A Great Investor Discusses His Evolution

March 27, 2007 Professor: Tonight‟s speaker is one of our most valuable. What is particularly important is that he is one of the people who as much as anybody else has kept the discipline of value investing alive during the years when it scarcely existed (at Columbia Business School). He started out with Walter Schloss whom you read about in the outstanding investors of Graham & Doddsville. Who along with Ben Graham and Warren Buffettt are the fathers of value investing? He was also, after going out on his own, an extraordinarily effective producer of other value investors. Who has taken XX‟s class? Talk to people who did. It is an extraordinary class. He was also the person who recruited and trained Beth Lilly (Manager for the Woodland Fund) from a fate worse than death, which is Goldman Sachs. In particular, he actually is the person who funded the first revival of value investing here at Columbia. He gave the money to have the first value investing breakfast to bring value investors back. He has spoken at every class since its inception. Applause! OPENING REMARKS Great Investor (“GI”): Thank you. It is always a pleasure to return to this class. I am a Columbia MBA myself and I graduated 37 years ago. I have been a securities analyst my entire life which means I haven‟t had to work very hard for a living. I met Walter Schloss after a great deal of effort to do so, early in the 1970‟s. And through him I met a man named Sandy Gottesman, a very renowned value investor and currently a very large shareholder and Director of Berkshire Hathaway. I worked for Sandy at First Manhattan, and it is from Sandy that I learned much of what I know today. I was instrumental in establishing the Graham & Dodd Program here. I also take some pride in helping reengage Warren Buffettt here at Columbia Business School after a long period where he was estranged. As the professor said, I talk every year for the course, and it is something I look forward to regularly. Every year after I do so, I ask him for a report card, and he says don‟t change a thing. PROFESSOR: But every year you do (change). GI: I do it first of all just to keep him a little off guard and make him nervous about what I may say or do. But I also try to keep changing myself. I try to keep learning. I constantly am thinking about what I have done, how I practice what I do and how I could do it better and how I could avoid repeating mistakes. To the extent that I am still active and still thoughtful, I change from year to year and I try to impart some of that change in my remarks to this class. Every year I have the challenge of distilling 37 years of experience into 1.5 hours. My first thought is that if I could really do that, it doesn‟t say much for the thirty-seven years—it wouldn‟t have been much of a career. It wouldn‟t be much, if it could be distilled (that easily). Distillation is very hard. You have heard of the newspaper reporter saying to the editor, “I am going to write a 2,000 word article because I don‟t have time to write a 500 word article.” In the class tonight I will try to distill in an hour and a half, and the outcome will be the very high points and literally I will not provide a lot of answers to you. I want to provide a lot of big questions for you to think about not just for tonight but for as long as you are doing this kind of work.



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A Great Investor Discusses His Evolution

I have said repeatedly to the Professor that I think the challenge of this course is to keep it at a high enough plain. At the onset when we were creating the course, the risk was that we would have people come from Wall Street who would tell very shallow, particular, antidotal experiences. I didn‟t think that was of high enough quality for the caliber of Columbia and the aspirations of this business school. So I try to keep my talk at the most general level. You may not agree with everything that I say, but I hope you will never be able to come back to me and say that something you said to me was outright wrong. There may be nuances but I am trying to get the most general points across. This year at the professor‟s suggestion I attended his two introductory lectures. I heard what he said. So I can dispense with introductory material. I do want to define value and what it means to me. Value is the present value (PV) of the distributable cash flows. But we all know that is an easy definition to make but a hard one to implement. The other definition of value is the price at which an equally knowledgeable buyer and seller would negotiate a transaction freely and not under duress for cash. In terms of value investing, I want to emphasize the idea of self-awareness—of knowing yourself, knowing what you know, and what you don‟t know. The idea of a circle of competence is important. There are areas where you know just as much as anybody else and there are areas that are not analyzable by anyone. The idea of value is something that you should always think of as a range. I see too often among security analysts a false sense of precision. The idea that there are many more significant digits in their work than there really are. Since studying here at Columbia and over the years I have been teaching this class, I have become increasingly interested in the study of behavioral biases not only of other market participants but also to help understand how I am thinking and why. I know there is a behavioral finance program here at the business school. I think it is something that you should take a passing interest in. Those are the opening remarks and I would now like to go quickly through the handout. HANDOUTS The list of books that I suggest on the first page is--believe it or not--a carefully culled list. I read constantly. I try to read as many investment books that may have something new or important. I want to identify a couple of books I think are especially worth reading and worth having. The first one is Value/Growth Investing published in England. There appears to have been a lot of cooperation with Warren Buffettt and Charlie Munger. This is about the best single book I know on the kind of investing that we will be talking about.
Title * = highly recommended *Valuegrowth Investing *Franchise Value: A Modern Approach to Security Analysis *Irrational Exuberance (2nd Ed.) *Inefficient Markets: An Introduction to Behavioral Finance Fooled by Randomness The Battle for the Soul of Capitalism Fortune‟s Formula The Theory of Gambling and Statistical Logic (rev. ed.) Fischer Black and the Revolutionary Idea of Finance My Life as a Quant: Reflections on Physics and Finance Author Glen Arnold Martin L. Leibowitz Robert J. Schiller Andrei Shleifer Nassim Nicholas Taleb John C. Bogle William Poundstone Richard A. Epstein Perry Mehrling Emanuel Derman Publisher FT Prentice Hall John Wiley & Sons 2004 Princeton University Press 2005 Oxford University Press 2000 Texere 2001 Yale University Press 2005 Hill and Wang 2005 Academic Press 1977 John Wiley and Sons 2004 John Wiley & Sons 2004



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When you look the mainstream institutional investors. easy read. I have also excerpted from John Maynard Keynes about investor short-sightedness back in the 1930s. the Fidelity. there will be swings of price around intrinsic value. The Introduction to Behavioral Finance by Andrei Shleifer. The Battle for the Soul of Capitalism (2005) brings home the enormous size. From my experience I have almost never found a company trading at ½ of value. how important they are and how they can move markets.1 King Kong: America‟s Largest Money Managers from John Bogle‟s book. The Fischer Black idea that companies trade at ½ value and 2x value most of the time is something that meshes nicely with my experience. Interest and Money). I think almost all markets are efficient almost all of the time..A Great Investor Discusses His Evolution The John Bogle book. The Irrational Exuberance book by Robert Schiller is a must read. As an aside there is a subset to this little excerpt from Warren. i.csinvesting. I can‟t think of a time when there were a large number of stocks trading at ½ of value.” That is over the long-term and that is of course true for any company. This is a tremendous book. I excerpted this one. and a share price that fluctuates around that intrinsic value over time. the aggregate gains made by Berkshire shareholders must of necessity match the business gains of the company. the price is more than half of value and less than twice value.com teaching/studying/investing Page 3 . Journal of Finance 410). A few pages in I have a quote from Fisher Black from the book. particularly the second edition. It is quite succinct and it reminds me of what Buffettt said to me on more than one occasion when we were talking about the US government bond market. By this definition. very important idea. The second edition is important because it updates the book from discussing the boom and bust in the stock market to the boom and bust in the housing market. You can‟t underestimate how big they are. There are a couple of large institutional investors (Sequoia. Except in times of extreme pessimism or extreme gloom and doom like year-end 1974. It is a collection of his lectures. The General Theory of Employment. and Davis Funds) that I am aware of who hold Berkshire for their www. the Van Guards and so forth. How he thinks of market efficiency. 1986. (Chapter 12 in the book. “We might define an efficient market as one in which price is within a factor of 2 of value. The real estate bubble. If we believe there is an intrinsic value that will accompany a stock.wordpress. Fischer Black and the Revolutionary Idea of Finance by Perry Mehrling (2005). You may have had people come to this class and tell you that they can find stocks trading at half of value. bond market is efficiently priced almost always. “Over time. „Almost all‟ means at least 90 percent. The Box 4. A good. You should read it.” (Fischer Black. It is a very. behavior and influence of mutual funds. Every day we hear so much about how big the money management business is in aggregate. basically they are three quarters of the market. Fairholme. In the long run the returns of owning the stock will be equal to the growth in value generated from the business. The book talks about the behavior and management of these funds which you need to be aware of to understand valuation anomalies. He was a brilliant man—the originator of the Black-Scholes option model—and he had a number of valuable insights. It is almost never able to present an opportunity that he would consider worthwhile. He said the US govt. Usually when my analysis leads me to believe that the company is trading at 50% discount to value or less and I go back and do my analysis again to see where I made my mistake.e. Warren Buffett excerpts from his 1990 Berkshire Hathaway Annual Report where I underlined one section.

