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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A Great Investor Discusses His Evolution

The John Bogle book, The Battle for the Soul of Capitalism (2005) brings home the enormous size, behavior and influence of mutual funds. The book talks about the behavior and management of these funds which you need to be aware of to understand valuation anomalies. A few pages in I have a quote from Fisher Black from the book, Fischer Black and the Revolutionary Idea of Finance by Perry Mehrling (2005). “We might define an efficient market as one in which price is within a factor of 2 of value; i.e., the price is more than half of value and less than twice value. By this definition, I think almost all markets are efficient almost all of the time. „Almost all‟ means at least 90 percent.” (Fischer Black, 1986, Journal of Finance 410). He was a brilliant man—the originator of the Black-Scholes option model—and he had a number of valuable insights. I excerpted this one. How he thinks of market efficiency. 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. He said the US govt. bond market is efficiently priced almost always. It is almost never able to present an opportunity that he would consider worthwhile. 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. You may have had people come to this class and tell you that they can find stocks trading at half of value. From my experience I have almost never found a company trading at ½ of value. 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. Except in times of extreme pessimism or extreme gloom and doom like year-end 1974, I can‟t think of a time when there were a large number of stocks trading at ½ of value. The Irrational Exuberance book by Robert Schiller is a must read, particularly the second edition. 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. The real estate bubble. A good, easy read. The Introduction to Behavioral Finance by Andrei Shleifer. This is a tremendous book. It is a collection of his lectures. The Box 4.1 King Kong: America‟s Largest Money Managers from John Bogle‟s book. Every day we hear so much about how big the money management business is in aggregate. When you look the mainstream institutional investors, the Fidelity, the Van Guards and so forth, basically they are three quarters of the market. You can‟t underestimate how big they are, how important they are and how they can move markets. I have also excerpted from John Maynard Keynes about investor short-sightedness back in the 1930s. You should read it. (Chapter 12 in the book, The General Theory of Employment, Interest and Money). Warren Buffett excerpts from his 1990 Berkshire Hathaway Annual Report where I underlined one section. “Over time, the aggregate gains made by Berkshire shareholders must of necessity match the business gains of the company.” That is over the long-term and that is of course true for any company. It is a very, very important idea. If we believe there is an intrinsic value that will accompany a stock, and a share price that fluctuates around that intrinsic value over time, there will be swings of price around intrinsic value. In the long run the returns of owning the stock will be equal to the growth in value generated from the business. As an aside there is a subset to this little excerpt from Warren. There are a couple of large institutional investors (Sequoia, Fairholme, and Davis Funds) that I am aware of who hold Berkshire for their
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A Great Investor Discusses His Evolution

clients. They argue that the stock is undervalued. 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. He doesn‟t want big gaps up or down between price and value. The people who own this stock and argue for its cheapness are arguing against the man himself. The excerpts here I have from the Economist. You must appreciate that long-run profitability is extraordinarily high and has been for many years—way, way above the long term norm and if you believe in mean reversion, as I do, it is something to be well aware of. I also included a quote from an interview in Barrons'. Excerpt from interview with Jeremy Grantham on Feb. 6, 2006 in Barron‟s: “Perhaps the most surprising thing to me is the inability of even market professionals to adjust for profit margins. 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. The least we can do, as professionals, is to normalize between economic boom and economic bust, between low profit margins such as those in 1982 that were half normal and dramatic profit margins such as those in 2000 and today. A lot of people think profit margins can be sustained. Profit margins are provably the most meanreverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” Annotation on Reversion to the Mean on Profit Margins In the Wall Street Journal C-1 page on March 29, 2007: Profit Pullback May Foretell Cost Cutting by Justin Lahart: A month ago, former Federal Reserve Chief Alan Greenspan stirred markets when he remarked on the possibility of a recession. Profit margins were “stabilizing,” Mr. Greenspan said, a sign that an economy is in the late stages of expansion. So what happens when they start to shrink? When it reports its final estimate of fourth-quarter GDP today, the Commerce Department will also report on corporate profits. Alliance Bernstein economist Joe Carson estimates pretax profits were 13% above their year-ago level, which would market it the 19th quarter in a row that the broad measure of profits has grown by better than 10%. But that estimate also implies that fourth-quarter profits have grown by better than 10%. But that estimate also implies that fourth-quarter profits were 4.7% below the third-quarter level. Such a sequential decline is rare. And since the overall economy grew in the fourth quarter, that would mean that companies saw a smaller portion of their sales fall the bottom line. In other words, profit margins got smaller. One simple way to measure profit margins is to look at pretax profits as a share of GDP. In the third quarter, this came to 12.4%--up from 7% five years earlier and at its highest level in over 50 years. Mr. Carson‟s estimate implies that it fell to 11.7% in the fourth quarter; it looks like its getting slimmer.

