The following article is based on the inaugural video lecture given to the new value investing class at the Richard Ivey School of Business in 2005. Mr. Irving Kahn delivered the lecture alongside his brother Thomas. Irving served as the second teaching assistant to Benjamin Graham at the Columbia University Business School and he has over 78 years of experience in the investment business. Irving and his brother founded their investment firm, Kahn Brothers & Company, in 1978.
The Kahn brothers are firm believers that value investing is an art, not a science. In making this point they allude to an artist that paints masterpieces as this artist will surely have some poor paintings along the way. If value investing were a science then it would be replicable. One would be able to run equations in a machine all day and consistently right answers would emerge, but since it doesn’t work this way it has to be an art.
As value investing is more art than science, a value investor has the greatest chance of success studying industries that they understand. The Kahn brothers recommend paying attention to smaller cap and obscure companies, as these will offer the investor who takes the time to learn more about the company, than does the public, a chance for great profit. This means looking at places where the markets are not overpriced and where there are companies that will enable a value investor to truly benefit. Sometimes to find these opportunities one must be patient and not necessarily have their portfolio invested all the time. Ultimately, the value investor has to stay strongly contrarian, as sometimes not committing capital to the markets is the best thing to do. You don’t need all your money on the table all the time and if markets are high don’t invest. Be very selective and keep your standards. At the time of the lecture (2005), the Kahn brothers were not finding a general theme in which they invest that they can say to go and look into. They are very adamant that while occasional themes evolve, all they can say is that they maintain that very strict contrarian approach. If something is very popular and everyone is buying the same stock they are, they stand back and ask themselves what they’re doing wrong. Half the price of a common stock is probably current fashion so if you can buy what’s currently out of favor, you are well on your way to investing successfully.
The Kahn brothers have a few important factors that they keep in mind when evaluating a potentially undervalued company:
• The company should either be obscure or out of favor. It can be a big company that is not obscure though if it is very much out of favor.
• Their analysis is very much balance sheet oriented. They are not interested in companies with excessively levered balance sheets and they like companies with little to no debt.
• Management should be on the same page that the brothers are on. If management can own a lot of stock and are incentivized as shareholders that is a big positive.
• They avoid companies that have, in combination; volatile cash flows, are excessively levered and have management that are not too swift. This would be a very bad combination.
• The brothers are not so focused on the income statement initially. What they would ask is, what’s the earnings potential of the business? If it were run properly, if management succeeded in their plan to close a losing division, etc then what would be a reasonable earnings level? They check to see if the stock is cheap based on this earnings level and if they are confident that management can achieve this goal.
• The brothers really don’t care if a company is losing money and they actually would like a company to be losing money (although not hemorrhaging cash) because that knocks the stock down and presents some wonderful investment opportunities.
The newspaper seems to be a major source of investment ideas for the Kahn brothers. Thomas points out that the new highs and lows lists, and their relative size to one another, give a good indication of the direction of the general market. While shopping the new lows list doesn’t seem like a hi-tech, sophisticated way to invest it can actually bring forth some interesting ideas. Events that will also be presented in the paper are if certain companies are having problems and their stock tanks as a result, or if entire industries are affected by a current event. When you find a problem in a company or industry, pull out the financials, do some work and see if any of the stocks have gotten knocked down to where they are attractive. You must then decide if they are attractive investments. The value investing philosophy has nothing to do with what’s on TV (i.e. the talking heads) as the journalists are interested primarily in which stocks are moving.
Value investing will not go away. One may think that with so much information out there, and available to the public, that for instance standard value screens such as price/earnings and price/book may not be as effective. In reality however it’s not about opening up Yahoo Finance and looking at the latest data. The Kahn brothers have positions in some very complicated to understand companies. They also have a position in a company that hasn’t filed in a year. Institutions can’t hold this company and one can’t pull the latest data up online. As a result, if you’re confident that management is sound then this presents an interesting buying opportunity. You ultimately have to look behind the situation and you have to do your homework to get a leg up on other investors.
Once value is found, the brothers tend to ease into a position rather than to buy in all at once. They like to buy a small stake and get to know the company better. Frequently shares they buy will go down, so they will do their homework and see if they were right in their analysis but just maybe bought too early. If so then they stick to their convictions and they buy some more. Some of the brothers’ best capital gains have come from this process of averaging down. They warn to not be fooled by “snake oil salesmen” who advertise making money extremely quick. Most of the Kahn brothers’ investments have a holding period of 3 to 7 years, and sometimes longer. There comes a point, where as with a plant, the company begins to wither. Management may no longer be good, competition may be getting worse; you can see this in advance and make a profit. Personally I would sell an investment as it approached my estimate of intrinsic value, as there are likely other underpriced opportunities where I can put this capital to work for above average returns. This is even for companies that remain strong.
When it comes to placing a value on the notion of growth, the Kahn brothers don’t see a point. They want to grow their capital and don’t care whether it’s by way of a growth company or not a growth company or whether earnings are growing quickly or not, they just want their capital to grow. If a company has clearly defined, great prospects then it’s common knowledge already. How can one determine how many of these great prospects are already priced into the stock? The brothers don’t feel particularly comfortable paying up for those great prospects as they don’t have a way of figuring out what they’re worth. As a result of avoiding stocks like these, the firm has very successfully grown their capital over the years and can postulate that they’ve taken less risk than the overall market. Everyone is enamored with growth stocks, but how about just growing your capital with non-growth stocks? That’s alright too.
Jonathan Goldberg, MBA