Value Investing Conference Report
Board: IV Value Central
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I attended a good chunk of the Value Investing Conference here in Omaha today. I missed yesterday's portion because I was still logging Delta Sky Miles.
Some good stuff here from smart folks. Hope you enjoy!
David Rolfe, Chief Investment Officer of Wedgewood Partners
Rolfe spoke at length about one of the best businesses he knows -- GEICO. The direct auto-centric insurer, headquartered in D.C. and wholly owned by Berkshire, was founded in 1936. In 1948, Buffett's mentor, Ben Graham, bought half the business for his investors for $712,000. It later proved his partnership's biggest ever winner.
GEICO was a bit of a departure for Graham -- his version of Breaking Bad, as Rolfe awesomely put it -- as the shares then sold for about a 10% discount to book value. While a 10% discount to book may sound like a lot these days it wasn't much to write home about back when the Father of Investing was still running money.
Nonetheless, the investment treated him very, very well. GEICO grew like gangbusters because of disciplined underwriting, cost management, and smart customer service. It started an incredibly run in 1940 of 35 (!) straight years of underwriting profits.
Alas, GEICO's amazing streak was shattered in 1975. The company posted a nasty loss as sloppy underwriting that had been implemented in the name of growth had caught with GEICO. Jack Byrne, who passed recently and earned supreme praise from Buffett, was brought in from Travelers as CEO. Byrne, like Walter White, was not messing around -- he fired 50% of GEICO's staff and raised prices 50%. He managed to save the company, which was on thin financial and regulatory ice, and got it back to profitability in 1977.
A young Buffett stumbled upon GEICO when he learned that his professor, Graham, was the Chairman. He famously went to visit GEICO's headquarters in D.C. on a Saturday looking to speak with someone. There was only one guy there, Davy Davidson, who would later go on to become CEO. Davidson spent the rest of his Saturday explaining the insurance model to the young Buffett. A very powerful, valuable lesson.
Buffett back home to Omaha after graduating and become a stock broker. He pushed clients to invest in GEICO and they made a killing.
He also aggressively bought shares in 1976 after Byrne became CEO. He kept adding. By 1980 Berkshire owned 33% of GEICO, which was 31% of Berkshire's equity portfolio. In 1994, he tried to buy the rest he didn't already own. To GEICO's board's eternal regret, they passed on his offer of Berkshire shares as currency and insisted on cash. Berkshire's shares are now worth 10 times they were then. Oops.
It was Buffett's gain and their loss. Buffett and CEO Tiny Nicely boosted the marketing budget and new policies took off. Market share has since growth 4X from 1996 through 2012 and has $12 billion float. The business remains a jewel with a bright future. Indeed, Buffett recently said that GEICO is the last Berkshire company he would give up.
Buffett says GEICO is the one business with Berkshire that he would keep.
Michael Shearn, Founder and Portfolio Manager of Time Value of Money.
Shearn is probably best known for his book The Investment Checklist. I must say that I wasn't blown away from most of his presentation, but I did like one observation he's made about management teams. He likes to see Like to see product-focused CEOs instead of sales-focused CEOs. The best innovations at Big Pharma came in the 1980's when they were run by scientists instead of financial engineers.
Ryan Floyd, President and Founder of Barca Capital
An interesting presentation on emerging markets investing. Barca was founded in 2008 and Floyd is a long-term, value-oriented investor. They're focus is on locally-focused businesses with high returns on equity and investment. Specifically, he's looking at businesses in places like Tanzania, Vietnam, Peru, and Nigeria.
Interestingly, there's a lot of money flowing into these markets. I read a Bloomberg story recently about management teams in Nigeria getting somewhat tired of taking meetings with investors from Europe and the U.S. Nigeria! Sure enough, a money manager buddy of mine recently made a trip over there.
Floyd is having a hard time finding bargains today in these markets and is not accepting new money. In fact, he's giving back capital this year. A pretty unusual move among managers, especially young ones like Floyd. It's hard to say no to capital.