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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. …If the cuts turn to jobs then Ben Bernake may need to throw his inflation caution to the wind and cut rates. Pretax profit margins as a percentage of GDP went from 8% in 2000 to 7.3% in 2001 during the last shallow recession up to 12% in 2007. -Yes, P/E multiples are moderate by historic norms but the earnings part of the P/E are very high. This is something I will take exception with GI when he talked about 7.5% returns on the stock market— implied total returns on current valuations. I would say that is an optimistic assumption because corporate profits as a percentage of GDP are at record highs. So the idea that corporate profits will stay at the same percentage of GDP assumes that corporate profits will maintain their high levels. To me that is a difficult assumption to make since they are at unprecedently high levels. The other reason is that if corporate profits grow as fast as GDP, the risk assessment of owning equities could change from the low risk assessment of today. Investor‟s appetite for risk could decline such that they will not value equities as highly as they do now. You could get profits growing as fast as GDP but prices fall. So there are two specific risks that you may not get a 7.5% implied rate of return.

As you can see, the GI seemed accurate in assessing possible risks. This lecture given in 2007.

This idea of investing for a 7.5% rate of return is something that I disagree with strenuously. The idea— GI spoke about this earlier in your class: the idea--that the default option is cash or a piece of the index. Many institutional money managers operate that way, but I would hope that when you manage your own money, you wouldn‟t act that way. I can‟t imagine that any of you would say that if I can‟t find enough investment ideas so, therefore, I will then buy an index fund with what is left. That is the difference between the institutional mindset and the appropriate individual mindset. 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 7.5% with a expected standard deviation of 12% or 15%, I don‟t think very many of you and, certainly I would not, find that an appealing choice. But institutions do that kind of investing all the
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time. Because they are in the relative performance game. What they have learned is that the market goes up over time, and they have to be fully invested all of the time. So, even for a small advantage that entails some risk, they will invest in equities. Another book that I talk about, The Fooled by Randomness, where the author talks about black swan events. The idea that events can occur that you never think could occur. Just because you have not seen a black swan doesn‟t mean it doesn‟t exist. So when people talk about the standard deviation of stock market returns, they are looking at historical data—we could talk about the dotcom crash, the 1987 crash, we could talk about the bear market of 1973-74. But when we talk about risk in the stock market, value investors don‟t talk about risk in the sense of volatility. Warren Buffett talks about risk as the permanent impairment of capital. Many generations have learned that the stock market returns to some sort of normalcy even after a serious downdraft. It has been a long time since a well-diversified investor has suffered a permanent loss. The risk, however, is that the game is more complicated than it seems or that history will tell you. I hope all of you have read his new annual report and letter to shareholders. In it (2006 Annual Report to Berkshire Shareholders) he talks about his desire to recruit a new, young investment professional. Here is what he says, “It is not hard to find smart people, among them individuals who have impressive investing records. But there is far more to successful investing than brains and performance that has recently been good. Over time markets can do extraordinary, even bizarre things. A single big mistake can wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered.” Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior are vital to long-term success. I‟ve seen a lot of very smart people who lacked these virtues. -GI: I think I understand what he is saying. He is saying there probably is some extremely low frequency, high severity risks to stock market investments that nobody has recently lived through. Maybe no one has encountered. I have a list here; it certainly is not an inclusive list: major earthquake, bird flu, Martial Law, suspension of civil liberties, nuclear attack. These are all unthinkable things but just because they haven‟t happened in 25, 50 or 100 years, doesn‟t mean they can‟t happen or they won‟t happen. Whether you like it or not when you invest in stocks, you are assuming these types of risks. My belief is that you should try to get paid for that risk. Annotation: Charlie Munger on page 73 in Charlie’s Almanac: Insist upon proper compensation for risk assumed.” If you can‟t…Warren Buffettt doesn‟t say run for the hills; he wants someone to think about it and be aware of it (risk). He says the investments he likes to make are the ones where he would be happy holding them if the stock market were closed. I think in the context of what he said in his letter here that is something to think about. What does that mean? I don‟t have all the answers. 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. I believe the institutional nonsense of accepting low returns and being invested all the time, being exposed to 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.
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Investors will pull away from the market when they see that the returns are not adequate for the risks. EVOLUTION OF GI‟S INVESTING STYLE I want to talk about what I do and how my investing style has evolved. The professor has heard me evolve and heard me change what I talk about. I am…nearly all value investors have a little element of contrarianism in them. We lean against the tide. We like to buy when things are out of favor and sell when they are in favor. Benjamin Graham used to write in a Latin phrase for it, “Nothing is ever as bad as it seems, nor as good as it seems.” (From the 2nd Edition of Security Analysis—“Many shall be restored that now are fallen and many shall fall that now are in honor.” Horace--Ars Poetica). It means in modern terms that there is a tendency toward mean reversion. When businesses are doing well, they have a tendency to go back to their long term performance measures and vice versa. (Competition enters, there is over-expansion, etc. Prices revert). Businesses go back to their long-term norm. All businesses are cyclical to some extent. That is a deception that people perpetuate on themselves—that is to say I am going to buy businesses that are not cyclical. One way or the other all businesses are cyclical. 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 used to deal with severely depressed cyclical companies—steel companies, oil & gas companies, businesses that would have wide ups and downs, and I would buy them when they were way out of favor, when the businesses were doing poorly. And I would sell them when the prosperity would return. It was a successful style of investing. I earned good positive returns but the volatility of those returns was quite high. I have no problem with that kind of volatility but I wasn‟t getting high enough returns for that volatility. It took me a long time to figure out. I had stocks where I made twenty times my money but it took 25 years (a 9.648% CAGR). But that is ….getting back to Buffett‟s idea of the longterm that the stock will track the underlying business in the long run. I decided after a lot of thinking and a lot of analysis of what I could have done, should have done, might have done, and I decided that there is a better way. Annotation: Warren Buffett: “The chains of habit are too light to be felt until they are too heavy to be broken.” This is Warren quoting the English philosopher Bertrand Russell, because his words so aptly describe the insidious nature of bad business habits that don‟t become apparent until it is too late. 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. This was something Warren was able to do with great success during the 1950s and early 1960s. But he stayed with this approach long after it wasn‟t viable anymore—the chains of habit were too light to be felt. When he finally woke up in the late 1970s to the fact that the Graham bargain ride was over, 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. Annotation: Buffettt: “Turnarounds seldom turn.” The world is full of businesses with poor economics selling at what seem to be bargain prices. Warren looks for a good business that is selling at a fair price, or even better, a great business at a bargain price. Poor businesses tend to stay poor businesses. In Warren‟s early days he was only concerned with the historical financials of a company, he didn‟t really care about the products it produced. His mentor Graham believed the numbers reflected everything there was to know; he didn‟t separate a commodity-type business such as textiles, which has
