The Inoculated Investor Creighton Value Investing Panel (4/29/11) Panelists 1. 2. 3. 4.

Whitney Tilson: T2 Partners Vitaliy Katsenelson: Investment Management Associates Michael Green: Evergreen Capital Management Patrick Brennan: RBO& Co.

http://inoculatedinvestor.blogspot.com/

Moderators 1. Charles Heider: Moderator Emeritus (served on the Board of Directors at Creighton for 17 years) 2. John Manginn: Manginn Associates 3. Mark Mowat: Frontier Capital LLC Question 1- John Manginn: What are the common characteristics of value stocks? Which are most important? Whitney Tilson: From chapters 8 and 20 of Ben Graham’s The Intelligent Investor, we learn that intrinsic value and margin of safety are the most important. The key is to be very patient until you find a situation in which there is a big margin of safety. But, you also want to find something that is trading at a major discount to intrinsic value. (Addressing other panelists) How do you figure out intrinsic value and what causes a stock to trade at a discount to that? Vitaliy Katsenelson: The first thing to do is analyze a company and this is where the concept of core competency comes in. Insurance is not in his core competency. Once you understand a business you can value it. It may be best to use all of the valuation techniques if you can. Margin of safety is function of a firm’s management, competitive advantage, growth prospects, and dividends. The higher the quality the company, the less margin of safety you need. You need less margin of safety with Wal-Mart (WMT) than you need for Sears (SHLD). You need less of a margin of safety for a growing company than you do for one that is not growing. Michael Green: Agreed with the previous comments. Competency is intangible and very important. If he cannot understand how a company makes money then he moves on. It doesn’t matter how cheap it is on valuation metrics, if you can’t understand how it makes money you can’t understand when it could become undervalued. Question 2: Michael Mowat- Are there any industries or sectors that lend themselves better to value investing? Has that changed over time? Patrick Brennan: The name of the game is to trying to predict streams of free cash flow. You want businesses where there is confidence in terms of the yearly free cash flow. You don’t want to worry that they won’t make any money at all. You want to have an idea regarding free cash flow over the next 2 years. Technology companies are very tough to predict free cash flow for. It is hard to know which phone or tablet will take market share so he stays clear of those. He likes companies with nice brands and that can raise prices. Sometimes financial companies lend themselves to value investing analysis because they trade below liquidation value. You are dealing with assumptions in terms of returns, but right now they are seeing opportunities in this space.

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

Vitaliy Katsenelson: A client came to his office with a portfolio that was bought in 1998. A bunch of the stocks were bought when they were trading at 30x-50x earnings. These are the types of companies whose stocks trade at 9x-10x EPS now. They were overvalued back then and now psychology has changed. Earnings have doubled or tripled since then—Wal-Mart (WMT) and Cisco (CSCO) are good examples. People hate these companies if they bought the stocks back then. The companies did what they were supposed to do, but the prices were just too high. Portfolio managers won’t listen to analysts when they bring up or pitch these companies. People ask why buy now since they have lost so much money? Stocks go from extremely overvalued to extremely undervalued and large cap, high quality companies that you would put in your mother’s account are extremely cheap now. Question 3: John Manginn- Buffett biographer Alice Schroeder said she has never seen Buffett use a single valuation model. Instead, he uses a simple filtration process of handicapping and assessing management. Is there value to modeling? Whitney Tilson: It is a good idea for students to learn traditional discounting and valuation models. Buffet doesn’t have to do this because he has been doing this 24/7 for 50 years. He is doing the models, just without Excel or a calculator. Just like you learn to fly an F-16 after many years—it becomes part of your DNA. Investing is an experienced -based business. Becoming a great investor is like becoming a great surgeon or fighter pilot. You initially learn from someone else and then go out on your own. How do you get up the experience curve as soon as possible? Buffet took everything else out of his life to a scary degree, at least according to Alice Schroeder. At one point Whitney pitched a building company to Buffett. He responded back in one day and Whitney was surprised to learn that Buffett had a great knowledge of the company. He remembered an obscure company from 40 years earlier and named a price he would be willing to buy it at today. This is where we are all trying to get to—after 50 years of practice. This is also why Buffett doesn’t need a spreadsheet. You first have to learn the basics—walk before you can run. Patrick Brennan: Discounted cash flow (DCF) analyses do have value. He did a lot of these during his investment banking career. It is really important to make assumptions about revenue growth and margins because it gets you to ask a lot of crucial questions. Are their political headwinds? What are the next 10 years going to look like versus the past 10 years? When you do a DCF you have to make assumptions about certain things that get you thinking about the stock. He understands the limitations of the model. But, he believes in going through the exercise so that you ask the right questions about the company. Question 4: Michael Mowat- How do you gain confidence in your valuation of companies? How do you stay within your circle of competence? Michael Green: Said that if he can understand how the company makes money, he can get comfortable with the valuation metrics. The models used today versus what Buffett has used for years are just tools. You need to know the limitations of your tools. You need to apply your own limitations when using those tools. You can crunch numbers all day but if you can’t understand how the company makes money, the competitive environment or management decisions, then you can’t understand a company. You need to be able to explain the company to him like he was a 6 year child. You need a simple story of how a company makes money. He remembers being on conference calls during the tech boom. Analysts were pitching companies that were growing revenue but had no profits. They claimed it was a new paradigm and that profits and return on equity were no longer important. But fundamentals are always still the basis for equity