2006 in Barron‟s: “Perhaps the most surprising thing to me is the inability of even market professionals to adjust for profit margins. between low profit margins such as those in 1982 that were half normal and dramatic profit margins such as those in 2000 and today. www.wordpress. 2007: Profit Pullback May Foretell Cost Cutting by Justin Lahart: A month ago.4%--up from 7% five years earlier and at its highest level in over 50 years. But that estimate also implies that fourth-quarter profits have grown by better than 10%. I find that a very difficult case to agree with because Warren says from this excerpt here and one of his important missions in life is to have a fair value for Berkshire. They argue that the stock is undervalued. which would market it the 19th quarter in a row that the broad measure of profits has grown by better than 10%. The people who own this stock and argue for its cheapness are arguing against the man himself.7% below the third-quarter level. Carson‟s estimate implies that it fell to 11. as professionals. Profit margins were “stabilizing. 6.” Mr.A Great Investor Discusses His Evolution clients. The excerpts here I have from the Economist. is to normalize between economic boom and economic bust. A lot of people think profit margins can be sustained. a sign that an economy is in the late stages of expansion. He doesn‟t want big gaps up or down between price and value.csinvesting.7% in the fourth quarter. Excerpt from interview with Jeremy Grantham on Feb. former Federal Reserve Chief Alan Greenspan stirred markets when he remarked on the possibility of a recession. as I do. the Commerce Department will also report on corporate profits. Profit margins are provably the most meanreverting series in finance. then something has gone badly wrong with capitalism. In the third quarter. Greenspan said. In other words. If high profits do not attract competition. this came to 12. profit margins got smaller.com teaching/studying/investing Page 4 . You must appreciate that long-run profitability is extraordinarily high and has been for many years—way. that would mean that companies saw a smaller portion of their sales fall the bottom line. But that estimate also implies that fourth-quarter profits were 4. And since the overall economy grew in the fourth quarter. Alliance Bernstein economist Joe Carson estimates pretax profits were 13% above their year-ago level. People will talk about the P/E being reasonable at 19 times without mentioning that it is 19 times the highest profit margins ever reported. it is something to be well aware of. Such a sequential decline is rare. and if profit margins do not mean-revert. One simple way to measure profit margins is to look at pretax profits as a share of GDP. there is something wrong with the system and it is not functioning properly. it looks like its getting slimmer.” Annotation on Reversion to the Mean on Profit Margins In the Wall Street Journal C-1 page on March 29. way above the long term norm and if you believe in mean reversion. Mr. So what happens when they start to shrink? When it reports its final estimate of fourth-quarter GDP today. I also included a quote from an interview in Barrons'. The least we can do.

The other reason is that if corporate profits grow as fast as GDP. What is the history of the stock market—a 9% rate of return with a 12% standard deviation? If someone said to you that you could buy a treasury bill for 5% or you can buy the average stock with an expected return of 7. the GI seemed accurate in assessing possible risks. As you can see. The idea— GI spoke about this earlier in your class: the idea--that the default option is cash or a piece of the index. I will then buy an index fund with what is left.csinvesting.wordpress. So the idea that corporate profits will stay at the same percentage of GDP assumes that corporate profits will maintain their high levels.com teaching/studying/investing Page 5 .5% implied rate of return. therefore.3% in 2001 during the last shallow recession up to 12% in 2007. This is something I will take exception with GI when he talked about 7. P/E multiples are moderate by historic norms but the earnings part of the P/E are very high. the risk assessment of owning equities could change from the low risk assessment of today. find that an appealing choice. But institutions do that kind of investing all the www. …If the cuts turn to jobs then Ben Bernake may need to throw his inflation caution to the wind and cut rates. I don‟t think very many of you and.5% rate of return is something that I disagree with strenuously. Many institutional money managers operate that way. Pretax profit margins as a percentage of GDP went from 8% in 2000 to 7. Investor‟s appetite for risk could decline such that they will not value equities as highly as they do now.5% with a expected standard deviation of 12% or 15%. but I would hope that when you manage your own money. To me that is a difficult assumption to make since they are at unprecedently high levels. You could get profits growing as fast as GDP but prices fall. I would say that is an optimistic assumption because corporate profits as a percentage of GDP are at record highs. -Yes.5% returns on the stock market— implied total returns on current valuations. I can‟t imagine that any of you would say that if I can‟t find enough investment ideas so. This lecture given in 2007. So there are two specific risks that you may not get a 7. That is the difference between the institutional mindset and the appropriate individual mindset.A Great Investor Discusses His Evolution Companies in their quest to stay on the right side of shareholders may react to even an incremental decline in profit margins by cutting costs sharply. This idea of investing for a 7. certainly I would not. you wouldn‟t act that way.

Martial Law. where the author talks about black swan events. Over time markets can do extraordinary. doesn‟t mean they can‟t happen or they won‟t happen. Maybe no one has encountered. Independent thinking. even bizarre things. it certainly is not an inclusive list: major earthquake.wordpress. It has been a long time since a well-diversified investor has suffered a permanent loss.csinvesting. Is Coca-Cola worth owning if there was no opportunity to trade it? Those are individual choices but it is something to be aware of.” If you can‟t…Warren Buffettt doesn‟t say run for the hills. I think in the context of what he said in his letter here that is something to think about. Here is what he says. www. including those never before encountered. These are all unthinkable things but just because they haven‟t happened in 25. I have a list here. Another book that I talk about. suspension of civil liberties. So. young investment professional. What does that mean? I don‟t have all the answers. Warren Buffett talks about risk as the permanent impairment of capital. Just because you have not seen a black swan doesn‟t mean it doesn‟t exist. they will invest in equities. however. The Fooled by Randomness. and they have to be fully invested all of the time. I believe the institutional nonsense of accepting low returns and being invested all the time. What they have learned is that the market goes up over time. bird flu. So when people talk about the standard deviation of stock market returns.” Temperament is also important. Whether you like it or not when you invest in stocks. He is saying there probably is some extremely low frequency. 50 or 100 years. -GI: I think I understand what he is saying. nuclear attack. you are assuming these types of risks. playing the relative performance game—all of that will come to an end when there is a permanent impairment of capital--when something bad happens. they are looking at historical data—we could talk about the dotcom crash. He says the investments he likes to make are the ones where he would be happy holding them if the stock market were closed. But there is far more to successful investing than brains and performance that has recently been good. value investors don‟t talk about risk in the sense of volatility. In it (2006 Annual Report to Berkshire Shareholders) he talks about his desire to recruit a new. among them individuals who have impressive investing records. Many generations have learned that the stock market returns to some sort of normalcy even after a serious downdraft. even for a small advantage that entails some risk. But when we talk about risk in the stock market. high severity risks to stock market investments that nobody has recently lived through. The idea that events can occur that you never think could occur. We therefore need someone genetically programmed to recognize and avoid serious risks. “It is not hard to find smart people. and a keen understanding of both human and institutional behavior are vital to long-term success. The risk. My belief is that you should try to get paid for that risk.com teaching/studying/investing Page 6 . emotional stability. being exposed to risks. A single big mistake can wipe out a long string of successes. is that the game is more complicated than it seems or that history will tell you. I‟ve seen a lot of very smart people who lacked these virtues. Annotation: Charlie Munger on page 73 in Charlie’s Almanac: Insist upon proper compensation for risk assumed. he wants someone to think about it and be aware of it (risk). Because they are in the relative performance game. we could talk about the bear market of 1973-74. I hope all of you have read his new annual report and letter to shareholders. the 1987 crash.A Great Investor Discusses His Evolution time.