His talk centers on his experience investing in the Ivory Coast market. He purchased shares of the country's largest bank back in 2008. It seemed like a good deal at the time. It has 20% of the market's share in loans and deposits and is twice the size of its next biggest rival. The shares were yielding 10% at the time, which helped. And he did all the due diligence you'd expect for someone investing in a Nigerian bank. He went to the country, met with management and competitors, read books and reports on the country and company.
January 2011 -- things get nasty. Civil war breaks out over a disputed presidential campaign. The government sent troops into the banks to take cash out of them. Fortunately, there wasn't much physical cash actually in the banks. The stock fell 40% in 5 months.
Floyd, in hindsight, says this was a process failure on this part. He was essentially selling volatility, betting against fat tail events from happening, thinking that the world has moved on from terrible events. It hasn't.
He considers it almost a global cliché that emerging markets are growth. Improved banking and technology in the likes of Nigeria. This is no longer a secret. The question for Floyd is quantifying the political risk from an investment perspective.
Floyd did a deep dive on country risks and found that infant mortality rates, violent deaths, and country size correlate highly (or inversely, in a couple of those cases) to high-level risk. He's run the numbers and believes the economic impact of a Civil War as 1% reduction in GDP. Doesn't sound like much but it is sizable if you're investing in high-growth companies.
Big fan of using power laws to tease out fat tails. Frequency versus magnitude using two log axes. You can extrapolate the change of a huge event that hasn't happened yet. Works in wars, earthquakes, stock price changes, and interest rate volatility. Nate Silver writes about this in his book, btw. I recommend it.
Violent deaths and civil rest follow power laws as well. Floyd looks at these and sees prices as not reflecting likelihoods of violence in Nigeria. Using these extrapolations, you can estimate there's a 2% chance of 200,000 people dying in Ivory Coast in a single year. An absolute tragedy but not a Black Swan, even though pundits would describe it as such. He takes this approach up to the portfolio level. There's a 15% chance that 20% of his portfolio could experience civil war at the same time. Fascinating and smart if these are the markets you're investing in, though I must confess I have not critically assessed civil war risk for the IV portfolio. That said, there are long-tail risks I do spend a lot of time thinking about. Rampant inflation, for example, or a dramatic upshift in interest rates. These we are fairly well prepared for -- especially higher rates.
But anyway. How does Floyd price this into the stock valuation? The discount rate. Takes a normalized 10-year bond yield, a U.S. equity risk premium, and a 1.5X country CDS (credit default swap )rate. I actually disagree with this -- it isn't internally consistent to use U.S. inputs on, say, a Russian company. But I do appreciate the emphasis on country-level risk.
Says multiples are very high because investors aren't pricing in the chance of something very bad happening. Blames negative yields on bond guys buy stocks, U.S. investors overpaying for emerging markets. Hard to argue with.
The Ivory Coast incumbent, by the way, went to the Hague for war crimes. Floyd wanted to unload his shares but couldn't actually get a buyer. He was able to eventually get out at a decent price.
"It's no good investing in a place where people are shredding themselves."
The lessons for U.S. investors? Don't short long tail risk. Try to think about risks in terms of probabilities, teasing out the odds and impacts of long tail risks. Understand the real impact of these things on valuation. Sometimes, maybe not much. Sometimes a lot.
Potential fat tail risks in the US? Hyperinflation, default, negative real GDP growth for 20 years.
Howard Marks, Oaktree
Marks is one of the more famous value investors operating today. He has an outstanding track record, mostly with a focus on distressed debt, and his book The Most Important Thing has been very widely praised, including by Buffett.
Oaktree's investment philosophy: Dedication to understanding and controlling risk, insistence on consistency, involvement in less efficient markets only, high degree of investment specialization, no reliance on macro-economic projections, and no raising of cash for purposes of market timing. The common thread running through the tenets of the philosophy is recognition of -- and respect for -- the limitations imposed by real-world considerations.
Theory: People are risk averse. Riskier assets must provide higher returns than safe assets in order to attract capital.
Practice: Riskier assets usually appear to promise higher returns, but that doesn't mean those returns will arrive.
Theory: An appropriate risk premium is incorporated into the promised returns on riskier returns.
Practice: Sometimes the risk premium is appropriate, sometimes it inadequate, and sometimes it is excessive.
