Michael Burry: Like Benjamin Graham but Better

Most people know Michael Burry due to the role he played in the subprime mortgage crisis. Burry was one of the first hedge fund managers to warn about the risk subprime mortgages posed to the financial system, and he was also one of the first to bet against the market.

Burry’s first mover advantage paid off handsomely for the hedge fund manager and his investors, but despite this great success, it is his early work on value investing that has earned him a reputation as one of the world’s best investors.

Graham with a twist

Burry’s style of investing builds on the same principles as Benjamin Graham and Warren Buffett (Trades, Portfolio). As is characteristic of his style, however, Burry has put his own spin on value investing, which is arguably the reason why he has been so successful over the years.

So how has he adapted the strategy first established by Graham to make it better and more lucrative? Just like Graham, Burry likes to concentrate on bargains. But unlike Graham, who started investing when fundamental investing was virtually unheard of and it was difficult to get accurate financial information for companies, making it relatively easy to find the market's most undervalued equities, Burry has to work hard to find bargains. What’s more, unlike Graham, Burry is not afraid to run a relatively concentrated portfolio and invest in companies that look cheap compared to earnings power, not just book value.

As Burry explained in an investor letter:

“…Everyone knows that domestic construction is slowing down. I don’t care. Why? Let me explain. Let’s pose that a hypothetical company will grow 15% for 10 years and 5% for the remaining life of the company. If the cost of capital for the company in the long term is higher than 5%, then the life of the company is finite and a present 'intrinsic value' of the company may be approximated. But let’s say the cost of capital averages 9% a year. Starting with trailing one-year earnings of $275, the sum present value of earnings over 10 years will be $3,731. If the cost of capital during the remainder of the company’s life stays at 9%, then the present value of the rest of the company’s earnings from 10 years until its demise is $12,324. What should strike the intelligent investor is that 76.8% of the true intrinsic value of the company today is in the company’s earnings after 10 years from now…”

And on the topic of portfolio diversification:

“I like to hold 12 to 18 stocks diversified among various depressed industries, and tend to be fully invested. This number seems to provide enough room for my best ideas while smoothing out volatility, not that I feel volatility in any way is related to risk. But you see, I have this heartburn problem and don’t need the extra stress.”

Both of these ideas vary widely from Graham’s teachings. Graham preferred to have a well diversified portfolio of 30 or more equities and only liked those companies trading at a deep discount to net asset value or book value, so-called "net-nets" or "cigar butts."

The fundamental difference between Burry and Graham’s portfolio comes down to loss aversion. Graham, thanks to his experience in the great depression when he lost a lot of money, wanted to invest in a broad portfolio of deeply discounted securities to minimize the risk of loss. Burry, on the other hand, is looking for securities the market dislikes the most but will only buy those securities where the potential for permanent capital impairment is low. As he has described:

“Ick investing means taking a special analytical interest in stocks that inspire a first reaction of ‘ick.’ I tend to become interested in stocks that by their very names or circumstances inspire unwillingness – and an ‘ick’ accompanied by a wrinkle of the nose on the part of most investors to delve any further…Fully aware that wonderful businesses make wonderful investments only at wonderful prices, I will continue to seek out the bargains amid the refuse.”

These two strategies sound very similar but have some fundamental differences, the most important of which is, as noted above, that Burry is not afraid to break the value mold.

This is the interesting difference between Burry’s value strategy and that of Graham. I believe investors can learn more from the manager of Scion Asset Management than his teacher because of the way the investing world has changed over the years.

Today, it is almost impossible to find the sort of high-quality stocks trading at a deep discount to net asset value that were available to Graham. But that is not to say there are no value opportunities.

Just as Buffett’s strategy changed as Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) grew, Burry adapted his strategy with the market but kept the most important part -- the desire for loss aversion – in place. If anything, Burry’s strategy is contrarian. He looks for unloved stocks with minimal downside and buys as much as he is comfortable holding. This approach undoubtedly requires more work than Graham’s, but the returns speak for themselves.

Disclosure: The author owns no stock mentioned.

Start a free 7-day trial of Premium Membership to GuruFocus.

• Warren Buffett Undervalued Stocks
• Warren Buffett Top Growth Companies
• Warren Buffett High Yield stocks, and
• Stocks that Warren Buffett keeps buying