This is what happened to Warren with the Benjamin Graham-inspired investment strategy of buying bargain (“cigarbutts”) stocks that were selling below book value regardless of the nature of the company‟s long term economics. oil & gas companies.csinvesting.” This is Warren quoting the English philosopher Bertrand Russell. “Nothing is ever as bad as it seems. Prices revert). The professor has heard me evolve and heard me change what I talk about. We lean against the tide.getting back to Buffett‟s idea of the longterm that the stock will track the underlying business in the long run. he didn‟t really care about the products it produced. When businesses are doing well. there is over-expansion. (Competition enters. Businesses go back to their long-term norm.” Horace--Ars Poetica). I have no problem with that kind of volatility but I wasn‟t getting high enough returns for that volatility. In Warren‟s early days he was only concerned with the historical financials of a company. We like to buy when things are out of favor and sell when they are in favor. EVOLUTION OF GI‟S INVESTING STYLE I want to talk about what I do and how my investing style has evolved. and I decided that there is a better way. because his words so aptly describe the insidious nature of bad business habits that don‟t become apparent until it is too late. he didn‟t separate a commodity-type business such as textiles.” (From the 2nd Edition of Security Analysis—“Many shall be restored that now are fallen and many shall fall that now are in honor.wordpress. When he finally woke up in the late 1970s to the fact that the Graham bargain ride was over. But he stayed with this approach long after it wasn‟t viable anymore—the chains of habit were too light to be felt. Warren looks for a good business that is selling at a fair price. nor as good as it seems. This was something Warren was able to do with great success during the 1950s and early 1960s. His mentor Graham believed the numbers reflected everything there was to know. or even better.” The world is full of businesses with poor economics selling at what seem to be bargain prices. I used to deal with severely depressed cyclical companies—steel companies. And I would sell them when the prosperity would return. Poor businesses tend to stay poor businesses. I had stocks where I made twenty times my money but it took 25 years (a 9. a great business at a bargain price. One way or the other all businesses are cyclical. It was a successful style of investing. Annotation: Warren Buffett: “The chains of habit are too light to be felt until they are too heavy to be broken. That is a deception that people perpetuate on themselves—that is to say I am going to buy businesses that are not cyclical. etc. It means in modern terms that there is a tendency toward mean reversion. businesses that would have wide ups and downs.A Great Investor Discusses His Evolution Investors will pull away from the market when they see that the returns are not adequate for the risks. Companies that report very smooth earnings are fudging the numbers through accounting that would make the earnings smoother than the underlying business‟s true earnings really should be. I am…nearly all value investors have a little element of contrarianism in them.com teaching/studying/investing Page 7 . I decided after a lot of thinking and a lot of analysis of what I could have done. they have a tendency to go back to their long term performance measures and vice versa. and I would buy them when they were way out of favor. which has www. All businesses are cyclical to some extent. But that is …. Annotation: Buffettt: “Turnarounds seldom turn. when the businesses were doing poorly. might have done.648% CAGR). It took me a long time to figure out. I earned good positive returns but the volatility of those returns was quite high. he shifted to a strategy of buying exceptional businesses at reasonable prices and then holding them for long periods—thereby letting the business grow in value. Benjamin Graham used to write in a Latin phrase for it. should have done.

and he doesn‟t have to wait for it to be selling cheap. they tend to have lower debt. I deal with seasoned companies. Now. I am also no longer interested in companies where there is a story or a narrative.com teaching/studying/investing Page 8 . I am interested in its long record. They buy stocks on a quarter-point drop in interest rates and a month later will sell the same stocks at a quarter point rise in interest rates. if he holds on to it long enough. I refine or restrict my list to companies with superior financial characteristics. which requires them to buy a stock when it is rising quickly in price and sell it if it is rapidly falling in price. reports earnings that are a penny or two higher or lower than expectations. you can have the divergence between price and value. it would appear that stock prices are much more variable than the changes in their underlying intrinsic values. I am talking about long-term high profitability. but over a series of days. You see these stories every so often like IBM. little companies. Warren will only buy a consumer-monopoly-type company that has a competitive advantage. he soon realized that it was the consumer-monopoly-type companies that had the competitive advantage and were producing the superior results. (The Tao of Buffett) www. We will talk about what that means. (The Tao of Warren Buffett pages 46-47) CURRENT METHOD OF INVESTING What do I do now? First of all. consistent profitability and consistent cash generation. will move the stock price of these enormous companies 3% to 5% in a day. they are successful and they are not tiny. But in general these are companies that are cash generating. if I said to you. Graham would buy anything as long as it was cheap. They generate cash in excess of their cap/ex and reinvestment needs. businesses that are more than self-financing. And while I can‟t prove it. inflations--and see how the business performs. with free cash flow. Wall Street because of its short-run obsession is very twitchy. the value didn‟t move 5% but the price did.A Great Investor Discusses His Evolution poor long-term economics. Not in a single day. They utilize a strategy called momentum investing. Annotation: Warren Buffett: “We believe that according the name investor to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic. The insight that I bring to these companies is that their stock prices—this is historically demonstrable--are much more volatile than their underlying values.csinvesting. I am not talking about long-term growth. for which he paid approximately 20 times earnings. I am not interested in a company that is going to do something new and different. The opportunities for value investors can and do present themselves. from a consumer-monopoly business such as Coke. almost no company doesn‟t have some degree of cyclicality in its operations.” The trading madness that goes with the mutual and hedge funds is almost boundless.wordpress. A fair price is all he needs. an enormous company. through recessions. But for the new Warren it was a more-thanfair price that paid off for him in the billions. But as Warren became active in running a struggling commodity type business. which has great longterm economics. By that I mean companies that have been around for long enough to have a record that shows how the business behaves in various economic environments—a business that has been through good times and bad. The old Warren would never have made this investment because the Grahamian valuation techniques would have deemed it way too pricey. These are big companies and they have been around long enough to be seasoned by my definition. Because they are cash generating. An excellent example of this was his investment in Coca-Cola. Pretty much unavoidably these are pretty big companies. We will talk about specific examples in a few minutes when we look at some Value Lines. I presume that a company of a certain size has a long record. For sure. I look for companies that have a long enough track record so what you are looking at present can‟t possibly be an aberration.

