Monthly Archives: September 2010

Links of Interest – September 17, 2010

Research Report on Becton, Dickison and Co. (BDX) – Good research on a company recently purchased by over a dozen leading investors, including Buffett, Yacktman, Akre, and Michael Price (GuruFocus holdings). Also provides a good template for how to research a stock

East Coast Asset Management Second Quarter 2010 Update – See section on group think in today’s market and how to position yourself to take advantage of it.

Some contrarian bulls are feeling blue … chips – Business – Stocks & economy – msnbc.com – More on how investors are finding good value in blue chips.

Buffett Rules Out Double-Dip Recession Amid Growth – Yahoo! Finance – Buffett weighs in on the economy. Buffett’s perch atop Berkshire gives him great visibility into the U.S. economy, particularly now with the purchase of Burlington Northern Santa Fe.

Op-Ed Contributor – The Greenback Effect – NYTimes.com – A good piece by Buffett that is worth a second read.

Screening for the Best Stock Screens – A good article on tools to generate stock ideas. Checkout Finviz.com, (http://finviz.com/)

FAYEZ SAROFIM & CO. – 2ND QUARTER 2010 – Commentary by a great large cap growth investor.

JARISLOWSKY FRASER LIMITED INVESTMENT OUTLOOK 2nd QUARTER 2010 – Commentary by a great Canadian large cap investor.

CNBC’s Fast Money : For Long Term Investors Stocks Are Cheap, Aren’t They? – CNBC – Still more on finding value in blue chip stocks.

YouTube – Jim Rogers “Canadian Dollar Is The Soundest Currency” – Rogers, along with Niall Ferguson, are bullish on Canada.

O Canada: Investing in the World’s Safest Economy — Seeking Alpha – A few more thoughts on investing in Canada.

Debunking Beta Page 2 of 2 – Forbes.com – A few stock ideas from David Dreman.


Berkshire’s Scott Fetzer: A Lesson in Durable Competitive Advantages

Followers of Warren Buffett spend a lot of time writing and thinking about durable competitive advantages – what Buffett calls a moat. Buffett likes to buy companies with a strong moat and asks Berkshire’s managers to focus on making the moats of their respective businesses deeper and wider, with alligators added, if possible.

Buffett has argued that one of the best tests of whether a business has a moat is its ability to raise prices. Buffett writes about how it was near impossible for Berkshire Hathaway to raise prices on its textiles, such as suit linings, while See’s was able to take price increases on its candy virtually every year.

Academicians and analysts have attempted to categorize the source of durable competitive advantages and construct a framework for understanding them. Michael Porter of Harvard is famous for his five forces. Bruce Greenwald of Columbia teaches that high returns on invested capital and stable market share provide quantitative evidence that a business has a moat. Greenwald’s basic argument is that these high returns could not persist without a durable competitive advantage because, absent a moat, new entrants would come into the market and compete away any excess returns. Greenwald indentifies four areas of advantage.

1. Economies of scale (high fixed costs, network effects)

2. Customer captivity (habit, switching costs, search costs)

3. Cost advantages (proprietary technology, being ahead on the learning curve, access to resources)

4. Government protection (licenses, patents)

Greenwald does not view operational effectiveness as a competitive advantage, but rather the “first priority and the last” of businesses without a competitive advantage. Here’s Greenwald from the book Competition Demystified (pages 10-11):

“If the advantages dissipate, whether through poor strategy, bad execution, or simply because of the unavoidable grindings of a competitive economy, these firms will find themselves on a level economic playing field … – where life is all work and where profits, except for the exceptionally managed companies, are average at best.”

What about those exceptionally managed companies? Should investors be looking for those too, if they can deliver exceptional returns on invested capital, even if they don’t have a competitive advantage that fits the academic model?

