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.
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.