Monthly Archives: July 2009

Buffett and the Folly of Human Nature

In 1979, Warren Buffett wrote a telling piece in Forbes entitled “You pay a very high price in the stock market for a cheery consensus” about the folly of human nature when it comes to investing. Buffett’s point was that many investors seem almost “hard wired” to take actions that are not in their best interests.


“Pension-fund managers continue to make investment decisions with their eyes firmly fixed on the rearview mirror. This generals-fighting-the-last-war approach has proven costly in the past and will likely prove equally costly this time around.

Stocks now sell at levels that should produce long-term returns far superior to bonds. Yet pensions managers, usually encouraged by corporate sponsors they must necessarily please (“whose bread I eat, his song I sing”), are pouring funds in record proportions into bonds.

Meanwhile, orders for stocks are being placed with an eyedropper. Parkinson–of Parkinson’s law fame–might conclude that the enthusiasm of professionals for stocks varies proportionately with the recent pleasure derived from ownership. This always was the way John Q. Public was expected to behave. John Q. Expert seems similarly afflicted. Here’s the record.

In 1972, when the Dow earned $67.11, or 11% on beginning book value of 607, it closed the year selling at 1,020, and pension managers couldn’t buy stocks fast enough. Purchases of equities in 1972 were 105% of net funds available (i.e., bonds were sold), a record except for the 122% of the even more buoyant prior year. This two-year stampede increased the equity portion of total pension assets from 61% to 74%–an all-time record that coincided nicely with a record-high price for the Dow. The more investment managers paid for stocks, the better they felt about them.

And then the market went into a tailspin in 1973-74. Although the Dow earned $99.04 in 1974, or 14% on beginning book value of 690, it finished the year selling at 616. A bargain? Alas, such bargain prices produced panic rather than purchases; only 21% of net investable funds went into equities that year, a 25-year record low. The proportion of equities held by private noninsured pension plans fell to 54% of net assets, a full 20-point drop from the level deemed appropriate when the Dow was 400 points higher.

By 1976, the courage of pension managers rose in tandem with the price level, and 56% of available funds was committed to stocks. The Dow that year averaged close to 1,000, a level then about 25% above book value.” (continue reading)


The more things change, the more they stay the same. An article in today’s Wall Street Journal entitled “Rally Spurs Stocks to ’09 Highs” quotes Kevin Mahn, Managing Director & Chief Investment Officer of Hennion & Walsh. Mr. Mahn said, “Institutional and retail investors are so anxious to make up the lost returns of the last year, they are using any cue to buy aggressively. We got to the point in the first quarter, when everyone was so risk averse they lost out. And, in just six months, they have now become overly aggressive.”

As I wrote in the Comments section at WSJ.com, “It never ceases to amaze that many people would not touch stocks that were “screaming buys” just four months ago. Now, the same people are clamoring to get in after these same stocks have made massive moves to the upside – many over 100%.”

Takeaway: Learn to think properly about market prices. Faulty, self-defeating behavior can be overcome through education and discipline. “How to think about market prices” will be a topic I will broadly cover on this blog.

Geico: The Security Buffett Liked Best

In 1951, Warren Buffett wrote an article about the Government Employees Insurance Company (GEICO) in the local newspaper entitled, “The Security I Like Best”. The article is instructive because it clearly shows the factors that Buffett used to analyze and value a stock. The story of how Buffett came to own it provides a model of how to find and research a stock.

Buffett was first attracted to GEICO in the 50’s when he learned that his idol, Ben Graham, was chairman of the board and an owner. He thoroughly researched the company and invested three-quarters of his portfolio in the stock. Although he eventually sold his original position, in the late 70’s, he again, through Berkshire Hathaway, made a major investment in GEICO, when its share price tumbled as a result of underpricing its insurance risk. Finally, in 1996, Berkshire Hathaway purchased the balance of the company, and GEICO became a wholly owned subsidiary of Berkshire Hathaway. Today, GEICO continues to thrive and take market share under its low-cost model.

Here are some of the lessons we can take away from Buffett’s early purchase of GEICO.

