The richest one percent of this country owns half our country's wealth, five trillion dollars. One third of that comes from hard work, two thirds comes from inheritance, interest on interest accumulating to widows and idiot sons and what I do, stock and real estate speculation. It's bullshit. You got ninety percent of the American public out there with little or no net worth. I create nothing. I own.
Tuesday, May 26, 2015
A Dozen Things I’ve Learned about Value Investing from Jean Marie Eveillard
Jean-Marie Eveillard “started his career in 1962 with Societe Generale until relocating to the United States in 1968. Two years later, Mr. Eveillard began as an analyst with the SoGen International Fund. In 1979, he was appointed as the portfolio manager of the Fund, later named the First Eagle Global Fund. He then went on to manage the First Eagle Overseas and First Eagle Gold Funds at their inception in 1993 as well as the First Eagle U.S. Value Fund in September 2001. After managing the Funds for over 30 years, Mr. Eveillard now serves as Senior Adviser and Board Trustee to First Eagle Funds and as a Senior Vice President of Arnhold and S. Bleichroeder Advisers, LLC.”
1. “Benjamin Graham’s book The Intelligent Investor has three lessons. The first is humility, that the future is uncertain. There are people on Wall Street who will predict the Dow will be at a certain level, but that is nonsense. The second thing is that because the future is uncertain, there’s a need for caution. The third thing was especially important. Graham values the idea that securities can be more than just paper. You should try to figure out the intrinsic value of a business. In the short term, the market is a voting machine where people vote with their dollars, but in the long term, it’s a weighing machine that measures the realities of business.”
“You need humility because you know you can be wrong, and when you admit that you stress caution by assigning a margin of safety to your investments so that you don’t overpay for them.”
“I focused mainly on stocks that were trading at 30 to 40 percent below my intrinsic value calculations.”
This passage is a distillation of many key points about value investing. The Great Depression made Ben Graham humble as an investor. As a result of that experience he developed his value investing system. This system is only appropriate for people who can take a long term viewpoint and sometimes underperform a benchmark in the short term. Many people can’t do these things for psychological or emotional reasons, or won’t do the work required to actually understand the business underlying each security.
Value investing is not the right investing system for everyone, but it is unique in that can potentially be successfully implemented by an ordinary investor with slightly above average intelligence and a sound work ethic. The limitation of the system is that very few people actually have the full set of skills and personal attributes required to be successful in implementing the system. Value investing is simple but not easy.
As for the 30-40% discount to intrinsic value which creates the margin of safety, Matthew McLennan (one of Jean-Marie Eveillard’s colleagues at First Eagle) notes:
“We’ve typically looked to buy 70 cent dollars. I think the mental model of paying 70 cents for a business makes great sense; if the normal equity is priced for 7% returns, and you’re going for 70 cents on the dollar, you’re starting with a 10% ROI. Closing that valuation gap over five to ten years may generate a low-teens return. If it’s a great business, there’s an argument to be made, not necessarily for paying 100 cents on the dollar, but for paying 80 to 85 cents on that dollar. As Charlie Munger would say, it’s a fair price for a great business. Your time horizon’s long enough that you’re capturing less spread day one, but if the business has a drift to intrinsic value of 4-5% a year, held for a decade, you may potentially reclaim that and then some. The more patient you are, the more you’re potentially rewarded for holding good businesses.”
2. “By being a value investor you are a long-term investor. When you are a long-term investor, you accept the fact that your investment performance will lag behind that of your peers or the benchmark in the short term. And to lag is to accept in advance that you will suffer psychologically and financially. I am not saying that value investors are masochists, but you do accept in advance that your reward, if any, will come in time and that there is no immediate gratification.”
“I think one of the reasons I didn’t enjoy growth investing was because it assumes the world to be perfect and certain, which it is not! Becoming a value investor allowed me to acknowledge the fact that I am uncertain about the future.”
What Jean Marie Eveillard is talking about here is something that you either understand and embrace or you don’t. It is also something that you are comfortable with or not. People who are not humble about their ability to predict the future or who need immediate gratification are not good candidates to be successful value investors. These people should put value investing in the “too hard” pile and move on.
3. “We don’t buy markets. We buy specific securities.”
“An investor who buys a building or an entire corporation gives a great deal of attention to the price to be paid for the asset. So does the buyer of a car or even a bathing suit. They all seek value. What’s so different with equities? Are they just pieces of paper to be traded in and out of on the basis of psychology, sentiment, herd instinct?”
