If you are not familiar with Prof. Greenwald, Bruce Greenwald is the Robert Heilbrunn Professor of Finance and Asset Management at the Columbia Business School and academic director of the Heilbrunn Center for Graham & Dodd Investing. He is considered an authority on value investing with additional expertise in productivity and the economics of information. He was call “Gurus of Wall Street Gurus” by Wall Street Journal.
Thanks to Syvenna Siebert at De La Salle academy, who kindly connected Prof. Greenwald with our readers. On February 8th, De La Salle academy hosted a conversation between Michael Fascitelli, the CEO of Vornado Realty Trust and Prof. Greenwald. The two discussed the current state of the economy and their outlook for economic growth in the U.S.
This is the details of the Q&A.
This is a question from our readers. “As a teacher, you have watched some promising students fail to reach their full potential. What mistakes do you think they made? Why do you think this happened?”
Why? Mostly because we turn smart people into smart people. When you talk to good investors, that is, the really great ones, they will almost all say, and I think they almost all believe, that really successful investing is more a matter of character, discipline, and the right investing philosophy than it is of any particular skills.
So if you ask me what I really do, it’s that we have a concentrated program at Columbia that accelerates people’s careers. Now it used to be nobody would ever hire anybody straight out of school for an analyst job, and we place about the 40 students a year in the program, in good years we place all of them, in those kinds of jobs, and that’s because I and the other teachers, and probably more of the other teachers than me, in the program do a good job of preparing them so that they don’t have to do the 5 years apprenticeship that would normally be required. But having said that, the ones who subsequently do really well, you can almost predict during the first day of the program because they’re obsessive, they're careful, they have the right basic philosophy, they know how to favor things, and they don’t stretch to buy Apple and things like that. So I think that in terms of their long term careers, I take no credit for it at all. In terms of their immediate prospects, I, but as much the other people who teach the investing program at Columbia, do a pretty good of accelerating the opportunities that they get.
So you think that their characters basically play the most important rule in their long term success?
Yeah, as I say, about long term success, it’s all an optimal illusion. Smart, disciplined value-oriented kids usually go on to go well. But in their short term, we probably help them.
This is another question from our readers. “I am a big fan of yours, I wish that I could take a value investing class with you. My question is regarding to your lecture about buying stocks that are cheap and out of favor. Could you please explain why you want to buy those types of companies? They may be cheap, but they are losing money for shareholders”
Okay, first of all, if you just build portfolios of those companies, they outperform the market, depending on the period, in any 10 year period, in almost any country in the world, they outperform the average of the market by 3-6%. And this is with no discrimination about which ones are really bad and which ones are good, so this is without any further research. If you just statistically pick all of the diseased companies, they outperform the market by, I would say, in the range of 3-5 or 6%.
If you buy all the companies that everybody loves, they are expensive. The exciting, the rapidly growing, the glamorous, they underperform by somewhere between 2 and 4 or 5%. And that’s just statistically, so that’s without doing any discrimination, anything careful, and those progressions have worked since Ben Graham spotted this regularity in the 1940s, and even the 30s, and even back to the 10s when they work, and they work almost al over the world. And the reason we think they work is that because there are deeply engrained individual behaviors that cause those stocks to be undervalued. They are, first of all, loss aversion, people hate to look at those stocks. The second thing is lottery preference, people love lottery tickets. And the third is that people are much surer of what they think they know that what they have any right to be. So, typically, when someone thinks that a stock is a good stock, they think it’s a good stock with probability 90 or 100%. If they think it’s a bad stock, they think it’s a bad stock with probability 90 or 100%. But in practice, if someone is right about good and bad 60-65% of the time, then they are in the top 1% of all investors.
So when people look at a stock and say “Oh, that’s ugly,” and they’ll dump it. And they don’t sort of say, “Well, that may be ugly, but at this price, it may be worth buying.” Your chances, because nobody is looking at its careful, of seeing something that no one else sees, is greater, and when you ask yourself at the end of the day if you think you’ve found a real bargain, why has the god of the market been so kind as to make this only apparent to you, looking in that particular population of stocks, tells you that most people are just no interested, including most professional investors.