and he owns stock like Amazon. He didn’t think in terms of franchises and growth. Raymond ``Chip'' Mason. Tyco By Danielle Kost March 30 (Bloomberg) -.The bad news streamed down via satellite to a private yacht cruising somewhere off the Leeward Islands. one of the greatest in the history of investing. of course. had beaten him at last. not anybody. www. There is a highly regarded money manager with a wonderful performance record who manages a lot of money (Bill Miller). Mired in Worst Slump of Career. the mastermind behind the $21 billion Legg Mason Value Trust mutual fund. below working capital (below net/nets). That is…… Benjamin Graham writes about not paying at all or anything for the future. you are getting little for the here and now of the total price you pay.had come to an end. The final numbers showed he'd returned 5. inter-related. is finally over. What is the present value and what is the future value? GI will tell you how they are. if you look at the reinvestment needs of the business. He calls himself a value investor. Sometimes 60% to 80% (of the market value of the company) represents the remote future so that is not something value investors would do. He didn’t want to pay for the future. but I don‟t believe on any consistent basis he or anyone else can project cash flow for businesses 20 or 30 years in advance on any consistent basis to buy stocks based on their valuation. Now when I create a normalized financial model.” Not you. On board. You may know whom I am talking about. Miller.15 years of besting the Standard & Poor's 500 Index -. that is where opportunities present themselves. Legg Mason Inc. the next thing I try to do is to try to break down the components of the business. You look at sales growth. “nonsense. Miller says there was no buck-up message waiting for him from his boss. Embraces AES. trailing a 15. His streak -. stable companies with superior characteristics are performing at below normal or trend. the variability of sales growth around trend and if you look at the cash generated per dollar of sales. You can look at IBM. And that when you pay a high valuation for a company that seems to be growing far into the future.9 percent in 2006. He was paying a discount for the present at a discount by buying below book value. they can tell therefore if Amazon is undervalued. he knew. says people often ask if he's somehow relieved that his run. It may turn out that he is right and his projections of the cash flows are correct. When these big. He submits that he and his people working for him. for whatever reason.A Great Investor Discusses His Evolution What I do with these companies is to create a normalized financial model.com teaching/studying/investing Page 9 .csinvesting. Annotation: Bill Miller. Nor were there condolences from his friend Warren Buffett.wordpress. How much the price represents the present and how much is the future? All of us value investors who come before you in this class will tell you that what we don‟t do is pay much for the future.8 percent gain by the S&P 500. I would just say. If I could meet him face to face. and you can see that it is a business that is so big that it really can‟t really change very much from one shortrun period to the next. You can then decide whether it is performing above or below a normalized performance level. who make long very long run predictions of Amazon‟s cash flows and discount them back. I won‟t tell you precisely how I do it.com. There was little cheer at Baltimore-based Legg Mason when Miller returned from his late-December sail. The professor demonstrated for you early in this class about high growth companies and their cash flows and how much of their cash flows are far into the future. money manager Bill Miller was bracing for the blow: The market. but this is a way to think about businesses. you can create a model that normalizes all these factors.

who posted an average annual return of 16. Two weeks later. ``I said. unlike Miller.' We will analyze spectacular errors. another of his favorites. `I don't. But as I looked at these better companies.com Inc. I used to say….'' Miller. with a 24.. A third choice.. then the odds of beating the S&P 500 for 15 consecutive years would be the same as the odds of tossing heads 15 times in a row.8 percent from 1991 to 2005. His recent showing was a rare misstep for Miller.5 percent. In the center of his bookcase sit framed stock certificates of past bloopers. ``We are paid to do a job.2 percent from 1990. Buffett. he put his odds at 1 in 2.com teaching/studying/investing Page 10 . UnitedHealth Group Inc. something with odds of 1 in 2.'' Miller said. he scraped by in the final days of December. ``Many of the best managers run into periods of weakness. ``It still would be hard not to see Miller as one of the best investment managers of his generation. Warren Buffettt says he would rather pay for a great company at a good price than a good company at a great price. ``On the other hand.wordpress.4 percent in 2006. Miller wouldn't have beaten the S&P 500 for 15 years. ``So there was probably some skill involved. Value Trust pick Sprint Nextel fell 10.'' Losing Picks ``I got asked.'' Such assurances don't change the fact that Miller is mired in the worst slump of his career.3 percent last year. In 2005. I could find enough investments with a 30% margin of safety to put to work the amount of money I was managing. I would submit that really superior companies—Coca Cola. Luck or Skill? In his January letter to investors. As Fischer Black says most companies‟ trade between ½ to 2 times value most of the time (90%). Miller's bets on homebuilders soured in 2006. Value Trust's return sank below that of the S&P 500. including Enron Corp. sank 16. `How do you go about analyzing your mistakes?' Miller says. lost 13. If I wait for a really great company to trade at two-thirds of value then I will never buy anything.A Great Investor Discusses His Evolution ``The answer is: No. That is what I think he is talking about.and I am not at all happy or relieved about that. but not garden variety errors. when they are really www.'' says Christine Benz. when he became sole manager of Value Trust. I don't analyze my mistakes.. for example. delivered an average annual return to shareholders of 18. to 2005. Using the actual probabilities of beating the market in each of the years from 1991 to 2005. For starters. and WorldCom Inc. like tossing a coin. Sometimes.4 percentage point. too.S. I began to understand that they don’t get as cheap as lesser companies do.'' Miller has picked some doozies in his day.I don‟t find companies trading at half of value.2 percent return. and we didn't do it this year -. beat the S&P 500 in 2006. told Value Trust shareholders in a January letter discussing his 2006 performance. I used to have a cut off for a margin of safety of about 30%.which is what the end of the streak means -. Miller said that if beating the market were purely random. so you never know. Amazon.csinvesting. these superior financial companies. his run reflects a fluke of the calendar: If Pope Gregory XIII hadn't tweaked the Julian calendar in 1582 to shorten the average number of days in a year.'' -I want also to talk about and to get back to this Fischer Black idea to refine my thinking of a Margin of Safety and the kind of companies I am interested in. he beat the index by a mere 0. whose Berkshire Hathaway Inc. Buffett's League His record puts him in the same league as his friend Buffett. 57. director of fund analysis at Chicago-based Morningstar Inc.3 million happens to about 130 people per day in the U.3 million. P&G—may be selling. He's the first to say his streak was partly luck anyway.

In fact. They…but the horse racing game is a negative expected value game. But few people—none I know--would realize how big the IPOD would become. it means that the price is not rising enough. I actually bought this when it was new in the 1980‟s. Dr. What this is if you think about it… If a value is created. If the price is rising and the value is rising this is a very interesting and special case-Possible. Delta of Value Price UP Flat Down Down (-) NO NO Possible Flat (0) NO Possible Possible Plus (+) Yes-special case-Possible. Extreme favorites with odds of 1-10 and 1-20 are actually under bet to the extent that even with the track take you make a little bit of money in the longrun by betting on them. 0. rigorous. GI said below. but that is probably a misstatement) intrinsic value. If you take the track take and breakage. where the stock market is a positive expected value game. Price up and value down-NO. Z Beat the Race Track. This is the hardest opportunity for a value investor like me to identify.A Great Investor Discusses His Evolution cheap. It took a little while for the adjustment to take place. Just about anybody could figure out that was a pretty important plus to change the value of Apple. There is a point here at the end—try to bear with me. There is a very interesting chapter in here called. Across the top we have the recent delta of value: -. investors underestimate the probability that good horses will win and overestimate that long shots will win. Possible Possible but unlikely Now we will try to fill in some of these boxes. Apple’s stock went up. Price is flat and value down-NO. it is a negative 20% expected value game. Stock Market Efficiency Concepts to the Horse Racing and Betting Markets. we talked about understanding that great companies do not get as cheap as lesser companies. it did not go up enough.csinvesting. is that at the horse track and the stock market too. I have a three by three matrix here. The idea. and now we look at the margin of safety. I brought along another book here called. + then Down we have price: +. even though the value is rising and the price is rising. This idea of betting on favorites and the consequences of betting on favorites is something that I find interesting and applicable to stock investing. It means an under-reaction to good news in the case like the introduction by Apple of the IPOD. There has actually been exhaustive. Favorites do win. The people who bet favorites actually lose much less money than people who bet long shots. I labeled this margin of safety with three pre-conditions for an emergence of a margin of safety. statistical research on horse race betting and what it proves is there is a body of research that bettors in aggregate do know how to pick winners. though. I have what I hope is a helpful rule with this matrix here that I made up. www. at a 10% discount to intrinsic value and most of the time they sell above (Mr.com teaching/studying/investing Page 11 .wordpress. 0. Finally. nearly enough.