1. Use public disclosures as a way to generate ideas. Buffett closely followed the investments of Benjamin Graham’s investment company, Graham-Newman Corp. As a result, he invested in Marshall Wells and Timely Clothes. He became interested in Geico, when he learned that Graham was the chairman and an owner. A great way to generate ideas today are Form 13Fs, which disclose the equity holdings of large institutional investment managers. They are available for free at the SEC website and available from a number of free and paid service providers such as Gurufocus, Portfolio Reports, The Manual of Ideas, and SuperInvestor Insight. Caution! These ideas are a starting point and you should always do your own research to understand the company and why its stock may be undervalued.

2. Do thorough research. It was not enough for Buffett to know that Graham was chairman of Geico. He wanted to understand the company for himself. On a Saturday in 1951, Buffett took a train from New York to Washington and went to Geico’s office in downtown Washington. Since it was closed, he had to bang on the door until the janitor finally let him in to see an executive, Lorimar Davidson, who happened to be working. Buffett ended up spending four hours with Davidson. Lowenstein tells us in his biography of Buffett that, “He asked searching and highly intelligent questions. What was Geico? What was its method of doing business, its outlook, its growth potential? He asked the types of questions that a good security analyst would ask. I was the financial vice president. He was trying to find out what I knew.”

3. Invest based on the facts and have confidence in your own judgment. Ben Graham would say, “You are neither right not wrong because the crowd disagrees with you.” After Buffett returned from Washington, he was excited about what he had learned about Geico. He did additional research and found out that Geico’s profit margins were five times higher than those of its competitors and that their premium volume was growing at a fast clip. However, when he visited a number of insurance experts of the day to get their take, they told him that the stock was overvalued. In the end, Buffett proceeded to invest based on his own work, putting three-quarters of his portfolio into the stock.

4. Make meaningful investments. It is difficult to find a great company at a great price. If you do, you should commit enough capital to make a difference in your results. A 1% position in a great company, with a clear competitive advantage, that you understand, with great management, available at a significant discount, does not make a lot of sense. Think how a private investor would approach it, if he had a chance to invest a portion of his capital in the best company in town at a fair price.

5. Look for good economics with a competitive advantage. Capitalism breeds intense competition. As Bruce Greenwald wryly put it, “In the long run, everything is a toaster”. Buffett recognized this and that GEICO was special. First, GEICO had great economics: its profit margin on underwriting was 27.5% vs. an industry average of 6.7%. Better yet, it appeared sustainable. Buffett identified that GEICO had a cost advantage over its competitors because it sold policies directly and therefore did not have to pay the industry-norm agent commissions. Moreover, this advantage was sustainable because the large established companies would not risk alienating their agents by providing an alternate direct channel. GEICO further reduced costs by focusing on lower-risk customers such as government employees, military personnel, and educators. Finally, Buffett liked the fact that most people have to purchase auto insurance and that, since premiums are paid in before claims are paid out, an insurance company gets to invest and benefit from the float.

6. If growth is part of your valuation, make sure its potential is grounded in reality. In spite of its rapid growth, GEICO had, until 1950, been licensed in only 13 states, plus Hawaii and the District of Columbia, and had a miniscule market share. Its growth potential was enormous. During periods of recession, Buffett recognized that GEICO would take share as consumers focused on reducing costs. GEICO continues to take share today for precisely the same reason.

7. Purchase shares at attractive prices. Buffett paid about eight times what he viewed as poor earnings, meaning he paid more like seven times normalized earnings.

A Lesson from Eddie Lampert on How to Invest Like Buffett

A February 6, 2006 story in Fortune, entitled “Eddie Lampert: The best of his generation”, said the following:

“His hedge fund, ESL Investments, has delivered average annual returns of nearly 30 percent, after fees, since its 1988 launch, according to several of its investors, who include Dell founder Michael Dell, media mogul David Geffen, and the Tisch family. Geffen, who gave Lampert $200 million to invest in 1992 (when Lampert was just 29), says that had he not periodically taken money out for diversification, he would have $9 billion today. As it is, says Geffen, “I’ve made more money from Eddie than from all the businesses I’ve created and sold.”

Lampert is wealthier than Warren Buffett was at his age. And his $15 billion fund has outperformed Buffett’s Berkshire Hathaway during its 18-year span (though of course the bigger Berkshire is a heavier load to move). Unlike other hedge funds, ESL doesn’t typically short stocks, or trade derivatives, or dabble in currencies, or use aggressive leverage.