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poor long-term economics, from a consumer-monopoly business such as Coke, which has great longterm economics. But as Warren became active in running a struggling commodity type business, he soon realized that it was the consumer-monopoly-type companies that had the competitive advantage and were producing the superior results. Graham would buy anything as long as it was cheap. Warren will only buy a consumer-monopoly-type company that has a competitive advantage, and he doesn‟t have to wait for it to be selling cheap. A fair price is all he needs, if he holds on to it long enough. An excellent example of this was his investment in Coca-Cola, for which he paid approximately 20 times earnings. The old Warren would never have made this investment because the Grahamian valuation techniques would have deemed it way too pricey. But for the new Warren it was a more-thanfair price that paid off for him in the billions. (The Tao of Warren Buffett pages 46-47) CURRENT METHOD OF INVESTING What do I do now? First of all, I deal with seasoned companies. 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, through recessions, inflations--and see how the business performs. I look for companies that have a long enough track record so what you are looking at present can‟t possibly be an aberration. Pretty much unavoidably these are pretty big companies. These are big companies and they have been around long enough to be seasoned by my definition, they are successful and they are not tiny, little companies. 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. And while I can‟t prove it, it would appear that stock prices are much more variable than the changes in their underlying intrinsic values. I refine or restrict my list to companies with superior financial characteristics. We will talk about what that means. But in general these are companies that are cash generating, with free cash flow, businesses that are more than self-financing. They generate cash in excess of their cap/ex and reinvestment needs. Because they are cash generating, they tend to have lower debt. I am also no longer interested in companies where there is a story or a narrative. I am not interested in a company that is going to do something new and different. I am interested in its long record. I presume that a company of a certain size has a long record. We will talk about specific examples in a few minutes when we look at some Value Lines. I am not talking about long-term growth; I am talking about long-term high profitability, consistent profitability and consistent cash generation. Now, if I said to you, almost no company doesn‟t have some degree of cyclicality in its operations. Wall Street because of its short-run obsession is very twitchy. You see these stories every so often like IBM, an enormous company, reports earnings that are a penny or two higher or lower than expectations, will move the stock price of these enormous companies 3% to 5% in a day. For sure, the value didn‟t move 5% but the price did. Not in a single day, but over a series of days, you can have the divergence between price and value. The opportunities for value investors can and do present themselves. 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 trading madness that goes with the mutual and hedge funds is almost boundless. 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. They utilize a strategy called momentum investing, which requires them to buy a stock when it is rising quickly in price and sell it if it is rapidly falling in price. (The Tao of Buffett)
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What I do with these companies is to create a normalized financial model. You can look at IBM, 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 look at sales growth, the variability of sales growth around trend and if you look at the cash generated per dollar of sales, if you look at the reinvestment needs of the business, you can create a model that normalizes all these factors. You can then decide whether it is performing above or below a normalized performance level. When these big, stable companies with superior characteristics are performing at below normal or trend, for whatever reason, that is where opportunities present themselves. Now when I create a normalized financial model, the next thing I try to do is to try to break down the components of the business. What is the present value and what is the future value? GI will tell you how they are, of course, inter-related. I won‟t tell you precisely how I do it, but this is a way to think about businesses. 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. That is…… Benjamin Graham writes about not paying at all or anything for the future. He was paying a discount for the present at a discount by buying below book value; below working capital (below net/nets). He didn’t think in terms of franchises and growth. He didn’t want to pay for the future. 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. And that when you pay a high valuation for a company that seems to be growing far into the future, you are getting little for the here and now of the total price you pay. Sometimes 60% to 80% (of the market value of the company) represents the remote future so that is not something value investors would do. There is a highly regarded money manager with a wonderful performance record who manages a lot of money (Bill Miller). He calls himself a value investor, and he owns stock like Amazon.com. You may know whom I am talking about. He submits that he and his people working for him, who make long very long run predictions of Amazon‟s cash flows and discount them back, they can tell therefore if Amazon is undervalued. If I could meet him face to face, I would just say, “nonsense.” Not you, not anybody. It may turn out that he is right and his projections of the cash flows are correct, 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. Annotation: Bill Miller, Mired in Worst Slump of Career, Embraces AES, Tyco By Danielle Kost March 30 (Bloomberg) -- The bad news streamed down via satellite to a private yacht cruising somewhere off the Leeward Islands. On board, Legg Mason Inc. money manager Bill Miller was bracing for the blow: The market, he knew, had beaten him at last. His streak -- 15 years of besting the Standard & Poor's 500 Index -- had come to an end. The final numbers showed he'd returned 5.9 percent in 2006, trailing a 15.8 percent gain by the S&P 500. There was little cheer at Baltimore-based Legg Mason when Miller returned from his late-December sail. Miller says there was no buck-up message waiting for him from his boss, Raymond ``Chip'' Mason. Nor were there condolences from his friend Warren Buffett. Miller, the mastermind behind the $21 billion Legg Mason Value Trust mutual fund, says people often ask if he's somehow relieved that his run, one of the greatest in the history of investing, is finally over.