You won‟t identify it. you know Apple’s stock has already tripled. you are just a generalist. they filed for bankruptcy. There is something that distracts people. One reason this can occur is because there could be an external distraction—a global event. an assignation. you are not going to be able to assess how significant the IPOD will be. it is not adequately discounted the tremendous change value the IPOD created. and the market gets panic stricken. That is the hundred dollar bill that has been lying on the ground because nobody else saw it and it has been there for awhile. A good example of this many years ago was Texaco losing a lawsuit.com teaching/studying/investing Page 12 . But it is possible that there can be a margin of safety if the market for whatever reason has been asleep and has not appreciated the value that has been in existence for awhile. You are not going to be able to say. Price flat and value flat-Possible. a gold mine. The stock and the bonds sold off very sharply on that news and the drop in prices created tremendous opportunities. a war. There was a period of panic where people said. let‟s fill in the rest of the boxes…… Price flat and value falling-NO. So that is a possibility but not likelihood. Something has happened that is positive. so the stock market…. that has enhanced the value. „Oh my gosh. Inc.A Great Investor Discusses His Evolution Value and Price moving higher but the price is not discounting the increase in value fast enough.csinvesting. Yes. the news was www. It under-reacted. Investors are slow to recognize how significant the discovery really is relative to the size of the company. The price goes down more than it really should. Apple Computer. This is genuine overreaction to bad news. Down here at the bottom. That is a delayed reaction to significant positive change in value. Texaco filed for bankruptcy after losing a lawsuit. Price is falling and the value is falling-Possible. Here it doesn‟t react enough. The price is flat and the value is rising-Possible. A simpler example of an adjustment to good news would be a relatively small oil company finding a relatively large oil find.wordpress. and the market for whatever reason is slow to digest. It means that if you are not a real expert on the field.so opportunity exists but people are slow to deal with it. This is when there is genuine bad news. This is the possible one—under-reaction to significant good news. Other natural resource companies could be like that—a coal mine. OK. but it is still cheap.‟ The investors‟ way oversold the stock. And that falls into the circle of competence category.

the price has risen a lot. but it really isn‟t. there are six that are preconditions—logically they are preconditions—for the appearance of a margin of safety. Even though the stock went up a bunch. Finally. This is what I categorize where the news is perceived as bad news so the price goes down. but again looking over at the little box over on the left column on Coke you see for the last five to ten years the growth rates and cash flow have been growing 5% to 7%. Now let‟s look at Nokia. This stock is trading at 20 times earnings. in investing for the future particularly if it has a short run negative impact on earnings and cash flow. Sometimes companies will make announcements where they make changes for the improvement of the company (more marketing expense. The amount of information that is available in this one page is just astonishing. It is amazing the amount of information in these pages. raises the dividend every year. Again. in fact. We all know that Coca-Cola has had slowing growth. This one down here is possible: price is falling and the value is flat. more R&D) but in the short run it will depress earnings. the last box I call possible but unlikely. investors sell on that news because they are not interested in long-term investing. its margin of safety is there. but the reaction in the market was excessive. It can happen. VALUE LINE HANDOUTS Now I want to talk about the Value Line handouts. generates lots of cash. the circle of competence. I am saying for myself and for the most of you it is rare that we find situations where we can say. I want to start out by talking about Coca-Cola and Nokia. And what you should remember and take away from all of this: Five out of six of these involve a share price that is going nowhere or is falling.A Great Investor Discusses His Evolution bad. “Yes. you have enough knowledge to say that I know more than the market does that is a monster discovery that is worth a lot more than the market is attributing to it now. If you have this type of specialized knowledge that is an area where you can hunt. but there is a misinterpretation to the news. Coca-Cola is everybody‟s poster child for a great company. It is necessary and it is almost sufficient for the type of investing that I do. it is absolutely essential. it could be a big external distraction. we can have all types of hypothetical situations why these situations might arise. When Wall www. But the punch line for all of this is that of the nine boxes. For example a drug company discovers a new drug. And unfortunately. and net repurchasers of stock most years.csinvesting. This is where value is rising and the price is falling. There is good news about the company but the news in the world is so bad. The value is unchanged. GI has talked about that. Go through this rigorously and logically and you have to be looking at stocks that are flat or are falling.com teaching/studying/investing Page 13 . but look at the numbers on Nokia. This is the exception up here (both share price and value increasing-IPOD example). SEARCH: The punch line again are stocks that are going down or are not going up. That is where you should be hunting. Anyway. where you know you know something. These are great big companies—Coke has $113 Billion market capitalization while Nokia is $85 billion. I will start out by saying that if you are not familiar with Value Line. It is a high profit margin company. essentially unlevered. Or the more subtle way is the short run/long run trade-off. Nokia‟s price is higher now. but I know because of my knowledge of the industry and company the price hasn‟t gone up nearly enough and. it has not gone up nearly enough.wordpress. That is an unlikely set of circumstances. This is the special case. yes they had a $10 billion dollar judgment against them. Price falls and a valuation disparity occurs because value remains unchanged so a value disparity occurs.

This narrative.com teaching/studying/investing Page 14 . It has similar returns on equity—earning 30%. Look at the little box over here of annual rates of growth of sales. and the margins are getting smaller and smaller. This fits the character…these are seasoned companies. and it trades at 15 times earnings. www. the dividend has been rising—22% compounded over the past 5 years. not a flash in the pan. cash flow and earnings much higher than Coca Cola.wordpress. Pays a dividend every year. 40% ROE with no debt. The financials tell the story. There is always a story. This goes back to 1996. this story that we are going down market with headsets.A Great Investor Discusses His Evolution Street talks about Nokia.csinvesting. But look at these numbers. they are getting smaller and cheaper. they compare it to Motorola and what is going on with China. The company has a significant share buy back every year.

there are not many companies with these types of characteristics.5% 21% / 19% 18. I look deeper.com teaching/studying/investing Page 15 . Nokia 16x 36% 36% 0. This is the type of company that could reward work particularly if we could develop an understanding of what it is that creates its competitive advantage.0% / 9.5% / 7.5% / 14% 18. www.5% < 5% P/E Return on Total Capital Return on Equity Debt as % of Capital Growth 10-yr/5-yr in Book Value Sales Cash Flow Dividends Buy backs I would argue that the financial performance is just as good and the growth seems to be faster.5% / 11% 33. They (Nokia‟s Management) are doing something very right. There is something else going on.5% 10.5% 4. This is not a fluky thing. The financial performance says their products are not commodities.wordpress. I don‟t know how they achieve this.5% 6.5% / 12. My superficial understanding of Nokia is that what they make are commodities.5% / 22. You can spend some time going through Value Line by hand or do some screens.% 30.0% 12.5% >5% Coke 20x 28. Now let‟s turn to Cisco (CSCO). But it is sure something I would like to know.csinvesting. Extraordinary! To tell you the truth. We talked about Cisco here a year ago.A Great Investor Discusses His Evolution This is the first step that I recommend to you in terms of finding stocks to research. This is not a brief hula-hoop type of thing (a one trick pony or a company with a hot product).0% / 3. Prima Facie evidence suggests that there is really something good going on here. this is not a flash in the pan. When I find a company with these characteristics which are extraordinary. There is some moat here.0% 7. Compare the numbers to Coca-Cola. and the stock is cheaper.

