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Exclusive Interview with

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Charles de Vaulx joined International Value Advisers, LLC (IVA) in May 2008 as a partner and portfolio manager, and serves as chief investment officer, partner, and portfolio manager.

Until March 2007, Charles was portfolio manager of the First Eagle Global, Overseas, U.S. Value, Gold and Variable Funds, together with a number of separately managed institutional accounts. He was solely responsible for management of the Sofire Fund when it won an Absolute Return Award for “Fund of the Year” in the global equity category in 2005 and 2006. In addition to sharing Morningstar’s “International Stock Manager of the Year” Award in 2001 with his co-manager, Charles was runner-up for the same award in 2006. From 2000 to 2004, Charles was co-portfolio manager of the First Eagle Funds. He was named associate portfolio manager in 1996. In 1987, he joined the SoGen Funds, the predecessor to the First Eagle Funds, as a securities analyst. He began his career at Societe Generale Bank as a credit analyst in 1985.

Charles graduated from the Ecole Superieure de Commerce de Rouen in France and holds the French equivalent of a Master’s degree in finance.

The Manual of Ideas: It’s a pleasure to have with us Charles de Vaulx, Chief Investment Officer at International Value Advisers. Charles, welcome.

Charles de Vaulx: Thank you.

MOI: Charles, how did you become interested in investing?

de Vaulx: I became interested at an early age. My first investment was a gold coin in late 1975 at the age of fourteen years old. My first stock was in 1976, after what had been two very difficult years following the 1973-’74 oil crisis and recession. At that time I was in Paris, but I had just been there for a few years.

Prior to that, from age five to twelve-and-a-half, I was living with my parents in Johannesburg, South

Africa, and before that I was born and spent five years in Morocco. My father worked in the oil industry with Total. I think that my time in South Africa and my exposure to business through my father helped me get interested as a child in understanding businesses. Even before the oil crisis of ’73-’74, there were major ideological challenges. Communism was still a major threat worldwide. We tend to forget.

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Both of my grandfathers had been in the military. It occurred to me at an early age, perhaps at the age of 9, that going forward the real wars may no longer be military, but more economic wars, ideological wars and, hence, I felt that I needed to understand money, industry and finance as opposed to doing what my grandfathers had done and go into the military.

Exclusive Interview with Charles de Vaulx

Both of my grandfathers had been in the military. It occurred to me at an early age, perhaps at the age of 9, that going forward the real wars may no longer be military, but more economic wars, ideological wars and, hence, I felt that I needed to understand money, industry and finance as opposed to doing what my grandfathers had done and go into the military.

As a young child in Morocco and later traveling with my family through Southern Africa, I was exposed to poverty growing up, which scared me. It impressed upon me the importance of saving so that you can at least have the essentials — shelter, clothing, food. These experiences made me realize that nothing is a given.

After I bought my gold coin and my first stock my interest only grew. I read the financial newspapers each day and during my lunch breaks at school I would sometimes take a quick subway ride to the Paris Bourse. Much later, in 1983, as a part of my studies in France, I was able to get a six-month internship in New York City in 1983. I was twenty-one years old at the time, and three out of the six months I spent with Jean-Marie Eveillard,

with whom I worked subsequently for a long time. Jean Marie taught me what I knew nothing of at the time, which is value investing- the concept that investing is not necessarily about finding growth stocks, and that markets can be inefficient enough sometimes that some stocks can trade at times at a 30% or 40% or 50% discount to what the companies are actually worth.

MOI: How did working with Jean-Marie Eveillard influence you? Can you share with us perhaps the single biggest lesson from working with Jean-Marie?

de Vaulx: There are several things I want to mention, but if there was one overriding theme, it’s the clarity with which he conveyed to me the obvious if one is mathematically inclined: if you can minimize drawdowns, and if you can minimize losses one stock at a time in your portfolio, that is mathematically one of the surest and best ways to compound wealth. This is opposed to shooting for the moon, betting the farm and trying to find stocks that may go up ten times – the ten baggers.

Other related themes would be that conventional wisdom among money managers, back then and still today, was that the only form of active money management was a concentrated approach — having only ten, fifteen, twenty stocks and trying to do as much homework as possible on those stocks. You’re supposed to have conviction, go for it.

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Jean-Marie [Eveillard] understood that there was another way — his way — which was to have a highly diversified portfolio, oftentimes a hundred, hundred and fifty, two hundred names, be benchmark agnostic, and be willing to make large negative bets by owning little or nothing of what would sometimes become the biggest part of the benchmark.

Jean-Marie understood that there was another way — his way — which was to have a highly diversified portfolio, oftentimes a hundred, hundred and fifty, two hundred names, be benchmark agnostic, and be willing to make large negative bets by owning little or nothing of what would sometimes become the biggest part of the benchmark. Oftentimes, what becomes the biggest part of the index is the stuff that has gone up the most, which can be the least desirable whether it’s Japan in the late ‘80s, or TMT stocks in the late ‘90s, or financial stocks in ’06-’07. It’s important to note that diversification is okay as long as it has nothing to do with the benchmark, as long as you’re willing to make big negative bets and as long as you know your companies well enough to have accurate intrinsic value estimates. We define intrinsic value as the price a knowledgeable investor would pay in cash to own the entire business.

I think it’s Warren Buffett who many times said that diversification can be an excuse for ignorance. If you only have a forty basis point position in a stock you can get lazy and you don’t feel you need to know everything. I think we showed over time that our estimates of the intrinsic values of the companies we’ve owned have been quite accurate. The reason is that even though we’re not catalyst-driven, it just so happens that on average maybe 15% of the stocks we’ve held for many years have been taken over. Through all of these takeovers we’ve been able to compare our own internal estimates of intrinsic

value worth versus the price that was paid and history shows that our estimates have been fairly accurate. I believe that there’s no need to know every detail, rather there’s a need to understand the key three, four or five factors affecting the company.

Another insight that Jean-Marie had, which I guess I implicitly shared – having told you my little story about my gold coin and my stock – is the idea that one could be eclectic. One did not have to be confined to only large cap stocks. It’s okay to consider bonds - high-yield corporates and Treasuries (when they yield 15% and when they are labeled Certificates of Confiscation – that was the term in 1982). It’s okay also to consider bonds to try and get equity-type returns. It’s okay also to have cash – cash as a residual, not as a way to time the market. If you cannot find enough cheap securities, it’s okay to hold cash and just wait

for those opportunities to present themselves. The main objective is not losing money and compounding wealth over the long-term.

Obviously, like the fathers of value investing – Warren Buffett, Walter Schloss, Ben Graham – Jean Marie was very much a disciple of the notion that leverage had to be avoided at the portfolio level. He also believed that one had to avoid as much as possible investing in companies that have too much leverage or banks or insurance companies that are undercapitalized.

Also, I think what was unique with him, especially as a value investor back then – this was pre-2008 – is that he was willing to pay some attention to the macroeconomic environment. Value investors are typically very proud to say that they are only stock pickers. “Only God knows the future and He ain’t telling us”, so why waste time trying to guess next year’s inflation, interest rate, GDP growth rate and so forth. I think that Jean-Marie, having been a student of the Austrian economists as I had been myself in school, was keenly aware of credit cycles.

Being a reader of Jim Grant’s Interest Rate Observer and other publications, he was aware, especially after 1982, that there were many countries in the world where the use of debt became more and more pervasive—debt at the corporate level, at the household level, at the government level. I think being mindful of those credit cycles made him understand that

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We own a billboard advertising company in Switzerland called Affichage [Swiss: AFFN], and it’s quite small.

…our portfolio today is truly eclectic and multi-cap. Of course, if you look at the top ten holdings you’ll find mid-cap or larger cap stocks. But if you look at our holdings in Asia, where statistically today the small-cap stocks are much cheaper than the large-cap stocks, you will find a wide array of stocks

sometimes stocks look cheap – as they did in Mexico in 1994 – but then again it was an optical illusion because those stocks were cheap based on earnings that were artificially inflated because of a big lending boom that had been happening in Latin America from ’92 to ’94 or in Asia from ’95 to ’98 and, more recently, a big credit boom in Europe and the U.S. from ’03-’07.

Then finally, I’ve appreciated that Jean-Marie understood that it was wrong to forecast. You’re deluding yourself if you think you can forecast. On the contrary, you have to be aware of how many unknowns there are as well as fat tails and black swans. Also, from a marketing standpoint, Jean-Marie taught me to never promise anything to clients and certainly never to overpromise.

MOI: You describe your investing approach as cautious and opportunistic. How is that reflected in security selection and overall portfolio construction?

de Vaulx: Well, I think I’ll try to answer your question in a sense of how that cautious and optimistic approach is reflected today, as we speak, in the overall portfolio construction of our funds and the way we pick stocks.

I think that our portfolio today is truly eclectic and multi-cap. Of course, if you look at the top ten holdings you’ll find mid-cap or larger cap stocks. But if you look at our holdings in Asia, where statistically today the small cap

stocks are much cheaper than the large cap stocks, you will find a wide array of stocks. We also hold some mega-cap stocks: Total [TOT], I don’t know if Berkshire Hathaway [BRK] qualifies as one (probably) as well as tiny, little stocks in Japan, Korea or Switzerland. We own a billboard advertising company in Switzerland called Affichage [Swiss: AFFN], and it’s quite small.

the next year or two or three or four. So it’s short-duration, high-yield corporates. The yield is not huge. Today, we’re talking about 4%, but these are what we deem extremely safe instruments and because the duration is short, there’s no interest rate risk there.

You also will notice the eclectic nature by the fact that we have some sovereign debt, and it’s approximately 5.1% of the portfolio. It’s mostly short-dated government debt from Singapore. The coupons, the yields, are de minimis. Here the attempt on our part is to hopefully get an equity-type return out of the underlying currency. The hope is that the Singapore dollar will keep appreciating over time and, of course, in two years from now when those bonds mature the idea is to just roll them over and buy new similar short-dated bonds and to remain exposed to the Singapore dollar. Because that country doesn’t have much of a fiscal deficit, there’s not much of a long-dated government bond market to begin with.

You’ll see the eclectic nature by the fact that we hold some gold in the portfolio, both bullion and gold-mining shares. I am happy to have convinced Jean-Marie Eveillard in late 2001 that gold-mining shares were so obscenely expensive, overpriced, that if we wanted exposure to gold we had to modify our prospectus to give ourselves the right to hold gold bullion. It’s been a great move! We own a few gold mining shares, but it’s really de minimis and only in our

You also see our cautious and opportunistic approach reflected in the fact that we own some bonds. In the IVA Worldwide Fund here in the U.S., we have a little less than 9% in high-yield corporate bonds, mostly a residual from a lot of bonds we were buying late ’08-’09. So, as a result, many of these bonds will be maturing shortly in

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Another negative bet you’ll notice is that, other than a few stocks in South Korea, we have virtually no exposure to emerging markets. We have no direct exposure to the BRICs – Brazil, Russia, India and China – because even though these stocks have come down a lot last year and some of them this year, we believe that these stocks are dead. We are cautious and worried about what’s going on in China.

U.S. registered mutual funds. Our preference remains, by far, towards holding gold bullion.

You’ll notice that at the end of June [2012] we had 12.4% in cash. In some ways you may want to view those short-dated, Singapore dollar bonds as quasi cash in Singapore dollars. The fact that we’re not fully invested tells you that we are worried that we think that, by and large, stocks are not dirt cheap enough to be fully invested.

If you look at the kinds of names we own in stocks or at least if you look at the top-ten holdings, you’ll notice that the balance sheets of the companies we own are very strong. We are very fond of the expression Marty Whitman coined a while back, which is that it’s not enough for a stock to be cheap, it also has to be safe – “safe and cheap”. Safety starts with the balance sheet.

The cautiousness of the portfolio is expressed by the fact that we are making some negative bets. We have virtually no financials except for a few insurance brokers, except for – and we may talk about it later – some tiny positions in Goldman Sachs [GS], UBS [UBS]. Financials in the U.S. are slightly too expensive and in Europe we think that most banks remain grossly undercapitalized

Another negative bet you’ll notice is that, other than a few stocks in South Korea, we have virtually no exposure to emerging markets. We have no direct exposure to the BRICs – Brazil, Russia, India and China – because even though these

stocks have come down a lot last year and some of them this year, we believe that these stocks are dead. We are cautious and worried about what’s going on in China. We believe that a soft landing is in the cards, and hopefully that will not become a hard landing. Any sharp slowdown in China will have major consequences for commodity prices, which in turn will hurt many emerging countries.

Some specific countries like India have obvious issues with inflation and current account deficits, not to mention problems with their electricity. We’ve seen in Brazil over the past year-and-a-half how government intervention has had the ability to hurt investors. Investors in Petrobras [Sao Paolo: PETR] have seen President Rousseff, basically ask the company to think more about what’s good for Brazil Inc. as opposed to doing what’s right for the company’s shareholders.

Also, we worry about what’s going on in Europe. We’re not sure what the outcome will be. It’s a big unknown and the way we express our skepticism towards what’s happening in Europe is by being 65% hedged on the euro. We are willing to hold quite a few European stocks because we believe that many of them are multinational and not necessarily that Euro-centric.

Conversely, let’s not forget that quite a few American companies have a lot of their revenues in Europe. Also, even in the instances when some of our European stocks

are quite Euro-centric in terms of where their business is conducted, we think that some of these businesses may not be as cyclical as others, or if they are, the price of the stock may already reflect that it’s going to be a difficult economic environment for a long time in Europe. So, in other words, there are many stocks in Europe where we think the bleakness of what’s going on has already been priced in.

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I’m obviously very familiar with the expression “buy-and-hold” and that expression, frankly, makes me cringe. I don’t think it belongs to the lingo that value investors use. Value investors know about price and value.

MOI: In your Owner’s Manual, you state that in the short term you try to preserve capital while in the longer term you attempt to perform better than equity indices. How much of a role does portfolio management play in achieving this versus a buy-and-hold strategy in essentially the same equities for the long run?

de Vaulx: Let me start with the second part of the question. I’m obviously very familiar with the expression “buy-and-hold” and that expression, frankly, makes me cringe. I don’t think it belongs to the lingo that value investors use. Value investors know about price and value. “Price is what you pay, value is what you get.” Sometimes the price is way below that value, sometimes the price is at or close to that value and other times the price is much above that value.

The underlying premise for most value investors is that it may take two, three, four or five years for the price to meet that value. Maybe some of the company’s problems have to be sorted out. Maybe some of the good attributes of the company have to be better recognized over time by investors. So, yes, value investors are prepared to wait for awhile for the value to be recognized or realized. If for some reason that value gets recognized sooner then so be it and it’s a bonus!

Another reason why buy-and-hold does not make sense is because the strength, the moat of many businesses, is often not permanent. Because of globalization or

technological changes, the odds are high that a business today will be very different fifteen years from now. For instance, retailers that were popular fifty or sixty years ago—Montgomery Ward, J.C. Penney [JCP], Sears [SHLD]—none of these names are truly relevant today. Nothing’s permanent.

understanding correlations. For instance, if you are managing a global portfolio, you should be mindful that if you own stocks in China along with stocks in Brazil, you need to understand that maybe they are a lot more correlated and joined at the hip than you would normally think. If you are concerned about the outlook for natural gas, it can be useful to know what companies in your portfolio would benefit should prices of natural gas go up in North America and conversely which companies would be hurt.

I think understanding correlations is very important, especially in a global world where there’s a lot more debt in the system than in the past. We’ve seen the global nature of banks. A good example of this is the paradox of what’s going on in Europe. In countries like Italy, France and Germany there has been no residential lending bubble to speak of, yet the banks in these countries still managed to misbehave, not by lending to their own people, but by lending to Greece, Spain and Eastern Europe and buying subprime here in America.

Now, there are a few exceptions, obviously. Warren Buffett has tried to look for those – the Coca Colas of the world, the American Expresses of the world. I think as an investor it’s important, especially from a qualitative standpoint, to look at the past ten years’ earnings, but it’s always important to be mindful that businesses may change and sometimes for the worse. Technology, the internet, has revolutionized what’s been going on in the media industry. It has destroyed, to a large extent, the economics of the newspaper industry. So I think from that standpoint, buy-and-hold is — and I mean by that buy and hold for fifteen or more years — a very bizarre concept.

Now, the first part of your question- I’m intrigued that very few value investors ever comment on portfolio construction, in particular

…understanding correlations is very important, especially in a global world where there’s a lot more debt in the system than in the past. We’ve seen the global nature of banks.

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Another thing that’s not discussed enough is position sizing. I think I’ve made my point about us not being big fans at all of running concentrated portfolios. I don’t think I could sleep well at night if I had positions of 8%, 9%, 10% in individual names. There is an art to position sizing, whether this should be a fifty basis point position or 1% or 3% position. It may be tempting as a shortcut to believe that you should always overweight stocks that offer the highest discount to intrinsic value and vice versa.

In reality, you have to size your positions to take into account four variables plus a fifth one. The first variable is: Does the company have a good enough business that there’s scope for some intrinsic value growth, between the retention of some of the free cash flow and maybe some organic growth? Can that company see its intrinsic value grow by 7%, 8% or 9% per annum, which in itself would be an equity type return. Conversely, is it a mediocre business, a static or declining business, where intrinsic value at best will be static and at worse maybe declining over time. Obviously, the more scope for intrinsic value growth, the more you can justify allowing for less of a discount, both when you own it and then when it’s time to sell it.

The second variable is leverage. The more leverage there is, because leverage magnifies everything, you should ask for a bigger discount. You may also, depending on the leverage, want to size your position accordingly.

Something that should have a bearing on the position size is corporate governance and capital allocation; for example, if a company operates in a country like Brazil where shareholders may be mistreated by the government or the regulators. Also, regulators may ask SK Telecom [SKM] or China Mobile [CHL] to be good corporate citizens and help the population by not raising their fees or keeping the price of fuel low, but that’s at the expense of the company.

It’s important to consider corporate governance from a government standpoint and policymakers’ standpoint, but also from a controlling shareholder standpoint and/or management. Most companies in Japan and South Korea do an extraordinarily lousy job at paying dividends, and you have to factor that into both the discount you should require when you get in and the sizing of the position. And, of course, if the company has a history of di”wors”ification, you should either not buy it altogether or, if you do, make sure the position size remains modest to take that risk into account.

The fourth variable is liquidity. If a security is only somewhat liquid, it is often wiser to ask for a bigger discount when you buy it.

The fifth variable is comfort level. For us to be willing to have 3%, 4% or 5% of the portfolio in one security, our comfort level has to be very high. It has to be high in terms of the discount to intrinsic value, our respect for management in

terms of running the business from a capital allocation standpoint and, most importantly, our comfort level that we understand the business well enough. For instance, I can sleep like a little baby having 1.8% in Microsoft [MSFT], but the fact is that I don’t know where the company will be ten years out and I would be unable to sleep at night if it were an 8% position.

I can sleep like a little baby having 1.8% in Microsoft

[MSFT], but the fact is that I don’t know where the company will be ten years out and I would be unable to sleep at night if it were an 8% position.

Obviously, part of portfolio management in our case is the idea that there’s no requirement to be fully invested, which should be obvious if you’re a value investor. If many stocks in your portfolio go up and get closer to their intrinsic value estimate, your self-discipline kicks in. You have to trim your positions, raise cash, and you should hold onto that cash unless you find new securities that offer discounts to intrinsic value that are wide enough, and just wait.