At the beginning of 1986, Berkshire purchased Scott Fetzer for $315.2 million. This extraordinary business earned $40.3 million on $172.6 million of book value in 1986 for an ROE of 23.4%. ROE was understated because Scott Fetzer held excess cash; it paid Berkshire a dividend of $125 million in 1986.

By 1994, earnings had grown to $79.3 million on a beginning book value of $90.7 million for an ROE of 87.4%. According to Buffett, that meant Scott Fetzer ranked 4th among all Fortune 500 companies, and would have been first but for some accounting flukes in the ROE calculations of the higher ranked companies.

Here’s Buffett in Berkshire’s 1994 shareholder letter on Scott Fetzer’s stellar economic performance:

“You might expect that Scott Fetzer’s success could only be explained by a cyclical peak in earnings, a monopolistic position, or leverage.  But no such circumstances apply.  Rather, the company’s success comes from the managerial expertise of CEO Ralph Schey [emphasis added], of whom I’ll tell you more later.”

“The reasons for Ralph’s success are not complicated.  Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.  In later life, I have been surprised to find that this statement holds true in business management as well.  What a manager must do is handle the basics well and not get diverted.  That’s precisely Ralph’s formula.  He establishes the right goals and never forgets what he set out to do.”

So, Scott Fetzer was clearly one of those “exceptionally managed companies” that Greenwald mentions in passing. My take on this is that, in addition to searching for companies that possess the classic durable competitive advantages listed above, you should not overlook companies that, absent these advantages, possess exceptional management. These are the Michael Jordon’s of managements.

I’ll give one example. Prem Watsa of Fairfax Financial started with $30 million in assets and $7.6 million in equity in 1986. At the end of 2009, assets stood at $28 billion and equity at $7.4 billion. That’s almost a thousandfold increase in a business (insurance) that, according to Buffett, has no competitive advantages.

Powerful Evidence: Companies with High Returns on Equity Outperform the Market

Over the weekend, I read a book entitled Buffett and Beyond by Dr. J.B. Farwell, who is both an investor and professor of finance. The book presents compelling evidence that stocks of companies with high returns on equity materially outperform the market.

Buffett has been a longtime proponent of investing in these types of companies, which make up the bulk of Berkshire’s portfolio. Also, Joel Greenblatt has presented research which shows that cheap stocks (as measured by the ratio of EBIT/Enterprise Value) with a high return on invested capital outperform the market by a large margin over the long-term. Greenblatt’s approach has been popularized as the “magic formula”.

Buffett and Beyond chronicles Dr. Farwell’s journey as an investor and how he came to focus on stocks of companies that earn a consistently high return on equity.

In order to compare different companies, Farwell normalizes earnings in his calculations by omitting non-recurring items in the income statement and certain non-cash items that would affect a company’s equity, such as a large write-off of a future pension liability. He calls these adjustments the Clean Surplus Accounting Return on Equity. (See the book for exact details.)

The Test

Dr. Farwell tested his ideas by comparing the performance of the eight stocks in the Dow 30 with the performance of the entire DOW 30 and the S&P 500.

Here is his methodology.

“The Portfolio of 8 Dow stocks for any one year was selected by taking the 8 Dow stocks with the highest ROEs for the previous year. Fourth quarter of the previous year was comprised of estimated earnings and dividends, as these numbers are not known with absolute certainty on January 1st.

The 1987 portfolio consisted of the eight stocks out of the Dow 30 with the highest ROEs of 1986.

The calculations were performed on the first day of the year. Thus on January 1st of 1987, the 1986 ROEs were calculated. The eight stocks with the highest ROEs became the 1987 portfolio.

All eight stocks were held for the entire year.”

The Results from 1987 to 2002 – Average Returns

Dow 30 – 13.50% ($100,000 becomes $658,012)

S&P500 – 12.35% ($100,000 becomes $522,651)

DOW TOP 8 18.74% ($100,000 becomes $1,286,085)

Did Farwell Find a Correlation Between the ROE’s and Returns of Stocks?