So that’s why it’s a good idea, then, if you can bring to bear a superior valuation methodology, and that’s what we try and teach people at Columbia, which will sell all these stocks that are diseased, if there is some industry problem, or some company problem, but some of them are terminally ill, and you don’t want to own them, and some of them only have a bad cold. So if you’ve got a superior valuation methodology, that enables you to distinguish the ones that are really impaired form the ones that are only temporarily impaired, then you get the opportunity to use that methodology most compellingly in the context of the stocks that we’re talking about.
And that’s why I think that both because just naturally history tells and human behavior tells us that this is where you’re going to make money, and because it’s an opportunity to bring to bear all the advantages of the valuation approach of Graham, over the stupidity of just counting cash flows or multiple valuations, that it’s really just a good place for capable people to look.
We know that Ben Graham buys net-net picks. Do you think that most of net-nets belong to this group?
No, and I think Ben Graham did not just have net-net picks. The thing that you have to understand is that net-net picks are basically safe asset buys, and statistically, by the way, portfolios of net-nets do pretty well. But, the ones that you get killed on by the net-nets are the bad managements, the ones that, for example, they run an industrial company, and they decide that they want to go into media, or they want to go into Hawaiian land or something glamorous like that, or they pay themselves high salaries, or they reprice their options. So a net-net in the hands of a truly destructive manage will kill you. That’s what people think about when they think about a value trap. On the other hand, a net-net in any reasonable management or even a slightly incompetent management, is going to produce returns, because the assets are really cheap, and even if they only realize 80% of the value of the assets, not 100%, then you’re going to make money.
Yes. And I totally agree with you, we even have a net-net screener on our website, and also we publish a monthly Net-Net Newsletter
Right. But what you want to add to that screener is the net-nets with poor managements that have been net-nets for a long time. If you want to do the net-nets with merely mediocre managements, and I think when you look at the history, when you exclude the net-nets with terrible managements, you’ll do a lot better.
Thank you for the comments. Back to your comment, what’s the best way, do you think, to distinguish the ones that are temporarily sick from the ones that are terminally ill?
The first judgement that you have to make is that is it a franchise business or is it not. And the reason that judgment is so important is, that if this is a franchise business, then the growth is valuable, and temporary slow growth may give you a bargain. If it’s not a franchise business, you don’t care what the growth is, the growth neither creates nor destroys value, and that, too, will give you a view into where the opportunities are, because if it’s been growing and now it’s stopped growing, and people are upset about that, because the growth in the long run doesn’t create value, you don’t care about that at all. So the first thing you have to understand is, is this a Buffett franchise type business? And the answer to that is that typically, they’re going to dominate niche markets, and if it’s not a franchise business, you’re crazy to pay for the growth, and you only are going to get the earnings in the asset value. So if it’s not a franchise business, you look at the earnings, you look at the asset value, and if the earnings value is close to the asset value, and there are some other filters that you can look at, and this is not a destructive management, and together that average value is way below what the company is trading below in the marketplace, then that’s a company where the disease is not coming. So then if it’s a franchise business, the nature of the terminal disease is different. If it’s a franchise business, the terminal disease is where the franchise is either shrinking or going away, by competition. And the newspapers are an example, I think Apple (AAPL) is going to be an example of that, so I think in that case whether the disease is terminal or not is if the company continues to enjoy the standard competitive advantages. Do they dominate their particular local markets in geography, do they have customer captivity, or is that going away, and if they have propriety technology.
Okay. This comment makes lots of sense, but it’s kind of different from what Warren Buffett said. Warren Buffett said “I’d rather buy a good company at fair price, than a fair company a good price.”