There’s another concept that I enjoy, which I’ve read in one of Ben Graham’s books, where I think he argued that if at any given time you can put together a portfolio of genuinely cheap securities- while at the same time Mr. Market as

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a whole is quite expensive, you should keep some cash and/or bonds on the side, maybe 20%-25% of the portfolio. You’re deluding yourself in believing that the stocks you have — however factually cheap they are — will not suffer a temporary unrealized loss as Mr. Market may go down.

MOI: You state that you are trying to deliver returns that are as absolute as possible. Describe the challenges of doing so in a low-return environment. How do you best preserve purchasing power over time?

de Vaulx: That’s a great question. We wrote a piece, Volatility as a Friend in a Low-Return World, in which one of the points we make is that an additional difficulty of being in a low-return environment is that there’s volatility. And, historically, times of high volatility and low returns typically have been associated with difficult economic times. I obviously have in mind the ‘30s after the crash and the following depression, and the period from the ’73-’74 crisis and then the stagflation that took place in the late ‘70s until stocks and bonds troughed in early August of ’82.

Today’s low-return environment is unique from these other low-return periods in history in that stocks today are not cheap. For example, if you think about 1974 or 1982, when the S&P was trading at eight times depressed earnings, the average dividend yield was 6.8%. Today the average yield is 1.9%. One of the obvious reasons why stocks were

able to get so cheap in the past is because we had high inflation and very high interest rates. When you have very low interest rates as we have now, it becomes a lot harder for stocks to become dirt cheap. And even though stocks are in many cases, especially outside the U.S., as cheap now as in March 2009, and much cheaper than 2006-’07, the reality is that after the crisis, stocks did not go down at all as much as they did throughout the ‘70s.

Because the economic outlook is difficult, because stocks are not dirt cheap, because I believe that corporate profit margins will go down in many instances, I believe that stocks may only deliver returns of 4-6% for the next 4-6 years, which is less than the 7-9% equity-type return that one typically would expect out of equities.

bonds, these things yield close to zero and after inflation they yield less than zero. If you look at the ten-year Treasuries today, in America they yield 1.84%. If you look at the ten-year TIPS and subtract one from the other, the implied inflation expected for the next ten years is 2.6%. So anyone who buys a ten-year treasury implicitly is willing to lose, after inflation, 75 basis points per annum. If you compare that to a stock offering 7-10% or more FCF yield and if a portion of that FCF is paid out in dividends that represent 4-7% or more of the stock price, that stock starts to look compelling.

On the one hand, because stocks are not cheap enough to offer an equity-type return, you may not want to be fully invested and, yet, if you decide to only be 60% or 65% invested in stocks, which we are now, then you’re diluting your returns even more.

This environment clearly makes it harder to always be up every calendar year (last year the IVA Worldwide Fund I share class was down 1.96% while the MSCI AC Worldwide index was down 7.35%) and makes stock picking even more essential, as mistakes that you make carry with them much steeper penalties. However, the underlying volatility makes it possible for a good stock picker to do better than the equity market over time. For example, if equity markets return an average of 5% over the next 5 years, it becomes a lot easier to do better than that if those returns come with volatility (helping you buy low and sell high) than if markets achieve those low returns in a straight line.

Because the economic outlook is difficult, because stocks are not dirt cheap, because I believe that corporate profit margins will go down in many instances, I believe that stocks may only deliver returns of 4-6% for the next 4-6 years, which is less than the 7-9% equity-type return that one typically would expect…

That in itself would argue for some caution, but then again, the trouble is, if you’re not fully invested in equities, what do you do with the rest of the portfolio? If it’s cash and

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As I mentioned earlier, times of high volatility and low returns typically have been associated with difficult economic times. And in difficult economic times, you have the additional complication of government intervention in markets. Policymakers tend to try to make things better or be tempted to kick the can down the road and postpone the problems. We have seen policymakers intervene through financial repression, putting a cap at very low levels on what savings accounts can pay whether it’s here in the U.S. or in India or China or if it’s through manipulating foreign exchange rates. Right now, for example, we see the Swiss trying to make sure that the Swiss Franc does not appreciate against the euro. In a low-return world, all of these interventions further increase volatility and also increase the binary nature of possible economic outcomes. Whatever policies are put into place by governments may lead to deflation, as we saw in the ‘30s, or it may lead to inflation and maybe stagflation.

When you’re in the business, as we try to be, of preserving purchasing power over the short and long term, I think that you have to be all the more careful not to bet the farm if you don’t know whether the final outcome will be inflation or deflation. For example, you should resist the temptation to go all out and only own twenty-year or thirty-year treasury bonds, or in our case you should not necessarily be 100% in gold or stocks with the premise that if there’s inflation or hyperinflation that’s the best way

to be protected. At this time, we have not made a call either way- deflation versus inflation- and have positioned the portfolio as such.

If you look at our portfolio today you’ll notice that some of what we have would be good if the deflationary forces were to gain strength, for instance, which could happen if there’s a major slowdown in China or if things get worse in Europe. What would help our portfolio is the cash, especially since we are invested in top-notch quality commercial paper. In addition, the majority of stocks that we own have strong balance sheets, which should perform better than lower quality stocks in a deflationary environment.

Conversely, many of the stocks that we own share attributes that should help them do well in an inflationary environment. These are the kinds of stocks that Buffett owned in the late ‘70s when he worried about inflation – non-capital intensive businesses, businesses where the companies should be able to raise prices by at least as much as inflation. Importantly, with non-capital intensive businesses, all of the earnings are free cash flow that can be paid to shareholders as opposed to being reinvested at higher prices in the business.

Gold, you could argue, is only a hedge against inflation. We’ve always believed that gold historically has been an equally good hedge against deflation. Gold did very well in the ‘30s, not only because there was a gold exchange status, not only because

the U.S. devalued the dollar, which led gold to go from $20.67 in 1932, ’33 to $35 in ‘34, but because gold becomes very desirable when you have deflation because there’s no counterparty risk associated with gold. Gold is not an IOU. So when banks go bankrupt – 40% of banks went bankrupt in the U.S. in the ‘30s – any IOU is at risk due to counterparty risk, even cash deposited at the bank. Gold does not have that problem. So, inflation can be good for gold. We saw it in the’70s. Deflation can be good for gold. Conversely, what is typically bad for gold is disinflation.

…gold becomes very desirable when you have deflation because there’s no counterparty risk associated with gold. Gold is not an IOU. So when banks go bankrupt – 40% of banks went bankrupt in the U.S. in the ‘30s – any IOU is at risk due to counterparty risk, even cash deposited at the bank. Gold does not have that problem.

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MOI: You state that you seek investments in companies of any size that typically have one or more of the following characteristics – financial strength, temporarily depressed earnings, or entrenched franchises. What are some examples of these temporary challenges, temporary depressed earnings for otherwise financially strong and entrenched businesses?

de Vaulx: I’ll give you an example from the past and a more recent example. I remember in the late ‘90s we bought McDonald’s [MCD], the fast food company. Why? Because we were impressed by how global they were, much more global than some of their competitors. We also, early on, understood what Bill Ackman saw a few years later, which is the real estate angle, the fact that they own so much real estate, a lot of it they rent out to franchisees. Addressing your question of temporary challenges, the reason why that stock became so cheap back then is that the company was suffering because the food had become very bad — much worse than the competitors. And the service — there were many complaints about the quality of the service.

We felt that those two issues were fixable. Once those issues were recognized by top management, they were eventually able to fix them and the stock over time has gone up extensively.

A more recent example would be was last summer, News Corp. [NWSA], Murdoch’s media company. They had the scandal associated

with their tabloids in the UK. The stock came down and, yet, we were comfortable building a decent-sized position. The company had a very strong balance sheet, so we thought that they could suffer having to pay some fines. With hindsight, the balance sheet was so strong that, in fact, the company has been very aggressive buying back their own shares since then. On a sum of the parts basis, a year ago, the stock fell as low as $15 or $16. We had, on a sum of the parts basis, a value of around $30.

News Corp. is a very different company than it was 20 years ago. News Corp. almost went bankrupt in the early ‘90s and at the time it was mostly newspapers, magazines, but today’s businesses, BSkyB, Fox, there’s very little print, in the sense of being threatened by the Internet. These are very powerful businesses — one of the businesses is 20th Century Fox, which is a decent business, so pretty un-cyclical businesses with no major immediate sort of threat to their businesses – high margin businesses, a very strong balance sheet.

The way we interpreted the scandal is, we thought it had a silver lining because via some super-voting structure, Murdoch controls the company. We thought that the scandal – because it’s such a public business– he would be forced to improve corporate governance, which I think he has. We felt the Chief Executive Officer, Mr. Carey, was very competent as was the predecessor, Mr. Chernin.

We realized that the super-voting control allowed him to make some mistakes in the past, but small mistakes.

He lost a lot of money when he overpaid for Dow Jones, the publisher of The Wall Street Journal. He overpaid for MySpace, but in the grand scheme of things these were small deals and, conversely, to his credit as a media guy, he saw the changes that were happening in the newspaper industry and moved away from that over the years. Today, the stock is at over $24. I think that was a good example of what we thought was a temporary challenge and one that was limited to just one part of their empire.

News Corp. is a very different company than it was 20 years ago. News Corp. almost went bankrupt in the early ‘90s and at the time it was mostly newspapers, magazines, but today’s businesses, BSkyB, Fox, there’s very little print, in the sense of being threatened by the Internet.

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One stock we’ve bought over the past six, nine months is a French company called Teleperformance [Paris: RCF].

One stock we’ve bought over the past six, nine months is a French company called Teleperformance [Paris: RCF]. They run corporate call centers, and that’s a case where all of the earnings pretty much come from the United States. They’re very powerful in the U.S. In fact, for all practical purposes, the company should be headquartered and listed here. It’s sort of an accident that it is listed in France. The French founder happens to live in Miami, and it’s an interesting case where the French operations are losing a lot of money.

It’s much harder in France than in the U.S. to fire people and so they are not able to stop the bleeding right away in France, and I think we feel that we can quantify what those losses will be. Worst case, the company can hopefully shut down the business over time, and I think those losses in France mask the quality of their earnings in the U.S. Historically, there have been many instances where we have dabbled a lot in what we call high quality, yet, cyclical businesses.

If you think about temporary staffing companies – Randstad, Manpower; if you think about the freight forwarding companies – Kuehne + Nagel, Panalpina, Expeditors International… If you think about the advertising companies, billboard advertising, they are good businesses in the Warren Buffett sense of return on invested capital — service businesses, high returns on capital, high free cash flow. They are cyclical because, oftentimes,

other investors have a shorter-term horizon than we do. Whenever the economy goes south, in the world or in the country, these stocks go down, sometimes excessively so, so that the stocks implicitly forget that there’s a prospect that it’s just a cyclical downturn, not a secular change in the business. So we’ve often been doing some of this in the past.

not global. It has operations mostly in Switzerland and in a few other European countries, but to a large extent, the business model is the same as similar companies in the U.S. or elsewhere.

The way we are organized internally at IVA is that the work has been divided among analysts along sector lines.

Value investing is an American invention. American value investors were adamant against international investing for a long time. Even in the late ‘90s Warren Buffett was not willing to invest internationally because there was this belief that foreign accounting is difficult to understand, disclosure is not as good. The notion was that managers outside the U.S. don’t care about shareholders and so forth. The other theme at the time was that if all you want to do is play in economic growth in the rest of the world, you don’t need to invest internationally. Instead, you can do it through Coca-Cola [KO] or McDonald’s or Microsoft [MSFT] or Colgate [CL].

In terms of understanding the companies, we think it’s a huge competitive advantage to look at things on a global scale and by sector. At the same time, we remain mindful that there are still some risks associated with international investing we have to factor in. For example, disclosure is not as good as it is in the U.S. In the U.S., you have 10-Ks where companies have to give some description of some of the business segments they’re in. They typically will tell you if they

MOI: How does your approach to international investing differ from that to investing in U.S. equities, if at all?

de Vaulx: For a long time, until almost in 2008 you typically had, especially in the institutional world, the distinction between domestic investors that invest in domestic U.S. stocks and international investors that invest outside the U.S. We’ve always felt that being a global investor made more sense because many industries are global. If you look at the automobile industry, it would be absurd to look at GM [GM] and Ford [F] without being aware of Tata Motors [TTM] and Volkswagen [Germany: VOW] and Hyundai and Toyota [TM] and so forth. Or that billboard advertising company I mentioned earlier, Affichage in Switzerland, that company itself is

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We own a stock in France called GDF Suez [Paris: GSZ]. One of the businesses is the distribution of gas to both retail clients and corporate clients; and even though there have been contracts going back a long time stipulating that if certain costs escalate — contracts with the government — the company has the right to pass along those increased costs.

own some of the real estate of the plants, the plant and the equipment. In general, international companies give less granular information regarding the business segments. Also, although there have been improvements in corporate governance and laws to protect minority shareholders, I think it’s fair to say that there are still risks in international stocks.

I’ve talked about the risk of government interference. We own a stock in France called GDF Suez [Paris: GSZ]. One of the businesses is the distribution of gas to both retail clients and corporate clients; and even though there have been contracts going back a long time stipulating that if certain costs escalate — contracts with the government — the company has the right to pass along those increased costs. More recently, the government over a year ago told the company, no, they cannot. Even though a recent court – some sort of Supreme Court – has argued in favor of the company, our understanding is that the government is not bound to honor what that court has decided.

With international investing, if you look at companies in Europe and Asia compared to the U.S., more of those companies, especially the small ones, are controlled by a family or group. The risk associated with being a minority shareholder is all the more prevalent, relevant, and I think you have to be mindful of it. Not necessarily in the sense of not buying any of the stocks, but maybe sometimes asking for

bigger discounts to intrinsic value when you get in and also making sure that the position size, which we were discussing earlier, doesn’t get too big.

the Procter & Gambles, the Coca-Colas go down.. Conversely, we have to be mindful, when we invest in yen or in Malaysia, or if we were to invest in Spain, we have to be mindful of the foreign exchange risk. Either way, understand that we might want to control it through hedging the currency assuming that the risk of hedging is not prohibitive.

MOI: How do you generate investments?

de Vaulx: Compared to many of our peers, it would be fair to say that we may rely a lot less on screens. It would be easy every week to run screens globally about stocks that trade at low price to book, high dividend yield, low enterprise value to sales, enterprise value to operating income, and so forth. Generally speaking, a lot of our value competitors begin the investment process —by that I mean the search for ideas—by trying to identify cheap-looking stocks.

However cheap a stock such as SK Telecom [SKM] would become it would be hard for me to have an 8% position in SK Telecom knowing that it’s a Korean company. Korea is not known for the greatest corporate governance, and it’s a regulated business where you are at the mercy of the regulator who may want to favor the number two player, the number three player in the industry as opposed to let SK Telecom grow market share.

Another obvious challenge — which also impacts U.S. companies — has to do with foreign exchange. Of course, U.S. companies — and we’re seeing it now with the dollar going up against many currencies, including the Indian rupee, the Brazil real — from a translation standpoint, we see the earnings of

However cheap a stock such as SK Telecom [SKM] would become it would be hard for me to have an 8% position in SK Telecom knowing that it’s a Korean company. Korea is not known for the greatest corporate governance, and it’s a regulated business where you are at the mercy of the regulator…

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Sometimes using screen devices they look for cheap-looking stocks and once they have identified a list of cheap-looking stocks, then they decide to, one at a time, do the work and investigate each of these companies. The pitfall with that approach is typically those cheap looking stocks that you’ve identified will typically fall in two categories. Either stocks that are of companies that operate in overly competitive industries or overly regulated industries where the regulator may not always be a friendly regulator. So you may find steel companies, or some retail companies, or the insurance industry in many parts of the world is notorious for its overcapacity and lack of barriers to entry.

So, either you’ll find companies in overly competitive businesses where it’s hard, or even worse, you’ll find typically some of the lousiest competitors in their respective industry. If you had run a screen a day before a company went bankrupt, the stock probably looked cheap on maybe a practical basis or probably enterprise value to sales basis.

The problem with these cheap-looking stocks of both categories is that it’s going to be hard for these stocks to see their intrinsic value go up over time. If anything, especially in the second category, the worst competitor type category, some of these companies may actually see intrinsic value go down over time.

Conversely, what piques our curiosity, what makes us want to investigate an investment idea is

not that it looks cheap at first sight. It’s rather that the business looks neat or that the company seems uniquely good and well positioned in what they do, and then we hope and pray that, for one reason or another, the stock happens to be cheap. I’ll give you an example which goes back many years. Maybe 15 years ago, I was reading briefly about a company I had never heard of – Thomas Nelson, a U.S.-based company.

They were the leading publisher of bibles in America, maybe in the world. They were also a leading publisher of inspirational books and I said, well, book publishing used to be a great business. It changed from being a great business to a good business. Margins went from being obscenely high to just high because authors asked to be paid more over time. I said, gee, a bible publisher… There’s not much in the way of author rights. That’s pretty neat. Next to that brief description of the business was a P/E ratio that did not look low- it was15 times earnings, a P/B that did not seem low and a dividend yield that did not look enticing. So the stock did not look cheap, but I said maybe there’s something hidden. Maybe the earnings are temporarily depressed, and so maybe the stock is cheap even though it does not look so at first blush.

I was intrigued by the business, and I took a look at it and realized that the company had, for the five years just prior, started to come up with five new bibles – bibles for children, bibles for the elderly

and so forth – and they had capitalized the costs of creating these new products. Now that those bibles were available for sale in bookstores, the company was amortizing over five years, or maybe three years, that cost. So now the company’s earnings per share were after a pretty big amortization of capitalized costs, which was not a cash charge. What looked like a high price to earnings ratio of 15 times was only a 10 times price to earnings before amortization of capitalized costs. So the price to cash earnings was much more reasonable.

I was intrigued by the fact that the company, two years prior, had misbehaved. Since they had a good business, they had decided to diversify and buy into a difficult business. They had bought a printing business in the UK. They had borrowed money for that, but to their credit, a year later they realized their mistake and had sold that business at a loss, but they had sold it and the proceeds were high enough to pay down debt. The bottom line is that for the few people who knew that company in the past, who owned it, they were disappointed in management because of that one time mistake. I felt that, hopefully, management would have learned from their mistake.

Oftentimes, we will study over the years great businesses, whether it’s a Google, an Expeditors International [EXPD], 3M [MMM], and we keep them in mind and we have a tentative intrinsic

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value estimate, and sometimes there could be a crash. There can be a crisis like ’08, something happens and sometimes these stocks fall enough that we revisit them. I talked about these great businesses that are cyclical, the temporary staffing companies, most of the time they’re too expensive for us to catch, but once in a while, especially during an economic downturn, we’re able to buy them.

Even L’Oreal [Paris: OR], the French-based yet global cosmetics company, a few times in the past during an economic downturn, sales slowed down and the growth guys that typically own the stock don’t want to own it, because the growth rate is not there. So they dump it. It still optically looks too expensive for the deep value guys. In other words, instead of staying at six, seven, eight times EBIT, it may still trade at nine, ten, eleven times EBIT. So the growth guys don’t want it, the deep value guys don’t want it. It sits in limbo, and that’s when we’re able to get those things.