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

analysis—ever since Ben Graham was alive. Modeling techniques are just different ways of looking at the same thing. Whitney Tilson: Said he knows of a company with 80% gross margins and 30% net margins. The stock trades at 8x EPS—net of cash. There is no other company that is statistically so cheap and has such great fundamentals. Of course he is talking about Microsoft (MSFT). The stock has been a value trap—flat over the last 10 years despite revenue growing 150%. It is one of the best companies in the history of the world because it generates infinite returns on capital. You will never find a better company. Then why is it so cheap? He doesn’t think it should be—that’s why they own it. But, no spreadsheet can answer that question or any of the following. Is this a company at the very tail end of its growth story or is it an incredible growth company? Is it going the way of newspapers? Is technology passing it by? In other words, is MSFT declining? Tilson does not think so. The company is still growing right now because of Windows 7 and Office. The consensus view is that it is a lumbering dinosaur being leapt by Apple (AAPL) and salesforce.com (CRM). Betting against the consensus is very hard psychologically. You can look very dumb for a long time. The crowd is right more often than it is wrong. You have to bet against the crowd and be right to make money. That’s the hard part—the second one. Question 5: John Manginn- Does your circle of competency come in to help avoid value traps? Whitney Tilson: The 1st question they ask is whether the company fits in their circle of competence. They look at dozens of companies each week and ask: is this in their circle of competence? Buffet is 80 years old and is expanding his circle of competence every year. Some recent examples of new Buffet companies include Iscar, BYD, and PetroChina (PTR), and Lubrizol (LZ). He has been buying cyclical companies that he would never have invested in 5-10 years ago. He is actually getting better with age. Your circle of competence does not have to be huge as long as you know its boundaries. But, the wider the net, the better chance you have of finding hidden gems. Glenn Tongue (his partner at T2 Partners) and Whitney have 40 years of combined experience but don’t invest much in biotech or international stocks. You have to be humble about it because you can get clobbered when you stray outside your circle of competence. In some recent cases they found out that they were the sucker at the poker table. But, it was not their spreadsheets that let them down. Michael Green: People fail when they don’t know when to sell a stock. A stock can do well but people don’t know based on their circle of competence what the value truly is. It is easy to lose money that way. Know what you know and what you don’t know. Vitaliy Katsenelson: It is nice to expand your circle of competence but you don’t always have to. In many cases, you can find great companies outside of the US—not in China or Russia. He is talking developed companies (like some in Europe) where there is a rule of law and democracy. You have to expand the pond you fish in without taking too much risk or needing to expand your circle of competence. However, you will be taking a new risk—currency risk. For example, HP’s (HPQ) revenues come largely from outside the US so you have currency risk there. If you buy a UK company then you have risk of the pound crashing. You can diversify to mitigate that risk. His advice is to stay in your circle of competence but increase the pond in which you fish. Patrick Brennan: When you are looking within your circle of competence you find other opportunities in areas that you do not expect. Right now, very overcapitalized banks are trading at book value or below book value and have great loan growth, even without the trouble the big banks have had. Further, Bladex is bank in Panama that he mentioned last year. It has a New York subsidiary so the company is

