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Cover Story

Graham, Buffett
and beyond
In a two-hour, free-wheeling interview,
Jean-Marie Eveillard explains how his investment
style has evolved over the years. A Swiss chocolate
aficionado, one of his most successful investment
calls has been Swiss chocolate maker Lindt.
Eveillard insists that his contribution to the
company’s sales must be counted as one of the
reasons for its success!
Mohammed Ekramul Haque & N Mahalakshmi
balance sheet, with necessary adjust- is always something that can go wrong
ments to the asset side and/or the lia- and if over the following years the com-
bility side. There is no attempt to peer pany loses money every year, and after
into the future as Graham said the fu- five years the cash is gone, then obvi-
ture is uncertain. There is not even ously it is a terrible mistake.
1970 –At the office in New York City an attempt to assess the strengths or The availability of net cash stocks is a
weaknesses of the business from a good indicator of how cheap the stock
Can you tell us about your investment qualitative standpoint. So buy equity market is. If we don’t find any Graham
style in your early days? worth $40 per share based on balance type stocks or Buffett type stocks then
I ran the fund alone between 1979 and sheet strength at $25 a share, and sit we let the cash build up.
1986, so, most of the stocks I bought on it. Then at $35, start selling and at
were the Benjamin Graham type. Gra- $40 you sell it all. That’s what Buffett Do you look at the macro situation?
ham’s approach is less time consum- called the cigar butt type approach. Value investors are bottom-up inves-
ing and in the late 70s, which were You get one good puff from $25-35 and tors. But when we establish intrinsic
terrible for the stock markets, there then it is all over. values and update them, we do not
were quite a few Graham stocks avail- assume eternal prosperity but accept
able not only in the US but throughout How do you arrive at the intrinsic that there is a business cycle. But we
the world. Later I graduated to Warren value of a stock? say, hey, what are the odds of consider-
Buffett’s style as we added more peo- I’m intrigued by the balance sheet-de- able economic difficulties for a year, or
ple and had a bigger team. (Graham’s rived intrinsic value which two, or three? Based on that
approach involves picking a basket of is basically stock holder’s we may be more demanding
cheap stocks based on financials with- equity with some adjust-
When we in terms of valuations.
out involving rigorous research on the ments to assets side and li- bought
quality of business. Central to Buffetts’ abilities side. I used to look Berkshire, we Did you switch to the Buf-
style is buying concentrated bets in in- at companies which had were getting fett approach because you
dividual companies after thorough re- cash plus marketable secu- could not find enough Gra-
search.) Originally, Graham’s book, rities minus financial debt the talent and ham type stocks?
(The Intelligent Investor), and later the in excess of the market cap. skills of Buffett Yes, partly that. The main
annual reports of Berkshire Hathaway And while valuing securi- without having reason was that as we staffed
influenced my thought and approach ties we assume they are liq- to pay for it up we could try the Buffett
to investing. uidated so we take a cut for approach, but not without
taxes. trepidation because I don’t
What got you attracted to Graham? So I would want the net cash to be re- have the skills of Buffett. But my feel-
It was a common-sense approach. The ally close to market cap, because if the ing was that if it could be done reason-
idea of order as opposed to chaos, the market cap is less than net cash I’m ably well, it could be more rewarding.
idea of long-term investing, the idea of paying less than nothing for the busi-
intrinsic value made a lot of sense. ness. The important thing is also to en- Do you like to buy holding companies
sure that a company should not have where the chances of unlocking secu-
Can you tell us about the kind of Gra- had instances of major losses in the rities held may be very limited?
ham stocks that you picked? past and the business is not in the be- We have seen that some holding com-
Most of the time it is derived from the ginning of a permanent decline. There panies have been successful in re-
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Outlook PrOfit 19 September 2008
shuffling the assets. They may have touch a company that is not growing. from increase in the intrinsic value.
six-seven minority stakes in several But the truth is that even if the compa-
businesses and over time they reshuf- ny is not growing it may be worth a lot, Can you give us from your viewpoint,
fle -- sell one asset and buy another. If it may have a lot of cash, it may be in an businesses that will thrive in the next
they are successful, that is reflected in industry which is not growing but may 10 years and those that are going to
the net asset value (NAV). In such cas- have very few new entrants which, can see a secular decline?
es there is no reason for a discount to at times, can be an advantage. Buffett made a lot of his money with
exist. simple often mundane businesses. Val-
We are more comfortable when the How different is it to calculate intrin- ue investors, with exceptions, shy away
holding company management is intel- sic value using Buffett’s approach? from technology and capital-intensive
lectually honest and has been reason- The Buffett approach is best sum- businesses because there the returns,
ably successful in reshuffling assets marised by Buffett himself when he in terms, of capital, is low. For instance,
in the past. The best case is when a said he would rather buy a comfortable we have held the stock of Secom, a Jap-
company has demonstrated success business at a questionable price than a anese electronic security business, for
in reshuffling assets in the past but in- questionable business at a comfortable years. It is a good business and mostly
vestors have not recognised it. One of price. All value investors would first
the paradoxes with holding companies start with reading the annual reports
is that if the market goes down and if and then move on to the qualitative
the minority stakes of the company are aspects. You can easily skip the ini-
listed, the value also goes down. Plus, tial pages of the annual report, like
for the holding company, the discount the president’s letter, because in all
to its NAV too increases. So I may get a
double discount: first is the discount to
the asset value and second, the prices
of individual stocks may be underval-
ued.
Berkshire Hathaway was a holding
company, but now is a conglomerate
because Buffett has done so many
acquisitions over the past few years.
When we bought Berkshire Hathaway,
we bought it as a holding company at
a discount to its NAV. We were getting
the talent and skills of Buffett and we
did not have to pay for it!