Dows 30 (average ROE from 1987-2002)

ROE – 14.00%

Total Returns – 13.50%

Dow 8 Stock Portfolio (average ROE from 1987-2002)

ROE – 22.00%

Total Returns – 18.74%

Farwell’s data show a high correlation between a stock’s return on equity and its total return. Keep in mind that the ROE calculations were done using Farwell’s Clean Accounting method.

These are the types of stocks that are included in my watch list. I will add to the watch list each week. The watch list will continue to focus on stocks that have averaged a return on equity of 18-20% over the past 10 years.

Overtime, we can expect Mr. Market to offer shares of some of these companies at compelling bargains. One key to exploit these opportunities is to keep regular tabs on your watch list so you’re not sleeping when opportunity knocks. You will also need to do your own valuation homework so you have the conviction to pull the trigger when the time comes.

My Watch List plus Selected Valuations – September 14, 2010

I have updated my watch list for September 14, 2010.

The following companies have been added to the list:

ConocoPhillips (COP)

Exxon Mobil (XOM)

Ecolab (ECL)

NewMarket Corporation (NEU)

Praxair, Inc. (PX)

Sigma-Aldrich Corporaration (SIAL)

In addition, I have made some changes to the watch list. I have simplified the valuation methodology.

The valuation is now the sum of the current earnings yield and a simple projection of the expected growth in earnings. The current yield is based on the consensus estimate for the current year’s earnings (EPS estimate for the current year / current price).

The expected future growth rate equals 60% of the growth in EPS over the past ten years. The use of 60% is an attempt to be conservative, particularly given the challenges to the U.S. and global economies.

If a valuation sparks your interest and the company is within your circle of competence, you should research whether the factors that produced the growth over the past ten years are still in place and if the company’s position is weakening or strengthening. Where ten years of EPS data was not available, I tried to select a reasonable proxy and note it in the Comments column.

I have added valuations for stocks that are within 5% of their 52-week low or have an earnings yield that is greater than 8%.

In addition, I have added the consensus estimate for 2011 EPS to give some context to the EPS projection. I have also added the five-year average P/E to give additional context.

I stress that this watch list should only serve as a dashboard to keep you focused on areas of opportunity. These valuations are overly simplistic and should only serve as a catalyst for your own deeper analysis. I suggest calculating the earnings yield using normalized “Owner Earnings” as the numerator and also looking at the ratio of EBIT to Enterprise Value.

(The following was previously posted but provides important background information on my watch list.)

You will notice that the majority of the stocks on the watch list are categorized as a “Good Business”. That is intentional as the fourth tenet of my investing blueprint is Buy Good Businesses. I want to have an active dashboard where I can easily track all these good businesses and zero in on the ones that Mr. Market is making available at a cheap price. The basic screen for Good Businesses was inspired by Buffett in his 1987 letter to shareholders.

Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.  That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized.  But a business that constantly encounters major change also encounters many chances for major error.  Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise.  Such a franchise is usually the key to sustained high returns.

The Fortune study I mentioned earlier supports our view.  Only 25 of the 1,000 companies met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15% [emphasis added]. These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500.

To be categorized as a “Good Business”, I am looking for businesses that pass these Fortune tests. Given the severity of the recession, I might include a company that is close but not quite there. As you can see from the study, not many companies pass these stringent tests. If you are fishing in this pond, at least from a quantitative standpoint, you have eliminated many sub-par companies. Note that 24 out of 25 of the stocks that passed the Fortune screen outperformed the S&P over the decade preceding the study.

This approach for the watch list was also inspired by Mason Hawkins who said at a 2005 lecture at the Ben Graham Centre for Value Investing at the University of Western Ontario that he and his team revalue the top 200 businesses in the world every week to see if they are available for less than 60% of value.

By way of review, the other categories are as follows. The categories may be added to or evolve over time.