“The search for undervalued stocks beings with the idea that stocks are not just pieces of paper that are traded in the market. Every stock represents a business, which has its own intrinsic value. To determine that value, you have to estimate what a knowledgeable buyer would be willing to pay for the business in cash. It is important to understand that intrinsic value is not an exact figure, but a range that is based on your assumptions. Because you have to revise your assumptions from time to time to reflect business and market conditions, intrinsic value fluctuates over time, and it can go up or down.”
The best value investors are people who have significant experience in business. This allows the investor to successfully answer a key question: What would a private market buyer pay in cash for the business in question? The point made by Jean Marie Eveillard about intrinsic value not being precise is important. The future is always uncertain and a future business result is not an annuity.
One other important thing about determining intrinsic value is knowing that it is not always possible to determine intrinsic value in a given case. If you can’t reliably determine intrinsic value for a specific business, just move on (put it in the “too hard” pile). In other words, the value investor will try to find another security to buy which allows them to easily determine intrinsic value. Jean Marie Eveillard is also pointing out that a fuzzy intrinsic valuation result can be OK for a value investor since the investor is protected to a significant degree by a margin of safety. First Eagle’s approach as described by Matthew McLennan is as follows:
“There’s a willingness to pay higher multiples for franchise businesses. By going in at 10x – 12x EBIT, you could get a 6%normalized free cash flow yield that can potentially grow 4-5%sustainably over time, and thus you may achieve the prospect of a double digit return. If it’s a businesses that is more Graham in nature, with no intrinsic value growth, we may be inclined to go in at 6x – 7x EBIT, where we get our potential return through a low double digit normalized earnings yield.”
4. “We invest, if in the end we think we understand the business, we think we like the business and we think the investors are mispricing the business.”
“We try to determine what a knowledgeable buyer expecting a reasonable return would be willing to pay today, in cash, for the entire business. Our approach requires us to understand the business – its strengths and weaknesses – rather than just the numbers. As investors have learned, the numbers can’t always be trusted.”
“Buffett says that value investors are not hostile to growth. Buffett says that value and growth are joined at the hip – value investors just want profitable growth and they don’t want to pay outrageous prices for future growth because, as Graham said, the future is uncertain.”
As Howard Marks points out, investing is “the search for mistakes by other investors.” Sometimes a security is offered for sale at a bargain price that represents a 30% discount to the intrinsic value of the business. This will happen rarely, but when it does there will often be several opportunities available at the same time. In other words, the arrival of opportunities for value investors will tend to be lumpy.
5. “If one is wrong in judging a company to have a sustainable competitive advantage, the investment results can be disastrous.”
A “sustainable competitive advantage” is another name for a “moat.” Sometimes even the best value investors fail to see that the business has no moat or that the moat is about to disappear. For example, Warren Buffett found in buying Dexter Shoes that “What I had assessed as durable competitive advantage vanished within a few years.” Warren Buffett also thought the UK retailer Tesco had a moat at one point. Other investors thought at an inopportune time that Kodak had a moat, or Blackberry or Nortel. Without a moat a business has no pricing power. 0Matthew McLennan of First Eagle puts it this way:
“Unfortunately, asset-intensive businesses often lack pricing power. What sometimes occurs is a need to reinvest during a time of weak pricing power, and this results in balance sheet deterioration and reduced earnings power. Also, asset-intensive businesses tend to have longer tail assets. With those come management teams that promote their desire to reinvest and grow the business. As a result, there’s less return of capital.”
6. “Value investing is a big tent that accommodates many different people. At one end of the tent there is Ben Graham, and at the other end of the tent there is Warren Buffett, who worked with Graham and then went out on his own and made adjustments to the teachings of Ben Graham.”
“Over the past almost 30 years, we have sort of floated between Ben Graham and Buffett. We began with the Graham approach which is somewhat static and less potentially rewarding than the Buffett approach, but less time consuming. So as we staffed up, we moved more to the Buffett approach, although not without trepidation because the Buffett approach – yes, you can get the numbers right, but there is also a major qualitative side to the Buffett approach.”
“Having more people allowed us to spend a lot of time trying to find out the major characteristics of businesses and their sustainable competitive advantage – what Buffett calls a ‘business moat.’”