So it’s not much in the way of screening. It’s just the analysts, based on the sector they follow, and because some of us have been in this business for a long time – myself, over 25 years and Chuck [de Lardemelle] and Simon [Fenwick] and Thibault [Pizenberg] for many years – and because we’ve looked at tiny companies and huge ones, we have a pretty good idea of what the best businesses and companies are out there in the world, and we keep them in mind and try to revisit them when there’s a crisis or a big economic downturn.

MOI: Where do you see the biggest inefficiencies currently?

de Vaulx: Many bonds, especially U.S. Treasury bonds, German bunds, possibly Japanese JGBs strike me as very expensive. Because of the fear of the unknown, because investors have not done well for many years, the flight to safety is so extreme that investors are willing to buy those bonds that have yields that, in all likelihood, will be less than what inflation will be during the time period. In other words, owning a ten-year Treasury note yielding 1.8% strikes me as a good way to grow poor, but I think your question, really, is more on the long side, what do we think is cheap?

One of the biggest inefficiencies would be Japan, where the market trades at a level that’s lower than in 1983 – 29 years ago. In Japan, the smaller the stock, the less liquid a stock, the cheaper it is relative to other stocks, so small stocks in Japan are, by far, the

cheapest. I think some people have run screens, trying to identify Ben Graham’s net-nets around the world and an overwhelming number of names that pop up through that screen are many small-cap Japanese names. I think these stocks are cheap for a reason. So maybe inefficiency is not a proper word. Investors have been very disappointed over the years in Japan by the fact that many Japanese companies are well managed. They run the business properly, many businesses have a decent and sometimes very high return on capital employed, but the flaw is the capital allocation.

Dividend payout ratios are low in Japan and, oftentimes, companies will pay out no more than 20%, 25%, 30% of the earnings. At least companies do not di”wors”ify the way they used to in the ‘80s leading up to the bursting of the Japanese bubble, but we’ve seen many Japanese companies year after year keep most of the free cash flow that’s been generated by the business and let the cash pile up on the balance sheets. So there are many small-cap Japanese stocks that are quite cheap. There’s one called Shingakukai [Tokyo: 9760]. It trades below net cash and the business is profitable.

Even L’Oreal [Paris: OR], the French-based yet global cosmetics company, a few times in the past during an economic downturn, sales slowed down and the growth guys that typically own the stock don’t want to own it, because the growth rate is not there. So they dump it. It still optically looks too expensive for the deep value guys.

…there are many small-cap Japanese stocks that are quite cheap. There’s one called Shingakukai [Tokyo: 9760]. It trades below net cash and the business is profitable.

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The reason why there aren’t as many inefficiencies today as we would expect, especially in such a difficult economic environment, is that equity markets around the world over the past eighteen months have been quite efficient in discriminating and establishing a differentiation between stocks of companies that are average or mediocre from stocks of companies that have great businesses, especially those businesses that are not very volatile. If you look at certain stocks such as Nestle [Swiss: NESN], Diageo [DEO], Colgate [CL], Bureau Veritas [Paris: BVI], many of these stocks are close to their all-time highs. They are perceived as extremely high quality, very defensive, generate a lot of free cash flow, and especially if they pay some sort of dividend, they have been bid up accordingly.

I’m not suggesting that these stocks are overpriced. I’m saying that they don’t offer much in a way of a discount to intrinsic value. Even though emerging market stocks have come down quite a bit last year and in some countries even this year, we believe that many stocks look cheap based on earnings and cash flows, but these earnings and cash flows are at risk of being sharply reduced if there’s too much of a soft landing in China. So even though emerging market stocks have come down, we don’t deem them to be inefficiently priced.

MOI: When it comes to Japan, where do you see the biggest values?

de Vaulx: Not so much today among some of the leading exporters, global-type companies. If you look at the share price of Shimano [Osaka: 7309], which makes the bicycle parts, if you look at Keyence [Tokyo: 6861], Fanuc [Tokyo: 6954], these stocks are not outrageously expensive, but they are not cheap. I think it’s smaller businesses, oftentimes, although the example I’ll give you is not so small.

Our largest holding in Japan is Astellas Pharma [Tokyo: 4503], which is Japan’s second-largest drug maker. The market cap is in the billions of dollars and what’s interesting with Astellas is that over the past seven years they bought back 19% of their shares outstanding, which is unusual, it’s very un-Japanese. Companies typically don’t do buybacks, or not that extreme, so even though the company has bought back a lot of their own shares over the years, even though the dividend payout ratio is close to 50%, which is high by Japanese standards, the company’s net cash today still accounts for 18% of the market cap. So the company still has some net cash, and also the company has made a few acquisitions in the past. The last one was a year and a half ago, a U.S. based company called OSI Pharma. Because of those acquisitions, there’s a pretty large expense called amortization of goodwill and, basically, our sense

is that the local investors forget to take into account the amortization of goodwill. They may look at enterprise value to EBIT.

Most Japanese investors will only look at the price to earnings ratio. Some of the more daring investors will look at enterprise value to EBIT and that will help them factor in the fact that there’s all that cash, but EBIT, unfortunately, is 20% lower than EBITA, the amortization of goodwill of intangibles is quite high. Today, with the stock at 33,845 yen, the stock trades at 6.2x EBITA, earnings before interest, tax and amortization, 6.2x EBITA of [the year ending] March 2014. Yet, if you look at reported EBIT based on the estimate for [the year ending] March 2014, the EV to reported EBIT is 7.5x and that’s, at best, what the locals see.

Our largest holding in Japan is Astellas Pharma [Tokyo:

4503], which is Japan’s second-largest drug maker. The market cap is in the billions of dollars and what’s interesting with Astellas is that over the past seven years they bought back 19% of their shares outstanding, which is unusual, it’s very un-Japanese.

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The company has been very good at their core business. They have a pipeline that’s among the best compared to other pharmaceutical companies in the world. Because of the pretty high dividend payout ratio and the low stock price, the dividend yield is 3.4%. As you know, ten-year Japanese government bonds only yield seventy-six basis points. For a local investor, to get 3.4% dividend yield in yen is quite remarkable. On an EV to EBITA basis, the stock is very cheap at 6.2x. It has net cash and some great growth prospects because of many drugs that are about to be launched. That’s a good example of a cheap stock in Japan.

MOI: When it comes to Europe, most of your investments there are in companies headquartered in France and Switzerland. Why not more in Germany or peripheral European countries?

de Vaulx: Again, great question. Let me start with Germany. In the past, we have had quite a few investments in Germany. We used to own in the early 2000s, late 1990s-2000s, Buderus [formerly Frankfurt: BUD]. It was our largest holding. Buderus is a boiler manufacturer. We’ve owned shares such as Vossloh [XETRA: VOS], Axel Springer [XETRA: SPR], Hornbach [XETRA: HBH3], the DIY retailer and so forth, but the reality is that most companies in Germany are not listed. If you think about industry, industrial companies in Germany, they are not listed because they belong to what the Germans call the mittelstand. The

mittelstand are those thousands and thousands of basically small and mid-size companies, many of which are family-owned, and these companies are not listed. All those great German industrial companies basically are not available in the stock market.

Now, among the companies in the stock market, many have been recognized as good companies and so the stocks are no longer cheap — if you think about some of the auto manufacturers like Volkswagen. So for the time being, we don’t have much in Germany, although we did buy, a month ago, a large industrial German company.

Switzerland is an interesting country where there are many quality companies. Even though we’re value-oriented, we start our process with trying to identify not so much cheap-looking stocks, but quality businesses. We like quality and then we hope and pray that somehow, one way or the other, we can get it for cheap.

Switzerland has so many great businesses, whether it’s Kuehne & Nagel [Swiss: KNIN], which is an even better freight forwarding company than Expeditors International here in America. Nestle is a wonderful food company, better in my mind than Kraft [KFT]. Geberit [Swiss: GEBN] makes great plumbing products. Lindt & Sprüngli [Swiss: LISN], as I’m sure you know, makes delicious chocolates, and so it’s our bias to its quality that oftentimes has led us to Switzerland. Adecco [Swiss: ADEN] is a leading temporary

staffing company, has much higher margins than Manpower [MAN], has higher margins than Randstad [Amsterdam: RAND]. They just have top-notch companies in Switzerland, and sometimes we are lucky to get them cheaply.

France is an interesting country because even though France has had and today has those socialist tendencies, France has an amazing number of great businesses, which oftentimes are global leaders. Think of Pernod-Ricard [Paris: RI]. Pernod-Ricard started as a little family-controlled business in the south of France and through astute management and acquisitions they have become a leader in the sale of liquor competing very well against Diageo, which is best-in-class in that industry. Think about L’Oreal — what a wonderful, global consumer company. And of course everyone knows that France is the home of stocks such as LVMH and Hermes, the luxury good companies.

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In France, we own Sodexo [Paris: SW] a food catering company. They compete against Compass [London: CPG] in the UK. Sodexo is a very well-run, global company. They have a huge subsidiary here in America, Marriott Services, which they acquired a long time ago.

There’s a stock we don’t own now but we’ve owned in the past. It’s become somewhat of a darling, Essilor [Paris: EI]. They are, by far, the leading company worldwide that manufacturers lenses for glasses.

are family-controlled. We at IVA believe that more often than not family-controlled businesses do better than other types of business and could not agree more with Tom Russo from Gardner Russo & Gardner on that topic. One of his big themes is that he loves, for the same reason we do, family-controlled companies because they have a long term vision and often times do great things.

The final point I want to make about France, and it’s important from a protection of minority shareholders standpoint, is that France is a pretty good place to be a minority shareholder. When there are takeovers in places like Germany or Switzerland, not to mention Italy, you often, as a minority shareholder, can be abused.

In France, especially now, compared to 20 years ago, minority shareholders are well treated when there are squeeze-outs and takeovers. The protection of minority shareholders is pretty high in France. That’s important because it just so happens that quite a few of our companies, not by design, get taken over, and when that happens we want to be well protected.

If you look at places like Italy, there aren’t that many listed companies, sort of the same reason as Germany. All these companies, like industrial companies based in northern Italy, most of them are family-owned and not listed. So there’s not that much available in the stock market, and some of the other countries in Europe — Spain,

In France, we own Sodexo [Paris: SW] a food catering company. They compete against Compass [London: CPG] in the UK. Sodexo is a very well-run, global company. They have a huge subsidiary here in America, Marriott Services, which they acquired a long time ago.

Portugal, Austria — oftentimes the biggest stocks are just the big banks and insurance companies. Most of them are, especially on the banking side, grossly undercapitalized. They may look cheap, but they are certainly not safe. Again, not a lot of quality stocks are available in the Greek stock market, or the Portuguese or Spanish one.

…France is a pretty good place to be a minority shareholder. When there are takeovers in places like Germany or Switzerland, not to mention Italy, you often, as a minority shareholder, can be abused.

We’ve owned in the past Bureau Veritas. It’s a little bit like ISS [Group] in Switzerland. It’s an inspection service company and they have big market shares in many specific niches. It’s a service business, non-capital intensive. France has companies such as Legrand [Paris: LR]. Legrand is the leader worldwide in electrical switches.

France does have those global companies that are very good at what they do and, at the same time, many of these companies

MOI: You recently initiated a few small positions among large global bank stocks. What is the rationale for this, and why now?

de Vaulx: Let’s keep things in perspective. We’re just dipping our toes here. We have small positions in UBS [UBS] and Goldman Sachs [GS] and had a small position in Credit Suisse [CS] that we are now out of, as our confidence level was not high enough. In the case of UBS, their private wealth management business does strike us as having a lot of value. If you assign some value to the private wealth management business, and if you add that value to the shareholders equity of the firm, then you’ll reach the conclusion that the bank is more than adequately capitalized.

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The rating agencies, as a rule, don’t factor in the value of the private wealth management business, but we are willing to do that. On that basis UBS strikes us as well capitalized and somewhat cheap. Goldman Sachs we think has a unique culture. We think that being a global leader, as they are, will give them a competitive advantage. We think that Goldman Sachs will be willing to cut costs further to make sure their return on equity, two or three years from now, covers the cost of capital.

Goldman Sachs will see many of its competitors exit certain businesses like trading, market making, and investment banking. As capacity shrinks in the industry, with many of Goldman Sachs’ competitors abandoning certain businesses, Goldman Sachs will end up with a larger market share. They’ll be more dominant, and if they can reign in those compensation costs, they will end up with a decent return on capital. We have a two- to five-year horizon with Goldman Sachs, hopefully for them to do some good things.

MOI: In the case of UBS, I guess you own both equity as well as debt; one of your largest positions is debt in Wendel [Paris: MF]. I’m curious if you could explain just why you hold certain of these debt securities, perhaps also explaining the risk/reward versus holding the equity.

de Vaulx: In the case of UBS, we do own the equity and the debt. In fact, the UBS debt we own is a very unusual bond, which in a few years,

the fixed coupon will be replaced by a floating-rate coupon. So, basically, even though these are long-dated bonds, we do not take interest rate risk because they will have a variable rate. In essence, we view those UBS bonds as quasi-cash in terms of the interest rate. The yield is not huge, but it is still a very competitive yield that will be some 200 points higher than what we currently get on our cash.

In the case of Wendel, we have known the company for over a decade. We started buying the stock at my previous firm in the early 2000s. We did very well with the stock in the 2000s, but the company made a big mistake in 2006, I think, they overpaid and over-borrowed to buy a stake in Saint-Gobain, a French company, and so they levered themselves up just as the financial crisis was about to hit. When the financial crisis hit, we started buying some bonds at IVA. We own several bonds – some mature in 2016, others in 2017 and others in 2018. So it’s not too short and not too long. It is a perfect duration and those bonds, in late 2008, were so depressed that we were getting yields to maturity of 16%, 17%, 18%.

Since then, the holding company, which is a family-controlled holding company, has been able to shed assets. They’ve reduced their stake in Legrand. They’ve reduced their stake in Bureau Veritas. They’ve shed other assets, so the balance sheet has improved greatly and these bonds are, in our mind, very safe. I wouldn’t say extremely safe,

but very safe and now the yields have come down tremendously, but these bonds still yield in excess of 5%. So it’s still a pretty reasonable yield in a zero return world, and so we’re very comfortable with Wendel. Now, you may argue that 5% is not exactly an equity-type return of the 7-9%, but it’s a pretty safe piece of paper, so we’re happy to hold onto it.

MOI: How has your view on owning gold, cash and fixed income changed recently, if at all, and the rationale for each in terms of overall portfolio and risk management?

de Vaulx: Our view on gold – which is not only today, but in general – we think that gold is a nice tool to have. Of course, it’s a tool where we give ourselves the latitude to buy either gold bullion or gold mining shares. Sometimes which of the two you buy makes a difference. Sometimes gold may do well, but gold mining shares not so well, or vice versa. Gold is misunderstood. Gold tends to be viewed, too often, strictly as a hedge against inflation because people remember what gold did in the 1970s. I would argue

…we think that gold is a nice tool to have. Of course, it’s a tool where we give ourselves the latitude to buy either gold bullion or gold mining shares. Sometimes which of the two you buy makes a difference. Sometimes gold may do well, but gold mining shares not so well, or vice versa.

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that gold also should be viewed as a hedge against deflation. Let’s not forget that in the 1930s when we had the depression and deflation, gold did well. Under the gold exchange standard, we saw gold go from $20.67 in 1930 to $35 an ounce in early 1935.

Why can gold do well when there’s deflation? Because when there’s deflation, there’s counterparty risk. Companies default, banks default. In America, almost 40% of banks defaulted. Gold, not being an “IOU”, is a very precious tool in a deflationary environment.

What typically can hurt gold is an environment where real interest rates are high. The incentive to be in gold when you could earn a nice, fat, juicy, positive real return is a high burden to want to own gold. Conversely, when real interest rates are negative, when the cash at the bank or on treasury bills yields less than inflation, when you have a negative real interest rate, it’s infinitely more palatable and tempting to own gold, so negative real rates are a tailwind while real interest rates being positive would be a headwind.

Gold is not as cheap now as it was in 2001 when gold crossed $255 an ounce. Gold today is around $1750. At the same time, if you adjust all the inflation that has taken place since the late 1970s, inflation defined as what the Consumer Price Index (CPI) has done or money supply growth around the world, if you look at how much central bank balance sheets have grown over the years, so if you

adjust for that, you’ll notice that the price of gold today, in fact, is not that high compared to the late 1970s.

Within the context of portfolio management, the way we use gold is simple. The concept is as follows: when stocks and bonds are dirt cheap — as in hindsight they were in 1982, for instance — there’s no need for gold. What does being cheap mean? Cheap means that something, a stock or bond, trades way below intrinsic value, so the bigger the gap between price and value, the bigger the so-called “margin of safety”. So you don’t need gold. Conversely, when stocks and/or bonds are expensive, like many stocks were in the late 1990s and early 2000s at the height of the tech bubble, this is when it can be very handy in a portfolio to own gold. Of course, the beauty is that the market, in its all too unusual kindness, gave gold away for almost nothing. Gold was around $260 an ounce in 1999, and it hit a low of $255 an ounce in 2001. It is now over $1750 an ounce.

Going forward, if stocks and bonds became dirt cheap — we don’t view them as dirt cheap today — say, if stocks fell 20%, we would not need to own as much gold as we do. We roughly have 5.5% of the portfolio in gold right now. Conversely, if stocks move back up, and if some of the world’s economic imbalances have not been addressed yet, if all the policymakers do is kick the can down the road further, we probably will decide to add a little bit to our gold exposure. So we really view

gold as a hedge. We also realize that it does not always work as a hedge.

If you think of 2008 or 2011, gold performed as a hedge. When stocks were down in 2008, gold was up 6% or 7% for the whole year. Last summer, July and August 2011, when stocks were falling worldwide, gold went from $1,200 an ounce in July to over $1,900 an ounce in early September. Conversely, there are other times when gold, instead of being inversely correlated to stocks or bonds becomes positively correlated, and in those times gold does not act as a hedge. In 2009-10, we saw gold go up insipidly with stocks and bonds and did not act as a hedge during those two years.

Going forward, if stocks and bonds became dirt cheap — we don’t view them as dirt cheap today — say, if stocks fell 20%, we would not need to own as much gold as we do.

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MOI: When it comes to fixed income, you talked about some positions there essentially as a cash substitute. You also talked about gold, I believe, as essentially money. So is that really then, when we look at those three categories – gold, cash and fixed income – in a way would it be fair to say that is really all some form of cash… de Vaulx: No. In fact, typically whenever we buy fixed income, it’s an attempt to get equity-type returns, and so when we buy high-yield corporate bonds, sovereign debt, and distressed debt, it’s trying to get an equity-type return. Now, the exception would be, for instance, we have 6% of the portfolio in short-dated, Singapore dollar bonds issued by the Singapore government. Those bonds yield very little, but the attempt is for us to get an almost equity-type return out of the underlying currency. It is our belief that the Singapore dollar will appreciate over time and give us an almost equity-type return. One can also look at those short-dated bonds like quasi-cash in a currency other than U.S. dollars.

Now, when it comes to cash, I want to make a very important point. Whenever we hold cash – today we have 15% of the portfolio in cash – some investors believe that us holding cash is us attempting to do tactical asset allocation. It’s us trying to time the market. It could not be further from the truth. When a real value investor holds cash, cash is a residual. Cash reflects the portfolio manager’s inability to find enough cheap stocks.

