approach which we have followed for 17 years at Giverny Capital: investing for the long term in high-quality companies purchased at attractive valuations—investing in companies that will survive the crises of our civilization and the short-term irrationally of our economic system.
Rochon also likes to look back and assess his “best” errors of the prior year. This is a great practice and way to learn from your experience. Here is his Bronze Medal for 2009: BYD.
During the Berkshire Hathaway shareholder meeting last May, I listened attentively to Charlie Munger’s discussion of BYD, a Chinese company led by Wang Chuan-Fu. Charlie said with great admiration that “Chuan-Fu is a combination of Thomas Edison and Jack Welch: I have never met such a businessman.” When we consider that Charlie is 86 years old and that he has probably met the greatest businessmen of the last two generations, it’s an extraordinary comment. His words didn’t fall on deaf ears and I was instantly interested in BYD.
The company manufactures an array of products but the most important is a revolutionary battery used in electric cars. Based on this invention, BYD launched itself fearlessly into the car manufacturing business. As a fervent believer in the future of the electric car, I became enthralled with this highpotential company. Keep in mind that, with revenues of over $5 billion in 2009, BYD wasn’t exactly the new kid on the block.
My enthusiasm was cooled when I saw the company’s valuation on the market. The stock was trading at $15 on the Hong Kong market while the company only had EPS of $0.50 in 2008. A P/E ratio of 30 times seemed exaggerated in my mind. So being a persistent man, I woke up each morning to look at BYD’s closing price in Asia hoping that the stock had dropped so I could buy a stake in the company at a more reasonable valuation. This was in vain.
The company had an exceptional year in 2009. After nine months, BYD’s revenues climbed 39% and their new car division grew 50%. The company’s EPS has yet to be announced but it’s likely to have doubled to $1.06 for 2009 and analysts expect $1.84 in EPS for 2010.
The stock has soared 400% in a year, reaching its current level of $65. Sometimes, the artistic side of investing is to know when to let go, in a rare and exceptional moment, of market valuations and simply make a leap of faith based on an exceptional human being.
Here is the entire letter.
In addition, Francis Rochon was recently featured in Value Investor Insight.
In a 2000 article published in Money, Jason Jweig profiled a remarkable investor and friend of Warren Buffett named Joseph Rosenfeld who oversaw the investment committee for Grinnel College, a small school in Iowa.
“Joe,” says Buffett, “is a triumph of rationality over convention.” By ignoring the conventional wisdom about investing, Rosenfield has made money grow faster and longer than almost anyone else alive. Since 1968, he’s turned $11 million into more than $1 billion. He has heaped up those gains not with hundreds of rapid-fire trades but by buying and holding–often for decades. In 30 years, he’s made fewer than a half-dozen major investments and has sold even more rarely. [emphasis added] “If you like a stock,” says Rosenfield, “you’ve got to be prepared to hold it and do nothing.”
Here are the lessons from Joe Rosenfeld as summarized by Jason Jweig.
Do a few things well. Rosenfield built a billion-dollar portfolio not by putting a little bit of money into everything that looked good but by putting lots of money into a few things that looked great. Likewise, if you find a few investments you understand truly well, buy them by the bucketful. However, I think Rosenfield is a rare exception. Without his kind superior knowledge, skill and connections, most of us mere mortals need to diversify broadly across cash, bonds, and U.S. and foreign stocks.
Sit still. If you find investments that you clearly understand, hold on. Since it was their long-term potential that made you buy them in the first place, you should never let a short-term disappointment spook you into selling. Patience–measured not just in years but in decades–is an investor’s single most powerful weapon. Witness Rosenfield’s fortitude: In 1990, right after he bought Freddie Mac, the stock dropped 27%-. Rosenfield never panicked. Instead, he just waited. “Joe invests without emotion,” says Buffett, “and with analysis.
Invest for a reason. Rosenfield is a living reminder that wealth is a means to an end, not an end in itself. His only child died in 1962, and his wife died in 1977. He has given much of his life and all of his fortune to Grinnell College. “I just wanted to do some good with the money,” he says. That’s a lesson for all of us. Instead of blindly striving to make our money grow–or measuring our worth by our possessions–each of us should pause and ask: What good is my money if I never do some good with it? Is there a way to make my wealth live on and do honor to my name?