Our only variable is what Warren Buffett thinks of is a fair price. His idea of a fair price, by the way, is a price that gets him a return going forward on that investment without any improvement in the multiple of somewhere between 13 and 15%. By normal standards, when the average market return is 7-8%, that’s a really good price, he’s looking for a very good price. They call it a fair price because the multiple may be fairly rich, it may be 13, 14 times earnings. But the value of the growth may bring his return up to 13-15%. So when he says a fair price he’s talking in terms of normal value metrics, and there the reason that you prefer that to a poor company at a really good price is that because the good company can grow through reinvestment and things like same-store sales growth, your return will come in the form of capital game, not distributive income, and that, after tax, is much more valuable.
Moving on to another topic, back to 2008, we know that many famed value investors lost lots of money, some lost about 50% of their fund. Why do you think this happened?
I think that there are two reasons why this happened. One is that some of them were not careful about what were franchises and what were not. So they looked at the financials and they said “look at how much money these guys are making” and they ignored the fact that none of them were dominating any particular market, and they bought them because they were cheap but not on a sustainable earnings basis, they were cheap on a temporary earnings basis that wasn’t going to continue.
A perfect example of this is banking. There are three basic activities that banks are involved in. They do backoffice processing, and that’s a big competitive market, no one’s got any advantages there. Second thing is that they deploy assets in public markets, and they do investment banking operations. There are no competitive advantages in that, there are lots of smart people competing, and when they stretch to get extra returns from that they almost invariably do it by taking those outside risks, and they almost always pay for it later. But they don’t really make money there, even though in good times it looks like they’re making money there.
The real way they make money is that they dominate local markets, like M&T Bank (MT) up in Buffalo, and they have better information about local borrowers. That’s the way to make money, and people forgot that, and everyone forgot that. All these banks, like AIG (AIG), looked like they were making money by superior performance in financial markets, and we know that that’s not sustainable. And so the first thing is that they made a mistake by overestimating the earnings power of a lot of businesses, that they shouldn't have, and that’s one big source of loss.
A second source of loss is that you can convert a temporary loss into a permanent loss. Many went bankrupt, and they never had a chance to recover. So, I think it’s those two things that got people in trouble. Where they were careful about assets, and Buffett got in trouble, and he’ll admit it, on the Irish banks and the oil companies.
So you think that because these investors don’t think long term or long business cycles?
Right, I wouldn’t even say long business cycle, I would say that they look at earnings that are not really sustainable without a franchise, and they bought companies that they thought were franchise companies, on the theory that those earnings were sustainable, when I think when they looked carefully they would have seen that they weren’t. And they bought companies that did come back, and as a lot of you know, a lot of companies did come back, but some went bankrupt before they could.
Do you think that micro factor should play a rule here in value investing? Some value investors after the 2008 crash put more attention on micro-economic environment.
I think that in terms of doing macro forecast, all the evidence is that no one does that well, and you’re not going to make money by forecasting the economy. But, if you want to worry about risk, you certainly should have a sense on when the macro environment is very uncertain, like it is now and in 2007, and when the macro environment is much more stable. And there, I think, you should make a judgment. I don’t think that people should look at macro as a way to make money, but if they consider their risk posture, I think they’ve got to buy more insurance or be more careful in a macro environment that’s dangerous. That’s what they want to assess, not if the market is up or down, just if there’s a high level of uncertainty or not. And typically, the most dangerous kind from a macro perspective are not just when the market is all high and all expensive, but also when you look at the implied volatilities and the derivatives they’re incredibly low, so no one thinks there’s going to be any problems. Like housing was going to go up forever. And I think you’re not going to make money on a bet, unless you’re lucky, that housing is going to plant. But in that environment you know that sooner or later you’re going to get into trouble with the market, and insurance in a former derivative is being sold quite cheaply.
So if we cannot predict the micro economic trend, but what about the overall market valuations? Warren Buffett uses the ratio of total market cap over GNP, which is the single most important indicator of the market. Also we know that Professor Shiller used an adjusted P/E ratio.