Theory: People want more of something at lower prices and less of it at higher prices.
Practices: People tend to warm up to investments as they rise and then shun them when they fall.
Macro is in favor nowadays. Everyone wants to predict what the economy will do, where the Euro is going, etc.
Marks talks about the swing of the sentiment pendulum. The happy medium is rarely seen. Instead, there are frequent excesses.
The three stages of a bull market: 1) When a few people begin to believe that things will get better. 2) When most people believe that improvement is underway. 3) When everyone thinks things will get better forever. Risk is low in phase one and high in phase three. It isn't a matter of what you buy, it is a matter of when and the price you pay.
The three stages of a bear market: 1) A few people realize things are overpriced and going to fall. 2) When most people see that a decline is taking place. 3) When people think things will get worse forever.
You want to buy the things they hate and believe can only get worse, and sell the things they love and believe can only get better.
Few people are able to act in a contrarian fashion relative to these market cycles. But it is essential.
Whenever you find yourself on the side of the majority, it is time to reform. -- Mark Twain
"Being too far ahead of your time is indistinguishably from being wrong. Hanging on while you appear to look wrong is very challenging."
"Memory -- and the result, prudence -- always come out the loser when pitted against greed."
"Overestimating what you know about the future introduces great risk."
"We have two classes of forecasters: Those who don't know -- and those who don't know they don't know."-- John Kenneth Galbraith.
"To me, there's nothing scary about saying 'I don't know.'""
The I Know school. I know school investors invest for one outcome, concentrate, lever heavily, and target maximum gains. The I Don't Know school hedges against uncertainty, diversifies, avoids or limits leverage, and aims to limit losses.
"If we avoid the losers the winners take care of themselves."
There is never one future. There are always many futures. Anyone who invests as though the future is knowable is making a very big mistake. Even when you know exactly the probability distribution it is different than knowing what will happen. Most people think in terms of average or the norm and ignore the outliers. Recommends reading Fooled by Randomness by Nassim Taleb.
Most institutional investors expend extraordinary effort and often make decisions for the purpose of avoiding embarrassment. In particular, they over-diversify.
"Investing in an institution interferes with great investing."
In many ways, the forces that influence investors push them toward mistakes. Buying things with obvious appeal, that are easily understood, that are popular, that are doing well. Those are the things that appeal to the herd. They all imply elevated prices, limited return potential, and substantial risk.
At most points in time, the real bargains are found in doing things others won't do, not the things described above.
"Smart investing doesn't consist of buying good things, but buying good things well."
Asked about the current level of profit margins, you have to be leery. Looking ahead, you might see margins shrink but made up for in increases in the top line.
The dominant, most important element in investing today is the record low state of interest rates.
This is a time for caution. This is not a time for aggression.
Questioner: Specifically, what investments do you like best today?
Marks: Specifically, I'm not going to tell you. But Europe, dripping, U.S. commercial real estate (but not A buildings and A cities). Loved retort.
"I don’t think we're at a cyclical asset peak. Certainly not in stocks. But something more like the 6th or 7th inning."
High-yield bonds are the least seedy thing we do.
The 10-year Treasury will be a great investment with depression, deflation, or calamity. All very hard to predict.
"I think the big mistake today is buying long Treasuries. I don't think anybody is going to slit their risks over not buying Treasuries."
"I think buying when people are selling is better than buying when people are buying."
Bethany McLean, Author of All the Devils Are Here
McLean also wrote The Smartest Guys in the Room. Started as a journalist. In her earlier job, they told her to write a column focused on stocks that could double or triple over the next six months. Easy enough, right? She interviewed experts regularly and wrote about their ideas. But she found a few months later that it didn't work out that way. Instead, there was an inverse correlation between the stocks investors talked about enthusiastically and their ensuing performance.
One of the big misconceptions of giant frauds like Enron is that there was a clean, concise moment -- probably in a dark, smoky room -- when the fraud was perpetrated. In reality, it involves many people, some of whom may not even entirely grasp the magnitude of what is happening. It evolves and happens slowly.