As a value investor, if you’re lucky to find some cheap stocks, once you buy them, if you get even luckier, the price of the stock goes up and gets closer to the intrinsic value estimate that you have. This is when the self-discipline kicks in and you have to start trimming that position and when you do that, you raise cash again. As a value manager, you have to hold onto that cash until you find new stocks that are cheap enough to offer the margin of safety that Ben Graham defined, which oftentimes will be a 20%, 25%, 30% or 35% discount between the price and the intrinsic value. Cash is truly a residual and I’m sure you’ve read or heard of Seth Klarman from Baupost talk about how he uses cash as a value investor, and we use it in exactly the same spirit as he articulated.

MOI: What is the single biggest mistake that keeps investors from reaching their goals?

de Vaulx: If I have to mention one mistake, one overwhelming mistake is the inability of investors, be it individual or professional investors, to pay enough attention to the price. I think investors pay way too much attention to the outlook and not enough to the price. When they wait for the sky to be blue or at least for the gray sky to become bluer and when the outlook looks better, they will want to buy, but typically it’s too late. It has already been priced in.

Conversely, when the outlook is bleak, investors are too scared to realize that maybe the bleakness of the outlook may have been more than priced in. As you know, markets tend to overshoot on the way up and on the way down. So when the outlook is bleak, when everybody worries about what’s going to happen to Europe, for example, they forget that a lot of that negativity typically will already be priced in, and sometimes more than priced in. So I think that is, by far, the biggest mistake.

If there was a second mistake I could comment on, it’s these two types of investors – those that trade too much, which is not healthy, and those that have too much of a buy-and-hold mentality. As a value investor, I don’t like the expression “buy and hold.” All I know is price and value. I know it may take two, three, four years for the price of the cheap stock to go up and get closer to the company’s

Whenever we hold cash – today we have 15% of the portfolio in cash – some investors believe that us holding cash is us attempting to do tactical asset allocation. It’s us trying to time the market. It could not be further from the truth. When a real value investor holds cash, cash is a residual. Cash reflects the portfolio manager’s inability to find enough cheap stocks.

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intrinsic value, but that has nothing to do with buy and hold. If, for some reason, markets are so volatile that the price of the stock, within six months, gets closer to the intrinsic value estimate, the value investor has to sell. Self-discipline kicks in. There’s a mistake both from people that overtrade on the one hand and those who have too much of a buy-and-hold mentality.

MOI: How have you improved your investment process or investment judgment over time? Have you tweaked anything as a result of the crisis in 2008-‘09?

de Vaulx: Well, specifically 2008-2009, the answer — and I don’t want to sound arrogant is no. We have been mindful, starting in 2003-’04, that there was a big credit bubble taking place in Western Europe, in the United States, in Eastern Europe, and we also noticed that more and more companies around the world were becoming more and more levered financially, including banks that were becoming more and more undercapitalized, and so the crisis that took place did not take us by surprise at all. Frankly, we were surprised that it took so long for the crisis to hit. I would have imagined that the crisis would have happened in 2006, frankly.

The fact that we, going back 20 to 25 years or so, had paid enough attention to the big picture – credit cycles, reading carefully Grant’s Interest Rate Observer or Gary Shilling’s deflation pieces – and having paid attention to the macro helped us identify that there was a big credit bubble happening and, as

value investors, being insistent that not only must a stock be cheap, but that it also needs to be safe. The balance sheet has to be strong, and that also kept us out of trouble. So from 2008-’09, I do not think there was a lesson to be learned. Marginally speaking, over time, in terms of how do we improve the process and the judgment, I would mention two improvements.

One, for many years, we typically only calculated one core intrinsic value estimate for a company, and typically we did not do discounted cash flow (DCF). We did not try to guess what the future earnings of a company would be. We would typically rely on merger and acquisition multiples, private market value, that sort of thing, but the one thing we started doing a few years ago is we computed a worst-case intrinsic value. We make much harsher assumptions regarding revenues. We make much harsher assumptions regarding operating margins. We try to better understand what costs are fixed, what costs are variable, and when we run these worst-case scenarios, it gives us, of course, worst-case intrinsic values that can help us identify some good entry points into stocks.

Say a company has a core intrinsic value of 50, the stock’s trading at 35, the worst-case intrinsic value is 32 — the stock price is almost at that worst-case intrinsic value, and that typically creates a pretty solid floor below which the stock will not go. That’s the big improvement — to have worst-case intrinsic value

We would typically rely on merger and acquisition multiples, private market value, that sort of thing, but the one thing we started doing a few years ago is we computed a worst-case intrinsic value. We make much harsher assumptions regarding revenues. We make much harsher assumptions regarding operating margins.

estimates because it forces our analysts, even more so than we had ever done in the past, to worry about what can go wrong. We always have done it, but this takes that worry to another level and also you quantify it.

The second improvement, if I may say, is that a long time ago — 10, 15, 20 years ago — we had a strong bias towards quality within the value camp, away from the guys who like to dabble in cigar butts and mediocre businesses. We were willing to pay up for quality, the way Warren Buffett learned to do at one point. Today, in a very difficult economic environment worldwide with, at best, very modest economic growth and low returns going forward, I think we are trying to pay even more attention to the qualitative aspects of the business and not relying on the rearview mirror. More than ever, we try to ask ourselves more and more questions such as: are these high margins sustainable? What will Microsoft look like 10 years from now? In a

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low-return, low economic growth world, quality deserves to be at a premium to lower quality stocks, and we need to focus even more than ever on the qualitative aspects of the businesses.

MOI: I think you mentioned some books, but what resources in general have you found helpful to become a better investor? You mentioned the bias toward quality and quality businesses, quality management teams who have perhaps some of the businessmen that one should study to learn about how to operate a business, how to allocate capital effectively — anything you can share with us in terms of books or resources or people that we should study?

de Vaulx: Besides the classics, Ben Graham, of course, Berkshire Hathaway annual reports. One has to not only read them, but re-read them. I’m fond of Vladimir Nabokov, the writer of Lolita. He said, “a good reader is a re-reader”.

I think some of the books that are a must would be Peter Bernstein’s book about risk, Against the Gods: The Remarkable Story of Risk.

I believe that awareness of history, in particular, economic history, financial history, history of how technological improvements and technological breakthroughs have impacted the world, and history of geography — are important, so I think some history books are a must. Financial history, there’s a wonderful historian who passed away a year or two ago, Charles Kindleberger, who many people

There is a great book by David Kynaston called City of London. It goes back 300 or 400 hundred years and basically walks through the financial history of the world through what happened in the city of London.

know. One of his most famous books is Manias, Panics and Crashes, but he also wrote more in-depth books. One is called, The Financial History of Western Europe, and there are other books that are a compilation of many of his essays, and I think these are very valuable.

There is a great book by David Kynaston called City of London. It goes back 300 or 400 hundred years and basically walks through the financial history of the world through what happened in the city of London.

Some reading that delves into behavioral finance and psychology can be very interesting. Daniel Kahneman’s books should be read along with Poor Charlie’s Almanack, which has transcripts of many of the speeches that Charlie Munger has made over the years.

Otherwise, for anyone who begins as an investor, I would recommend books by John Train. Some 20 or 30 years ago he wrote, The Money Masters, where you have a chapter on Ben Graham, one on Philip Fisher, one on Warren Buffett and so forth ,and then ten years later John Train wrote,

The New Money Masters, with Peter Lynch, Mario Gabelli, and so forth. The advantage of those books is that you have one chapter on one money manager, and that book helps the reader understand that there are many ways, many recipes to invest money, and each of these ways has its own internal logic and own set of rules. If someone who starts as an investor reads the book, he or she will appreciate that there are many ways to do it, many ways to cook, and he or she will probably be able to, based on his or her temperament, identify and find some affinity with one of those investment styles, whether it’s George Soros or Paul Tudor Jones or Ben Graham with the cigar butts, or Philip Fisher. I think The Money Masters and The New Money Masters are great books to read to begin in our business.

MOI: On that note, Charles, thank you for your time and all the insights.

de Vaulx: I really enjoyed it.

The Manual of Ideas is indebted to Christopher Swasbrook, Managing Director of Elevation Capital Management, for making this conversation possible.

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Pat is President of Sanibel Captiva Investment Advisers, where he leads the investment team and helps guide capital allocation. Pat was previously Director of Equity Research at Morningstar for over ten years, where he was responsible for the direction of Morningstar’s equity research effort. He led the development of Morningstar’s economic moat ratings as well as the methodology behind Morningstar’s framework for competitive analysis. Pat is the author of The Five Rules for Successful Stock Investing and The Little Book that Builds Wealth.

The Manual of Ideas: Please tell us about your background and how you became interested in the topic of moats.

Pat Dorsey: I was director of equity research at Morningstar for about 10 years. I basically built the equity research team and process there, starting with about 10 analysts and building it to about 100 analysts when I left. I formed the intellectual framework that we use to evaluate companies. A big part of that is a focus on a competitive advantage, or an economic moat. I became interested in the topic because some companies essentially defy economic gravity and manage to maintain high returns on capital despite competition.

It’s a fascinating topic because economic theory suggests that all companies should just revert to

Exclusive Interview

with Pat Dorsey

It’s a fascinating topic because economic theory suggests that all companies should just revert to mean over time. Competition shows up, capital seeks excess profits, and you drive returns down. But, both empirically and intuitively, we all know that’s not the case.

mean over time. Competition shows up, capital seeks excess profits, and you drive returns down. But, both empirically and intuitively, we all know that’s not the case. We can all name a dozen companies off the tops of our heads who have basically defied the odds and maintained high returns on capital for decades at a stretch. What frustrated me when I got into the topic is that most of the literature on competitive advantage is written from a strategy standpoint. Most of your readers are familiar with Michael Porter’s Five Forces model, which is very useful and a great starting point, but it’s always from the perspective of a manager of a business. In other words, I manage a company or a unit of a company, and what can I do to make that piece of that company better? So, it’s all about maximizing the assets that you have.

As investors, we have a different challenge. We’re not stuck with a set of assets of which we need to maximize the value; we can choose from thousands of different sets of assets called companies. So we need more objective characteristics by which we can assess the quality of competitive advantage and then make some judgments about whether a company is likely to have high returns on capital in the future or not.

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Exclusive Interview with Pat Dorsey

The smartest manager in the world will not make an airline have the economics of a software company or an asset manager; it’s physically impossible.

MOI: Let’s start from the beginning. Can you define what you mean by moat?

Dorsey: When you think of an economic moat—and let’s be clear I stole the term from Warren Buffett; he’s the one who coined it. If you’re going to steal, steal from the smartest guy around—a moat is structural and sustainable. I think those are the two key things for investors to think about. It’s structural in that it’s inherent to the business. The Tiffany brand is inherent to Tiffany [TIF]; you can’t imagine Tiffany without it. The switching costs of an Oracle [ORCL] database are inherent to the way databases are used in business. Contrast that with a hot product or a piece of a hot technology that may come or go.

Moats are also sustainable. They are likely to be there in the future. As investors, we are buying the future. Look at the investments we make today. How they turn out will depend largely on what happens three years from now, five years from now, or ten years from now. So, we need to think about sustainability of a competitive advantage. A company with a very hot product and a cool brand right

now may have very high returns on capital, but the sustainability is in question. Whereas you can look at a railroad or a pipeline that would not have as high returns on capital as an Abercrombie & Fitch [ANF], but it’s very sustainable because you can predict the likelihood of that competitive advantage sticking around for many years, and that makes the investment process easier.

MOI: So it sounds like, almost by definition, good management would not qualify as a moat. Is that right?

Dorsey: Not by itself. There’s a wonderful quote from Buffett on this: “When management with the reputation for brilliance meets a company with a reputation for bad economics, it’s the reputation of the company that remains intact.” But there’s another one that I think people are less familiar with that “Good jockeys will do well on good horses, but not on broken down nags.” That’s how investors should think about competitive advantage. The smartest manager in the world will not make an airline have the economics of a software company or an asset manager; it’s physically impossible.

Smart management is a wonderful thing to have; I’d rather have smart people running my companies than dumb people. Smart managers can build moats; they can enhance moats; they can destroy moats, but they are not moats themselves because management comes and goes. Corporate CEO turnover is higher today that it has been in the past. Getting back to this idea of buying the future, the economics of businesses change slowly. Airlines don’t suddenly overnight become wonderful businesses. Software companies don’t overnight become bad businesses, whereas managers can come and go. It’s hard to make a confident bet, in most cases, absent high managerial ownership or a family position, that the guy who’s in charge today will be there five years from now.

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CoStar Group, which is basically the FactSet or Bloomberg of commercial real estate. If you’re C.B. Richard Ellis, you can’t live without CoStar’s data. What they did is they scaled very quickly because they realized that if they could stitch together a lot of very fragmented databases of commercial real estate information from different parts of the U.S. and different parts of the world, that would give them an advantage over the competition…

MOI: What about people in general in an organization? A lot of companies say, “Our biggest advantage is our people,” and there are, in fact, a lot of businesses where that’s the case, where the assets essentially walk out the door at night and walk in in the morning. Can that be described as a moat, or do you feel that those people will find ways to extract the economics for themselves if they are, in fact, the asset of the company?

Dorsey: That’s a fascinating question. You see the people extracting the rents when they are unique. So this is why, for example, in the entertainment industry, usually it is the producer, the director, or the actor who extracts the economic rents, not the minority shareholder of a movie studio. That’s typically the case because there’s only one Tom Cruise; there’s only one Ridley Scott. So they will extract all the economic rents they can.

But then if you look at Southwest [LUV], for example, which arguably did create a corporate culture that, for a time, gave it something of an edge over the competition. Those individuals did not extract excess economic rents from Southwest, and I think it’s reasonable to say that was a factor in Southwest’s success. Was it a more important factor than Southwest being one of the first airlines to do point-to-point, fast-turn, single-model aircraft, and all the other issues and attributes people are familiar with? I think it’s hard to say; the two go together. I would say that corporate culture

as an economic moat is very fuzzy, and unless you’re prepared to get to know a company incredibly deeply, it can be hard to qualify as a competitive advantage.

MOI: You mentioned that moats are structural, and it almost seems like they’ve been there forever. How do moats actually come into being? How are they born at a company?

Dorsey: You can build moats over time. We’re not talking only about businesses that have been around for 50 years, like a Coca-Cola [KO] or Procter & Gamble [PG]. It’s important for the management of the company to be thinking about how it builds competitive advantage. One example might be, in addition to selling a product, you sell a service relationship along with the product. Look at the way jet aircraft engines are sold today. Rolls-Royce will often price engines by hours used, so you’re really buying a service more than you are buying a big chunk of metal you stick underneath an airplane. That increases the switching costs tremendously.

You’re seeing a lot of manufacturers of mission-critical equipment, start to realize that if they sell a service relationship along with the product, they can really increase customer loyalty and thus increase customer switching costs down the road. If a company moves from just selling a thing — and things can be swapped out — to selling a relationship or service, it’s a stickier proposition. That’s what you would do if your goal is to create a network effect.

A good example here might be CoStar Group [CSGP], which is basically the FactSet [FDS] or Bloomberg of commercial real estate. If you’re C.B. Richard Ellis [CBG], you can’t live without CoStar’s data. What they did is they scaled very quickly because they realized that if they could stitch together a lot of very fragmented databases of commercial real estate information from different parts of the U.S. and different parts of the world, that would give them an advantage over the competition because they would benefit from a network effect, where the more users they have, the more data they have and so forth. For them, the key was scale. You wanted them to get big fast. That’s not always what you want from a company, but given the moat they were trying to build, it made sense for them.

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…for Wal-Mart, simply buying more stuff isn’t what gives them the lower costs so much as it is efficiently moving that stuff around.

MOI: In your book The Five Rules for Successful Stock Investing you also talk about moats. You state that companies generally build sustainable competitive advantage through either product differentiation, real or perceived, driving costs down, locking in customers with high switching costs, or locking out competitors through high barriers to entry. Can you tell us what type of moat you prefer, and which are generally more sustainable?

Dorsey: I’m not sure one is better than another. I get this question a lot, and I thought about it quite a bit. I would say that there are weak and strong brands. There are weak and strong switching costs. There are cost advantages that are very durable and some that are a little bit more ephemeral. I’m not sure that I would regard one type of moat as stronger than another, with the possible exception of a network effect, which you see in financial exchanges, credit card processors like Visa [V] and MasterCard [MA], and businesses that tend to get more powerful the more users they have because the way a potential competitorers they have, the more would need to try to articulate their economic profits is essentially by creating a similarly sized network, and that can be a very difficult thing to do. Generally speaking, if you can identify a true network effect and it’s a business that is reasonably priced and has a lot of room for reinvestment of capital at high marginal returns on capital, you’ve probably found a business that’s going to have high returns for some

time to come. But that would be the exception more so than anything else.

MOI: Would you consider businesses that are, in a sense, natural monopolies or essentially have this virtuous cycle of volume and price like a Wal-Mart [WMT], related to the network concept because the more customers they have the cheaper they can sell things. Is that a good moat? Is that sustainable?

Dorsey: It’s interesting to characterize Wal-Mart as benefiting from a network effect, and I would say that for Wal-Mart simply buying more stuff isn’t what gives them the lower costs so much as it is efficiently moving that stuff around. If I had to think about Wal-Mart and think of it just as pure volume versus efficient use of capital, in other words, the hyper-efficient distribution system driving down working capital as much as possible, I would say the latter is more important than sheer size.

If you think about it, we use Visa or MasterCard because lots of other people do, and that’s why it’s accepted at lots of merchants. We trade securities on a particular exchange because we get a tight spread and a deep level of volume, and we get that benefit because of the people who are there, too. We don’t care that lots of people shop at Wal-Mart; we just want the lowest price. Wal-Mart happens to get that low price by being very, very efficient, but the simple fact that you can frequently see is that there are people who can undercut

Wal-Mart. We just wind up going to Wal-Mart because they have everything in one spot. It’s an interesting question, but I would say that, generally speaking, I don’t think that the network effect is always driving down costs because usually it’s what you do with that buying power that tends to matter more than simply having to share buying power.

MOI: We also posed this question of moats to some of our members, and Josh Tarasoff of Greenlea Lane Capital wrote that his least favorite moat is customer captivity because it tends to be kind of static and it doesn’t really imply progress for a business and may actually make it harder to win new customers if they know they’re going to become captive for a long time. It also seems to me that if that’s your moat, you may not have a very happy customer base; you just may kind of have them by the guts and they can’t get away, but the minute they see an alternative they might jump at it because they’re not very happy. They’re just there because they’re captive.

Dorsey: I don’t know about that. It’s true that you see very strong switching costs. You often see that in more mature areas. So, you think

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Look at the elevator companies, whether it’s Otis, Schindler or Kone — once it’s in the building you typically don’t rip it out and put another one in — they’ve experienced pretty reasonable levels of growth as you’ve seen the urbanization of China and other areas of the world.

of a Jack Henry [JKHY], which does back office processing for banks, usually smaller ones. The customer retention rate is in the high 90s. Of course, the number of banks isn’t growing a lot year to year, so they’re not losing anybody but not gaining anybody either. Oracle is a pretty similar business. Oracle doesn’t lose much market share, but databases are a very mature business; it doesn’t grow a lot from year to year. Oracle mainly grows the core database business by raising the price a little bit from year to year.