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``The answer is: No,'' Miller, 57, told Value Trust shareholders in a January letter discussing his 2006 performance. ``We are paid to do a job, and we didn't do it this year -- which is what the end of the streak means -- and I am not at all happy or relieved about that.'' Losing Picks ``I got asked, `How do you go about analyzing your mistakes?' Miller says. ``I said, `I don't. I don't analyze my mistakes.' We will analyze spectacular errors, but not garden variety errors.'' Miller has picked some doozies in his day. In the center of his bookcase sit framed stock certificates of past bloopers, including Enron Corp. and WorldCom Inc. Value Trust pick Sprint Nextel fell 10.4 percent in 2006. UnitedHealth Group Inc., another of his favorites, lost 13.5 percent. A third choice, Amazon.com Inc., sank 16.3 percent last year. Miller's bets on homebuilders soured in 2006, too. His recent showing was a rare misstep for Miller, who posted an average annual return of 16.2 percent from 1990, when he became sole manager of Value Trust, to 2005. Buffett's League His record puts him in the same league as his friend Buffett, whose Berkshire Hathaway Inc. delivered an average annual return to shareholders of 18.8 percent from 1991 to 2005. Buffett, unlike Miller, beat the S&P 500 in 2006, with a 24.2 percent return. ``It still would be hard not to see Miller as one of the best investment managers of his generation,'' says Christine Benz, director of fund analysis at Chicago-based Morningstar Inc. ``Many of the best managers run into periods of weakness.'' Such assurances don't change the fact that Miller is mired in the worst slump of his career. He's the first to say his streak was partly luck anyway. For starters, 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; Miller wouldn't have beaten the S&P 500 for 15 years. Sometimes, he scraped by in the final days of December. In 2005, for example, he beat the index by a mere 0.4 percentage point. Two weeks later, Value Trust's return sank below that of the S&P 500. Luck or Skill? In his January letter to investors, Miller said that if beating the market were purely random, like tossing a coin, 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. Using the actual probabilities of beating the market in each of the years from 1991 to 2005, he put his odds at 1 in 2.3 million. ``So there was probably some skill involved,'' Miller said. ``On the other hand, something with odds of 1 in 2.3 million happens to about 130 people per day in the U.S., so you never know.'' -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. I used to say….I don‟t find companies trading at half of value. I used to have a cut off for a margin of safety of about 30%. I could find enough investments with a 30% margin of safety to put to work the amount of money I was managing. But as I looked at these better companies, these superior financial companies, I began to understand that they don’t get as cheap as lesser companies do. Warren Buffettt says he would rather pay for a great company at a good price than a good company at a great price. That is what I think he is talking about. If I wait for a really great company to trade at two-thirds of value then I will never buy anything. As Fischer Black says most companies‟ trade between ½ to 2 times value most of the time (90%). I would submit that really superior companies—Coca Cola, P&G—may be selling, when they are really

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cheap, at a 10% discount to intrinsic value and most of the time they sell above (Mr. GI said below, but that is probably a misstatement) intrinsic value. I brought along another book here called, Dr. Z Beat the Race Track. I actually bought this when it was new in the 1980‟s. There is a very interesting chapter in here called, Stock Market Efficiency Concepts to the Horse Racing and Betting Markets. There has actually been exhaustive, rigorous, 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. They…but the horse racing game is a negative expected value game. If you take the track take and breakage, it is a negative 20% expected value game, where the stock market is a positive expected value game. The people who bet favorites actually lose much less money than people who bet long shots. Favorites do win. 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. The idea, though, is that at the horse track and the stock market too, investors underestimate the probability that good horses will win and overestimate that long shots will win. This idea of betting on favorites and the consequences of betting on favorites is something that I find interesting and applicable to stock investing. Finally, we talked about understanding that great companies do not get as cheap as lesser companies, and now we look at the margin of safety. I have what I hope is a helpful rule with this matrix here that I made up. There is a point here at the end—try to bear with me. I labeled this margin of safety with three pre-conditions for an emergence of a margin of safety. I have a three by three matrix here. Across the top we have the recent delta of value: -, 0, + then Down we have price: +, 0, Delta of Value Price UP Flat Down Down (-) NO NO Possible Flat (0) NO Possible Possible Plus (+) Yes-special case-Possible. Possible Possible but unlikely

Now we will try to fill in some of these boxes. Price up and value down-NO. Price is flat and value down-NO. If the price is rising and the value is rising this is a very interesting and special case-Possible. This is the hardest opportunity for a value investor like me to identify. What this is if you think about it… If a value is created, even though the value is rising and the price is rising, it means that the price is not rising enough. It means an under-reaction to good news in the case like the introduction by Apple of the IPOD. Just about anybody could figure out that was a pretty important plus to change the value of Apple. But few people—none I know--would realize how big the IPOD would become. Apple’s stock went up. In fact, it did not go up enough, nearly enough. It took a little while for the adjustment to take place.