www. Cisco has $19 billion in cash with $6 billion in debt. When we talked a year ago. but I would certainly argue the case that these are not efficient capital structures. that is true. There could be a paradigm shift. I am a long way out of corporate finance at Columbia Business School. In the case of Cisco.wordpress. When you look at these seasoned companies you are entitled to presume that something good is going one here. The opportunity in these companies is for them to recapitalize themselves. In 2000. almost certainly.5 billion in cash. Not many people come before you and talk about these kinds of companies--TV. Coca-Cola has nominal debt and $3. But I say. but there is no reason for Cisco to have $19 billion in cash. Huge cash generation and in the recent years an enormous buyback. Cisco traded at $82 and in 2002 it traded at $8 (a decline of 90. Debt 3% of total market capital. I am not saying they should go to the razor‟s edge and operate like an LBO. They are afraid to come to grips with this. People say well I don‟t understand it. These are very substantial cash flows.3%). Nokia has no debt and $12 billion in cash. it was overvalued and undervalued because companies don‟t fall 90 percent without creating some kind of investment opportunity. Somewhere in there. Another thing you should be aware of—look at Nokia—these huge returns for Nokia are after spending 11% of revenues on R&D. but these numbers speak for themselves--extraordinary financial characteristics. This is more interesting because its financial performance is more volatile than Coca-Cola or Nokia’s.com teaching/studying/investing Page 16 . Cisco was generating $500 million a month of free cash flow and it is using it to buy back stock. and its share price is more volatile-much more volatile. So these discretionary cash flows. these are all things we value investors are trained to look at. “What the hell do you know about Kraft?” I know a little bit about package cheese business. Now what I want to point out also about Cisco. It seems unreasonable to expect that it is all going to go to hell five minutes after you purchase it. cigarettes. The investment characteristics are extraordinary—very high returns (20% to 25% returns on total capital. Nokia and Coca-Cola and bring up Intel to your attention—all of these companies operate without debt. In this case volatility creates opportunity. tobacco--yes.csinvesting. they spent even move (14%) on R&D. Not only are they operating with 100% equity but they are actually operating on 100% equity and lots of excess cash.A Great Investor Discusses His Evolution This turned out to be a very successful investment for us a year ago.

These create tremendous investment opportunities. Then we will talk about another company that the professor and I have talked about—Analog Devices (ADI). look at the revenue growth. the degree of leverage. Look at the free cash flow.8% of its revenues on R&D. $2. Wall Street gets very worried. Even after that R&D and cap/ex and you are still seeing enormous cash generation. This is a business. I would like to find out what is going on here. it traded as low as $26 per share.A Great Investor Discusses His Evolution We talked a little about volatility. Almost every company has fixed costs that they can‟t cope in the short run with on a revenue decline. this is a specialty integrated circuit manufacturer that custom designs its products. the cash generation.com teaching/studying/investing Page 17 . the operating business was $19 per share. look at the financial characteristics of this company: No debt.csinvesting. as I said earlier. When you see companies like this. year after year. Companies that are highly profitable—the revenues may fall from time to time. WOW. Wall Street is always ready to say the sky is falling at the first sign of a revenue decline. www. This looks like a business that is being nurtured. This is not a business that is being milked for cash.wordpress. This would not be a difficult company for you to model. Intel has a bad year and revenue falls and earnings fall a lot. How did that happen? Well. return on total capital 14% to 15%. What it is about this company that enables it to earn these kinds of returns? I included IBM. If you look along the top of the page here. the consistency of the net profit margins and the relative consistent ROE. it happened because the company reported earnings that disappointed people and the management guided future earnings down a few pennies and the stock goes down 20% in a day. you should say to yourself. When the stock was $26 and it had $7 per share in cash. there is something really interesting going on here. This company is spending 20.24 billion in cash (or $6 to $7 per share in cash with no debt). Again.

Look.A Great Investor Discusses His Evolution For you to do a mean reversion model about what normalized profit should be. for example. Even if the company invented something new it couldn‟t possibly be big enough to have much of an impact because the company is so huge. this volatility has dampened down somewhat. If you separate in your mind the difference between price and value. But even in the last year or two. The stability of intrinsic value and the share price volatility is what gives us the opportunity. Because the value of IBM is not changing to the same degree as the price of IBM.wordpress.com teaching/studying/investing Page 18 . and it will not change much from quarter to quarter. www. you will think IBM is the quintessential aircraft carrier.csinvesting. The value is not changing a lot here. whatever metaphor you want to use. it has traded down in the low $70s and $100. I submit to you that opportunities arise in a company like IBM.

www. huge cash generation. This is an interesting company because there are two classes of stock. no debt. high return. the footwear company. They do not have to worry about being taken over. The conventional wisdom is that this is a crummy business—to be in the shoe business—every kind of shoe business has gone broke in the US. major. they are using the cash flow to buy back stock and increase their own ownership.csinvesting. Again. Nonetheless.A Great Investor Discusses His Evolution I included here one of my favorite companies.com teaching/studying/investing Page 19 . Look at these numbers. something really good is going on inside of Timberland here. and you ought to find out what it is. Timberland (TBL). There is a family that has control of the company. When you look at 1997 and the ten years since then.wordpress. I am a broken record here—extraordinary financials here. major share buybacks going on. one-third of the shares have been bought back.

com teaching/studying/investing Page 20 . On the other hand.wordpress. They have a perfectly good business. “What should we do with this business? Should we raise the dividend? Should we buy back some stock? Should we make a small acquisition? Oh.A Great Investor Discusses His Evolution One other thing. this has a strong family ownership with large inside ownership. it is a commodity business. but the salad dressing business is a phenomenal business—very high profit. as you can guess. The bad business makes floor mats for the after-market for autos. they have a branded packaged salad dressing and these products are sold under various names without the customer being aware of the corporate name. It has three businesses and I don‟t know how they all came into the business. share buy backs. a mediocre business and a bad business. And it creates through Lancaster Colony a business where the management has only good decisions every year they say. As in many such companies. Value-Line doesn‟t get excited about it. I don‟t know why they are in it. high cash generation. that is a bad business. and. they don‟t earn any type of returns.csinvesting. but every year. www. This is a company you probably never heard of. there is value accretion through dividend increases. And so it is very prosaic. Lancaster Colony (LANC). it is not exciting. I want to talk about another type of investment. And next year they have the same problem and they do it again. let‟s do all of that.