There is probably a decent correlation between the strength of a switching cost and the maturity of a market; I think that’s a reasonable thing to say. But just because a market isn’t mature doesn’t mean that the business isn’t a quality business and can’t be mispriced. If it’s being valued as a declining business, for example, look at the elevator companies, whether it’s Otis [owned by United Technologies, UTX], Schindler [Frankfurt: SHR] or Kone [Helsinki: KNEBV], despite the very high switching costs of an elevator or escalator — once it’s in the building you typically don’t rip it out and put another one in — they’ve experienced pretty reasonable levels of growth as you’ve seen the urbanization of China and other areas of the world. I guess I wouldn’t say that it’s my least favorite kind of moat. You do tend to see it more often in mature businesses, so you have to be a little more careful of what you pay for those, obviously. I think being able to raise prices every year on

your customers is a pretty good thing. The key there is to not abuse it.

you’re delivering versus the cost to the client, you can keep that going for quite a while without really making the customer want to go somewhere else.

MOI: When you talk about a business that has a moat through network effects, those network effects directly make the customer experience better. There’s just more value to each customer from the network. With something like customer captivity, it seems to have the connotation that if the customer could decide every day to make a blank-slate decision where it would want to take its business and there would be no switching cost, it might actually go to a competitor because they might have a better product or a better price. Even if a competing offering is better, the customer captivity makes a customer stay there and there’s that gap…

Dorsey: Exactly. You could call up a bunch of the smartest engineers you know and create “The Manual of Ideas Database.” Maybe it’s 15% faster and 20% cheaper than anything Oracle has on the market, and you walk over to Procter & Gamble or Amazon.com and say, “I think you should buy my new MOI database; it’s really cool.” They’re going to have to invest tens of millions of dollars and how many hundreds of thousands of man-hours to rip out their current one and install yours. If you had something that was 80% faster and 80% cheaper, they might do it. There is some point at which you do switch, but it’s scientifically a pretty high one.

If you want to think about a business that really does have some of its customers by the short hairs, CoStar would be a good example. CB Richard Ellis, Jones Lang [JLL] and other big commercial real estate brokers literally can’t live without this data. Morningstar hosted the CEO of CoStar at their conference, and I remember asking how he thinks about pricing because he has a lot of pricing leverage over customers. He obviously thought about it very carefully. He said, “We’re interested in long-run profit maximization, not in angering our customer base.” I think that’s how you have to think about it if you’re a business with a product that is critical to a customer’s business where you have enormous pricing power. If you really do that in a very strong and aggressive fashion, you will invite competition, as Josh was implying—that the customers are going to want to go somewhere else. But if you balance the value

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MOI: Ideally, you have a moat and it’s sustainable for a very long time. Buffett has been great at finding businesses like that and investing for the long term. Do you think that consumer-facing businesses that essentially build up mindshare in the consumer, like a Coca-Cola, have the most sustainable moats, or do you think business-to-business companies can have similarly sustainable moats?

Dorsey: What matters less is who your end customer is, a business or consumer. It’s more about the speed of evolution of the product set. Soda doesn’t evolve; soda doesn’t change a lot from year to year. Software does. If I had to make a bet today as to who is more likely to have high returns on capital ten years from now, I’m going to bet on a soda company before a software company simply because there’s less stuff that’s likely to change over the next decade, so that’s what’s important. It’s more about, what is the product and not about who is the end customer.

The thing with brands is they take constant care and feeding. Brands don’t just run themselves. Management teams can try to destroy brands. Do you remember Schlitz? Schlitz was number one or number two in market share in the U.S. beer market from the mid-50s to the early 70s. It was number one or two for each year. What did they do? They changed their recipe. Well, that’s not smart. You have the number one beer and you change the recipe. You can’t tell what stupid management teams

are going to do. Remember New Coke? My point is that these things don’t run on autopilot; they require constant care and feeding. You can look at some consumer product categories. Would you imagine ten years ago that there would be private-label beer? Kirkland. Costco [COST] sells private-label beer, and it’s not bad. It’s not great, but it’s not bad. That’s an area where I think it’s hard to say it’s not all about whether it’s consumer or business. If you had asked me ten years ago what product categories would be least susceptible to private-label competition, I probably would have put alcoholic beverages and confections as number one and number two. I would have been wrong on one of them. Now I’m waiting for Kirkland-brand chocolate. That’s probably not going to happen.

That’s kind of a long answer to a very interesting question. It’s more about the speed with which a product category changes than really anything else.

What matters less is who your end customer is, a business or consumer. It’s more about the speed of evolution of the product set. Soda doesn’t evolve; soda doesn’t change a lot from year to year. Software does.

MOI: It seems that in the business-to business market the customer is pretty rational; they’re going to weigh the costs and so forth. Does it matter how rationally the customer makes his or her decision?

Dorsey: You’re right, there’s less of an emotional standpoint. But there are, sometimes, emotional reputational factors. Remember the old quote: “You don’t get fired for buying IBM.” Reputation in brands can matter in a business-to-business market as well. But the key thing to look at is — and this gets back to your initial point about mindshare — does the brand change customer behavior? Does it make the customer act differently? It can do that in one or two ways. It can either increase the customer’s willingness to pay. You pay more for Coke than you do for President’s Choice Cola. You pay more for Hershey’s [HSY] than you do for lower-end chocolate. Or does it reduce search costs? You become familiar with a product. You don’t want to compare prices all the time on a stick of gum; so you just buy Wrigley [owned by privately held Mars]. You buy Wrigley because it’s what you want, and it’s a $0.50 pack of gum. I’m not going to sit here comparing 50 cents. You’ve reduced my search costs.

But if the brand doesn’t change my behavior one of those two ways, I would argue it’s not worth a dime. Think of the Sony [SNE] brand. The Sony brand is incredibly well known. It’s one of the top 20 most valuable brands in the world, according to

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the big annual Interbrand survey. But would anyone reading this interview now pay 20% more for a Sony DVD player relative to one from Philips [PHG] or Panasonic [PC]? I doubt it. So, there you have a company with mindshare. Sony has mindshare. We’ve all heard of it; we know Sony well, but it doesn’t change our behavior. So what good is the brand?

network effect, and we can validate this by looking at initial iPod sales.

When the iPod first came on the market, remember the Zune [sold by Microsoft, MSFT] was on the market at the same time. In the first year or two of the iPod’s existence, that was before iTunes, and the iPod sold reasonably well, but it wasn’t a huge hit. Then iTunes came along and suddenly you could buy songs by the drink, but only if you had an iPod. Hockey stick growth. If you’re a music publisher, why do you want to be on iTunes? Because you have all those people with iPods out there. Why, as a user, do you want to buy an iPod? Because it’s the only thing I can use to buy songs one by one legally — this is before they shut down Napster — it’s a network effect for Apple.

The Sony brand is incredibly well known. It’s one of the top 20 most valuable brands in the world, according to Interbrand. But would anyone reading this pay 20% more for a Sony DVD player relative to one from Philips or Panasonic?

It’s not the [Apple] brand; it’s the network effect. Pure and simple. I get this question all the time. People think that Apple buyers are all just about the brand and looking cool and having the little white threads dangling out their ears. It’s the network effect.

increases the difficulty I would have of switching from my iPhone to an Android, anything they can do to make that path dependence stronger — that once I have an iPhone, I want the next generation and next generation. That’s what strengthens their moat more than anything else.

MOI: Could you tell us a few examples of companies that you consider have strong durable moats? Perhaps some names that are not as well-known as maybe some of the Berkshire Hathaway [BRK] holdings.

Dorsey: I always want to try to go off the beaten path when I can. It’s not the easiest thing. What’s cheap now and what’s been cheap for a while has been the big stuff, so that’s what I’ve been focusing on. Do these need to be well-priced right now or just have good moats?

MOI: Let’s just have good moats for now.

Dorsey: Good, because the smaller stuff tends to get more expensive. CoStar, which I mentioned before, has data on property and tenants for commercial real estate users. Commercial real estate is much more differentiated than residential real estate because each office building is unique. Having a rich set of data gives them an enormous advantage. They have about 90% client retention and usually inflationary price increases. To replicate this database you would basically need to spend everything that CoStar has been acquiring over the past eight years, and even then

MOI: If we flip that around and let’s take Apple [AAPL], which is doing phenomenally well right now…

Dorsey: It’s not the brand; it’s the network effect. Pure and simple. I get this question all the time. People think that Apple buyers are all just about the brand and looking cool and having the little white threads dangling out their ears. It’s the network effect. The iPhone does have a wonderful user interface and lots of good features, but it also has tens of thousands of apps. Why does it have tens of thousands of apps? Because developers want to write for the platform with the most users, and the users want to buy the phone with the most apps. It’s a beautiful

When I look at Apple and when I think about Apple as a business — and it’s in the portfolio — I’m far less concerned about nice advertising or cool design than I am about anything that increases the switching costs, anything that

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MSCI indexes is a pure index licensing business model that’s just gorgeous because every time a Brazil ETF launches, they need to license MSCIs. They also have a business called Barra that is basically the gold standard for risk management software for asset managers.

you would have a hard time doing it because typically what they’ve done is bought the best regional commercial property databases, and so there isn’t another one out there. So you would need to replicate this from scratch, which would be very difficult. So that’s a very interesting little business that I don’t think people know as well.

What would be another really interesting one? Express Scripts [ESRX] or MSCI [MSCI]. The latter is in the financial business. It spun off from Morgan Stanley a while back. They own the MSCI indexes, which is a pure index licensing business model that’s just gorgeous because every time a Brazil ETF launches, they need to license MSCIs. That generates them a fairly small but essentially no-cost revenue stream, and that’s just an unbelievably beautiful business. They also have a business called Barra that is basically the gold standard for risk management software for asset managers. An asset manager will often get asked “What’s your Barra risk?” or ”Show me your Barra printout.” And even if they don’t believe in Barra and even if they don’t think Barra’s philosophy of assessing risk based on volatility is worth a hoot, it doesn’t matter because the consultant is going to want to see it, so you’re going to have to have it. So, they have about an 85% renewal rate, which is pretty good. That’s a wonderful little business.

MOI: Do Moody’s [MCO] and S&P Ratings [owned by McGraw-Hill, MHP] have a moat?

Dorsey: Their returns on capital and margins certainly suggest that they do. You don’t have to love them. Last quarter, Moody’s operating margins are still running in the high 30s. That’s down from the mid-50s, but it’s not chopped liver by any stretch. I wouldn’t mind having those kinds of margins. I would say they do. At the end of the day, the nature of the bond rating market lends itself to a natural oligopoly. Sean Egan at Egan-Jones has had some wonderful calls. He’s a controversial guy, but they’ve done good work. They really haven’t gained much market share at all.

It’s a business that is not particularly cheap right now, and I think it’s pretty hard to figure out what the growth rate looks like going forward. I think the hard thing with Moody’s is not figuring out whether they still have good margins five years from now, but figuring out, how big is the business. That’s the hard thing. In terms of is it a natural oligopoly

and will it retain its high returns on capital, I don’t think there’s much question of that. I think a much harder thing is figuring out what the size of that business is and then how you price that cash flow stream. I can’t do that, which is why I don’t own it.

MOI: Do you think American Express [AXP] or Visa/MasterCard have a wider moat? What I’m alluding to is the closed-loop model of American Express versus the more open model of Visa and MasterCard.

Dorsey: It’s close, but they’re also different businesses. AmEx is lending money, whereas Visa and MasterCard are not. I think it’s an important distinction to make because you saw that in the run-up to the credit crunch, AmEx had some serious underwriting mistakes. Some of their underwriting metrics were based on home prices, and that came back to bite them. The nice thing about credit cards, unlike mortgages, is that the problem loans run off pretty quickly; they reprice pretty fast. So, it didn’t kill it because it was a well-capitalized business, but you saw that sub-optimal underwriting really did damage to them. Visa and MasterCard are not lending money to anybody, so it’s a much less risky business in that sense. I think that the scope for management to mismanage those businesses is a lot lower than AmEx. AmEx has learned from its mistakes; certainly it’s gotten better at the underwriting.

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The hard thing with MasterCard and Visa right now is that you are seeing some chance of technological disruption with the emergence of PayPal [owned by eBay, EBAY] and other mobile platforms. How likely are they to really hurt things is hard to say, but you have more risk of disruption than you would with a Coca-Cola or Budweiser [owned by Anheuser-Busch InBev, BUD].

The other difficulty they’re facing is that you’re seeing a bit of a price war emerging where they are engaging in these rewards programs, and it’s almost like, who can give the most rewards out, and that’s how consumers are starting to choose what card they use. That’s probably, in the long run, not a great thing for the business. I don’t think they’re losing sleep over it, but I don’t think it’s a great thing in the long run.

MOI: What do you think of major pharma? Those businesses have high returns and have always had high returns, but it seems that if you have a blockbuster drug, it’s all about when the patent expires. Do you feel that those really big pharma companies have sustainable competitive advantage?

Dorsey: Yes. Again, it’s a little bit like Moody’s. The margins are there; it’s the growth that’s hard. I think big pharma was very slow to realize that the business model had changed. Two decades ago, even one decade ago, it was all about bringing out big blockbuster drugs that treated chronic conditions: high blood pressure, depression with Lexapro, and drugs like

that. These are drugs where it’s a chronic condition and so you need to get it out to lots and lots of potential patients at a relatively low marketing cost. So, what do you need? You need an army of salespeople. So that was a business model 15-20 years ago.

Then, as we got what you would call “good enough” products for treating high blood pressure, cholesterol, depression, and those went generic, the opportunity to improve upon the prior drug is very small, so you would see the business model shift to higher-priced drugs, especially in oncology. They’re higher priced drugs, but you need to market to a much more specialized set of doctors. So you don’t need tons and tons of salespeople; you need a smaller number of very highly-trained salespeople. That business model shift took some time, and it was only really a couple of years ago after one of the two big pharma mergers that you started to see sales forces really come down. There were big cuts in sales forces, and I think that was an important moment because it meant that big pharma was sort of realizing that the world had changed a bit.

I think of big pharma almost as a distribution platform more than anything else. Part of their value is, to some extent, those giant R&D labs, but so much of the innovation is happening in large molecule drugs and in biologics right now. You hear the big pharma companies buying the more innovative smaller businesses and that the value a big pharma

company generates is in having this massive distribution platform, trusted relationships with tens of thousands of practitioners around the globe, and that’s going to be very hard to replicate, much more so than having a new innovative molecule.

…the value a big pharma company generates is in having this massive distribution platform, trusted relationships with tens of thousands of practitioners around the globe, and that’s going to be very hard to replicate, much more so than having a new innovative molecule.

MOI: Buffett talks about how he wants Berkshire subsidiaries to essentially just think about how they can widen the moat every day. What would be your advice to companies and CEOs on what they can do to widen the moat of their companies?

Dorsey: I think it really depends on what kind of moat you’re trying to build. If I had to think about a few themes, one would be that you tend to see commoditization is correlated with management impact. If you’re the manager of a retailer, an insurance company, a commodity company, a miner, or a bank, you can have a huge impact on whether your business is great or good. If you’re managing a business that already has a wide

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…think about Amazon.com’s laser focus on the customer experience. That drives everything they do; it’s how can they make the customer experience better. That really is what created their moat…

moat, you’re more of a caretaker. Your job is to not screw up. Your job is not to roll out New Coke. Your job is to keep the business going the way it is. But waking up every morning — this goes back to what have you done to widen the moat — whatever your moat is should constantly inform every business decision that you make.

We began this conversation with Wal-Mart. Think about five to seven years ago when Wal-Mart started to try and compete with Target [TGT] in fashion. Did it work? Not really because you don’t go to Wal-Mart for hot clothes; you go there for cheap club prices. They got off-strategy; they forgot the reason why their customers shopped there, and then they kind of retooled and that laser focus on low prices is what matters to them.

Think about LVMH [Paris: MC] and their focus on exclusivity. They’ll actually destroy unsold bags. They’ll take a $2,000 bag and just shred it to keep that scarcity out there.

Or my favorite example — because it’s one that I got wrong — think about Amazon.com’s [AMZN] laser focus on the customer experience. That drives everything they do; it’s how can they make the customer experience better. That really is what created their moat and wasn’t anything else, because Jeff Bezos realized early on that online shopping is different than offline shopping. With offline there’s no trust involved. If I walk into a store, I hand somebody cash and they had me a product. Our relationship is finished; there’s no trust.

But online I have to trust you’ll send me the right product; I have to trust you won’t steal my credit card; I have to trust you send it to me in the time you say you’re going to send it to me. There’s a lot of trust there, so brand matters more online. I think Bezos figured it out very early on. Everything Amazon does is about making the customer experience better, and that’s why people use it. I’ve probably given 50 talks on moats around the world, and I always ask the audience how many people have bought something off Amazon without checking the price anywhere else. Usually over three-quarters of hands go up, which is an amazing statement when you think about the ease of checking the price somewhere else. So focus matters, not diversifying.

uniform rental to fire safety and document management. Stupid. Cisco [CSCO] moving into set-top boxes and buying the Flip. Stupid. Garmin [GRMN], the GPS company, trying to expand into handsets and competing with Nokia [NOK] and Samsung [Korea: 005930]. Stupid.

In all three of those cases, the company would have been far better off just sticking with what it did best and then taking whatever capital it couldn’t reinvest in the core business and returning it to shareholders. But, of course, because CEOs of bigger companies get paid more than CEOs of smaller companies, the institutional imperative for growth is always there and always a risk to a minority shareholder.

MOI: Is there anything that we haven’t touched on that you like to mention in your talks and maybe highlight here?

Dorsey: When people are thinking about how to value a moat, and when a moat is really valuable and when it is less valuable, the key to think about is the length of the runway. What are the reinvestment opportunities that a company has? So Visa or MasterCard or a Chicago Mercantile Exchange [CME] or a C.H. Robinson [CHRW] or Expeditors [EXPD], these are all companies that are in growing markets or in mature markets with very small market shares. There’s a lot of opportunity to reinvest capital at a high incremental rate of return, and that moat and that ability to reinvest for ten years before someone really wanted to

You frequently see CEOs have a good but slower-growing business that has a great moat and high returns on capital, and then they say, “My gosh, we still have to grow.” Then they take the capital and they basically set it on fire, investing in a business where they have no competitive advantage, like when Cintas [CTAS] moved from

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steal your competitive lunch are incredibly valuable.

Contrast that with a Microsoft [MSFT] or a McCormick [MKC], both of which have very strong moats, but the volume of Windows isn’t going up much year to year; the volume of spice consumption in the U.S. is not increasing much year to year. McCormick’s moat doesn’t really add a lot of economic value; it adds stability and predictability, but it’s not worth paying a ton of money for because it doesn’t allow the company to grow all that much. Whereas the moat for a business that has reinvestment opportunities is very, very valuable. That’s often how I think about the “when do I want to pay up for a moat” question, is whether that moat is actually going to allow the company to reinvest a lot of capital at a high rate of return, or does it just add stability and predictability.

MOI: Do a few companies come to mind that fit the bill of having a wide moat and ability to reinvest a lot of capital.

Dorsey: I think Fastenal [FAST] still has that characteristic. They still have a single-digit market share and maybe even a double-digit, but they certainly have plenty of runway ahead of them. Both Expeditors and C.H. Robinson, which are in different parts of the freight forwarding market, have plenty of runway ahead of them right now. I think Visa and MasterCard have that attribute.

Although their market shares are unlikely to grow, the evolution of payment from paper or check to plastic is not as far advanced as you might think. So they have a nice secular tailwind behind them, even if they don’t wind up gaining much market share from one another. So those would be a few examples. There are plenty of other ones, but those would be the ones that come immediately to mind.