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

regulated by the Federal Reserve. 75% of its portfolio matures in 1 year because the bank is focused on foreign trade. When a Latin American exporter is selling something in China then Bladex is the intermediary and everything is in dollars. The stock is at $17 and book value is over $19. A lot of people are familiar with this bank. Its Tier 1 Capital ratio is 20%--way higher than that of JPMorgan (JPM). Also, some thrift conversions and de-mutualizations pay a 2-4% dividend yield and are trading at book value or below. All he needs to make money is for them to reach book value. Why is book value relevant? It used to be that the mark to market value was close to book value. In theory, you used to be able to analyze all of the assets and liabilities and then figure out true book value. But then we got CDOs and MSRs (mortgage servicing rights) and those made these calculations much more difficult. Once these banks convert they often sell and he wants their companies to sell in 3 years. Question 6: Mark Mowat- Can you each describe a mistake you made in your career and how you turned it into a benefit that exceeded the initial cost? Michael Green: Said he made a mistake with the Baby Bells in the 1990’s. Everyone was laying cable in anticipation of a telecom boom. Competitor Level 3 (LVLT) was in Omaha for a conference and was talking about they were going to take market share from the Baby Bells. However, the Baby Bells had cash flow that dwarfed that of Level 3. How could Level 3 compete with them when the company had to borrow money and the Baby Bells were printing money? He had faith in the tried and true franchises that were printing money. The Baby Bells also had high dividends and high returns of capital. But, they were laying a lot of fiber optic cable and when the tech bubble burst, they got killed. Their traditional cash flow was actually declining as they were feeding their investments and trying to convert to a new technology. All he saw were the increasing dividends and strong cash flow generation. But the truth was that cash flow was declining, Whitney Tilson: One of the most vivid mistakes has come in past 8 months. His firm has completely missed the recent 30% stock market rally. Accordingly, he is feeling really dumb these days. But they haven’t lost money. Their long book is up 30% and short book is down 30%. They have been murdered on the short side—on Netflix (NFLX) especially. Short selling isn’t it the same thing as long investing— except the reverse. The mistake they made was that the short book was too large. They were drawn into to shorting momentum stocks and got burned. The main lesson is that shorting is a horrible business that requires a lot of skill. But these are not the same skills as are required to be successful on the long side—analytically or psychologically. The truth is that shorting kept them in business in 2008. They could have been out of business due to the draw down in the long book. The wrong lesson to learn from that experience was that shorting was a good business. They now have learned the hard way that they were not great short sellers. As such, they are now are running a smaller short book and are not stepping in front of freight trains. They understand that there is no limit to how expensive an already expensive stock can get. Vitaliy Katsenelson: Said he has learned similar lessons. He bought shares in a company and understanding it got so complicated that he needed a CFO to help him read the financial statements. For example, Computer Associates had a 15 page presentation on how to understand the accounting. If understanding a company becomes too difficult, just move on. There are 10,000 stocks out there. Patrick Brennan: If you are involved in a highly levered situation then you better know your stuff— where the cash is and what the covenants say. When something goes to $0 it is very painful to look your investors in the eyes. They think you are so dumb. But investors never get to see what you did day-today in March of 2009, for instance. At that time he really liked CBS Corp. (CBS) because it had a 45% free