Lampert buys cheap stocks and holds them for long periods. He made his first big money in the 1990s with IBM and financial stocks like Wells Fargo, and became a billionaire by buying AutoNation and AutoZone, which have tripled and quadrupled in value, respectively, since he invested in them.”

So, how did Lampert achieve such mind-boggling success? A November 22, 2004 article in BussinessWeek, “The Next Warren Buffett” provides some insight.

“Lampert has carefully studied Buffett for years. He started reading and rereading Buffett’s writings while working at Goldman after college. He would analyze Buffett’s investments, he says, by “reverse engineering” deals, such as his purchase of insurance company GEICO. Lampert went back and read GEICO’s annual reports in the couple of years preceding Buffett’s initial investment in the 1970s. “Putting myself in his shoes at that time, could I understand why he made the investments?” says Lampert. “That was part of my learning process.” In 1989 he flew out to Omaha and met Buffett for 90 minutes, peppering him with questions about his investing philosophy.”

Part of the objective of this blog will be to go back and carefully look at Buffett’s past purchases. I’ve already started with Commonwealth Trust Co., which you may want to look at, if you haven’t done so already. The point is to get crystal clear in our minds what we should be looking for. Buffett likes to talk about waiting for the perfect fat pitch to come across the plate. The lesson most often taken from this is to be patient, and rightly so, but it’s also about making distinctions. Will you recognize the “fat pitch” when it comes? Not without hard work.

Ted Williams, the great baseball hitter who inspired Buffett’s “fat pitch” metaphor actually mentally divided the strike zone into seventy-seven baseball-size areas. To be a .400 hitter, he knew he had to hit the ball in only three and a half of those sub-zones. This required an ability to make distinctions that only yielded itself to careful study and determined practice.

Tomorrow, I’ll take a look at Geico and write about why it is not only a text book example of the types of things to look for in a prospective investment, but also why the story of how Buffett came to own it provides a model of how to find and research a stock.

Lessons from Harvard’s Endowment Fund

A new article in Vanity Fair, “Rich Harvard, Poor Harvard” chronicles how Harvard is reeling from massive losses in its once mighty endowment fund. Financial journalist Edward Jay Epstein of the Huffington Post estimates that in the second half of 2008, the endowment declined as much as 50%, which would equate to an $18 billion loss. If memory serves, there was a time not so long ago when alumni were clamoring to gain access to the endowment’s fund managers. Now, Harvard is facing large operating deficits and hard choices about where to make cuts.

The situation at Harvard is once again a reminder of some important financial lessons. It is amazing that we need to keep learning these same lessons over and over.

1. (Very) Smart people are capable of doing dumb things. This speaks for itself and is reminiscent of Long Term Capital Management, whose founders included two Nobel Prize winning economists.

2. Don’t risk what you need for what you want (and don’t need). Harvard’s $39.6 billion endowment was the envy of academia, and there was every reason to believe, given Harvard’s uber-successful alumni, that large gifts would continue. Why then did the University take on this kind of risk?

3. Don’t invest by looking in the rear-view mirror. Between 1990 and 2008, Harvard’s endowment “boasted an average annual growth rate of 14.3%”. It appears that Harvard’s leadership came to think that these past returns were a kind of guarantee of similar returns in the future.

4. Don’t spend beyond your means. Harvard used its gains to ratchet up spending in the form of a huge expansion program, big pay raises, and a program that made tuition free for large numbers of students. These decisions now seem high on hubris and low on prudence.

5. Stay within your circle of competence. It is very hard to believe that Harvard’s fund managers really understood all the investments they put on. In my judgment, anytime you invest in something you don’t understand, you are speculating.

6. Think about risk first – and then rewards. Value investing is about taking risk seriously, not the kind of risk that academicians measure with Beta, but the risk of losing most or all of your capital. That type of risk management was not on display at Harvard.

7. Beware of the danger of an asymmetric incentive system for investment managers. “Heads I make tens of millions of dollars in bonuses, tails I walk away (and leave Harvard holding the bag.)” You generally can expect to get the type of behavior that your incentive system encourages.

8. Beware of the dangers of leverage. The article documents that over time Harvard’s fund managers added considerable leverage in order to jack up returns. As I wrote about yesterday regarding John Griffin, you have to build your ark on sunny days to withstand periods of great distress.