Do you need to be convinced about


how a stock will play out before you
make the purchase? probability it is written by the public
We’re value investors, we think long relations firm, so it’s worthless. What
term, so we don’t need a trigger or a is towards the end, especially the 1940 –Jean-Marie with
catalyst. There is never genuine vis- footnotes are the ones to watch out his mother in France
ibility: the future is uncertain. for. The qualitative aspect is to figure
out the major strengths and weak-
What about companies with nesses of the business, and what
peripheral assets? matters and what does not. commercial (as opposed to residential)
Yes, we buy companies with peripheral What matters are the three or four ma- where it is subscription based. Busi-
assets. Sometimes investors tend to ig- jor characteristics of a business that ness corporations pay a small amount
nore peripheral assets such as surplus would constitute a sustainable com- of money every month for electron-
real estate, portfolios of securities, mi- petitive advantage or what Buffett ic security and Secom is the biggest
nority stakes and analysts of the sell calls a moat. electronic security company in Japan.
side ignore these. In Japanese com- Some 20 years ago we realised that And there are advantages to size and
panies, many analysts ignored that forest products (paper, for instance) scale in that business because they
these companies were sitting on a ton business was actually two businesses, have a central security headquarters
of cash. Cash is cash, cash is worth 100 not one: first the ownership of timber and if the electronic security system
cents to a dollar. land, which is a great business because works well then the corporation which
trees grow and you don’t have to wor- uses the systems of Secom is unlikely
What do you do if you buy a stock at ry about wasting the asset; the second to move to another security business.
40 per cent discount and it does not is the processing of the wood which is The numbers look good too. Unfortu-
go up? a highly capital intensive commodity nately, the management has used the
If I establish the intrinsic value at 40 business, a terrible business. So you cash generated by the security busi-
and it is trading at 25 and, if over the got to identify what is a good business ness for other endeavors that were not
next few years, I keep updating the in- and what is a bad business. successful.
trinsic value at 40-42-45 then I can be Buffett says most of the money that
very patient and wait for 5-10 years. I he is going to make in the next 10 years Do you look at discounted cash flows
would prefer that the intrinsic value is not from the reduction or elimination to value companies?
increases. A lot of investors will not of the discount to intrinsic value but No, we never use discounted cash
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19 September 2008 Outlook PrOfit
Cover Story

flows. Buffett does not consider dis-


counted cash flow either, because the
way things work, after 10 years you
have a residual value which is often
about half the net present value. So not
only do you pretend to know what is
going to happen over the next 10 years
but even beyond. So we never do dis-
counted cash flow, which I think is gar-
bage. It’s as bad as the efficient market
hypothesis.
We don’t look at price to earnings but
we see EV/EBIT. It’s the best form of
valuation we could come up with. It’s
not perfect but it is much better than
using P/E as it introduces the balance
sheet into the picture. It is true that
interest and taxes have to be paid but
value investors don’t like too much
debt so the interest costs are modest
or nil so often EBIT is equal to pre-tax 2008 - With wife Betty
income. We own a group of Japanese (right) and daughters
companies that are sitting on a ton of Suzanne and Pauline
cash that is earning very little income
(second from right) at
but why should I ignore the cash. Price
Chicago university
earnings ratio ignores that they are sit-
ting on a ton of cash.

