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Valuex Vail: Re-evaluating the Investment Process

August 12, 2013
Investing is a peculiar industry because randomness is so deeply embedded in everything we do. I am always fascinated by the investment processes of other successful firms. The outcome of every decision we make results from two inputs: our skill and our luck (randomness, whether good or bad). When you analyze anyone's investment decisions solely based upon outcomes, you may unknowingly be attributing successes or failures to skill when randomness was actually responsible for the results.

Because randomness, unlike skill, is not permanently attached to an individual but travels where it will, results driven by randomness are not consistently repeatable. Therefore, in the investing industry (unlike, let's say, the widget making industry, where one's results could be objectively ascertained by the number of widgets produced per hour and their quality), we should focus on how an investor arrived at a particular decision. In short, we should focus on the investment process. In the long run, randomness will cancel out and the process will shine through in the results. At an investment firm, cultivating the process is challenging because you want the process to live in the firm and not just in its individuals; you want the process to be transferable from one generation of portfolio managers and analysts to the next. To achieve this, the firm's culture and the inherent quality of its investment process are paramount.

This is why I was extremely interested in Win Murray's dessert talk at Valuex Vail. Win is director of research at Chicago-based Harris Associates, an investment firm that manages $90 billion and runs the Oakmark funds.

Harris is focusing on the sustainability of the investment process so that it will last far beyond the current generation of analysts and portfolio managers. The process starts with how the firm recruits analysts. Win has interviewed more than 100 research candidates since January 2011, but he has extended offers to only four. Asked what he looks for in analysts, he said their math skills must be intuitive; they must have the ability to sum up an idea succinctly; they must be able to think creatively and employ allegory; they have to function in some ways like investigative reporters — and their bosses must give them enough tools and rope. (As an interesting aside, James Chanos talked last year at Valuex Vail about how he loves to hire analysts who used to be journalists, because they know how to dig deep for the story.)

At Harris the analyst holds a highly respected position — in fact, many senior people, including portfolio managers, the director of research and even the previous CEO are analysts too. It was refreshing to hear that analysts are not evaluated on the outcomes of their ideas so much as by the quality of their ideas. An analyst who brings an idea that is poorly reasoned is not valued as much as the one who brought a well-­reasoned idea that happened not to work out. That is, Harris puts more value on the process than on immediate outcomes. Twice a year the firm's analysts have to write a devil's advocate memo on one of their large holdings. The holdings are debated in the open and then voted on by the three most senior investment people in the room. If a stock fails the vote, it is sold.

Germany, Europe and Mother Russia

I always look forward to Hendrik Leber's presentations. Hendrik runs a value investment fund named Acatis Investment out of Frankfurt, but he invests globally. In preparation for the conference, I asked him if he could talk about investing from a European perspective, so he did.

Hendrik believes that there is no immediate danger of Europe's monetary union falling apart, but he notes that problems in the EU go far beyond the PIIGS (Portugal, Italy, Ireland, Greece and Spain); they are in countries that don't recognize their problems: Belgium, France and the Netherlands.

He was not very bullish on Germany because it is so dependent on exports. (German exports to China are expected to reach $70 billion in 2013.) And Germany has an "idiotic" energy policy, as Hendrik puts it: In 2011, after the Fukushima Daiichi nuclear disaster, Germany decided to walk away from nuclear energy and toward alternative sources, but it has not found those alternatives yet. Because nuclear power plants supplied one quarter of the country's electricity, the lack of growth in the energy supply has been hurting the German economy. German companies are opening factories in countries that have stable energy policies and cheaper energy — mainly, the U.S. Ironically, by lowering its dependence on nuclear power, Germany has increased its dependence on Russian natural gas. If Germany were any other European country, it would not be a big deal, but Russia has in the past used the natural-gas spigot as a bargaining weapon in negotiations with its neighbors.

Hendrik also discussed Germany's own version of a social security crisis. The country has an off-balance-sheet-debt problem: its liabilities to the beamte, or civil servants. However, unlike most German public employees, who are subject to the same rules and laws as workers in the private sector, beamte belong almost to a special class, and they usually perform services that only the state can provide (such as issuing official documents or teaching state-approved curricula, for example). Like U.S. postal workers, beamte cannot be fired. The German government pays for the bulk of their health care, and they don't pay certain taxes, but they give up the right to strike. (I strongly believe that all government employees should give up their right to strike, but that is a topic for another discussion.) Beamte are well compensated and receive a good pension that is guaranteed by the state, not by public insurance. You know how this story ends: The government made promises that it will have a hard time keeping. As the beamte get older, the German government's liabilities to them are starting to outweigh the country's explicit debt of €2 billion ($2.6 billion) by a factor of between two and five.

Hendrik presented three stocks in his presentation. Two of them — German chemicals company BASF and U.K. bookmaking company William Hill — looked very interesting but only mildly undervalued. (According to Hendrik, they had little margin of safety.) They are perfect watch-list, buy-at-lower-price stocks. The third one, Pharmstandard, a Russian pharmaceuticals company, looked very interesting, and I'd be lying if I said I was not tempted to take a look at it. But to me, after the Yukos incident, when Russia confiscated one of its largest private oil companies and jailed its founder, Russia became uninvestable.

P.S. After I wrote the preceding, I got an e-mail from Hendrik, who told me that Pharmstandard had fallen victim to Russian corporate governance. Shareholders were basically told that if they don't agree to a proposed spin-off, the company can buy them out at an 18 percent discount or they will get unlisted shares of the stock. Predictably, the stock collapsed. This is white-collar mugging; there is no other way to put it. The company effectively says, "You are a shareholder as long as you agree with management; otherwise we'll screw you." Now Russia is uninvestable to me for another reason: Its corporate governance makes Tony Soprano look angelic.

About the author:

Vitaliy Katsenelson
Vitaliy Katsenelson is Director of Research at Investment Management Associates and teaches at the University of Colorado. To read more of his articles visit www.ContrarianEdge.com . His book Active Value Investing was published by John Wiley & Sons in September 2007.

Visit Vitaliy Katsenelson's Website


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