Graham And Doddsville

As I mentioned when I began this blog, I intend to use it as a tool to gather valuable resources as I continue to become a better securities analyst.  Most value investors have learned from Mr. Buffett and Mr. Munger that one of the most important parts of an investor’s job is to read, read, and read.

I especially enjoy reading anything written by or about value investors.  Very often, I walk away from reading an article or an interview with a few key “nuggets” of wisdom.  Unfortunately, my mind is like a sieve.  I often though about finding a place to record these “nuggets” and I think I have now found that place.  From time to time, I plan to post “SuperInvestor Studies” which will contain the few key lessons that I take away from my readings. These posts should in no way suggest that you should not read the original article.  Many times, the key lessons can only be understood in the context of the original article.  Over time, I hope to build a useful collection of lessons that can be organized using the Blog’s categories.  With that introduction, here is the first in what I hope to be a series…

Jean-Marie Eveillard is a legendary manager with First Eagle Funds.  While he tried to retire in 2004, he was drawn back to First Eagle after his successor, Charles De Vaulx, left after 2 years.  Jean Marie was interviewed in the May 30, 2008 edition of Value Investor Insight.

• Margin of Safety:   Whenever Ben Graham was asked about his thoughts on the future of the economy or the future profitability of a specific company, he would quip “the future is uncertain.”  Jean-Marie suggests that this is “precisely why there’s a need for a margin of safety in investing, which is more relevant today than ever.”
• Value Investing is a Large Tent:  Jean-Marie has floated between what he calls the “Graham Approach” and the “Buffett Approach.”  The “Graham Approach” as described by Jean-Marie is “static, quantitative and focused on the balance sheet.  There is no attempt to look into the future and judge the more qualitative aspects of the business.”  The “Buffett Approach” is to look more qualitatively for those few businesses with apparently sustainable competitive advantages and where the odds are fairly high that the business will be as successful ten years from now as it is today.  In “Buffett-type” situations, Jean-Marie looks to make money from the growth of intrinsic value over time, as opposed to the elimination of any discount to intrinsic value.
• Where to Hunt:  Jean-Marie usually buys companies whose short-term outlook “stinks” for either company-specific or cyclical reasons.  It is even better when the company was recently a favorite among growth investors.  On Wall Street, these problems are often perceived to be permanent.  However, if you believe the problems are not permanent, and you turn out to be right, you can make a lot of money.
• What You Must Know About the Business:  The most important qualitative aspect of successful investing is figuring out the three, four, or five most important characteristics of a business.  Many of Eveillard’s past mistakes have been the result of getting these characteristics wrong.  Jean-Marie reflects on newspaper stocks as an example.  Many value investors held onto these stocks for too long, not recognizing that there was a fundamental change which is likely to lead to a “quasi-permanent decline” in the business.
• When to Buy:  First Eagle looks at a businesses over a five year horizon.  Since most sell side research is focused on looking out six- to twelve- months, Eveillard does not find it useful.  He also dislikes discounted cash flow models, since they tend to give investors a “false impression of precision about very uncertain future outcomes.”  Instead, he tries to determine what a knowledgeable buyer, expecting a reasonable return, would be willing to pay in cash for the entire business.  His favorite measure is EV/EBIT compared to comparable transactions and market values.   Investments are generally made when a company is valued at 8x to 15x EV/EBIT – the more “questionable” the business, the lower the required multiple.  In today’s market, you can find good companies selling for 6x EV/EBIT.  Even if you consider a fall of 30% in operating profits, many of these businesses would still be valued at 8x EV/EBIT, which is still on the low-end of Jean-Marie’s preferred range.
• When to Sell:  As long as a company is able to maintain a sustainable competitive advantage, Jean-Marie won’t sell until he believes the company is “highly overvalued.”

For more on Jean-Marie Eveillard, see my interview, originally published in Columbia Business School’s Newsletter Graham and Doddsville.