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Value and Price moving higher but the price is not discounting the increase in value fast enough. Apple Computer, Inc.

A simpler example of an adjustment to good news would be a relatively small oil company finding a relatively large oil find. Investors are slow to recognize how significant the discovery really is relative to the size of the company. Other natural resource companies could be like that—a coal mine, a gold mine. This is the possible one—under-reaction to significant good news. And that falls into the circle of competence category. It means that if you are not a real expert on the field, you are just a generalist; you are not going to be able to assess how significant the IPOD will be. You won‟t identify it. You are not going to be able to say, you know Apple’s stock has already tripled, but it is still cheap; it is not adequately discounted the tremendous change value the IPOD created. OK, let‟s fill in the rest of the boxes…… Price flat and value falling-NO. Price flat and value flat-Possible. 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. So that is a possibility but not likelihood. 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. The price is flat and the value is rising-Possible. That is a delayed reaction to significant positive change in value. Something has happened that is positive, that has enhanced the value, and the market for whatever reason is slow to digest. It under-reacted. Here it doesn‟t react enough. One reason this can occur is because there could be an external distraction—a global event, a war, an assignation. There is something that distracts people, so the stock market….so opportunity exists but people are slow to deal with it. Down here at the bottom. Price is falling and the value is falling-Possible. This is genuine overreaction to bad news. This is when there is genuine bad news, and the market gets panic stricken. The price goes down more than it really should. A good example of this many years ago was Texaco losing a lawsuit. Texaco filed for bankruptcy after losing a lawsuit. The stock and the bonds sold off very sharply on that news and the drop in prices created tremendous opportunities. There was a period of panic where people said, „Oh my gosh, they filed for bankruptcy.‟ The investors‟ way oversold the stock. Yes, the news was
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bad, yes they had a $10 billion dollar judgment against them, but the reaction in the market was excessive. This one down here is possible: price is falling and the value is flat. This is what I categorize where the news is perceived as bad news so the price goes down, but it really isn‟t. The value is unchanged, but there is a misinterpretation to the news. Price falls and a valuation disparity occurs because value remains unchanged so a value disparity occurs. Finally, the last box I call possible but unlikely. This is where value is rising and the price is falling. That is an unlikely set of circumstances. It can happen. Again, it could be a big external distraction. There is good news about the company but the news in the world is so bad. Or the more subtle way is the short run/long run trade-off. Sometimes companies will make announcements where they make changes for the improvement of the company (more marketing expense, more R&D) but in the short run it will depress earnings. And unfortunately, investors sell on that news because they are not interested in long-term investing, in investing for the future particularly if it has a short run negative impact on earnings and cash flow. Anyway, we can have all types of hypothetical situations why these situations might arise. But the punch line for all of this is that of the nine boxes, there are six that are preconditions—logically they are preconditions—for the appearance of a margin of safety. 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. 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. This is the exception up here (both share price and value increasing-IPOD example). This is the special case, the circle of competence, where you know you know something. For example a drug company discovers a new drug; 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. Even though the stock went up a bunch, it has not gone up nearly enough. If you have this type of specialized knowledge that is an area where you can hunt. I am saying for myself and for the most of you it is rare that we find situations where we can say, “Yes, the price has risen a lot, but I know because of my knowledge of the industry and company the price hasn‟t gone up nearly enough and, in fact, its margin of safety is there. SEARCH: The punch line again are stocks that are going down or are not going up. That is where you should be hunting. VALUE LINE HANDOUTS Now I want to talk about the Value Line handouts. I will start out by saying that if you are not familiar with Value Line, it is absolutely essential. The amount of information that is available in this one page is just astonishing. It is necessary and it is almost sufficient for the type of investing that I do. It is amazing the amount of information in these pages. I want to start out by talking about Coca-Cola and Nokia. Coca-Cola is everybody‟s poster child for a great company. It is a high profit margin company, essentially unlevered, generates lots of cash, raises the dividend every year, and net repurchasers of stock most years. We all know that Coca-Cola has had slowing growth, 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%. This stock is trading at 20 times earnings. Now let‟s look at Nokia. These are great big companies—Coke has $113 Billion market capitalization while Nokia is $85 billion. Nokia‟s price is higher now, but look at the numbers on Nokia. When Wall
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Street talks about Nokia, they compare it to Motorola and what is going on with China. This narrative, this story that we are going down market with headsets; they are getting smaller and cheaper, and the margins are getting smaller and smaller. There is always a story. The financials tell the story. This fits the character…these are seasoned companies, not a flash in the pan. This goes back to 1996. But look at these numbers. Look at the little box over here of annual rates of growth of sales, cash flow and earnings much higher than Coca Cola. It has similar returns on equity—earning 30%, 40% ROE with no debt. Pays a dividend every year, the dividend has been rising—22% compounded over the past 5 years. The company has a significant share buy back every year, and it trades at 15 times earnings.