Do you have a benchmark for EV/ the recent times. value. It works both ways, if the asset
EBIT? Your call on the stock was primarily is $55 then equity is $15, again, that’s
It is somewhat arbitrary. But we use based on the share price, or was it be- what leverage does to you. Leverage
eight for an average business and for cause of the strong product? works both ways and it reduces your
a terrific business, for intrinsic value, There were two advantages: It had a staying power. In my call, two things
we may go up to 15 times. superior product, plus the went wrong – I overestimated the val-
In the case of holding com- The problem stock was cheap. But the ue of the airline and, secondly, there
panies, we use this for the one disadvantage was that was an accounting problem – there
components of the holding with sum-of-the- the management was me- was more debt than the consolidated
company and for the hold- parts is that even diocre. Even if the man- balance sheet indicated and eventual-
ing company what matters if you go slightly agement was mediocre, it ly it resulted in bankruptcy. We lost 70-
is the discount to the sum- wrong in your would not have led us to 75 per cent. As someone once said the
of-the-parts. lose money, because we value of assets is contingent, but debt
estimation of bought the stock really is forever.
Can you tell us about a few the asset value, cheap.
of your successful calls, you can end up What has been your success factor?
how they panned out? losing terribly Can you tell us about We value investors play the game of
Many years ago we bought some of your worst calls? bridge and the others play pokers . The
Lindt chocolate business. Again, it was a Swiss stock, big difference is that there is much less
The company had gone public in the Swissair, which eventually went bank- luck in bridge than in poker. I think
mid-80s but the IPO was not very suc- rupt. We did a sum-of-the-parts - they the secret of success of most value in-
cessful. The company was at that time owned airlines, hotels, caterings, vestors is that when times became dif-
run by Rudi Sprungli, who was a mem- surplus real estate, and some two- ficult they stuck to their guns and did
ber of the family who controlled the three aviation-related businesses. We not capitulate.
business. He was a difficult man and a thought the market was not taking
mediocre manager, but he never com- into account those peripheral assets, Which books do you recommend
promised the quality of the product. but at the same time there was a lot apart from Security Analysis and In-
The stock was going very cheap so I of debt too. The problem with sum- telligent Investor?
was willing to buy it. of-parts is that even if you go slightly Seth Klarman has written a great book
The stock did nothing for three-five wrong in your estimation of the asset The Margin of Safety and Martin Whit-
years because Rudi Sprungli was value and the company has a debt, you man’s books are interesting too.
at the helm and, on top of it, he mar- can end up losing terribly. For exam-
ried an American woman who was the ple, if I come up with a value of assets If you had not been in investment
member of a cult. In Switzerland they at $50 and if $40 is the debt, then equity where would you have been?
are not well disposed to such women. value is $10. If I’m wrong on the asset My mother, who is 92, says I got lucky
The family got tired of Rudi Sprungli value by 10 per cent and it’s not diffi- because I got the only job where I could
and his wife) and fired him and hired cult to be wrong by that much, then be half decent. In any other activity, I
an American man who ran the John- assets are only $45. So the value of eq- would have been a miserable failure.
son & Johnson business in Europe. He uity is now $5. With just a10 per cent And I think she is right, though moth-
has transformed the business for the mistake in the value of assets one ends ers can be extremely critical some-
better, and the stock has done well in up with a 50 per cent decline in equity times! p
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Outlook PrOfit 19 September 2008
Incredible
India
Vinodh Nalluri, vice-president and research
analyst with First Eagle, was in the country for
a month, meeting executives of more than 40
companies. Nalluri plays a key role in helping the
illustrious investor decide on stock picks. An MBA
from Columbia Business School and an MS from
Arizona State University, Nalluri has been with
First Eagle for three-and-a-half years following a
five-year stint as engineer with Texas Instruments.
Here’s Nalluri’s first impression of Indian equities…

N Mahalakshmi


Can you tell us a bit about your market cannot be ignored any longer.
funds? If you look at the American economy,
We are an absolute return fund. As corporate earnings have grown rough-
We find that average Jean-Marie would say, at the end of the ly in line with GDP, over long periods.
day, we eat absolute returns not rela- Assuming something similar in India,
companies, in India, tive returns. Investing is about ensur- an earnings growth of 7 per cent to 10
have limited free ing that your purchasing power stays per cent for Indian corporates over the

float and even that
is tightly held by
institutions.
ahead of inflation. And that is the ob-
jective of our fund.
 