  1. Special Situation – restructuring, spin-off, bankruptcy, divestitures, etc.
  2. Book Value Aristocrat – exceptional book value growth over the past decade
  3. Strong Moat – evident durable competitive advantage
  4. Guru Purchase – recent purchase by a notable investor

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

Buffett’s Article on Geico: A Template for Growth Stock Investing

Warren Buffett has frequently acknowledged a debt of gratitude to Phil Fisher. While Graham taught Buffett about Mr. Market and investing with a margin of safety, Fisher taught Buffett about the merits of investing in a good business, ideally one with good growth prospects.

In Fisher’s classic book Common Stocks and Uncommon Profits, Fisher lists fifteen points to look for in buying a stock. Fisher makes it clear in the opening paragraph of the chapter where he enumerates his fifteen points that he is looking for criteria that can identify stocks that can advance several hundred percent in a few years and show a “correspondingly greater increase” if held for the long-term.

Although he does not say that the points are in order of importance, it is suggestive that the first point is about the company’s future growth prospects.

“Point 1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?”

As I have pointed out, Buffett’s 1951 article on Geico provides one of the clearest examples of an investment thesis that passes this test.

In his article on Geico, Buffett shows Geico’s track record of growth over the prior fifteen years: premiums written up 36% per year and policyholders up just under 30% per year, albeit from a small base. Then Buffett writes one of the most important sentences of the article and one that investors should focus on in their own analyses.

“Of course the investor of today does not profit from yesterday’s growth.”

It’s a simple sentence and a simple idea, but it encapsulates a great deal of wisdom. It’s the reason that investing can never be reduced to a spreadsheet or a database. It’s the reason why there is no substitute for thinking. As Buffett points out, it’s the reason that all librarians aren’t rich.

Buffett next lays out his case that Geico still had the potential for strong growth. He cites two areas of growth: 1) geographic expansion – prior to 1950 Geico operated in only 15 states, and 2) increased market share in states where they already operated – they only had 3,000 policyholders in New York State.

Equally important, Buffett explains why Geico could expect to capture business in these markets. Geico had no agents or branch offices and could offer policies at discounts of up to 30% off competitors’ rates. These savings would be amplified in periods of recession and would be even more meaningful as Geico expanded in states where the cost of insurance was high, such as New York State.

You did not need an MBA or CFA to understand why the odds were stacked in Geico’s favor.

Geico also enjoyed excellent profit margins (Fisher’s Point 5 – “Does the company have a worthwhile profit margin?) and a formidable Chairman of the Board, Ben Graham, whom Buffett trusted completely (Fisher’s Point 15 – “Does the company have a management of unquestionable integrity?”).

The most remarkable thing about the Geico story is that, in spite of its excellent economics and strong growth prospects, Buffett paid only about eight times depressed earnings for the stock. In short, he paid nothing for the company’s growth.

When pressed, many investors in growth companies cannot clearly identify where the growth will come from and, on top of that, they pay a hefty premium for that growth that leaves no margin of safety.

I think it is also worth mentioning that in 1950 Geico was unknown. Buffett’s conviction was grounded in the facts, not in the opinions of others.

Finally, although Buffett humbly and rightly acknowledges his debt to Fisher, the Geico article, which was published in 1950, eight years before the publication of Common Stocks and Uncommon Profits, suggests that Buffett already understood quite well what was involved in analyzing and valuing a growth company.

The Geico article should serve as a template for writing up an investment thesis. It can also be distilled into a highly useful checklist for investing in growth companies.

Here’s a checklist based on the article. Buffett hits all the points in his article.

Can you identify the reason the stock is undervalued? (In Geico’s case, stock casualty companies had poor earnings in 1950 and did not participate in the prior “bull market enthusiasm”.)

1. Is the company’s product or service a necessity?

2. Does the company have advantages or disadvantages in the following areas: inventory, collection, labor or raw material production?