MOI: Pat, thank you very much for sharing your insights with our members.

Fastenal still has single-digit market share and maybe even double-digit, but they certainly have plenty of runway ahead of them. Both Expeditors and C.H. Robinson, which are in different parts of the freight forwarding market, have plenty of runway ahead of them right now. I think Visa and MasterCard have that attribute.

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In this timeless interview from March 2009, Thomas S. Gayner, Chief Investment Officer of Markel Corporation, provides some much-needed perspective and investment wisdom.

The Manual of Ideas: You have stated that the businesses you seek should have (1) a demonstrated record of profitability and good returns on total capital, (2) high measures of talent and integrity in management, (3) favorable reinvestment dynamics over time, and (4) a purchase price that is fair or better. Perfection, however, is rarely attainable in the stock market. Have you had to compromise on these criteria, and if so, could you illuminate for us how you decide on acceptable versus unacceptable trade-offs?

Tom Gayner: While you say that perfection is rarely obtainable in the stock market, I would go so far as to say that it is never obtainable in the stock market. Perfection doesn’t exist in this world. All of my choices involve various degrees of compromise and tradeoffs. As an accountant, I can tell you that my wife and children are sick of hearing

me use the phrase “opportunity cost”. Every decision is also another decision (at least) and every non-decision is also a series of other decisions.

The challenge is to get the balance roughly right between the choices that actually exist. All of the four points I lay out are north stars that guide me. I admit though, that I have never personally been to the North Pole.

The one area where I will not compromise is in the area of integrity. I may not make every judgment correctly when I’m trying to make sure I’m dealing with people of integrity but I will never knowingly entrust money to people when I am concerned about their integrity. Even if you get everything else right, the integrity factor can kill you. My father used to tell me that, “you can’t do a good deal with a bad person.” And he was right.

The other factors can be thought of as shades of gray and nuances. We look for as much of the good as we can find and weigh that against what we have to pay for it, our expectation of how durable the business will be, and what our other alternatives are. I don’t have a formula or algorithm to get that precisely right, I just spend all my time thinking, reading, and adapting as best as I can.

My father used to tell methat, ‘you can’t do a gooddeal with a bad person.’ Andhe was right.

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Exclusive Interview with Tom Gayner

MOI: How does your approach to international investing differ from that to investing in U.S. equities?

Gayner: I don’t think international investing is as different as it used to be. I believe that the world in general is becoming a smaller place. Given the advances in technology and communication, everything is starting to correlate with everything else. I think that growth rates, economic development, and rates of return on investment are all tending to head in the same direction. Capital has a universal passport and it heads to wherever it needs to go to earn the best returns possible.

Companies, especially the larger global companies where we tend to make most of our investments are doing business all around the world. All of these things tend to make nationality and borders slightly less relevant than what was previously the case.

One question I usually ask people when they ask me about our global investment approach is to mention two companies to them. I say that both companies make engines and move things from one place to another. One of them is Caterpillar and one of them is Honda. Which

one is the international company and which one is the domestic firm? Depending on my mood, I give the person either an A or F on that exam. While Caterpillar is headquartered in Peoria Illinois, it does more of its business outside the U.S. than inside. While Honda is headquartered in Japan, I believe the U.S. is still its largest market. Your brokerage statements or pie chart presentations will probably show CAT as a U.S. company and Honda as an International company. I think that is a superficial difference and not a good guide to know if you are investing internationally or not.

Both of those are global companies and doing business all around the world. In my mind it is a distinction without a difference to describe one as a U.S. company and the other as an international firm.

That same sort of look through to where the company does business applies to a lot of the companies we invest in. Even though Markel is a relatively small company in the grand scheme of things, over a third of our business comes from outside the U.S. these days. That is just business written outside the borders of the U.S. Digging deeper,

I think you would find that a lot of our U.S. written business relates to companies doing meaningful foreign sales and a lot of our internationally written business relates to activities that circle back to the U.S. The world is increasingly interconnected and I just try to make sure we are investing in the best business possible at the appropriate price.

MOI: You emphasize the impact of the passage of time on your investments. With the trend toward compression of time horizons and a focus on short-term performance in the investment industry, we are seeing many investors—even those who consider themselves value investors—emphasizing near-term stock price catalysts. Do you see a growing inefficiency in the pricing of “boring” investments that will deliver returns over time versus investments that are expected to pay off at a foreseeable point in time?

Gayner: Yes. To expand on that one word answer, I think there is a real time arbitrage opening up right now. An old saying is that in a bull market, your time horizons grow longer and longer. In a bear market, they grow shorter and shorter.

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If a bad person is going to try and steal some money, they will logically want to steal as much as possible. Typically, that means they will have as much debt on the books as possible in addition to equity in order to increase the size of the haul.

The bear market experience of the last few years compresses time horizons for a lot of people. Even if they want to remain focused on the long term, there are inevitable career risks in not putting results on the books today when people are so anxious about every aspect of their lives.

I think that means the playing field for longer term investing is getting less crowded. Fewer people are able to think about the long term and I believe that creates an opportunity to buy wonderful, long duration investments, at better prices than has been the case in the last decade or so.

…the playing field for longer term investing is getting less crowded. Fewer people are able to think about the long term and I believe that creates an opportunity…

MOI: What is the one mistake that keeps investors from reaching their goals?

Gayner: I’ve made so many mistakes over the years that I struggle to isolate just one as the biggest single mistake. Among the choices though I think excessive leverage has been the most personally painful. I did not fully appreciate the degree of leverage that existed in so many aspects of so many businesses and how painful the unwinding of that leverage would prove to be.

Leverage also can be a good guide on the integrity factor that I mentioned earlier. One of the great investors I’ve tried to learn from is Shelby Davis. Shelby said that you almost never come across frauds at companies with little or no debt. If you think about it, that statement makes perfect sense. If a bad person is going to try and steal some money, they will logically want to steal as much as possible. Typically, that means they will have as much debt on the books as possible in addition to equity in order to increase the size of the haul. Staying away from excessive leverage cures a lot of ills.

Another huge mistake that I think people in general make is to mislabel risks. Specifically, people seem to think about risks in nominal rather than real terms. To have a lot of cash or government bonds has been a comforting thing in the past few years, but I think it is a mistake to think that means you are not taking risks. You are, it’s just that you are taking real risks as opposed to nominal ones. The purchasing power of the currency continues to decline. It is a huge mistake not to take that into account.

The other types of mistakes are well known and probably not too valuable to rehash. Chasing performance, thinking you can really effectively trade in and out of the market, using volatility as a precise quantitative measurement of risks etc… are all potential mistakes that investors tend to make.

To circle back to your original question about what is the single biggest risk, I would try to summarize all of these things as examples of not thinking. You can never put things on autopilot in this world. You must be constantly and continuously engaged with what is happening in business, technology, marketplaces, governments, social trends, demographics, science and absolutely everything you can possibly process in order to be as good a thinker as possible. When you go to sleep each night, be prepared to get up in the morning and do it all again for as long as you are responsible for taking care of people’s money. There are no days off.

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Agents in general became too powerful recently and abused their stewardship responsibilities to their principals.

MOI: The rationale for institutions acting as conduits of capital has been that the average investor cannot possibly know as much as a professional devoted to researching companies on a full-time basis. However, as David Swensen and Warren Buffett have observed, investment funds of all stripes have failed investors on an after-fee, after-tax basis. Has our system of investment by agents rather than by principals destroyed value for the ultimate owners of American equity capital, and if so, is there any remedy?

Gayner: One risk I worry about in this interview is oversimplifying things. I run that risk again in trying to answer this question. I think that principal/agency conflicts describe a lot of what we are struggling with these days. Agents in general became too powerful recently and abused their stewardship responsibilities to their principals. First off, that is an incredibly broad statement and there are countless examples of agents who are doing a great and honest job. That being said though, in general, the agents have the upper hand and they’ve abused it.

I make that statement in a broad sense and beyond just the realms of investing and business. Buffett talks about the “institutional imperative” and the behaviors that stem from that notion. One of the central management challenges for any large institution or organization is how to keep the principal/agency conflict in balance. The familiar saying of, “The inmates are running the asylum” is really just another

way of describing how agents tend to push aside the interests of the principals over time.

Over the years, I guess that problem has mostly been solved by institutions growing so big that they gradually or suddenly decline or fail. The agents lose their positions and new principals emerge to build up new institutions. It seems like we are going through one of those cycles in a big macro way right now.

theoretically, and practicing them at a bench scale level. Do that as much as possible and scale up where it makes sense to do so. If you are thinking along the way it would seem almost impossible not to learn at the same time.

In my case, the academic training of accounting and the gradual increase in responsibilities in business and investing have all constantly worked together to help me understand, manage, and act. Over the last two years I’ve told people, “Every day seems like a dog year.” I can’t help but think that a lot of us are learning tremendous lessons from this period in our lives. Fortunately, with longevity increasing, being only 47 should give me a lot of years to continue to learn and apply better wisdom to my tasks.

MOI: You define a “fair” price as one that allows you to earn long-term returns in line with the returns on equity of the business in which you invest. When paying a “fair” price, the expected return therefore comes entirely from the business rather than from multiple expansion. Based on this definition, the recent market carnage has created an opportunity to pay less than a “fair” price for many great businesses. In Wall Street parlance, does this make you a bull?

Gayner: Yes. This too is a complicated question and I run the profound risk of oversimplifying again. Investing to me is the ownership of an interest in a business. Business to me is the form and organization by which

MOI: You have observed a “strong connection between managing companies and investing in them.” Unlike most investors, you have had an opportunity at Markel to be intimately involved in both managing and investing. How should investors go about building this critical skill set if they don’t have an opportunity to manage a business?

Gayner: Well, my wife did her undergraduate degree in chemistry and her master’s degree in chemical engineering. When asked about the difference between the two she talks about thinking about things theoretically, doing them on a bench scale, and then scaling them up to industrial quantities. Wherever you are and whatever you are doing you are probably at least thinking about some things

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I am bullish not just because of the valuation opportunity you describe but because of my fundamental belief that as a world we continue to make secular progress amid cyclicality.

My main worry right now is the possibility of inflation…

people creatively apply their skills and talents to solving problems or serving other people. The more a business serves others, and the more problems they solve, the more profitable they will be and the more an investor in those enterprises should make.

I believe that the path of human progress will continue forward. We are not going into a new dark age and I think comparisons with the great depression are over done. Frankly, I am bullish not just because of the valuation opportunity you describe but because of my fundamental belief that as a world we continue to make secular progress amid cyclicality.

The good news to come will surprise me just as much as the bad news did in the last few years but I believe good news will happen. The most energizing activity for me is spend time with my high school and college age children and their friends. They are not scarred by looking at their lower 401k balances. They don’t have 401k’s. They don’t talk about the market and a lot fewer of them are talking about going to Wall Street. They talk about alternative energy, biofuels, technology and other things that will propel human progress in real ways.

I would rather own a piece of their dreams and future economic prospects than a bar of gold or a government bond. Those pieces of dreams are called equities. Equities are congealed intellectual capital and that is what I want.

MOI: As equities declined precipitously in 2008, seemingly with little regard for valuation, some value-oriented investors adopted the view that it was no longer possible to invest from the “bottom up” but that survival depended on having a solid grasp of the big picture as well. Seth Klarman appeared to disagree with this view when he said that he worried from the top down but invested from the bottom up. Has your scrutiny of the macro picture changed as a result of the economic crisis of 2008 and 2009?

Gayner: Seth Klarman is smarter than me and I think he phrased it exactly right. The experiences of 2008 and 2009 exposed some things that I should have been more worried about than I was. I read a lot of financial history and studied about human nature. I’ve found it is a far different experience to live through this type of period as opposed to just reading about it and I think I will be a better investor as a consequence of having lived through this time.

My main worry right now is the possibility of inflation due to the actions of the government. Inflation is part of how the world is trying to get out from under the excess level of leverage that exists. Not

to contradict another gentleman who is smarter than I am, Milton Friedman, but inflation is not just a monetary phenomenon in my opinion. There are psychological aspects to it as well. If inflationary psychology takes hold I don’t see how you could keep long term interest rates anywhere near where they are today. If long rates go up then the price of every asset goes down. While I think intellectual capital with repricing ability is the best way to mitigate that risk it will not be fun to go through that process if inflation heats up too much. There is a “tipping point” as Malcolm Gladwell would say where a little inflation is helpful, but too much is absolutely destructive. And I mean destructive way beyond just the stock market but in terms of social fabric issues. I am constantly thinking about this dimension and trying to be a good steward of the finances at Markel in the context of this risk.

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MOI: In his 2008 letter to Berkshire Hathaway shareholders, Warren Buffett commented on the “once-unthinkable dosages” of government aid to banks and other companies. He warned that “one likely consequence is an onslaught of inflation.” How can investors protect themselves from the risk of accelerating inflation? Is buying good businesses with pricing power sufficient, or should investors try to expand their circle of competence to include companies engaged in the production of natural resources?

Gayner: I think I answered this question partially when I answered the previous question. If inflation really gets going, I don’t think anything I can do would really be enough to fully protect against that risk. I would rather own a dynamic business with pricing power than physical assets. Natural resource stocks would probably go up as that environment manifested itself but I’m not sure that those are really good businesses in the long run. Every time an oil company pumps out a barrel of oil, it needs to replace that to keep going next year. The costs of finding new supplies tend to go up just as much if not more than the sales prices. The accounting lags reality since the costs of goods sold reflect historical rather than future costs, which creates an illusory accounting profit that isn’t real in an economic sense. In fact, the misunderstanding of accounting, and agency risks often lead to uneconomic behavior on the part of many managements. As a result

of all these factors, I’m not sure that investing in natural resources accomplishes as much as you might want.

The most important real protection is to own businesses which can reprice their products faster than their costs rise. That is a lot easier to say and describe than it is to actually find.

MOI: In a 2007 interview with Morningstar you described Warren Buffett as “the leading teacher of all of us.” What is the single most important thing you have learned from Warren Buffett?

Gayner: It would be impossible to answer this question and do it justice in the context of this interview.

To list a few thoughts though, I think that remembering that investing is based on underlying businesses, constantly working to learn as much as you can about as many things as you can, telling the truth, remembering that you are a steward and that people are depending on you to do your best, and working as many hours of the day as you can stay awake covers a lot of what I think we can learn from his example.

MOI: What books have you read in recent years that have stood out as valuable additions to your “latticework of mental models”?

Gayner: There are a number of books that help you to think and teach you things you didn’t know. We all know Security Analysis and The Intelligent Investor and they have stood the test of time.

I think Mark Twain is a great writer and his insights and observations about human nature and money are invaluable. He was broke and rich several times in his life and his writing carries an undertone of his struggles with money. You get a twofer from Twain. You can laugh and learn at the same time.

I read endlessly. John Wooden, the basketball coach at UCLA during their dynasty is a hero to me. General Grant is a hero. Warren Buffett is a hero. Pick some good heroes and read everything you can about them.

I also like reading about history, psychology, and human nature, technological progress and scientific thought. The world is a fascinating place and you will never run out of rich material if you want to keep understanding more and more.

I think I saw a recent interview with Seth Klarman where he said something like, “value investing is the marriage of a contrarian and a calculator.” Some books, like Twain’s, the histories and biographies help you with the human nature and contrarian side of that equation. Some books, like the ones about science and technological developments, along with the accounting homework I did a long time ago, help you with the calculator side. Both elements are essential. Each is severely limited without appropriate balance and understanding from the other side.

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Joel Greenblatt founded Gotham Capital in 1985 and has amassed one of the best long-term track records in the investment business. He is co-CIO of Gotham Asset Management, a professor on the adjunct faculty of Columbia Business School, the former chairman of a Fortune 500 company, and a member of the investment boards of the University of Pennsylvania and UJA. Along with Blake Darcy, Joel is a major force behind Formula Investing, an investment firm that seeks to make the “magic formula” approach more widely accessible to institutional and retail investors. He holds BS and MBA degrees from the Wharton School.

The Manual of Ideas: Congratulations on the recent launch of the Formula Investing mutual funds and the publication of your third book, The Big Secret for the Small Investor. What is your vision for value-weighted indexing?

Joel Greenblatt: I think value-weighted indexing makes so much sense — that is, placing more weight in those stocks that appear to be at bargain prices, rather than larger market caps or other weighting measures — that eventually logic will take over and many of the large investment firms will design their own value weighted indexes over time. I can’t imagine that this won’t be a very accepted way of creating indexes within a few years.

MOI: One of the reasons “magic formula” investing should continue to outperform is the fact that investors have a hard time sticking with

In our experience, eliminating the [“magic formula”] stocks you would obviously not want to own eliminates many big winners.

the approach during long periods of underperformance. Have you considered value-weighted indexing in a closed-end vehicle to avoid capital flight at times of greatest investment opportunity?

Greenblatt: In short, I think a closed end vehicle would be wonderful for value weighted indexes. Equity closed end funds, however, have not been particularly popular in recent years but I do believe they are very well suited to value investing strategies, especially value weighted indexes.

MOI: You shared the simple yet powerful magic formula in The Little Book That Beats the Market in 2005. To what extent do the Formula Investing funds make tweaks to the magic formula as described in the book? For example, have you considered using forward consensus earnings estimates instead of trailing

earnings, or eliminating any sectors beyond financials, such as miners or oil companies?

Greenblatt: There are a number of “tweaks” in the Formula Investing funds that we have created. First, we created our own database, we do not use a commercially available database. Instead, we have a team of analysts who analyze the balance sheet, income statement and cash flow statements of each of the companies in our investment universe. Second, we have developed a model for financials and those are included in our diversified value weighted funds.

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Exclusive Interview with Joel Greenblatt

Third, we have made some tweaks to the metrics we use to take advantage of the added information that we get from doing the fundamental work ourselves. One more difference is that we make small trades daily to continually reweight the portfolio towards those stocks that appear to be priced at the greatest value.

MOI: Ideally, “good” companies not only maintain high returns on existing capital but also have opportunities to invest incremental capital at high returns. Would it make sense to avoid companies that rank highly based on the magic formula (using trailing EBIT) but operate in industries with limited reinvestment? Newspapers, paper check processors, and legacy technology companies come to mind…

Greenblatt: No. In our experience, eliminating the stocks you would obviously not want to own eliminates many big winners.

MOI: Tell us a bit about your foray into non-U.S. stocks. How difficult has it been to implement a magic formula approach in overseas markets, what countries have you targeted to date, and what are your future plans for applying the magic formula globally?

…the biggest impediment to long-term success is having too short of an investing time horizon. I think the world has actually become more institutionalized and therefore more short-term focused in the last few decades than ever before.

Greenblatt: We have created our own international database covering 26 different countries outside of the U.S. In our experience, it is not possible to use commercially available data due to the fact that we need to homogenize the data between countries, and also the available commercial data does not appear to be high enough quality to use for our purposes.

MOI: Aside from magic formula stocks, what other types of situations do you consider to be particularly worthwhile hunting grounds for sophisticated investors?

Greenblatt: I wrote three books. I still believe in the methodology in You Can Be a Stock Market Genius; in fact, there are many more investable opportunities worldwide in this area than in decades past.

MOI: What is the single biggest mistake that keeps investors from reaching their goals?