Countrywide is another example. Angelo Mozillo is easy to point to, but there was no memo that said "Put people in homes they can't afford to enrich ourselves." Instead, Mozillo's pride, ego, and ambition instilled such a culture that empowered and emboldened loan officers to make terrible loans.
Never underestimate the incompetence of the experts of the world. Exhibit A: Moody's ratings of mortgage-backed securities that imploded during the financial crisis.
"I think incompetence is more dangerous than outright impropriety."
Listen to the skeptics. McLean used to get heat from fellow reporters for having short sellers as contacts because they were supposedly is biased. But, as McLean says, everyone in the market is biased. People who own shares want them to go up. Analysts who have rated the stock a buy want shares to go up. Managers want shares to go up.
Bob Robotti, Robotti and Company
Robotti, a fast-talking fella with huge amounts of energy, looks far afield for ideas. He likes putting boots on the ground abroad to help source ideas and has lived abroad himself for the same reasons, to help him broaden his horizons. I like this idea so much I did it myself. :-)
"There is no magic formula to being a successful investor." I'm sure Joel Greenblatt would disagaree.
How do you take advantage of Mr. Market's weaknesses? A behavioral edge, an analytical edge, or an informational edge. Robotti believes that his group's behavioral edge is their sharpest. I'd say the same of us here at The Motley Fool. Our greatest edge is our time horizon.
PriceSmart is a classic Robotti holding. They've been in and out for years. They've been able to take advantage of good prices on PriceSmart shares over the years because they've come to know the business, managers, and levers.
Robotti advises sitting on company boards. Sure. I'll remember that when Warren calls and offers.
Company Robotti likes now is Stolt-Nielsen Limited (OB: SNI). The world's leading chemical shipping company founded in 1959. A leading player in an oligopoly business with very strong barriers to entry. Ability to replace fleet is superior to dwindling competition. High insider ownership. Industry was in state of oversupply in the late 90's, which started a chain of events resulting in 15 years of underperformance -- current undersupply may do the opposite. Poised to benefit from a strong chemical manufacturing resurgence and trades for less than 50% of the company's estimated sum of the parts value. EBITDA is flat over the past five years though terminals and contains have solidly grown over the past five years. Bears think this one is a value trap.
Don Yacktman, Yacktman Fund
Manages about $24 billion. Focuses less on margin of safety and more long-term rates of returns. A key part of that is on the range of outcomes on what a company earn on its reinvested cash, which becomes a progressively larger portion of assets. Doesn't go overboard with spreadsheets -- focuses on key drivers instead.
"I'd rather be generally right than wrong to the fourth decimal."
"I have an iPhone in my pocket, but I don't know what I'll have in there 10 years from now. I do think, though, that Procter & Gamble will still do well selling detergent."
"Most true savers wish they could save their money and stuff it under the mattress. But that isn't possible. Inflation eats your money over time -- and potentially also bed bugs. A dollar has declined 87% in value over the past 50 years."
Inflation is an insidious reality. Yacktman focuses on avoiding making dumb decisions and protecting purchasing power. Measures their success by beating the market over rolling 10-year periods. He's certainly done that -- Yacktman's funds have crushed the market.
Looks at companies along a quadrant framework. Along the top you have Good Businesses, left to right. Along the left y-axis you have capital intensivity. Finally, cyclicality on the bottom. They're ultimately looking for high returns on tangible assets. The central tendency is to focus on capital-light businesses with low cyclicality, but most companies that check that box aren’t priced attractively. You can only hop on such great businesses at unusual times.
"A company that has 40% market share doesn't have twice the profits of a company with 20% share. It does four times the profits."
Yacktman is an especially big fan of shareholder-oriented management. Likes seeing share repurchases, synergistic acquisitions, and reinvestment in the business.
Yaktman delegates a good bit of position-level decision making to his two key lieutenants, though he signs off on everything. Sometimes the guys bring him something like a homebuilder or a USG and Yacktman will hold his nose but still let them run with it. "Those businesses are on moving walkways. I prefer businesses that are on escalators."
The Main Event
And that's my notes for the Value Investing Congress. Be sure to check out www.berkshire.fool.com for all our coverage of the weekend, including a link to today's marathon Q&A with Warren and Charlie!