3. What is the earnings and growth record of the company?

4. What is the reason the company can continue to grow?

5. Does the company enjoy any durable competitive advantages over its competitors, such as being a low cost provider?

6. What are the company’s profit margins and how do they compare to those of the competition?

7. What is the quality of management and the board? Do they have a meaningful stake in the company? (Geico’s directors owned one-third of the company.) You could also look for whether other leading value investors have been purchasing the stock.

8. Is the stock available at an attractive price?

The Larry Bird Work Ethic

Great article from Hoop Thoughts on what it takes to be at the top of your field. Look up virtually any top performer and there is a similar tale to be told.

While playing for the Celtics, Larry Bird’s daily program included a long-distance run, practice games with teammates, multiple sit-ups, and short-distance runs all sandwiched between lengthy shooting drills. No wonder he was such a superb fourth-quarter player — he was in better shape than anyone else.

More than 15 years later, Bird astounded many of the Pacers players by running a mile in 5:20. That achievement set the tone for the conditioning program the team endured over the summer as they approached training camp.

Veterans and rookies alike knew Bird had been obsessed with practice when he was with the Celtics, often showing up hours early so he could work on every face of his game. Other NBA coaches had used Bird as an example of a superb work ethics. One brought his team to Boston Garden early to see number 33 in action. To his amazement, Larry wasn’t on the court. Embarrassed, the coach headed for the sidelines before looking up to see Bird running on the track. He was working on his conditioning that day.

As well as his shooting. While most players waltzed into the locker room the required 90 minutes before game time, Bird has been on the floor by at least 6:00, more than two hours before tip-off. In the loneliness of Boston Garden, with only attendants and a few Celtics season ticket holders present, Bird shot more than 300 practice shots. He’d start with 6 to 10 free throws, move out on the court a bit, and then start firing away at a comfortable pace as comrade Joe Qatato hit him with perfect passes. Then the “Parquet Picasso,” as he was dubbed, would speed up the routine and by the end of the workout throw up rapid-fire shots, many featuring the Bird “drop back a step” maneuver that guaranteed him an opening from every angle. “I really don’t count my shots,” Bird said. “I just shoot until I feel good.”

(continue reading…)

Links of Interest – September 10, 2010

Hedgefundnews.com – 1999 interview with investor Morris Mark. Mark cut his teeth with First Manhattan, an investment advisory firm founded by Sandy Gottesman. (Per wikipedia, Gottesman, “began a friendship with Warren Buffett in 1962. He was an early investor in Berkshire Hathaway and today owns 19,000 shares worth $2 billion. He joined the Berkshire Hathaway board of directors in 2003.”) Morris Mark is also the mentor to value investor Ricky Sandler who runs the successful value oriented hedge fund Eminence Capital. I posted the interview because it is a good example of a sound investment process and how a great investor thinks.

Ricky Sandler’s Eminence Capital Favors High Quality Large Caps (Investor Letter) ~ market folly – Eminence Capital’s investor letter contains Sandler’s investment thesis for AON (AON) and Coca-Cola Enterprises (CCE). This is another example of an investor finding value in large-cap high-quality stocks.

Fiserv’s Got Your Back (Office) – Barron’s – Warren Buffett and Glenn Greenberg recently started large positions in the stock. Here’s Barron’s take as a primer for your own research. The stock is also on my watch list.

The Bank Of England Backs Buffett – 07/09/2010 – A good article on the virtues of patient investing. Check out the study on which the article is based.

The Lure of TV Advertising for Internet Businesses (comScore Voices) – Makes the case that TV advertising is alive and well. Good for thinking about the valuation of media companies such as NewCorp.

The Lonely Value Investor: Dell: Value Trap? – A value investing blogger raises concerns about a stock widely held by investment gurus.

Go For Silent Dividends – Forbes.com – William Baldwin on the merits of stock repurchases. Includes stock ideas.

Thanks to gurufocus for posting these outstanding notes on value investing from a great investor’s class at a major business school.