Greenblatt: In the Big Secret for the Small Investor, I suggested the biggest impediment to long-term success is having too short of an investing time horizon. I think the world has actually become more

institutionalized and therefore more short-term focused in the last few decades than ever before. This opens up huge opportunities for individual investors with longer-term investing horizons.

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The Manual of Ideas: You have published a book with the title The Most Important Thing, which has received praise from Warren Buffett and, and according to Joel Greenblatt, is destined to become an investment classic. Before we get into discussing some of the concepts in the book, tell us, what was your motivation for writing the book in the first place?

Howard Marks: I have been writing memos to my clients for 22 years. I started in 1990, and I frankly can’t remember what the initial motivation was; it was too long ago. I also can’t remember what kept me going for the first ten years, because the first

ten years I wrote these memos and I never had a response. I never had one response in ten years. So, as I say, I can’t remember what kept me going, but something did.

Then, on the first day of 2000, I wrote one called “bubble.com,” which talked about tech being a bubble and turned out to be right soon thereafter. So, as I say, after ten years, I became an overnight success. I have been publishing the memos continuously ever since. I always thought that when I retired I would pull it together into a book. My retirement is some years off, but then I got a letter from Warren Buffett a couple of years ago, and he said “If you will write a book,

I will give you a blurb for the jacket.” That was the deciding factor, so I wrote it. I was also approached by Columbia about doing it, and those two factors convinced me to write it in 2010, and then it was published in 2011.

Since the formation of Oaktree in 1995, Mr. Marks has been responsible for ensuring the firm’s adherence to its core investment philosophy, communicating closely with clients concerning products and strategies, and managing the firm. From 1985 until 1995, Mr. Marks led the groups at The TCW Group, Inc. that were responsible for investments in distressed debt, high yield bonds, and convertible securities. He was also Chief Investment Officer for Domestic Fixed Income at TCW. Previously, Mr. Marks was with Citicorp Investment Management for 16 years, where from 1978 to 1985 he was Vice President and senior portfolio manager in charge of convertible and high yield securities. Between 1969 and 1978, he was an equity research analyst and, subsequently, Citicorp’s Director of Research. Mr. Marks holds a B.S.Ec. degree cum laude from the Wharton School of the University of Pennsylvania with a major in Finance and an M.B.A. in Accounting and Marketing from the Graduate School of Business of the University of Chicago, where he received the George Hay Brown Prize. He is a CFA charterholder and a Chartered Investment Counselor.

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Exclusive Interview with Howard Marks

You have to understand that, first of all, the consensus has an opinion, and you have to understand that the consensus is not a moron.

MOI: You start the first chapter with a rather inauspicious but profoundly true statement that few people have what it takes to be great investors. You go on to introduce the concept of second-level thinking. Help us understand, what is that and how can it help us as investors.

Marks: The interesting thing about investing is what I call the perversity. The point is that it is so not intuitive. It is so not obvious — investing. A great example lies in the fact that, people think that to be a good investor, you have to understand companies. But the market has an understanding of companies, and if you understand the company the same as the market does, even if the market and you are right, you are not going to make any special profits.

The success, which is doing better than the market in a risk-return sense, comes from understanding things better than the market. Most people don’t understand things better than the market, and most people don’t understand the need for understanding things better than the market. As I say in that chapter, not only do I not want to try to simplify the process of investing, I want to show how not simple it is. Too many people try to simplify it.

I mentioned in that chapter the guy on the radio who says, “Well, you go into a store and you buy a product and if you like it, buy the stock.” That is so wrong, because liking the product has either nothing to do with making a good investment or it is just very, very first step of many steps. So you really do have to think, as I say in that chapter, either I mean or probably both better than the average better and at a higher level.

MOI: So how can we actually improve our chances of thinking different from the consensus while also being right? What is the impact of nature versus nurture, if you will?

Marks: You have to understand that, first of all, the consensus has an opinion, and you have to understand that the consensus is not a moron. So, much of the time the consensus is about right.

If to do better than the consensus you have to think differently than the consensus, it means you have to find the times when the consensus is wrong. It doesn’t mean that the consensus is always wrong and just thinking differently is the key to success. You have to find the time when the consensus is wrong, and then you have to think differently, but not just differently, differently and better, because you could think differently and worse. It is not just holding a non-consensus opinion. That is not the secret. It is having a correct non-consensus opinion when the consensus is wrong, which is not all the time.

I mentioned in the book when my son comes to me, who is a budding hedge fund investor, he gives me an idea, a stock, macro trend, or something like that, the first

The interesting thing about investing is what I call the perversity. The point is that it is so not intuitive. It is so not obvious — investing. A great example lies in the fact that, people think that to be a good investor, you have to understand companies.

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question I always ask is the same: Who doesn’t know that? That is really the question. When you think you know something, the question is whether the market knows it too. And if it does, then your idea has no relative superiority.

MOI: In the investment industry, where lucrative careers can be build just based upon consensus thinking, what types of work environments are conducive to develop ones second-level thinking abilities? How do you ensure that you have such an environment at Oaktree?

Marks: I think that the people there have to be deep and stimulated and stimulating and interested in discussing. I try very hard to create an environment where one person’s success doesn’t have to come at the expense of another. In fact, everybody collectively can be more successful than they would have been separately. I think these things are important. You have to start with smart people who are also wise or introspective. For example, I don’t get the concept of trading to make money. So I like to surround myself with other people who don’t get the idea of trading to make money. By the way, there are probably some people out there who trade to make money. I don’t say my way is the only way, but it is the way for us.

MOI: You have applied second-level thinking to great success in inefficient markets, which have been a focus for Oaktree. What types of mispricings are your favorite hunting grounds, and have they changed over time?

Marks: Thirty-four years ago when I started Citibank’s high-yield bond fund, it was easier because the investing world was much more narrow-minded at the time. Many, for example pension funds or endowments, had a rule: We won’t invest in any bonds that are rated below investment grade, below BBB.

Almost on the surface, if everybody says “We won’t do that,” then that is probably going to be cheap. The world has changed in this time since, and now most people will do anything to make money. Of course, the world has filled up with hedge funds whose job is to do everything. So it hasn’t gotten easier and arguably it has gotten harder, but, on the other hand, not necessarily because I think our margin of superiority versus the higher-yield bond averages has remained about the same.

We think the ability to make money in the distressed debt business still exists. I think there is this process that I call “efficientization” that in theory should happen and hasn’t really happened as fast as I thought it would, and I think it is all down to the foibles of people. Many are — people individually and markets — are ruled by emotion, and as long as emotion takes over, then efficiency will not be realized.

MOI: With a trend toward compression of time horizons in the investment industry, do you see a growing inefficiency in the pricing of longer-duration securities or securities that may lack a so-called catalyst?

Marks: It makes sense. When everybody thinks one way, then there should be a reward for thinking the other way. When I started off as an investor forty-three years ago, we used to think about holding things for five years or ten years, and now five months would be a long time, and maybe it is five days or five weeks.

On the one hand, there should be a return for thinking longer. On the other hand, a lot of people say that the long term is just a series of short terms. I would say that is one of the things working on the side of the patient investor, is the fact that he has a longer time frame. On the other hand, we don’t explicitly — there is a new phrase — time arbitrage. We don’t explicitly pursue time arbitrage, but we have patient capital, and we are patient people. In our distressed debt funds, for example, the money is locked up for ten or eleven years. So we can be patient. Again, if you are the only person in the world who is open to making Investment X, then maybe it will be available to you cheaply. Having patient capital is a great advantage.

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MOI: You state that an accurate estimate of intrinsic value is the indispensable starting point for investing to be reliably successful, but for you that is not enough. One needs to hold the view strongly enough to be able to hang in and buy even as a price decline suggests that you were wrong. How do you build such confidence in an uncertain world, and how do you walk this fine line between confidence and the overconfidence? Do you have any mental models or any check lists that are helping you and Oaktree in navigating this?

Marks: I really think the things in the book have been our models for the last seventeen years since we started the company and longer when we were working together before starting the company. It is not an algorithm. It is a mindset. I think that we always try to stress the danger of overconfidence. I forget if I put it in the book, but it is better if you invest scared, if you worry about losing money, if you worry about being wrong, if you worry about being overconfident because these are the things you want to avoid. They should be foremost in your mind.

The most dangerous thing is to think you got it figured out, or that you can’t make a mistake, or that your estimates are right because they are yours. You have to always recheck your information, bounce your ideas off of yourself and others.

On the other hand, it is really not a good business for people who don’t have some ego because you

have to do the things that Dave Swensen describes as lonely and uncomfortable. I think it was [Jean-Marie] Eveillard who said it was warmer in the crowd, in the herd. But if you only hold popular positions, you can’t do better than average, by definition. And I think you will be very wrong at the extremes.

MOI: You devote three chapters of the book to the concept of risk — how to understand it, recognize it, and how to manage risk. You take particular issue with the traditional risk-return graph, which you say communicates the positive connection between risk and return but fails to suggest the uncertainty involved. Tell us how your interpretation of the risk-return relationship helps you avoid the losers to achieve better performance?

Marks: First of all, as you know from reading the book, we define risk primarily as losing money, the potential for losing money. We don’t want to lose money. Our clients don’t want us to lose their money. They don’t mind if we experience volatility — we have patient capital which permits us to live through volatility. In the end, they don’t want to lose money. You have to be strong enough

in ego to hold difficult unusual positions and stay with them. As I say in the book, you have to have a view that is different from the consensus, and you have to be willing to stay with it, and you have to be right. If you have a non-consensus position and you stay with it and you are wrong, that is how you lose the most money.

I keep going back to what Charlie Munger said to me, which is none of this is easy, and anybody who thinks it is easy is stupid. It is just not easy. There are many layers to this, and you just have to think well. I can’t tell you how to think well. Some people get it, some people don’t.

The most dangerous thing is to think you got it figured out, or that you can’t make a mistake, or that your estimates are right because they are yours. You have to always recheck your information, bounce your ideas off of yourself and others.

…we don’t empathize with the view that risk is variability and that variability is the thing to be avoided per se. Every once in a while, especially in good times, I hear people say the way to make more money is to take more risk — and that is ridiculous, in my opinion. Taking more risk should not be one’s goal. One’s goal should be to make smart investments even if they involve risk, but not because they involve risk.

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Number one, we don’t empathize with the view that risk is variability and that variability is the thing to be avoided per se. Every once in a while, especially in good times, I hear people say the way to make more money is to take more risk — and that is ridiculous, in my opinion. Taking more risk should not be one’s goal. One’s goal should be to make smart investments even if they involve risk, but not because they involve risk. That is a very important distinction.

The figure I draw in the book — called 5.2 — shows that what risk means is a greater range of outcomes, some of which are negative. You have to bear in mind, when you make investments, the presence of the potential of negative outcomes. You have to only make investments where you are rewarded for taking that risk and where you can withstand the risk. That requires diversification, patient capital, and eventually being right in your ideas.

MOI: There is another profoundly insightful chart on page two of the book, which shows how the risk-return graph is affected by historically low interest rates in the U.S. With thirty-year Treasuries priced to yield 3%, what investment implications do you draw from this?

Marks: It is very difficult. When thirty-year treasuries yield 3%, that kind of sets the bar for everything else. Everything else trades off of that, which means not at very high returns. That means we are in a low-return environment. One of the things I believe is we must

understand the environment we are in, understand the ramifications — and accept it in the sense of accept the reality.

One of the hardest things is to make high returns in a low-return world. If you insist on doing so, you can get into trouble. If you say, “Well, Treasuries used to be 6% and high yield bonds traded at 500 [basis points] over, so I made 11% with ease on the average high-yield bond. So even though Treasuries are now 3%, or 2% on the ten-year, I still want 11%, and I am going to get my 11%.” Then you end up making investments that may appear poised to pay 11%, but because you now need 900 [basis points] over [Treasuries], you may take greater risks than you used to take to get the same return. So just insisting on making the same return that you used to make can be very dangerous.

Peter Bernstein once wrote brilliantly, or maybe he passed on a quote from Elroy Dimson, who said that the market is not an accommodating machine. It will not give you high returns just because you need them. You have to realize that. If you say, “I used to get 11% and I still need 11%, so I am going to take more risk,” you can do that. But the key is to recognize that you have to take more risk to do it, and to make a conscious decision that you are going to do it. Blindly accepting more risk to get the return you used to get in a high-return world can be a big mistake.

MOI: In this context, how worried are you about the potential risk of inflation as a result of this low-interest rate environment in the U.S. and the actions of the Federal Reserve? How do you ensure that you still keep up with the purchasing power ability for your capital?

Marks: It is very difficult. A lot of our investing is in fixed income. Fixed income, by definition, doesn’t adjust to inflation. If we buy 8% bonds today with inflation at 3%, and inflation goes to 6%, we still have that 8% bond, [but] our real rate return has gone down. Period. There is no adjustability in fixed income…

I am personally not worried about a return to hyperinflation. Inflation is modest and could go higher. Everybody would like to see it go higher because usually higher inflation is associated with prosperity. I would like to see that. Governments around the world would like to see it so they can pay their debts with low-value currency. I don’t think we are going to have hyperinflation.

I am personally not worried about a return to hyperinflation. Inflation is modest and could go higher. Everybody would like to see it go higher because usually higher inflation is associated with prosperity. I would like to see that. Governments around the world would like to see it so they can pay their debts with low-value currency.

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I always get in trouble with I stray into the macro, and I am far from an economist. But, where does inflation come from? Demand pull comes from too much money chasing too few goods. I don’t think we have that or will anytime soon. The cost push comes from an escalation of the cost of the factors of production. For the most part, I don’t see that unless the Chinese crowd us all out in terms of buying currencies. Most of the possible sources of inflation I think would come from international considerations like that — like the guy that works in China for $0.60 a day demanding $1.20 a day. It could happen, but I don’t think it is going to be pervasive enough to pitch us into hyperinflation.

MOI: Risk control is Oaktree’s first tenet in its investment philosophy. I hear you make an important distinction between risk control and risk avoidance. Help us understand this distinction, perhaps, by way of an example.

Marks: The greatest example is this: If you went to the horse races, would you always bet on the favorite? The favorite, assuming the crowd is intelligent, which usually it is, is the horse with the highest probability of winning. That doesn’t mean that the favorite is always the best bet. You might have another horse that has a lower probability of winning but the odds are so much higher, that’s the smart bet — leaving alone anything specific that you know about the horses.

The point is, this is second level [thinking] again. First level says,

“Native Dancer is going to win the race. It has always won. So we should bet on Native Dancer, even if the payoff is 6 to 5.” You put up $5, and if it wins you get $6. Maybe the better bet is Beetle Bound, which nobody expects to win and, consequently, it has a lower probability of winning but if it wins it will pay four to one. So it’s the same thing. You have to make investments where the risk can be assessed, diversified, and where you’re highly paid to do so.

The book is full of explanation of why so-called safe, so-called high-quality investments are not always and, in fact, maybe are rarely the best bet. That is what this distinction is all about. We want to make intelligent bets. We don’t want to invest in high quality or safe things because a so-called safe thing at bad odds is a bad investment. Sometimes I think the word “quality” should be banished from the investment business if you want to make money.

MOI: In today’s environment, there is a lot of talk about U.S. Treasuries being a safe haven and it is proving true. Do you see that as an example of what we just talked about?

Marks: U.S. Treasuries — Jim Grant called them “certificates of confiscation” — are a great example. They are a safe investment in the sense that the outcome is known and not really subject to variation. I think they are not a good investment because the known outcome is an unattractive one. Today you can buy the ten-year [Treasury] and with no risk, lock up

the certainty of 1.9% return for ten years. Is that really a good thing to lock up? Under what circumstances will that turn out to have been an attractive investment? The answer is, in my opinion, deflation or depression. I don’t think we are going to have those things, or we can’t plan on having them. So the range of outcomes under which that safe asset turns out to have been a smart investment is rather narrow. I was on a panel two days ago in Los Angeles with Jeremy Grantham, and he said, people talk about the risk-free return. Treasuries are the return-free risk. I think he has got something there.

Today you can buy the ten-year [Treasury] and with no risk, lock up the certainty of 1.9% return for ten years. Is that really a good thing to lock up? Under what circumstances will that turn out to have been an attractive investment? The answer is, in my opinion, deflation or depression. I don’t think we are going to have those things…

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MOI: You talk about the importance of being attentive to cycles and the pendulum-like oscillation of investor attitudes and behavior. However, most value investors tend to ignore macroeconomic events and investors sentiment, often relying on a measure of normalized through-the-cycle earnings and relying on their own convictions. How do you define being attentive, and how do we ensure we do not become too attentive?

Marks: First of all, all your questions start with the word “how.” It is very hard to answer that. There is no secret method for any of this stuff. You just have to be aware of concepts, smart in their application, and it helps to be an old man so that you have the experience that helps, or an old woman…

If you are a value investor and you invest whenever you find a stock which is selling for one-third less than your estimate of intrinsic value, and you say, I don’t care about the macro, nor what I call the temperature of the market, then you are acting as if the world is always the same and the desirability of making investments is always the same. But the world changes radically, and sometimes the investing world is highly hospitable (when the prices are depressed) and sometimes it is very hostile (when prices are elevated).

I guess what you are saying is we just look at the micro; we look at them one stock at a time; we buy them whenever they are cheap. I can’t argue with that. On the other hand, it is much easier

to make money when the world is depressed, because when it stops being depressed, it’s like a compressed spring that comes back.

If you buy a cheap stock when the market is high, it is a challenge because, if the market being high is followed by a general decline in prices, then for you to make money in your cheap stock, you have to swim against the tide. If you buy when the market is low, and that lowness is going to be corrected by a general inflation, and you buy your cheap stock, then you have the tailwind in your favor.

I think it is unrealistic and maybe hubristic to say, “I don’t care about what is going on in the world. I know a cheap stock when I see one.” If you don’t follow the pendulum and understand the cycle, then that implies that you always invest as much money as aggressively. That doesn’t make any sense to me. I have been around too long to think that a good investment is always equally good all the time regardless of the climate.

MOI: You say that the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. Where do you think perception has potentially reached such a level? Is the eurozone a potentially fruitful hunting ground for Oaktree?

Marks: You keep using the word “potential,” which gives me a good out because anything which has gone down in price a lot is

potentially a source of opportunity. But the question is, has it declined sufficiently relative to reality? If a stock was efficiently, fairly priced five years ago at X. Today the stock is down half, but in some sense reality is also down half — then the stock is only fairly priced, lower in price but not cheaper.

What the investor has to do is weigh out on the one hand price and on the other hand reality. Everybody thinks very dire thoughts about Europe and the Euro, and I would be the last person in the world to argue against that position. Then the next question is, European assets are lower in price because of the macro conditions, but are the macro conditions being viewed too pessimistically? The answer is, how do you know? Go back to second-level thinking. Are you capable of thinking different and better about the fate of Europe? I don’t think so. I don’t think I can. I don’t think anybody really has a good handle on what is going to happen in Europe.

What the investor has to do is weigh out on the one hand price and on the other hand reality. Everybody thinks very dire thoughts about Europe and the Euro, and I would be the last person in the world to argue against that position. Then the next question is, European assets are lower in price because of the macro conditions, but are the macro conditions being viewed too pessimistically?

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So then, how can gaming the Europe situation give you an edge?