9% and Value Line is projecting it to continue.A Great Investor Discusses His Evolution Finally. (JWN). To say that the P/E is reasonable on record high cyclical earnings. but beware of such companies. 31% ROE. The P/E multiple (19) does not seem very high. I cite that as an example of a good company has its own cyclicality.wordpress. I am not going to say anything bad about JWN. the valuation is reasonable. It may well. the profit margin will revert. Look at JWN’s financials. One of the guests who will be speaking here later is Lew Sanders. www. Inc. almost by definition suggests there is no margin of safety here and. and now we will look at Nordstrom.2% to 7. we spoke about the overvalued side. Now Lew is. there might be danger to the contrary. It is also quite conceivable to me that if the economy goes down. These are good financials-26% return to total capital. cyclical high.csinvesting. last year when I was here.com teaching/studying/investing Page 21 . Urban Outfitters (UGIN). Everything is booming. in fact. I don‟t know whether JWN’s profit margin which already is by far at a record will go higher. I don‟t know him. but I see it as an investment…This is a Jeremy Grantham idea. It is quite reasonable to me that a consumer driven business in a strong consumer cyclical recovery will have a big margin expansion. but its profitability is at a record. but I know what he does and what his analysts do for him as least as I understand—is that the typical research analyst does not factor in mean reversion in projecting the future. but if you look at the profit margin over this cyclical recovery which has risen from 2. My experience is that these are mean reverting kinds of numbers.

com teaching/studying/investing Page 22 .wordpress.csinvesting.A Great Investor Discusses His Evolution www.

Other people. We are buying companies with a margin of safety. I will submit to you roughly Warren’s table where every year he talks about his holdings. his biggest marketable securities and it shows his historical costs. or 12%--something like that. mimic those words. But now that you own it at fair value.com teaching/studying/investing Page 23 . I am going to qualify that a little bit and say don‟t ever assume a high degree of precision of what fair value is. and the stock rises. You have identified the margin of safety. So in three years. so that is a factor of 33%.csinvesting. The longer you hold it. I have decided it is worth some discussion.. you make the 10% compounded over three years. He writes that his favorite holding period is forever. my greatest success has been when I bought some stock and held it for a long time and that has been successful. We are buying businesses with an underlying intrinsic value where we believe the underlying intrinsic value is rising. some with and some without. You multiply that out and in three years it is $133. 15%. Now. you can continue to hold it if you so choose—it is a free country—but you are not a value investor at that point.. but if you take the effort to try to figure out when he bought those stocks and what he paid for them.wordpress. I want to talk about selling. will go to zero. you capitalized upon it and you earned a very high return. concluding remarks. And let‟s assume that you are fortunate enough that whatever caused the margin of safety to dissipate occurs. I did some numbers. Let us say we buy a business where the intrinsic value is $100. well. you will see that the long-term compounding is almost always. and you make the accretion of the discount. At that point by definition it is trading at intrinsic value and the margin of safety is gone. If you say you are trading at 100% of fair value give or take 10% or some variation. There are some very high appreciation in those positions. and where we believe the intrinsic value is growing at 10% per year and today you are able to buy that business at a 30% discount—at $70. You hold it for three years and. And here I even disagree with the great Warren Buffettt.A Great Investor Discusses His Evolution SELLING Finally.. You are—if you are in the business of holding things at fair value—that is not what we are talking about. 14%. in fact the intrinsic value compounds at 10%.this gets back to his statement that long-term price appreciation www. We buy into the business at a discount from its present intrinsic value and what we hope will happen is that the intrinsic value will rise and the margin of safety or discount to value will shrink--ideally. But when people say.

Especially when Warren‟s opportunity costs are so low. the big difference that he has between you and me is that Berkshire Hathaway is a corporation and his tax rate on long term capital gains is 35% while yours is much lower. I know of two people now who started with a hedge fund and as their fund grew with good performance. Contrarianism sometimes involves a knee-jerk reaction. So when he says my favorite holding period is forever. that is a unique circumstance and it applies to almost nobody else I know. NJ to meet with a friend who manages a hedge fund down there. Ask yourself. but I know for a fact that each of them has over $10 billion dollars. what is in it for him?1 Now. that is what the game is all about. the deferral of a 35% tax rate is very valuable. Now in the case of Warren Buffettt. If you are buying something at a sizeable discount. a stock picker and a marketer. He is always looking for more money to manage. You should harvest it and move on. Well.A Great Investor Discusses His Evolution equals the long-term value creation of the business plus the accretion of the margin of safety. what if I just keep holding on and compound it? At that point all you are hoping for is that the business continues to accrete intrinsic value at the rate that it has been.wordpress. You would not believe what is going on. Now I tell that story and you can take that at face value. and you have earned the accretion of intrinsic value and the vanishing of the margin of safety. you would never hear of or about it. He talks a lot to find people and encourage them to focus on his successes and ignore his failures. But if you are Berkshire Hathaway or a corporation. how am I able to see something such that other people can‟t see it? Over a long period of time on Wall Street I have come to appreciate that the smartest people. You don‟t know the names. If I know something for sure there are plenty of opportunities on Wall Street to place a bet and I will make money from it. incentives matter. who told me how he went down to Princeton. why is it apparent to me and no one else? What am I missing. Money managers who tell you that they like growth stocks. who are always being interviewed in Barrons’. I want you to be skeptical. I don‟t need to tell you about it. the most successful people talk the least. the simple answer in most cases is that almost every value investor wears multiple hats. why is he telling me this. George Bush says it is 15%. But then ask yourself.csinvesting. He is going to be loathed to realize big gains when he is already sitting with $45 billion in cash. always writing a report on CNBC or there on Bloomberg. a professional investor and former business partner. 1 As always. He is a portfolio manager. Do not forget at that point it can go too overvalued or it can go back to a discount. Ask yourself why is he telling me this? Why should I believe him that he has any insight? All of these insights if they were accurate are money making insights. who are the people who are so available. the yen is going to go up and the dollar is going to go down. FINAL THOUGHTS I used to describe myself as contrarian but I tried to think of something more flattering. and then came the clincher. they returned money to investors. My advice to you is that if you buy something at a discount to value and the discount goes away and you earn the excess return that is your reward for your analytical skills. And the HF manager said how much money he was managing and how well he was doing. Much of this is so far under the radar. That is not right. The professor said it that when you think you have identified an investment opportunity.com teaching/studying/investing Page 24 . www. I have an anecdote to relate from a close personal friend. I describe myself as independent and skeptical and I suggest that you should think of yourselves that way. So I would be skeptical of me and everyone else who comes here. But he went on to say how this really was a hedge fund Mecca.

I have not been good at sizing my positions. So when he talks about risks to the stock market that has never been encountered before that is worth thinking about. The Kelly Criterion is a way of optimizing your positions based upon your ability to estimate the probabilities.com teaching/studying/investing APPLAUSE. Anne is with me. I am old fashioned but the old rule of thumb I grew up with was that companies that spent 10% of their revenues on R&D was a lot. That is his megaphone to get out to the world. A lot of people talk about it. I am hunkered down and prepared for something bad to happen. What more can he say? Given the enormity of his business. he has done just about everything he can to say. but I don‟t know how many people actually put it to use. and I asked my wife for a Christmas present. but I did bring a visual aid. I don‟t know how to cope with that. his bond portfolio is high quality. He is short the US dollar. but that would not be of much use to him given the enormity of the assets he is involved in. The productivity on R&D is a difficult matter for an outsider to assess. extremely short duration. I think probably some type of position optimization like the Kelly Criterion is something I should consider. He is pulling in his horns in terms of the reinsurance that he is writing. I point it out to you as an example. I am fascinated by these companies that are earning high profits. I don‟t know if all the companies. If you look at Berkshire Hathaway. Insurance has been very cheap. It is a buzz word. How do you analyze that? GI: The answer is on a case by case basis. he is in a position of maximum defensiveness. He has got a huge amount of cash. The answer is no I don‟t. www. There is not a single word that he has not labored over for months. generating extraordinary amounts of cash after large R&D expenditures. I have always tended to buy as much as I can. There is a message.” I think that is something I will close on. Question: How would you look at the risks of a major nuclear strike? GI: I don‟t know. Since reading that book I have gone back and read the original which is this thick (2 inches) which talks about information theory.A Great Investor Discusses His Evolution To the extent that by talking so much tonight I may have undermined my own case. Question: Some companies are subsidized for their R&D. Now there are companies that spend 20%. and it has been in the family a long time. I have been interested in index options and index puts. This is in the introduction of The Great Crash by John Galbraith. Many years ago I read this on Wall Street.wordpress. “The Wise on Wall Street are Nearly Always Silent.csinvesting. The honest answer is that over my career. but Warren has certainly…let me tell you about his letter. The Foolish Thus Have the Field to Themselves. Page 25 . There are ways to filter out the signal from the noise. QUESTIONS Question: Do you use the Kelly Criterion to size your position? How do you size up your edge and your odds? GI: Good question. It is information theory that has to do with noise and signaling.