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This is the first step that I recommend to you in terms of finding stocks to research. When I find a company with these characteristics which are extraordinary, I look deeper. You can spend some time going through Value Line by hand or do some screens; there are not many companies with these types of characteristics. Extraordinary! To tell you the truth, I don‟t know how they achieve this. But it is sure something I would like to know. This is not a fluky thing; this is not a flash in the pan. This is not a brief hula-hoop type of thing (a one trick pony or a company with a hot product). They (Nokia‟s Management) are doing something very right. There is some moat here. Prima Facie evidence suggests that there is really something good going on here. Compare the numbers to Coca-Cola. Nokia 16x 36% 36% 0.5% 21% / 19% 18.5% / 14% 18.5% / 11% 33.5% / 22.5% >5% Coke 20x 28.% 30.5% 6.0% 12.5% / 12.5% 4.0% / 3.0% 7.5% / 7.5% 10.0% / 9.5% < 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, and the stock is cheaper. 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. My superficial understanding of Nokia is that what they make are commodities. The financial performance says their products are not commodities. There is something else going on. Now let‟s turn to Cisco (CSCO). We talked about Cisco here a year ago.

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This turned out to be a very successful investment for us a year ago. This is more interesting because its financial performance is more volatile than Coca-Cola or Nokia’s, and its share price is more volatile-much more volatile. In this case volatility creates opportunity. In 2000, Cisco traded at $82 and in 2002 it traded at $8 (a decline of 90.3%). Somewhere in there, almost certainly, it was overvalued and undervalued because companies don‟t fall 90 percent without creating some kind of investment opportunity. The investment characteristics are extraordinary—very high returns (20% to 25% returns on total capital. Debt 3% of total market capital. Huge cash generation and in the recent years an enormous buyback. When we talked a year ago, Cisco was generating $500 million a month of free cash flow and it is using it to buy back stock.

Now what I want to point out also about Cisco, Nokia and Coca-Cola and bring up Intel to your attention—all of these companies operate without debt. Nokia has no debt and $12 billion in cash. Coca-Cola has nominal debt and $3.5 billion in cash. Cisco has $19 billion in cash with $6 billion in debt. I am a long way out of corporate finance at Columbia Business School, but I would certainly argue the case that these are not efficient capital structures. Not only are they operating with 100% equity but they are actually operating on 100% equity and lots of excess cash. The opportunity in these companies is for them to recapitalize themselves. I am not saying they should go to the razor‟s edge and operate like an LBO, but there is no reason for Cisco to have $19 billion in cash. Another thing you should be aware of—look at Nokia—these huge returns for Nokia are after spending 11% of revenues on R&D. In the case of Cisco, they spent even move (14%) on R&D. So these discretionary cash flows, these are all things we value investors are trained to look at. These are very substantial cash flows. Not many people come before you and talk about these kinds of companies--TV, cigarettes, tobacco--yes, that is true, but these numbers speak for themselves--extraordinary financial characteristics. People say well I don‟t understand it. There could be a paradigm shift. But I say, “What the hell do you know about Kraft?” I know a little bit about package cheese business. They are afraid to come to grips with this. When you look at these seasoned companies you are entitled to presume that something good is going one here. It seems unreasonable to expect that it is all going to go to hell five minutes after you purchase it.

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We talked a little about volatility. Companies that are highly profitable—the revenues may fall from time to time. These create tremendous investment opportunities. Wall Street is always ready to say the sky is falling at the first sign of a revenue decline. Almost every company has fixed costs that they can‟t cope in the short run with on a revenue decline. Intel has a bad year and revenue falls and earnings fall a lot. Wall Street gets very worried. Then we will talk about another company that the professor and I have talked about—Analog Devices (ADI). If you look along the top of the page here, it traded as low as $26 per share. How did that happen? Well, 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. Again, look at the financial characteristics of this company: No debt, $2.24 billion in cash (or $6 to $7 per share in cash with no debt), return on total capital 14% to 15%. This company is spending 20.8% of its revenues on R&D. This is not a business that is being milked for cash. This looks like a business that is being nurtured. Even after that R&D and cap/ex and you are still seeing enormous cash generation. When the stock was $26 and it had $7 per share in cash, the operating business was $19 per share. Look at the free cash flow, year after year. This is a business; this is a specialty integrated circuit manufacturer that custom designs its products. When you see companies like this, you should say to yourself, WOW, there is something really interesting going on here. I would like to find out what is going on here. What it is about this company that enables it to earn these kinds of returns?

I included IBM; as I said earlier, look at the revenue growth, the cash generation, the degree of leverage, the consistency of the net profit margins and the relative consistent ROE. This would not be a difficult company for you to model.

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For you to do a mean reversion model about what normalized profit should be. Look, for example, this volatility has dampened down somewhat. But even in the last year or two, it has traded down in the low $70s and $100. I submit to you that opportunities arise in a company like IBM. Because the value of IBM is not changing to the same degree as the price of IBM. If you separate in your mind the difference between price and value, you will think IBM is the quintessential aircraft carrier, whatever metaphor you want to use, and it will not change much from quarter to quarter. The value is not changing a lot here. 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. The stability of intrinsic value and the share price volatility is what gives us the opportunity.
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I included here one of my favorite companies, Timberland (TBL), the footwear company. Again, I am a broken record here—extraordinary financials here, no debt, high return, huge cash generation, major, major share buybacks going on. This is an interesting company because there are two classes of stock. There is a family that has control of the company. They do not have to worry about being taken over. Nonetheless, they are using the cash flow to buy back stock and increase their own ownership. When you look at 1997 and the ten years since then, one-third of the shares have been bought back. 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. Look at these numbers; something really good is going on inside of Timberland here, and you ought to find out what it is.