There are many ways to be a value investor as long as the four bedrock principles of value investing are adhered to – 1. a security is partial stake in a business, 2. margin of safety, 3. Mr. Market is your master and not your servant, 4. be rational. Value investing styles can vary when it comes to issues like the level of diversification, whether quality of the business is taken into consideration, and the amount of the margin of safety. Some value investors diversify their investments more than Warren Buffett. Other value investors are numbers-driven cigar-butt investors who do not consider the quality of the business. Other value investors are “focus investors” (they concentrate holdings rather than diversify) and do consider quality of the company in question.
7. “I have a great belief that everything is cyclical in life, particularly in the investment world. Value investors are bottom-up investors. But when we establish intrinsic values and update them, we do not assume eternal prosperity but accept that there is a business cycle.”
Other people I have written about in this series like Howard Marks , Fred Wilson, and Bill Gurley also believe that cycles are inevitable in all types of businesses. That cycles are inevitable does not mean that their timing is predictable with certainty.
8. “I think the secret of success of most value investors is that when times became difficult they stuck to their guns and did not capitulate.”
It is easy to talk about being “greedy when others are fearful and fearful when others are greedy,” but actually doing so is harder than people imagine. It is warm and comforting for many people to sit inside a herd. Being genuinely contrarian is a lonely thing to do at times. Especially when fear of missing out is strong, people can do nutty things.
9. “Both closet indexing and shooting for the stars are exposing financial planners’ clients to undue risk. Both are a result of benchmark tyranny.”
“The knock on diversified funds is that they’re index-huggers, which given the geographic breadth of where we invest, is not at all the case for us. I know the argument that you should only own your best 30 or 40 ideas, but I’ve never proven over time that I actually know in advance what those are.”
“I think a concentrated portfolio is more of a bull market phenomenon. In a bear market, if you are too concentrated, you never know what can happen to your stocks. Some people have asked me whether I just invest in my best ideas, but the truth is that I don’t know in advance what my best ideas will be, so I’d rather diversify. Besides, the beauty of our global fund was that we could invest internationally, which helped to minimize country-specific risks. With that in mind, I am not saying that you should diversify the portfolio to the extent of creating a quasi-market index.”
“How come we don’t have more concentrated portfolio? Number one, because I’m not as smart as Warren Buffett. And number two, because truly, people say, “Well, why don’t you just invest in your best ideas?” But I don’t know in advance what will turn out to be my best ideas. So, that’s why we’re diversified.”
Some value investors own only six stocks, some 30 and some hundreds. The degree of diversification an investor uses is a choice that fits within value investing as long as it does not rise to the level of closet indexing (“index huggers”). Charlie Munger points out that “[With] closet indexing, you’re paying a manager a fortune and he has 85% of his assets invested parallel to the indexes. If you have such a system, you’re being played for a sucker.”
10. “By definition there are two characteristics to borrowing. Number one: borrowing works both ways. So you are compromising the idea of margin of safety if you borrow. Number two: borrowing reduces your staying power. As I said, if you are a value investor, you are a long term investor, so you want to have staying power.”
You can’t stay invested and participate in rising markets caused by a growing economy if you are out of the process since leverage has wiped out your equity stake. Howard Marks says: “Leverage magnifies outcomes, but doesn’t add value.” Charlie Munger has said: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.” Montier adds: “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad. When you are leveraged you can run into volatility that impairs your ability to stay in an investment or investing in general which can result in “a permanent loss of capital.”
11. “Sometimes in life, it’s not just about what we buy, but what we don’t buy.”
“A value investor doesn’t need to be constantly in touch with every security in every market in the world.”
This is consistent with Charlie Munger’s idea that instead of focusing all your energy on trying to be smart, a person should also focus on not being dumb. It is important to have a “too hard pile” and to limit decisions to areas in which we are competent. By focusing your research on a smaller number of businesses that fall within your circle of competence you can do a better job on your research. Risk goes down when you know what you are doing.
12. “Contrary to many mutual fund managers, we do not believe we have to be fully invested 100% of the time.”
“Our cash balance is purely a residual of whether or not we’re finding enough to invest in.”
Some people think that because value investors tend to have cash to invest when markets are near bottom, value investor are “timing” markets. Value investors tend to have cash near market bottoms since they stop buying securities when markets are near the top of the cycle due to individual company valuations that do not provide a margin of safety. If a value investor focuses on the micro aspect of individual businesses on a bottoms up basis, the macro tends to take care of itself. Matthew McLennan of First Eagle said recently: “We had our greatest cash levels in early 2009, not because we correctly timed the market bottom.” Value, not price determines how much cash a genuine value investor has in the portfolio at any given time since that cash is a residual of a disciplined buying process.