John Griffin at the Darden Value Investing Conference

When I was at Columbia attending the Executive Value Investing Course, several times Bruce Greenwald mentioned the name John Griffin as someone we should pay attention to. Griffin is a highly regarded and successful value oriented hedge-fund manager. Here is his bio from the Gurufocus website:

“John Griffin is the president of Blue Ridge Capital, an investment partnership that he founded in 1996. Mr. Griffin was known as legendary investor Julian Robertson’s right hand man. He and a few others are named as Tiger Cubs as they worked with Julian Robertson at Tiger Funds. Mr. Griffin is adjunct professor of finance at Columbia Business School and a visiting professor at the University of Virginia. He began his career as a financial analyst for Morgan Stanley Merchant Banking Group before moving on to Tiger Management, where he became president in 1993.

Blue Ridge seeks absolute returns by investing in companies who dominate their industries and shorting the companies who have fundamental problems. The firm employs fundamental analysis to make its investments.”

On November 20, 2008, as part of the Value Investing Conference at the University of Virginia’s Darden School of Business, Griffin spoke on a panel discussion entitled “Developments in the Investments Industry”. Here are my notes on his remarks:

In what he called “the spirit of honesty”, Griffin acknowledged that he has no position on the broader macro outlook. He has “no idea what is going on”. He is not concerned with this because, over his twenty-year career as an investor, he has focused on picking stocks that can produce a superior return over a three to five year time period and shorting stocks that will underperform, or “not make it”, over a one to two year period.

The likely reason his shorts work, that is, the underlying companies fail, is a poor economic environment.

His portfolio is generally net long.

The shorts help the portfolio because they can go to zero in a poor market, whereas the longs may go down a lot, but they will come back based on the strength of the underlying businesses.

Constructing the portfolio this way makes it perform in a neutral fashion in a down market and gives Griffin the luxury of being somewhat indifferent to the macro environment. [Note: this is very similar to the approach that Buffett took in running his partnership, although in lieu of shorting, Buffett primarily relied on other forms of hedging (arbitrage, control investing, etc.) to protect his downside risk.]

When Griffin started his own fund in 1996, it was a very difficult period because he did not have a long-term track record, and everyone was fixated on his short-term record, i.e. what he had done in the prior week, month, year, etc.

When Griffin started, he had a large amount of cash to deploy. It was very stressful to go from the comfort of holding cash to putting it at risk. At the time, he wrote on the board in his office, “The future is uncertain; it is always a difficult time to invest.” He constantly reminds himself and his staff of this.

People are very selective in their memories of the past. They remember back to “idyllic” times when it was obvious where to invest, i.e. that it was so obvious to have bought Microsoft when it went public in 1986, or that it was obvious that shorting stocks at the top of the Internet bubble was easy. In practice, this proved to be very difficult to do. Shorts that were highly overvalued become stratospherically overvalued.

It is never easy.

People tend to compare current conditions to past conditions and say that current conditions are abnormal. The problem is that we don’t know if the current conditions are actually normal and the past abnormal. It is a trap to assume that past conditions were normal, because it tends to make you susceptible to what Griffin calls the “reversion to the mean syndrome.”

The “reversion to the mean syndrome” is the idea that if you find a discrepancy, however you define it, that it will revert back to the mean. This has caused huge losses in the past, for example Long Term Capital Management, where huge bets were made that things would revert to the mean. Griffin argues that there is no law that things have to return to the mean and that we may not even know what the mean is. We often do not know what normal is and what it is not in investing.

Griffin had a period when he had success shorting specialty retailers. When these companies would miss very badly on earnings, they did not blame their poor business execution, i.e. merchandising strategy, real-estate strategy, etc., they blamed the weather or that there were a couple less days in the current shopping season. He sees this same attitude crop among investors who blame the market for not properly valuing their long and short investments. Griffin likens this to retailers blaming the weather for their poor performance. He says we should think about this notion of blaming these types of factors, instead of looking at ourselves and our own performance.

Everybody would become a better investor today if they would just acknowledge that they don’t know the direction of the market, and that nobody knows the direction of the market. Simply commit to doing the best job you can, in the most risk adjusted way, based on good research.