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

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Finally, last year when I was here, we spoke about the overvalued side, Urban Outfitters (UGIN), and now we will look at Nordstrom, Inc. (JWN). Look at JWN’s financials. These are good financials-26% return to total capital, 31% ROE. I am not going to say anything bad about JWN, but if you look at the profit margin over this cyclical recovery which has risen from 2.2% to 7.9% and Value Line is projecting it to continue. My experience is that these are mean reverting kinds of numbers. It is quite reasonable to me that a consumer driven business in a strong consumer cyclical recovery will have a big margin expansion. It is also quite conceivable to me that if the economy goes down, the profit margin will revert. One of the guests who will be speaking here later is Lew Sanders. Now Lew is, I don‟t know him, 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. I don‟t know whether JWN’s profit margin which already is by far at a record will go higher. It may well, but I see it as an investment…This is a Jeremy Grantham idea. The P/E multiple (19) does not seem very high, but its profitability is at a record, cyclical high. To say that the P/E is reasonable on record high cyclical earnings, almost by definition suggests there is no margin of safety here and, in fact, there might be danger to the contrary. I cite that as an example of a good company has its own cyclicality. Everything is booming, the valuation is reasonable, but beware of such companies.

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SELLING Finally, concluding remarks. I want to talk about selling. And here I even disagree with the great Warren Buffettt. He writes that his favorite holding period is forever. Other people, some with and some without, mimic those words. I have decided it is worth some discussion. We are buying companies with a margin of safety. We are buying businesses with an underlying intrinsic value where we believe the underlying intrinsic value is rising. 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, will go to zero. I did some numbers. Let us say we buy a business where the intrinsic value is $100, 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, in fact the intrinsic value compounds at 10%, so that is a factor of 33%. And let‟s assume that you are fortunate enough that whatever caused the margin of safety to dissipate occurs, and the stock rises. So in three years, you make the 10% compounded over three years, and you make the accretion of the discount. You multiply that out and in three years it is $133. At that point by definition it is trading at intrinsic value and the margin of safety is gone. You have identified the margin of safety, you capitalized upon it and you earned a very high return. But now that you own it at fair value, 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. You are—if you are in the business of holding things at fair value—that is not what we are talking about. Now, 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. If you say you are trading at 100% of fair value give or take 10% or some variation. But when people say, well, my greatest success has been when I bought some stock and held it for a long time and that has been successful. 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. There are some very high appreciation in those positions, but if you take the effort to try to figure out when he bought those stocks and what he paid for them, you will see that the long-term compounding is almost always, 15%, 14%, or 12%--something like that. The longer you hold it....this gets back to his statement that long-term price appreciation
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equals the long-term value creation of the business plus the accretion of the margin of safety. Now in the case of Warren Buffettt, 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. George Bush says it is 15%. But if you are Berkshire Hathaway or a corporation, the deferral of a 35% tax rate is very valuable. Especially when Warren‟s opportunity costs are so low. He is going to be loathed to realize big gains when he is already sitting with $45 billion in cash. So when he says my favorite holding period is forever, that is a unique circumstance and it applies to almost nobody else I know. 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. You should harvest it and move on. Well, 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. Do not forget at that point it can go too overvalued or it can go back to a discount. If you are buying something at a sizeable discount, and you have earned the accretion of intrinsic value and the vanishing of the margin of safety, that is what the game is all about. FINAL THOUGHTS I used to describe myself as contrarian but I tried to think of something more flattering. I describe myself as independent and skeptical and I suggest that you should think of yourselves that way. Contrarianism sometimes involves a knee-jerk reaction. That is not right. I want you to be skeptical. The professor said it that when you think you have identified an investment opportunity, why is it apparent to me and no one else? What am I missing, 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, the most successful people talk the least. I have an anecdote to relate from a close personal friend, a professional investor and former business partner, who told me how he went down to Princeton, NJ to meet with a friend who manages a hedge fund down there. And the HF manager said how much money he was managing and how well he was doing. But he went on to say how this really was a hedge fund Mecca. You would not believe what is going on. Much of this is so far under the radar, you would never hear of or about it. I know of two people now who started with a hedge fund and as their fund grew with good performance, they returned money to investors, and then came the clincher. You don‟t know the names, but I know for a fact that each of them has over $10 billion dollars. Now I tell that story and you can take that at face value. But then ask yourself, who are the people who are so available; who are always being interviewed in Barrons’; always writing a report on CNBC or there on Bloomberg. Money managers who tell you that they like growth stocks, the yen is going to go up and the dollar is going to go down. 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. 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. I don‟t need to tell you about it. So I would be skeptical of me and everyone else who comes here. Ask yourself, why is he telling me this; what is in it for him?1 Now, the simple answer in most cases is that almost every value investor wears multiple hats. He is a portfolio manager, a stock picker and a marketer. He is always looking for more money to manage. He talks a lot to find people and encourage them to focus on his successes and ignore his failures.