Again. His compensation is to give them short ideas. I suspect there will be a lot of consequences. Q: You spoke about the default option—cash vs. “tic. What Graham would say about the above approach: Graham‟s Advice on “Relatively Unpopular Large Companies” www. twisted person who always can find things that are wrong and bad and he is so valuable that there is a consortium of hedge funds in Greenwich that gives him office space for free and he sits there. the idea of writing insurance. What he said is that what you are talking about is the way I manage my own money. big pools of money have been selling risk. Q: Who is on the other side of the put buying to hedge portfolios? GI: The answer is that I don‟t know. the default option is cash. in a low volatility market. My hunch is that a lot of hedge funds are doing it. 90% you collect your little premium and then you get wiped out. I have been around Wall Street a long time and I have a lot of friends and I called everybody I could think of to see if they could put me in touch with people inside their organizations who could give me an education. Incumbent to this was the Magellan Money Manager who was fired because he raised too much cash and it caused the fund to fall behind their competitors/index. Almost certainly what they are talking about is writing out of the money options.wordpress. It is better to fail conventionally than succeed originally. a man I used to work for in insurance used to call these high severity and low frequency risks. Most portfolio managers are under pressure to mimic the market. Finally I did come up with a few people from Morgan Stanley. I have a friend who is a really cantankerous. investment strategies that have 99% success rates and these are the ones to suck in subscribers. an index? GI: Yes. BOOM. BOOM!” You underestimate the risk that is unlikely but it occurs. For a rational individual the default option is cash.com teaching/studying/investing Page 26 . I spent quite a bit of time two or three years ago trying to find out. Tic. End. The idea that the lending institutions have been spreading their risks around the world to hedge funds. Sometimes you hear of ads in the newspapers like Barrons. There is not a lot of hedging. high severity risk. There is a fair amount of money managed in Europe this way where there is a perpetual insurance policy in the form of index puts to offset the loss. The idea of making the bet is that I will write the insurance on very low frequency. They cliché is it is like scooping for nickels in front of a steam roller. And I found it difficult to find such people. What I have heard from reading the economist. Hedge funds are leveraged mutual funds. tic. tic.csinvesting.A Great Investor Discusses His Evolution Now in the case of …this idea…look at his holdings and ask yourself about these mega disasters what would happen to the IV of those businesses. I don‟t know if that will have a happy ending. tic. And what he has told me is that hedge funds are a misnomer. His current theme for decades has been I have positions in companies I am happy to hold if the stock market closed forever.

In Chapter 7 of The Intelligent Investor. but this is not a field that many investors feel comfortable with. Why Large Companies? There are certainly many unpopular companies of all sizes. so why should investors focus on larger companies? The following excerpt from Chapter 7 provides the rationale: If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason. the correct mindset that separates true investors from speculators. The Intelligent Investor clearly presents not only information regarding sound selection of securities but. The large companies thus have a double advantage over the others. However. it is logical to expect that it will undervalue — relatively. many of which trade at depressed levels. Benjamin Graham presents three recommended fields for “enterprising investors”: 1.A Great Investor Discusses His Evolution Few books have been able to withstand the test of time in better form than The Intelligent Investor [1].csinvesting. The Relatively Unpopular Large Company 2. (Fourth revised edition. at least — companies that are out of favor because of unsatisfactory developments of a temporary nature. The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. the market is likely to respond with reasonable speed to any improvement shown. perhaps more importantly. Second. Warren Buffett has recommended that readers pay particular attention to Chapters 8 and 20 covering how investors should think about market fluctuations and margin of safety. First. they entail the risk of a definitive loss of profitability and also of protracted neglect by the market in spite of better earnings.wordpress. Unpopular large companies. Special Situations or Workouts At the market lows in 2009. 1973: page 79) www. it is reasonable to assume that even someone as conservative as Ben Graham would have found ample “bargain issues” available for purchase. Written by Benjamin Graham in 1949 as a guide to investing principles designed to be accessible to the general public. Certainly there is no shortage today of large companies that are disliked or even despised by politicians and the general public.com teaching/studying/investing Page 27 . While small companies may also be undervalued for similar reasons. There are always special situations. and it suggests an investment approach that should prove both conservative and promising. Purchase of Bargain Issues 3. will always be with us for a variety of reasons. and in many cases may later increase their earnings and share price. the very strong bull market over the past year erased many deep bargain opportunities. they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base. This may be set down as a fundamental law of the stock market. however. For decades.

Unpopular Sectors Today … There are always several sectors facing economic or political headwinds but two in particular seem to be potential opportunities for investors today: 1. Oilfield Services. Market has misunderstood the situation and assumed that the difficulties are permanent rather than temporary. a larger potential market will exist for medical devices based on the aging population and a larger number of individuals having health coverage under the new system. It is still a good exercise to examine as many companies as possible so one is able to act promptly if market prices eventually offer a better entry point. Due to the disastrous oil spill that is still underway in the Gulf of Mexico. Medical Device Industry. oilfield service and equipment companies have been punished in general. Beyond those companies directly involved. There are many companies in both industries with long records of high profitability. there are different exposures to shallow vs. America and the rest of the world will be heavily dependent on oil for at least twenty years and probably much longer. These are just two examples of industries that are not popular with investors today for very different underlying reasons.csinvesting. Transocean. www.3 percent excise tax on gross sales of most medical devices. The other major headwind facing the industry is that consumers of medical devices (ultimately the insurers) are putting increasing pressure on suppliers to hold the line on price increases. In the coming days. but to examine unpopular situations based on how they might have looked to Benjamin Graham. By looking at larger companies that have the financial strength to withstand a potentially protracted period of adversity. These companies have various degrees of exposure to offshore drilling. Within the offshore oriented firms. few industries are facing as much near term uncertainty as those involved in the oil and gas industry. the investor can hedge against the risk that would exist in a smaller enterprise that may face similar headwinds but fail to make it to an eventual upturn.A Great Investor Discusses His Evolution Essentially. Despite the tragic situation in the Gulf of Mexico as well as the near certainty of higher regulatory costs going forward.wordpress. the argument is that if an investor can identify strong enterprises with a record of meaningful profitability. The difficulty is always separating the companies that may be facing long term decline from those that will recover once near term issues are resolved. The largest companies are obviously expected to bear the most significant cost [2] given the fact that this is a gross receipts tax. 2. Cameron International.com teaching/studying/investing Page 28 . Medical device companies will soon be facing a 2. a temporary setback may provide an opportunity to make a bargain purchase if Mr. The companies that are directly involved include BP. On a positive note. Some companies may be interesting but are not depressed enough to offer a margin of safety today. we will present some potential ideas from these industries. The new health care law has broad implications for all businesses involved in the delivery of health care. The idea is not to necessarily identify companies that qualify for immediate investment. deep-water along with regional differences as well. and Halliburton all of which are down sharply over the past month.

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