Class #1 Introduction to Value Investing

Collection of wisdom from great value investors from Value Investor Insight.

Value Investing Insights

Glenn Greenberg & The Importance of Clarity in Valuing a Business

I received a lot of positive feedback on my two-part article on Glenn Greenberg. It is clear that Greenberg is a very talented investor, not in a flashy way but in a way similar to Buffett. They both have a knack for getting to the core issue and for being able to explain a complex reality in a way that anyone can understand.

One of the parts of Greenberg’s talk that most impressed me was where he talks about dropping the use of discounted cash flows when analyzing and valuing businesses.

Investing is about trying to predict what will happen in the future. Our ability to do this is very limited. The future of most businesses is highly uncertain, because they operate without a durable competitive advantage and are therefore bounced about and pummeled by the waves of relentless competition and creative destruction.

On the other hand, there are a select few businesses where you can make meaningful predictions about where they will be in ten years. You are able to see that the conditions that led to their success over the past ten or twenty years – or, in rare cases, one hundred years – are likely to remain in place for the next ten or twenty years.

All this leads me to back to Greenberg saying that, in lieu of doing discounted cash flows, he feels the most important elements in valuing a business are to have a very clear view of why a company is a good business and a very clear view of where the business will be in a few years. The problem with cranking out discounted cash flows is that they create the impression of false precision – that we can actually look into the future and plainly see a company’s free cash flows for the next decade or more.

Greenberg prefers to spend his time and energy on what really matters and what is doable. Remember that there are things that are important and knowable and there are things that are important and unknowable. A company’s stream of cash flows over the next ten or twenty years is very important but for most businesses falls into the column of unknowable.

If you don’t get the part right about whether it’s a good business and where it will be in a few years, the investment most likely won’t work out as planned.

In my judgment, it is not that discounted cash flows per se are flawed; it is, rather, how they are often used – or misused.

Many successful investors use them. The great ones are well aware of their limitations. I believe they are useful to the degree that they make you think about the issues that will drive future cash flows, which brings us right back to Greenberg’s two fundamental questions.

Notice too that Greenberg says he wants to arrive at a “very clear” conclusion. He sets the bar high. This reminds me of when Buffett and Munger were asked at the 1996 Berkshire Hathaway shareholder meeting why they did not buy shares of Pfizer or Johnson & Johnson, seeing that both had a long-term track record pretty much equal to that of Coca-Cola. Munger answered that he and Buffett thought they understood Pfizer and Johnson & Johnson, but they knew they understood Coca-Cola. (1)

They simply decided to invest where they had greater clarity.

Finally, with regards to having a clear idea of where the business will be in a five to ten years, few businesses offer – or offered, when Buffett made his investments – better clarity than Geico and Coca-Cola. It is no surprise that Buffett singled these two out. My suggestion is that you use these two companies as a measuring stick when thinking about the competitive advantages and growth prospects of your potential investments.

Go back and read Buffett’s article on Geico, “The Security I Like Best”. Buffett lays out the growth prospects for Geico in simple, crystal-clear terms. Can you do that for each of your investments?

The same can be said for Buffett’s investment in Coca-Cola. Even after more than a hundred years of superlative growth and execution, they control only around 3% of world-wide consumption of beverages. You don’t need a computer model to see that there is still plenty of runway ahead.

The bottom line is to emphasize thinking and, if you can’t figure it out, move on. There are plenty of other fish in the sea. Cast your lot with one where you are certain and the odds are stacked heavily in your favor.

(1) Berkshire Hathaway annual meeting, 1996, Outstanding Investor Digest, August 8, 1996 edition.

Glenn Greenberg at Columbia: How a Great Investor Thinks (Part 2)

What constitutes a good business?

Greenberg asks the students to consider what they would look for in a stock if, over their entire career, they had to put all their savings into one stock and then live off that stock in retirement. The idea is to force you to think carefully about the qualities of a good business.