1

As always, incentives matter.

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To the extent that by talking so much tonight I may have undermined my own case, but I did bring a visual aid. Anne is with me, and it has been in the family a long time. Many years ago I read this on Wall Street, and I asked my wife for a Christmas present. This is in the introduction of The Great Crash by

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

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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. His current theme for decades has been I have positions in companies I am happy to hold if the stock market closed forever. Q: You spoke about the default option—cash vs. an index? GI: Yes, the default option is cash. For a rational individual the default option is cash. Most portfolio managers are under pressure to mimic the market. 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. It is better to fail conventionally than succeed originally. Q: Who is on the other side of the put buying to hedge portfolios? GI: The answer is that I don‟t know. I spent quite a bit of time two or three years ago trying to find 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. And I found it difficult to find such people. Finally I did come up with a few people from Morgan Stanley. What he said is that what you are talking about is the way I manage my own money. 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. What I have heard from reading the economist, in a low volatility market, big pools of money have been selling risk. They cliché is it is like scooping for nickels in front of a steam roller. The idea of making the bet is that I will write the insurance on very low frequency, high severity risk. My hunch is that a lot of hedge funds are doing it. I have a friend who is a really cantankerous, 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. His compensation is to give them short ideas. And what he has told me is that hedge funds are a misnomer. Hedge funds are leveraged mutual funds. There is not a lot of hedging. I suspect there will be a lot of consequences. The idea that the lending institutions have been spreading their risks around the world to hedge funds, I don‟t know if that will have a happy ending. Again, the idea of writing insurance, a man I used to work for in insurance used to call these high severity and low frequency risks, “tic, tic, tic, BOOM!” You underestimate the risk that is unlikely but it occurs. Sometimes you hear of ads in the newspapers like Barrons, investment strategies that have 99% success rates and these are the ones to suck in subscribers. Almost certainly what they are talking about is writing out of the money options. Tic, tic, BOOM. 90% you collect your little premium and then you get wiped out. End. What Graham would say about the above approach:

Graham‟s Advice on “Relatively Unpopular Large Companies”

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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]. Written by Benjamin Graham in 1949 as a guide to investing principles designed to be accessible to the general public, The Intelligent Investor clearly presents not only information regarding sound selection of securities but, perhaps more importantly, the correct mindset that separates true investors from speculators. For decades, 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. In Chapter 7 of The Intelligent Investor, Benjamin Graham presents three recommended fields for “enterprising investors”: 1. The Relatively Unpopular Large Company 2. Purchase of Bargain Issues 3. Special Situations or Workouts At the market lows in 2009, it is reasonable to assume that even someone as conservative as Ben Graham would have found ample “bargain issues” available for purchase. However, the very strong bull market over the past year erased many deep bargain opportunities. There are always special situations, but this is not a field that many investors feel comfortable with. Unpopular large companies, however, will always be with us for a variety of reasons. Certainly there is no shortage today of large companies that are disliked or even despised by politicians and the general public. Why Large Companies? There are certainly many unpopular companies of all sizes, many of which trade at depressed levels, 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, it is logical to expect that it will undervalue — relatively, at least — companies that are out of favor because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should prove both conservative and promising. The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in many cases may later increase their earnings and share price, they entail the risk of a definitive loss of profitability and also of protracted neglect by the market in spite of better earnings. The large companies thus have a double advantage over the others. First, they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown. (Fourth revised edition, 1973: page 79)

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A Great Investor Discusses His Evolution

Essentially, the argument is that if an investor can identify strong enterprises with a record of meaningful profitability, a temporary setback may provide an opportunity to make a bargain purchase if Mr. Market has misunderstood the situation and assumed that the difficulties are permanent rather than temporary. By looking at larger companies that have the financial strength to withstand a potentially protracted period of adversity, 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. 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. Due to the disastrous oil spill that is still underway in the Gulf of Mexico, few industries are facing as much near term uncertainty as those involved in the oil and gas industry. The companies that are directly involved include BP, Transocean, Cameron International, and Halliburton all of which are down sharply over the past month. Beyond those companies directly involved, oilfield service and equipment companies have been punished in general. These companies have various degrees of exposure to offshore drilling. Within the offshore oriented firms, there are different exposures to shallow vs. deep-water along with regional differences as well. Despite the tragic situation in the Gulf of Mexico as well as the near certainty of higher regulatory costs going forward, America and the rest of the world will be heavily dependent on oil for at least twenty years and probably much longer. 2. Medical Device Industry. The new health care law has broad implications for all businesses involved in the delivery of health care. Medical device companies will soon be facing a 2.3 percent excise tax on gross sales of most medical devices. The largest companies are obviously expected to bear the most significant cost [2] given the fact that this is a gross receipts tax. 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. On a positive note, 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. These are just two examples of industries that are not popular with investors today for very different underlying reasons. There are many companies in both industries with long records of high 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. In the coming days, we will present some potential ideas from these industries. The idea is not to necessarily identify companies that qualify for immediate investment, but to examine unpopular situations based on how they might have looked to Benjamin Graham. Some companies may be interesting but are not depressed enough to offer a margin of safety today. 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.

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