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

cash flow yield and was an investment grade company. At $3.50 they thought it would go to $3 and were hesitant to buy. Now the stock is at $24. They could have made a brilliant call. Whitney Tilson: These are errors of omission versus errors of commission, as Buffett always says. Patrick Brennan: One great investment can make a huge difference in a concentrated portfolio, even if you have a bunch of $0s. Whitney Tilson: Buffett bought Wal-Mart at $24 and then it went up to $24 and an eighth and then he stopped buying it. He just got annoyed that it went up immediately. He knew it was cheap but stopped buying because of the move. Being able to understand your emotions and the psychological traps is as important as your analytical skills. Vitaliy Katsenelson: Suggested that young investors take a little bit of money and invest it. You have to be fine with losing the money so you can learn from the mistakes. This is the only way you can learn how to invest. Whitney Tilson: Suggested to do it on a small scale, but to go out and invest. Question 7: John Manginn- Is buy and hold dead? Is momentum investing taking over? Michael Green: What we are seeing more of today are day trading outfits. There was a recent piece on 60 Minutes on one of these outfits. They are trading 100s of thousands of shares day. All they need is to make an 1/8th of a point on each trade to make big money. This has caused a lot of volatility. If you are going to stick to fundamentals you can buy and hold. The market will flash crash, but over time the market has proved that 9 out of 10 times the crowd is right. Good companies will return value over time as the price gets bid up. The vagaries of the market are going to get worse unless controls are put it. He is more cautious now due to trading volume concerns than he ever was in the past. It’s a case where the market has changed due to lots of new trading instruments. US investors have it tougher. They now need to know stuff outside of traditional company valuations. But his firm will continue to hold stocks over the long term. He is still a buy and hold investor. Vitaliy Katsenelson: Said he is a buy and sell investor. Why is that? Buy and hold is not dead—it is in a coma. Why do stocks go up? Stocks went up about 10% per year for last 100 years—5% of that came from dividends and 5% came from price appreciation. If investments were always fairly valued, then the chart of the Dow Jones would look like a straight line with wiggles due to recessions and economic factors. But, investors are not rational and thus you have cycles. Stocks move from undervalued to overvalued and through normalization. When EPS and multiples expand, then you can make a lot of money. This is what happened after the tech bubble—market multiples contracted after the bust. Traditional buy and hold is dangerous because he believes the market multiple is too high right now and may decline. However, he uses the same principles as other value investors. He wants to analyze a company and then sell it when it becomes fairly valued. When P/E multiples are going up, you get a boost even if EPS is flat. In this environment you want a bigger margin of safety—a $.50 dollar versus a $.70 dollar. Then you want to sell when it gets up to $.90. It may take years but you want to sell it then. Buy and hold is dead until we get back to an environment like the aftermath of the tech bubble. Question 8: Mark Mowat- We are taught that diversification is important. But is it hard to beat the market without concentration?

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

Patrick Brennan: JP Morgan puts 150 securities into its clients’ accounts. This is the Noah’s Ark approach to investing – 2 of every kind in the boat. For example, a JP Morgan client wanted exposure to Brazil and have some diversification as well. But, if you invest into the ETFs linked to Brazil, you are buying a concentrated position in Petrobras (PZE), a company that makes up 20% of the ETF. Whoever put the client in this Brazil ETF probably didn’t even know the ETF was so exposed to Petrobras. Instead, he wants to hold a concentrated portfolio of business and invest accordingly. He believes you can’t follow a lot of holdings closely enough. Also, the academic answer may not be completely accurate—you can get sufficient diversification with 10-12 companies. He sleeps better at night because he feels good about the 10-12 companies he owns. Vitaliy Katsenelson: Said he has spoken to a fund manager who outperformed the index by 8% in one day. Nortel was 40% of the entire index. She didn’t own Nortel so when it crashed by 8%, she beat the index by 8%. The lesson is that you want to have a small number of stocks, but not too few. Every decision you make should matter. You want to be black swan proof. Owning 20 stocks provides enough protection in his mind. Question 9: Audience- How do you find stocks? Whitney Tilson: Said that there is not just one way. Experience counts a lot because he now has a mental database and he reads a lot. Sometimes major business publications help him find stocks. Sometimes they study a stock and then buy it 5-10 years later. Glenn Tongue gets the Value Line paper version that covers 1700 companies. They also run some stock screens. This tactic was fruitful in 2008 and 2009 when there were lots of statistically cheap stocks. This is somewhat unique, but because of his CNBC and Motley Fool experiences, people write to Whitney and offer up ideas. He also trades ideas with other investors and view the work they both do as a competitive advantage. Next, they often look at the top 20 holders and call people they know. But they know they have to be careful of group think. It makes sense to follow 13-Fs of great managers with great track records. If they see that Seth Klarman is buying something they might look at it, especially if it is down since he bought it. Question 10: Audience- Can you explain the selling side of investing? As stocks approach intrinsic value things can get irrationally exuberant. Is there a way for value investors to take advantage of that? Patrick Brennan- Selling is very tough. It is a lot easier to get in than out of a stock. What they try to do is look at how much a stock has gone up, look at their original assumptions and new info to figure out when to sell. What’s hard is that when you are looking for a margin of safety, you are usually going to sell early. You have to accept that as a value investor. It is part of the discipline process. In terms of the experience with CBS, everything was cheap then—stuff you owned and everything else too. Part of the discipline is that you are going to have to sell stocks that are cheap to buy cheaper ones. This is very hard because you can be generating tax liabilities and they usually want to minimize tax costs. But, there are some situations that are so compelling that it is worth biting the bullet and selling. They are reluctant sellers and buy and hold investors. But they have to sometimes sell things they are not crazy about selling. Vitaliy Katsenelson: When you sell you have to know that you won’t catch the top. Once you know that and know what a company is worth –using a P/E multiple for example—you can later come back to the company to make sure that the earnings power has not increased a lot. Sometimes you just have to say