The students offer answers which include finding a business that has 1) a strong moat, 2) high returns on invested capital, 3) few competitors, 4) high profit margins, and 5) good management.

Greenberg comments that living with his Comcast investment for many years has convinced him of the importance of management having good capital allocation skills.

He mentions that he likes managers who are intensely focused on their business.

The severe market decline in 1987 convinced Greenberg to only own high quality businesses where he had high confidence in the fundamentals. That way he can hold his stocks with confidence through severe future market dislocations. If you buy low quality, Greenberg thinks you’ll be more likely to sell it and take permanent losses during a serve downturn. [Note: As an extension of that thought, it is likely that investors feel psychologically better about holding lower-quality cheap stocks when the market is relatively stable. An investor needs to think carefully about whether he would have the discipline to hold onto these types of stocks in a 1987 (or 2008) type downturn.]

GAAP earnings may not capture economic reality.

Greenberg then spends several minutes talking about Lockheed Martin, which is one of his holdings, and its large pension obligations. There are several different ways to measure the obligation and its impact on the company’s cash flows. Greenberg’s point is that GAAP earnings do not necessarily capture and reflect the true economic earnings of a business and that investors need to go beyond GAAP earnings and try to arrive at an investment’s true economic earnings.

Regarding Lockheed Martin specifically as an investment idea, although he did not give specific numbers, Greenberg suggests that the market punished Lockheed’s stock price because it has had to make several large payments into its pension funds which have impacted cash flows. The majority of these payments will be reimbursed by the government. Starting in a few years, when these reimbursements are made, this situation will reverse and cash flows will be materially greater than reported earnings. He cites this as example of value hiding in plain sight, if you do your homework.

Capital IQ is no substitute for thinking.

He then speaks briefly about Time Warner and Comcast. Both are in a sweet spot because they provide high-speed internet connectivity – a growing service which is in high demand – to large parts of the U.S. Time Warner is focused strictly on cable and is committed to returning capital to shareholders. Comcast is diversified into content and is run by an “empire builder”. Greenberg owns Comcast which is a lot cheaper than Time Warner and has a better balance sheet. His point is that Capital IQ (or any computer financial data service) will not help you decide whether to invest in one of these companies or which one is a better investment. There is no substitute for thinking and doing your own homework.

How can you get an edge when you buy large, widely followed companies?

A student prefaces a question by saying that value investors look for cheap and ugly companies (which are the most likely candidates for mispricing). He then asks Greenberg how he can get an edge and be on the right side of the trade when his portfolio is full of large-cap leading companies. Greenberg responds by first noting that there is much more competition today in the field of value investing and that hedge funds have the resources to put a dedicated analyst on a single industry. He acknowledges that it may make sense to look for obscure companies with little or no following, but that there is no guarantee that these are good businesses. This may make sense if you are managing a small sum of money. Greenberg has had to move up in size as his funds have grown. Greenberg then says that just because something is big and widely followed, does not mean that it is properly understood. Analysts can become myopic and focus on the wrong things.

The student further challenges Greenberg by asking how he could get an edge by investing in Google. Greenberg responds by saying that there is little or no real research being done on the company and that none of what is being done seems to be focused on what will happen in 3 to 5 years. No one is really looking at how Google’s various assets outside of search will develop over the long-term.

Greenberg says that his firm is looking at many companies but they are not seeing a lot of growth. They see many cheap stocks, but little growth. He is convinced that Google will grow. He compared Google to Goldman Sachs in that the best talent wants to work for these firms and that will give them an edge. They also have the money to buy up-and-coming companies with a lot of promise.

LabCorp and Varian Medical Systems offer low-risk growth.