What’s your first impression about
next decade implies pretty decent re-
turns on stocks at these levels.
However, the challenge is that India
is not a deep market. We find that aver-
Indian markets? age companies, in India, have limited
We missed the bus to the Indian mar- free float and even that is tightly held
kets as we did not participate in the by institutions. So trying to build a po-
big rally that happened in the past five sition can be quite difficult. And for us,
years. The Indian market looks more unless we take a position that consti-
reasonable after the recent correction. tutes at least 50 basis points (roughly
Currently, one-year forward multiples $150-200 million); it doesn’t make a
are around 16 to 17 times for BSE 100 significant difference to our perfor-
companies. Mid-caps look even more mance. Over three years, a 15 per cent
interesting. At these levels, the Indian return on a large-cap stock is thus
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19 September 2008 Outlook Profit
Cover Story

more meaningful for us than a small and processes they have are truly im-
stock that is a potential multi-bagger. pressive. The downside though is if
And as promoters begin to understand banks are allowed to sell securitised
that holding 51 per cent or 75 per cent products, then they will face an assault
makes little difference when it comes from banks. Some other names I can
to the control you have on the compa- think of are Nestle, which we own, Col-
ny, liquidity should improve. gate Palmolive in the consumer space
But the real challenge is picking and companies like Shriram Transport
the right candidates, because people Corporation. More importantly, most
are not really overlooking stocks out of the managements out here under-
here, especially the large-sized stocks stand their business models thorough-
that we are interested in. So we have ly and have a proper plan to spearhead
to look for the right price to emerge their business. We were a bit sceptical
– either because of behavioral aspects about Tata Motors, where we have a
or unfavorable business conditions or substantial position, because of their
other temporary problems that could Jaguar/Land Rover acquisition, but
depress valuations. after meeting with the management,
we feel a lot more comfortable. We also
So where do you see value? like their commercial vehicles busi-
There are several pockets of value, but ness where they have created a strong
then many of them also face their set franchise.
of challenges. Companies in the auto
sector, for example, seem to offer value In a market like India will you pay
QUALIFICATION because the near term outlook is weak. a price above book value for banks,
Vinodh Nalluri earned his MBA Similarly, public sector banks are trad- considering the growth?
from Columbia Business School in ing below book value and look cheap, Growth per se is not meaningful. What
May 2005. but then the challenge for them is how matters is profitable growth. For exam-
well they will be able to navigate in the ple, today in India, it is not difficult for
CAREER competitive space, going forward. a bank to produce a return on equity in
From 1998 through 2003, he The government owned excess of 13 to 15 per cent.
oil stocks are also trading So, even if a bank gener-
at less than 50 cents to a Banks like ICICI
worked in product development
ates an ROE of 15 per cent
for Texas Instruments. dollar. But then, those are Bank, which have or so, and grows at 30 per
not exactly attractive can- been aggressively cent, you are not going to
During the summer of 2004, he was didates because you know
part of the equity research team at there are valid reasons why
chasing growth, make money on the stock
if you pay more than book
Lions Gate Capital they are going cheap. But, have caused a value. Banks like ICICI
as a Grahamian approach lot of pain for Bank, which have been ag-
At First Eagle, Nalluri is responsible would dictate, if you buy shareholders. gressively chasing growth,
for capital goods, chemicals, con- a basket of undervalued have caused a lot of pain
sumer products, engineering, for- stocks, it can potential- for shareholders. In their
est products/paper, services, ship- ly deliver good returns. So instead of pursuit for growth they have taken
ping and shipbuilding, software, buying individual stocks, a portfolio of unnecessary exposure to certain sec-
technology and telecom equip- such stocks can offer decent returns. tors like real estate, and that combined
ment with significant asset-liability mis-
A lot of stocks trade at below book match puts them in a vulnerable spot.
MARKETS COVERED value out here. Do you recognise On the contrary, HDFC Bank, has re-
Spain, Portugal, Asia ex-Japan and them as value? frained from unprofitable growth and
Taiwan. Price to book value can be a starting focused very well on shareholder val-
point to ascertain the value in a com- ue creation. And that eventually gets
pany, but you got to look at what is ac- reflected in the valuations as well.


tually in the book. In India, normally
companies tend to depreciate their What do you think of India’s
assets over nine years which is lower outsourcing story?
than the economic life of the assets. I think companies like Infosys have
In India, normally To that extent, book value may be un- good potential for the next decade at
companies tend to derstated, and multiples exaggerated. least. They are no longer just a cost
depreciate their assets But, I think earnings multiples are arbitrage-based business model.
over nine years which is more relevant in the Indian context. They are moving up the value chain.
As growth rates in the industry come
lower than the economic Have you come across any Buffet- down, existing relationships will mat-
life of the assets. To that kind of stocks out here, in terms of ter a lot more than ever, and that gives
extent, book value may “ business model? the top players a clear advantage. Al-
be understated, and There are several stocks which have though the rupee appreciation im-
impressive business models and have pacts the companies negatively, we
multiples exaggerated the moat that Buffet talks about. HDFC feel given the high returns, and long-
is one stock that has a great business run growth rates in excess of about two
model. The franchises they have cre- times GDP, the Indian outsourcing sto-
ated in this country and the systems ry still seems intact. p
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Outlook PrOfit 19 September 2008