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

that you will sell at 15x EPS—set a sell price for the company so you don’t get emotionally involved. When you follow the company and talk to management you become attached and it can be hard to sell. John Maynard Keynes said that when the facts change, he changed his mind. He has respect for Whitney in saying that he was wrong on Netflix after writing up an 18 page short report. Said that you should forget about your ego and think to yourself, would I make the same decision again today? If not, then sell. Michael Green: This business is not an exact science—you need intuition. He has accepted that he will never catch the top or bottom. As such, value investors should not be concerned with those times. You want to identify a company selling below intrinsic value. Sometimes companies they buy go down and then they have to decide to either hold on or buy more. But it is very hard to know when to buy stocks. They sell stocks knowing that they do not know where the top is. Their holding period is not forever. The fundamentals can be fine but you need to have the discipline to know when to sell. Question 11: Audience- Said he thinks that large cap stocks are very cheap. But what is the variant perception here? People haven’t given up on mega-caps forever—index funds are in them. Is there too big a crowd in these stocks now? Whitney Tilson: A Legg Mason portfolio manager just cited evidence that suggests that mutual fund flows do not support that there are a lot of people buying large cap stocks. The Russell 2000 just hit an all-time high. Investors project the immediate past in to the future—they drive looking in the mirror. This provides an opportunity for people to make money who have a different view of the future. The people on CNBC laugh at Whitney when he goes on TV and pitches Microsoft. This is why he likes it. Michael Green: Said he remembers a similar mentality from the late 1990’s when value investing was out of favor and people said that Buffett had lost his touch. Then people started praising Buffett when the tech boom crashed and he look like a genius. Patrick Brennan: Don’t lump value and growth together. Not every large cap is cheap and not every small cap is expensive. He sees value in special situations. The dividend yield on some stocks is higher than the yield on 10 year corporate bonds. Abbott Labs (ABT) and Lockheed Martin (LMT) are in this boat. Dividends at these companies have gone up for many, many years and have a chance to increase further. In contrast, these 10 year pieces of paper have zero chance of the yields being increased. So, at a certain point it makes a lot more sense to buy these dividend-paying stocks than 10 year bonds. Question 12: Audience: Is money all that investing is about? Whitney Tilson: (Silence….) Whitney’s parents were in the Peace Corps. When he was younger, he had no interest in the stock market. He never used to read the C-section of the Wall Street Journal. For the 1st time in his life (after business school) he had money in his account that he had to invest. He had to learn about investing out of necessity. He then found out that he loved the game. The people who are really good have made enough money that they don’t need more—they continue to invest because they love the game. Don’t go into this business if you just want to make money. No one in this room is going to have to worry about putting food on the table. But there are billionaires who are miserable—money has been a curse for them. His advice is to find something you are passionate about and do it. If he had billions of dollars he would be doing the same thing. It is true that running a hedge fund is very lucrative but when he goes on vacation his pleasure reading is about stocks. He did not get into the business for the money.