Any of these measures will do fine. They’ll tell you when markets are out of the normal range of where they are because profits are characteristically over a very long period of time get a constant portion of GDP, and therefore the value of those profits should bear a constant relationship to GDP, and therefore P/E levels of those profits should be roughly stable, which is Shiller’s point, and therefore you can compare profit to GDP or you can use Shiller’s P/E and you’re going to come up with similar answers. And because Shiller also uses the average earnings over many many years, it would be constant relative to GDP. I think that’s certainly something you want to worry about, but again, you’re not going to predict one year ahead using that, but I think what you will be able to predict is when there’s a higher probability you’re going to get into trouble, and there you should take a more defensive posture.
So we can use this as a long term indicator of market valuation, maybe make some strategic change on portfolios?
Yes, I think that’s right. And derivatives, the VIX is pretty low at the moment, this is a slightly scary moment.
That’s opposite about what VIX is trying to telling us, but we are value investors. Regarding Berkshire’s (BRK.A)(BRK.B) acquisition on Burlington Northern, you commented that it’s not a good deal?
No, I don’t think it’s necessarily not a good deal, I just don’t think it’s a great deal. And when Buffett usually puts capitol to work, especially a lot of capitol, it’s been a great deal. And in particular, I think what he taught people was you want to be patient. And the time that you want to take advantage of your patience when you had a lot of cash was in the winter of 2009. And other than these protected deals, with Goldman Sachs (GS) and General Electric (GE), where you got the preferred stock with all the protection of the preferred stock, he didn’t buy a lot of stock that was available very cheaply, in February, March or even April of 2009. And given that he didn’t do that, paying as much as he did for Burlington Northern was a questionable decision. Now what you always depended on if you look historically is what happened to oil prices. And so when oil prices went up, there’s a big competitive advantage for railroads over trucking, and Burlington Northern has gone up with the oil company stocks. But it seems to me that there are probably better ways to make that bet than to pay above market value for Burlington Northern.
Another question, at GuruFocus, we track a lot of investors, and for the older generation, we know that Warren Buffett is the best. For the younger generation of investors, who do you think is the best?
I think that there are many good ones out there, but the consensus seems to be that Seth Klarman is probably the best, but there are lots of very good ones, I’m not going to name them all.
We have tracked Seth Klarman for a long time, but we don’t really understand how he invests, because sometimes he buys something that we don’t understand or we don’t think value investors would buy. For example, recently, he bought two pharmaceutical companies. Do you see value in those companies? One of the companies is PDL Pharma (PDLI), the second one is AVEO Pharmaceutical Inc. (AVEO)
The first one I know why he bought it. The problem with pharmaceutical companies is that they have these very stable cash stream from their portfolios of their existing paths of drugs. And then they give away a huge percentage of it in the research and development process looking for new drugs to replace the old ones that are coming off path. So really, if you can’t trust the management to be a good manager of the money, normal pharmaceutical companies are very risky companies. PDLI split off their royalties on the existing drug from the new drug R&D activity. And was interested in buying at a reasonably good price from the annuities stream from the existing drugs, so it is not a normal pharmaceutical.
Actually, PDLI is traded at lower prices than the prices that he bought. We believe that if someone is interested, they can buy at a lower price now.
Yes, but people are not always right. As I said, if you’re right 65% of the time, then you’ll do phenomenally well.
Definitely I agree with that. Another question, for your personal portfolio, what sector/industries do you hold?
Let me give you one stock when I think about what’s the obvious industry to look at: health insurers in the United States. You want the health insurer with the strongest competitive advantage, which is related to local economies. Most locally concentrated company is Wellpoint (WLP), and it’s traded for a very good price.
Do you have it in your personal portfolio?
You think that the reason you own it is because it has a strong local position?
It has a powerful local position, only in 17 states. The management buys back a ton of stock, that they sold their sub-scale subscription drugs service at a very good price to the industry leader and distributed most of the money to shareholders. It’s a cheap price, and you can’t do better than that in an industry that sooner or later is going to grow.
The P/E ratio is only at 10.
It’s actually a lot lower than that because they have a lot of cash embodied in the balance sheet.
Thank you very much for your time, Prof. Greenwald!