The next question is about Greenberg’s investment in the healthcare industry and the impact of the new healthcare bill on these investments. Greenberg first speaks about his investment in LabCorp, which operates in competition with only one other national firm, Quest Diagnostics. LabCorp has better economics than Quest. The business has high barriers to entry because most of the payments come through third-party reimbursements, and it would be nearly impossible for a new entrant to set up shop. It is slow growing and absolutely necessary. Genetic testing is growing rapidly. LabCorp has a 9% cash flow yield and can grow 3-4% per year which will give a satisfactory return. He thinks that, in a few years, there will be tests for cancer that will be the standard of care; this will be a huge windfall for LabCorp. Labcorp should make 13-14% per year with very little downside.

Greenberg’s other healthcare investment is Varian Medical System which sells products for treating cancer with radiation. They have 60% of the market in the U.S. The market is growing world-wide with a long runway. It has high returns on capital.

Why DCF analysis is overrated and how to set an appropriate hurdle rate…

Greenberg then speaks about discounted cash flows, hurdle rates and valuations. He came up doing all his analytical work on a yellow pad. He then went on to hire younger associates who were well versed in discounted cash flow analyses, and he began to use them. He has now come to the conclusion that these models have been worthless over the past three years, and he has gone back to his old methods.

Essentially what he does, and what he feels is more important, is to have a very clear view of why a company is a good business and a very clear view of where he thinks the business can be in a few years. He likes to start out with the free cash flow yield today and then look at how much he thinks the business is capable of growing over the next few years. If the sum of a the free cash flow yield plus his estimate of the growth rate over the next five years comes up to 15%, then he feels he has a pretty good investment. Given the expectation that the general market will return 6-8%, Greenberg holds that an investment is clearly undervalued if it can deliver 13-15%. He is really against using computers to value stocks and mentions that so is Buffett.

His old hurdle was to ask if a stock could go up 50% in the next two years. 2007 was particularly tough because Greenberg could not find anything to buy and yields on cash were extremely low. He had to keep lowering his hurdle as the markets got higher and competition increased. He successively lowered his hurdle rate in light of these new realities and arrived finally at 15%. He asked Buffett the same question and he said he will not go below 13%. Greenberg considers this a simpler and better approach. He wants a portfolio of high quality businesses that won’t shock him by falling apart.

How Greenberg sizes his investments…

He is asked how he weights his position sizes. His answer is that it is a matter of judgment. You find the best opportunity you can and then assess your level of confidence. Sometimes the one you think can go up the most you also judge to have the most risk. This may cause you to moderate your position size. He cites Ryanair as an example of a business with greater upside and greater risk, for example, the price of oil, or that the earnings are in Euros. The larger positions have greater certainty. Greenberg has had 20% positions.

He is asked about his worst investment. They have a rule that unless they are willing to invest 5% of their capital in a stock, they won’t invest at all. They have all their own money in the fund. They broke their own rule and put 2% in an LBO where they lost all their investment. They once bought puts on the S&P when the market was high; the market kept going up and they lost their money.

He thinks that you should not go away from the things you know about.

Iron Mountain

A student asks him about his investment in Iron Mountain which Greenberg no longer owns. Greenberg bought the stock because he liked Iron Mountain’s national footprint. He also thought data storage would be a sticky application and that they would have pricing power because data storage seemed like a relatively small expense for the firms, such as hospitals, that were buying it. These assumptions turned out to be incorrect. Iron Mountain also ended up having higher capital expenditures than Greenberg originally envisioned.

Lessons learned from the 2008 crisis…

The final question is about the lessons that Greenberg learned when he lost 25% of his portfolio in 2008. [Note: it was not clear if this meant that the value of the portfolio declined 25% or that he lost 25% of the fund’s capital through redemptions.] He said to never work with people who operate on margin because they tend to panic. Do your own research carefully and buy good businesses. Good businesses have come back. He cites American Express as an example. You make the most money when the sky is falling. If you know a company well and you’ve done your homework, you can take advantage of these situations. (Mr. Market) He thought very deeply about whether he should change his approach given 2008 and decided to stay with his existing process/philosophy.