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

Michael Green: You are going to spend 80% of your waking hours on this business. At some point, money won’t matter—if you hate your work then your quality of life will be terrible. Find something that keeps you awake because you love it and the money will take care of itself. Question 13: Audience- When it comes to free cash flow, earnings per share and owner’s earnings, what adjustments do you make? Vitaliy Katsenelson: Said that there are a lot of companies that have tons of cash on their balance sheet. Cisco (CSCO) has $25B in net cash, for example. But, he will not give them credit because they would have to bring it back and pay taxes on it as it was generated from sales from overseas. One of the things he does is discounts the cash by 30%. When you look at cash flow, you also have to also look at stock options. Earnings can be lower than free cash flow because of options. You must assume that the company has to buy that stock back. In finance, the assumption is that the value of the company is equal to the present value of future cash flows. But the implicit assumption is that the management team will manage the cash right. You have to look at management’s history in terms of capital allocation because you have to always be concerned about it doing something stupid. Patrick Brennan: When looking at banks, there is very little value to goodwill and intangibles. He stays away from serial acquirers. Said he cares more about tangible book value. He never wants to see less than fully documentation loans on the balance sheet. He will look at banks with $5B in assets and below. If you go bigger, you have to look at MSRs and decide what that they are worth. If you can do that—give him a call. Question 14: Audience- Stocks need catalysts. Where are the catalysts in some of the companies they like—Microsoft and Cisco, for example? Isn’t there risk that the monopolies turn into tech utilities and become dividend stocks? How much do you all look at catalysts? Whitney Tilson: Everyone is looking for catalysts because they want to make money quickly. All things being equal, he wants to make money quickly but he is willing to go into situations in which the catalysts are not obvious or immediate. He is buying Berkshire Hathaway (BRK) and MSFT because he thinks that intrinsic value will grow as earnings grow. Eventually the market gets it right. Ben Graham said: in the short run the market is a voting machine and in the long run it is a weighing machine. If intrinsic value is growing then the investment usually turns out OK. If you want to double your money in 6 months, do not buy MSFT and BRK. But, if you want to play a more patient game, then buy those companies. Michael Green: Catalysts are recognized instantaneously in this Twitter world. Everyone is looking for catalysts. People process information immediately. How much lead time could you have identifying catalysts before other people? Whitney Tilson: Brought up recent situations with General Growth Properties (GGP) and McDonald’s (MCD). GGP was shorted from $40 to $1. Then, Bill Ackman laid out why the stock could be worth $20 after the Chapter 11 process. They still are holding the company and the catalyst is GGP coming out of Chapter 11. If you develop familiarity regarding timing, you can know when things might happen. On the other hand, MCD was just a turnaround company. MCD’s earning kept going up. There was no single catalyst. They just generated high same store sales growth for the last 8 years. Situations like these are great because you can hold on and don’t have to pay taxes as intrinsic value and the stock go up at the same time. These are the best companies to buy and hold.

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

Question 15: Audience- Can you give us your predictions on where the stock market and economy will be in 3 years? Whitney Tilson: 2% GDP growth is most likely. Unemployment will trickle down but still be painfully high. The Dow might be up 10-20% in 2 years but nothing Herculean. He has been shockingly surprised at how resilient the US economy has been. Patrick Brennan: Thinks the US will muddle along and that things won’t be as bad as in the worst case scenario. Interest rates can surprise on the upside side though. None of us really know, however. Vitaliy Katsenelson: Said it is hard to judge the true performance of the economy because of the government intervention. The economy has been given steroids by the Fed and he has no idea how the economy is really doing. He is very conservative and thus is very concerned about the economy. Michael Green: Said he is astonished how far we have come with how high unemployment is. He thinks that profits will still be earned over the next few years and companies will use their cash wisely. He also thinks that the market could be up 10-20% over the next 2 years.