Graham And Doddsville

During the height of the recent economic crisis, David Einhorn became the public face of the “evil” short-selling hedge fund manager.  Einhorn, who was no stranger to being vilified for correctly identifying fraud in the public markets (if you don’t know what I’m talking about, click here), began raising questions about the strength of Lehman Brothers’ balance sheet in the middle of 2007.  We all know how that story ended.   If anyone wonders what it is like to be right most of the time, they should ask David Einhorn.

I have heard David Einhorn speak on several occasions.  While I have learned a great deal each time, there is one particular gem of wisdom I gleaned.  In the past, when David Einhorn has publicly stated a short position, he has always backed it up with a factual analysis.  Whether his analysis is right or wrong is not the issue.  One of the things that I admire most about Mr. Einhorn is that he has the courage to publicly disclose his analysis so that anyone with Internet access can debate its merit.  What is interesting to note is the public reaction to his analysis.  If someone were put together a presentation that successfully refuted a Greenlight short thesis, I honestly believe David Einhorn would be the first to admit he was wrong (and we’re not going to argue whether he would cover his position first).  However, in the case of Allied and Lehman, his analysis was not refuted by facts, but by public criticism of his character, and questions about the motivations of hedge fund managers and the morality of short selling.  As Mr. Einhorn has pointed out, when the first reaction to a solid analysis is defamation of character, you know you have uncovered a significant short opportunity.

David Einhorn was recently interviewed by Charlie Rose.  Given his track record, I think that investors would do well to at least ponder what he has to say.  See the entire interview here.

For more on David Einhorn, click here.

I recently came across a fantastic interview from The Wall Street Transcript with Donald Yacktman, Stephen Yacktman, and Jason Subotky of Yacktman Asset Management.   It is filled with gems of value investing wisdom.  A few examples include:

Ultimately, we think this business boils down to what you buy and what you pay for it.  Think of it as trying to be a good shopper. What we do is we’ll calculate a forward rate of return on prospective investments.  This is the rate we would expect if we hold the security indefinitely and the multiple we pay for the business does not change much.  We look at the cash being generated and the growth rates of the business, and by adding those components together, you get a forward rate of return.

We are not investing with a goal of mimicking a benchmark. I think that style evolved because managers could protect their personal business risk. We are bargain hunters and like it when securities go on sale. I don’t think you’ll find many long-only investors who are more excited than we are when the market declines. A lot of people talk a good game but when it really comes down to it, they flinch.

There is no substitute for knowledge. To really research and understand a situation is very important. The ability to buy into discomforting news is a function of having a really good understanding of what the business is and what its value is.

I would say we combine patience and opportunism. When valuations warrant it, particularly during dislocations, we’ve taken sizable positions very quickly.

[The original interview can be found here.]

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.