You should build your “ark” on “sunny days” for times of deep distress like this past year (2008-2009). This requires, if you are a money manager, having capital locked up so you don’t face redemptions in the downturn before your investments playout and having a portfolio that can withstand some “very serious” hits.

In Griffin’s view, the market has never been rational since he started investing twenty-one years ago.

Off the Beaten Track with Paul Sonkin

Since my earlier post featured an interview with microcap value investor Paul Sonkin, I thought I would dig into the past and post two interviews that Sonkin did with Barron’s. The picks are dated but the methodology is very fresh and definitely worth studying.

Areas of Neglect – March 4, 2002

As the Hummingbird Flies – November 24, 2003

The more a stock is followed and analyzed, the more it tends to be efficiently priced. For this reason, Sonkin focuses on stocks that are off the beaten track and which have a higher probability of being mispriced.

Graham & Doddsville Newsletter for Summer 2009

Here is the latest newsletter from value investing students at Columbia Business School. It contains an interview with Paul Sonkin, a highly respected value investor who focuses on microcap stocks. Sonkin has an MBA from Columbia where he now teaches applied value investing. He is a co-author of Value Investing: From Graham to Buffett and Beyond, which is, along with The Intelligent Investor and a handful of others, a core text in the discipline of value investing. The interview is quite instructive.

The newsletter contains valuations of Precision Castparts (PCP), which won the 2009 Sonkin Prize, and Apollo Group (APOL), which won the Second Annual Pershing Square Challenge. Both show the amount of research that is required to estimate the value of a business, and they provide a framework for the valuation process.

Here is a link to the newsletter.

S&P’s Earnings Yield vs. High Quality Corporate Bonds

In my blog yesterday entitled “How Cheap are U.S. Stocks?”, I compared the the 5-year average earnings yield of the S&P 500 with the yield of the 10 year U.S. Treasury. I then compared the ratio of these two yields to that of past bear market lows. Based on this metric, U.S. stocks look to be still priced attractively.

Today, I want to compare the the 5-year average earnings yield of the S&P 500 with the yield of 10 year AA corporate bonds. This is a meaningful comparison because investors have a choice between equities and bonds. If they can obtain a yield in high-quality corporate bonds that equals that of equities, it may put downward pressure on stocks.

As of July 23, 2009, the yield on 10 year AA corporate bonds was 4.9% compared with a 6.6% yield for the S&P 500, based on yesterday’s close. This gives the S&P an advantage of 1.7%. The advantage was 5.23% at the March 9, 2009 stock market low.

Here is a spreadsheet of the data I used.

Buffett’s Deal with General Electric

Yesterday in the Wall Street Journal’s “MarketBeat”, there was an article entitled “Warren Buffett’s Goldman Sachs Bet Worth $2 Billion on Paper”. The article praises Buffett’s deal with Goldman Sachs in which Berkshire Hathaway invested $5 billion by saying, “Looks like Warren has done it again”. The investment currently has an unrealized gain of about $2 billion. Reporter Lavonne Kuykendall says that “the jury is still out on a similar deal with General Electric” and that the “investment hasn’t performed well, yet.” I disagree. The GE deal was struck on substantially similar terms as the Goldman Sachs deal and in my opinion is performing very well for the shareholders of Berkshire Hathaway. I made the following comment at WSJ.com in response to the article.

“Saying the “jury is still out” on Buffett’s deal with General Electric seems to miss what a great deal Buffett put together. He is being paid $300 million per year on his $3 billion investment. He has no downside exposure to the stock and still has at least two more years to wait for the warrants to be in the money. If GE calls the preferred shares after three years, he will get his money back plus another $300 million. The warrants would certainly have significant value now if they traded. It would probably be impossible to put together a deal like that today. Buffett was able to do it because he could make a swift decision and had the capital to back it up. Moreover, his reputation, which functions as a type of competitive advantage, put him in a position to do the deal.”

The article judged the merits of Buffett’s deal with GE based on the current quotational loss of GE’s stock price with reference to the strike price of Berkshire Hathaway’s GE warrants, rather than focusing on the facts of the deal and its longterm economic value.

The take away is that a stock is not valued based on its quotation in the market, but rather on the underlying value of the business. As Buffett stated, “Price is what you pay, value is what you get.”