If you don’t have control over something, superior insight — I don’t see control in the sense of being able to make it work — if you don’t have superior insight, then how can something be to your advantage? One of the tenets of our philosophy — you named number one, which is risk control — number five is, we don’t bet on macro forecasts. It is very hard to consistently be above average in correctness with regard to the macro.

MOI: You say knowing what you don’t know can provide a great advantage as an investor. Warren Buffett calls this the circle of competence. What is Oaktree’s circle of competence? More importantly, can you give us an example of what lies just outside that circle?

Marks: We have been making credit-based investments since I started Citibank’s high-yield bond fund. We went from high yield and converts to international converts and European high yield to distressed debt, to distressed for control, to distressed mortgages, to mezzanine finance. So a lot of what we have done, although not all, has been credit based. We consider that, to use your term certainly, one of our greatest circles of competence.

We emphasize the things that have a high probability of paying off for us, albeit there are other people out there who are better than us at investing in things that have a low

probability of paying off but with are very high payoff. Our emphasis is on risk-controlled situations — we are probably more competent in that than other things.

I think maybe another example of something that may be outside our competence is, we never made an investment in sovereign credit. I use sovereign debt investing as largely a political analysis rather than economic analysis. I don’t know how to do it. I hope it can be done, and maybe one of these days we will go out and find somebody who can do it and maybe we’ll add that competence to what we do.

We would be silly to bet on the bonds of peripheral Europe just because they have gone down if we are not capable of superior second-level thinking. How would we know enough to out-think the person who is selling them to us and to have a high probability of a successful outcome?

MOI: In addition to corporate and distressed debt, a considerable amount of Oaktree’s portfolio is in a category you define as control investing. Help us understand better how you approach distress-for-control situations and what you think makes Oaktree more successful here versus other funds.

Marks: When I was talking about circles of competence, I think one of the elements on our side is that we have been doing it for a long time. We have a lot of experience in the things I have been discussing, and I think experience is very important. You have to learn the

hard lessons. One thing I mentioned in one of my memos is that the human mind is very good at blotting out bad memories. Unfortunately, most important learning is from bad memories. We have enough institutional memory to retain the lessons of the past.

We organized our first distressed fund in 1988 and then branched out into our first distressed-for-control fund in 1994. We figured that we could identify cases — we spun that fund out because we had done it in the past — we invested in big chunks of the debt of smaller companies so that when the debt was exchanged for equity we ended up as the controlling shareholder.

The question is, number one, is this a company that you would like to control? And number two, is this a company where the creditors will get control? And then number three, which creditors? Because usually there is something called the fulcrum security, which is the first impaired class. The unimpaired will get their money. The first impaired class may get the company, and the lower impaired classes may get nothing.

The question is, number one, is this a company that you would like to control? And number two, is this a company where the creditors will get control? And then number three, which creditors? Because usually there is something called the fulcrum security, which is the first impaired class.

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So it is the fulcrum, the one in the middle there, we try to identify that. We try to figure out if it will get control and how much it will have to pay for control. If it gets control at that price, will that be a successful investment? It is a very interesting area — of course, more moving parts to go wrong. The investments are by definition less liquid. I would say it’s the difference between dating and getting married. When you are a distressed debt investor, you are dating; but when you try for distressed-for-control, you get married. You have to live with the consequences, for better or for worse, richer or poorer. But, it can produce some good outcomes.

MOI: Listed equities are a rather small portion of Oaktree’s overall portfolio. Are those investments a residual of distressed-for-control strategy, or do you also target equities particularly. How you end up with equities in your portfolio?

Marks: We established a couple of strategies to invest in listed equities because we thought markets were inefficient or less efficient. The first case was in the middle of 1998 when we decided to go into emerging markets. So we formed an emerging markets long/short hedge fund that we have ever since.

Tenet number three of our investment philosophy says we are active in less efficient markets only. We probably wouldn’t do a hedge fund for large-cap New York Stock Exchange firms because the tendencies are that those would be more efficient than others. But emerging markets, yes. Japan,

yes. It didn’t work out so well — the world’s cheapest market has continued to get cheaper.

So it is not a residual of some other activity. We never pass securities from one strategy or portfolio to another… Just a few markets where we’ve concluded that it was worth investing in equities, despite the fact that our main circle of competence is credit.

MOI: You make a distinction between playing defense and offense when investing; in other words, limiting risk and striving for return. Does Oaktree’s ability to invest across the capital structure enable it to get the balance more right in terms of defense and offense versus other investors that may be more constrained?

Marks: If you have flexibility in where you invest, it stands to reason that you should be able to make adjustments that enable you to reach your goals. This goes back to what we said before. You said some value investors are willing to ignore the macro. They say if stocks are selling for one-third less than intrinsic value, I am going to buy it. But the question is, do you want to be equally aggressive all of the time, or do you want to play offense some times and defense at others?

I would argue that you should adjust your activities based on the climate of the market. So, that is what we do. Sometimes in a distressed debt portfolio, we want to be at the very top of the capital structure. That may be because

that is where the best bargains are, it may be because the macro environment is threatened and we don’t want to live with macro uncertainty. At other times when these things are cheaper and when the environment seems less treacherous, maybe we’ll drop down into the second level on the balance sheet or maybe the third. Historically, we don’t go to the bottom of the stack very often, but I think these adjustments are worth making.

It is a great dilemma because, on the one hand you want to stick to your circle of competence. On the other hand, it is probably a mistake to say, “I do this. I don’t do that.” Because, at the same time that you want to capitalize on your expertise, you want to be flexible enough to pursue the bargains where they are, and you don’t want to be so dogmatic that you say, “I only do this,” which implies, I do it whether it’s cheap or not. So this is one of the great dilemmas.

You asked earlier where inefficiencies come from. Largely they come from people who say, ‘I do this, and I don’t do that.’ What they are basically saying is, ‘I don’t do that regardless of how cheap it is.’ Well, that is silly because then you just leave bargains for others.

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You asked earlier where inefficiencies come from. Largely they come from people who say, “I do this, and I don’t do that.” What they are basically saying is, “I don’t do that regardless of how cheap it is.” Well, that is silly because then you just leave bargains for others. If you say, “I do this, but I don’t do that regardless of how cheap it is,” you are basically saying, “I do this regardless of how expensive it is.” That doesn’t make much sense either. This is why I think you have to be realistic. You have to be sensitive to conditions in your world, and you should adjust your tactics — offense and defense — based on conditions in your environment.

MOI: The title of the book is The Most Important Thing, but, as your readers will know, all of the concepts in the book are important and leaving out even one of them will likely lead to not optimal performance. So if all of these concepts — and we have touched on a few, risk, the relationship between value and price — if they are all important to achieve superior performance, what is the single biggest mistake that you think keeps investors from reaching their goals?

Marks: First of all, let me mention that I think the twenty things listed in the book are all the most important thing, and then I thought of the twenty-first. So later on this spring, I think we will be coming out with the new electronic edition of the book called The Most Important Thing Illuminated, which will include

comments on the content of the book from Seth Klarman and Joel Greenblatt and Paul Johnson and Chris Davis, in addition to myself, and a new twenty-first chapter, which says that the most important thing is realistic expectations. Because I think that people tend to get in trouble in investing when they have unrealistic expectations, especially when they have the expectation that higher returns can be earned without an increase of risk. That is a very dangerous expectation.

Which is the thing which is most dangerous to omit? I think it is risk consciousness. I think that the great accomplishment in investing is not making a lot of money, but is making a lot of money with less-than-commensurate risk. So you have to understand risk and be very conscious of it and control it and know it when you see it.

The people that I think are great investors are really characterized by exceptionally low levels of loss and infrequency of bad years. That is one of the reasons why we have to think of great investing in terms of a long time span. Short-term performance is an imposter. The investment business is full of people who got famous for being right once in a row. If you read Fooled by Randomness by [Nassim] Taleb, you understand that being right once proves nothing. You can be right once through nothing but luck.

The law of large numbers says that if you have more results, you tend to drive out random error. The sample mean tends to converge with the universe mean. In other words, the apparent reality tends to converge with the real underlying reality. The great investors are the people who have made a lot of investments over a long period of time and made a lot of money, and their results show that it wasn’t a fluke — that they did it consistently. The way you do it consistently, in my opinion, is by being mindful of risk and limiting it.

MOI: Thank you very much for your time and the insights you have shared.

Marks: It was a great pleasure for me, and I appreciate your interest in the concepts.

Which is the thing which is most dangerous to omit? I think it is risk consciousness. I think that the great accomplishment in investing is not making a lot of money, but is making a lot of money with less-than-commensurate risk.

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…always look for gaps between fundamentals—for example, the financial performance of a company—and expectations, which is the stock price. While that may be stating the obvious, the devil is in the details.

Michael J. Mauboussin is a Managing Director and Head of Global Financial Strategies at Credit Suisse. Prior to rejoining Credit Suisse in 2013, he was Chief Investment Strategist at Legg Mason Capital Management.

The Manual of Ideas: Tell us how you got started in finance. Michael Mauboussin: I joined Drexel Burnham Lambert straight out of college in 1986. It was an 18-month program that had a great mix of training and hands-on experience—we rotated through all aspects of the firm including trading, investment banking, research and operations. I figured even if it didn’t work out I’d have a good exposure to Wall Street and some sense of what I’d like to do.

The area that seemed the best fit with my personality was equity research. My breakthrough was getting hired as the food industry analyst at First Boston (now Credit Suisse) in 1992. A great deal of my focus in the early days of my research career was on valuation. I was deeply inspired by Al Rappaport’s book, Creating

Shareholder Value. The principles Al laid out were very consistent with what I had learned at Drexel and remain the cornerstone of my thinking today. One of my career highlights was writing the book, Expectations Investing, with Al. That book basically took the principles of creating shareholder value and applied them to the world of investing.

Around the mid-1990s, I started to expand my reading, including a fair bit on evolutionary theory. That led naturally into more reading on psychology including Daniel Kahneman and Amos Tversky’s seminal work on heuristics and biases. I also learned about complex adaptive systems, a focal point of the research at the Santa Fe Institute in New Mexico. I felt strongly that each of these areas had a lot to contribute to an investment process.

MOI: Explain the challenges you’re trying to address through your research. What is the “multi-disciplinary” approach to investing and why is it necessary?

Mauboussin: At the end of the day, successful investing is about buying something for less than it’s worth. Saying it somewhat differently, the idea is to always look for gaps between fundamentals—for example, the financial performance of a company—and expectations, which is the stock price. While that may be stating the obvious, the devil is in the

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Exclusive Interview with Michael Mauboussin

details. How do you know that price and value are misaligned? Why are markets inefficient? What makes it so difficult to go against the crowd?

I have come to believe in the mental models approach to investing. This approach has most famously been articulated and advocated by Charlie Munger. The basic idea is that it is really helpful to understand the big ideas from multiple disciplines. You might think of these ideas, or models, as tools in your mental toolkit. So when you face a vexing problem, you have access to lots of tools to solve it and one of them is likely to work.

The alternative is to go through the world with a narrow range of knowledge. When a problem arises that you understand, you’ll nail it. But there’ll be a lot of problems you won’t be equipped to solve. The challenge with a multi-disciplinary approach is that it requires constant learning. Most people aren’t willing or able to put in the time. That’s fine. But to me there appears to be a high correlation between intellectual curiosity and success in the investment business. Many great investors spend their days reading and thinking.

MOI: In your book Think Twice you argue that the right process for making decisions conflicts with how our minds work. When faced with complexity, our brains revert to simplified patterns that obscure better approaches. What are some of the default patterns to which investors are prone to succumb?

Mauboussin: Investors succumb to a number of mistakes, but I’ll highlight a couple in particular. The first comes from a paper by Kahneman and Tversky called “On the Psychology of Prediction.” The core idea is that when you make a prediction, you can consider the individual circumstances of the case and/or the base rate. In the first case, you’re taking the information you have and combining it with your own view of things. Psychologists call this the “inside view.” Consideration of the base rate basically means you ask the question: “when others have been in this situation before, what happened?” This is known as the “outside view.” Kahneman and Tversky showed that for most decisions, people rely too much on the inside view and not enough on the outside view.

Let me give you an example. A couple of years ago, an analyst did a bottom-up analysis of Amazon.com and suggested the company could grow 25% compounded annually, off a $20 billion starting revenue number, for ten years. This is the inside view. The outside view would ask how many companies have grown at that rate for that long off that base in history. As you might guess, the number is tiny. So the inside view often gives a projection that’s too optimistic, although it’s certainly possible that it’s too pessimistic as well.

The second mistake, which is somewhat related, is a failure to understand reversion to the mean. What’s funny is that most investors think they understand the concept, but when you look at the aggregate behavior, mistakes around reversion to the mean consistently show up. For instance, investors consistently buy a fund, or even an asset class, after it’s done well or sell after a spell of poor performance. In the aggregate, these actions lead to dollar-weighted returns that are lower than the stated returns. While it’s not too surprising that this would be true for individual investors, it’s also true for institutions.

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MOI: Institutionalization has compounded principal/agent problems. Buffett talks about the “institutional imperative.” Are your prescriptions for better decision-making destined to fall on deaf ears in the context of financial intermediation and escalating principal/agent problems?

Mauboussin: You need three types of edge to do well as a long-term investor: analytical, behavioral, and organizational. And you’re right, at the core of the organizational edge is being able to manage principal/agent problems.

The core issue is that there can be a tension between delivering long-term excess returns to your fund holders (Charlie Ellis calls this the “profession”) and creating revenues and profits for the money-management firm (Ellis calls this the “business”). The profession tends to be contrarian, long-term oriented, and valuation-based. The business tends to focus on what’s hot, is short-term oriented, and momentum-based.

Over the last four or five decades the pendulum has swung from the profession to the business. We see evidence of this with the greater incidence of closet indexing. Active share—a measure of how different a portfolio is from its benchmark—has been drifting lower since the 1980s, indicating that portfolios today look more like their benchmarks than they did back then.

But let me say that money management clients have some

You need three types of edge to do well as a long-term investor: analytical, behavioral, and organizational.

culpability in this, too. Investors appear to be less patient than they used to be and that has an impact on an investment firm’s ability to make long term-oriented decisions. The goal is to have the time horizons of the investors and the investment firm align. Easy to say but hard to achieve in practice.

The biases that are hardest to shake off, I believe, are the confirmation bias and anchoring. The confirmation bias says that once we’ve made a decision we seek confirming information and disregard or discount disconfirming information. Most of us have a strong need to feel like we’re right, and hence naturally seek information that proves our point.

Anchoring is also pernicious. The idea is that we tend to anchor on figures that may be arbitrary. For instance, if you ask people to write down the last four digits of their phone number and then ask them to estimate the number of doctors in Manhattan, you’ll find a strong correlation between low phone numbers and low estimates and high phone numbers and high estimates. You can then explain what’s going on to the group. And then you can rerun a variation of the experiment and get a similar result.

MOI: Understanding behavioral finance concepts such as “overconfidence” and “loss aversion” may equip investors to deal with the emotional challenges of investing. However, even if one can master emotional biases, the application of corrective tools in any given situation is likely too much to ask of the average human. What emotional biases are typically the hardest to shake off?

Mauboussin: Your point is extremely well taken. It’s one thing to know about the biases and another thing altogether to manage them effectively. That said, I do think there are some practices that you can weave into your process that can be helpful. For example, be aware of the outside view and make sure you implement it into your thinking. Or maintain the discipline to consider every situation probabilistically and keep an investment journal so as to track your thinking and give yourself honest feedback.

The biases that are hardest to shake off, I believe, are the confirmation bias and anchoring… Most of us have a strong need to feel like we’re right, and hence naturally seek information that proves our point.

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The good news is that you don’t need to weed out every one of your biases to do fine over time. But the more ways you can find to be aware of and manage your biases, the better off you’re likely to be.

MOI: To what extent do quantitative investment methods offer a remedy to investors who cannot master their emotions? For example, what is your view of Joel Greenblatt’s “Magic Formula” approach to investing?

Mauboussin: There have been certain empirical regularities that we’ve seen in markets over the long term—for example, value beats growth and small cap beats large cap. But these patterns are very sensitive to starting and stopping points. Had you invested in small caps in 1982 believing they would deliver superior returns to large caps, you would have had a couple of tough decades. And value struggled mightily in the late 1990s.

To me, the value of Greenblatt’s formula is that it identifies high-quality companies at cheap prices. If you can do that over time, you should be fine. So anything that can steer you toward stocks that have low expectations relative to the company’s fundamental prospects is useful.

MOI: It seems that many emotional biases can be classified under the headings of “greed” and fear.” Buffett’s advice is to be fearful when others are greedy and greedy when others are fearful. While many investors will agree with Buffett’s advice—be greedy when others

are fearful, and vice versa — few act on it. How do you explain this phenomenon in the context of investors’ choices and the nature of a “complex adaptive system” such as the stock market?

Mauboussin: This is a great question. The stock market is a canonical example of a complex adaptive system. These systems have three features: heterogeneous agents, interaction that leads to emergence, and a global system that has properties and features that are distinct from the underlying agents. In other words, crowds are wise under certain conditions and you can’t understand markets by talking to investors within the market.

But here’s the key: the market needs to meet certain conditions in order to be efficient. The investors have to have diversity (think fundamental and technical, short-term and long-term, etc.), there must an aggregation mechanism to bring together the information of investors, and there must be well-functioning incentives. When all three are in place, markets are efficient—and I mean that in a textbook sense.

The essential challenge for investors is figuring out when markets are inefficient, and the answer is when one or more of the conditions for efficiency are violated. By far the most likely to go is diversity. Rather than operating independently, our views tend to correlate. We become uniformly bullish (spring 2000) or uniformly bearish (spring 2009). In fact,

The stock market is a canonical example of a complex adaptive system. These systems have three features: heterogeneous agents, interaction that leads to emergence, and a global system that has properties and features that are distinct from the underlying agents.

you can say that the moment of maximum bullishness defines the market top while maximum bearishness defines the market bottom.

So this is why Buffett’s advice is so good but so hard. The point when there’s a valuation extreme is precisely the point when the emotional pull—in the wrong direction—is strongest.

MOI: In More Than You Know: Finding Financial Wisdom in Unconventional Places you draw on a range of fields such as gambling and biology to pinpoint parallels to investment challenges and the workings of the market. What can investors learn from poker players or the average “member” of an ant colony?

Mauboussin: Investing is a probabilistic field, similar to fields such poker or sports team management. You can also observe that some people in these fields do better than others. So the question is: what are the best in each of these fields doing that distinguishes them from the

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average person in those fields?

I think it boils down to three things. First, they focus on process and not outcomes. In other words, they make the best decisions they can with the information they have, and then let the outcomes take care of themselves. Second, they always seek to have the odds in their favor. Finally, they understand the role of time. You can do the right thing for some time and it won’t show up in results. You have to be able to manage money to see another day—that is, preserve options for future play—and take a long-term view.

From the ants you realize the colony has behaviors that are distinct for the underlying ants. You can’t understand the colony by talking to the ants. Hopefully, the similarity to the market is apparent. If you want to understand the market, look at asset prices. Don’t bother listening to the pundits. Market prices—whether you think they are right or wrong—convey useful information. MOI: You have long advocated the importance of investment process over outcome. What are the essential building blocks of a good investment process?

Mauboussin: There are three components. The first is analytical. This means that you should always seek gaps between fundamentals and expectations. Like most things, it’s easy to say but hard to do. I’d also include position sizing under the analytical heading. Lots of firms spend time finding what they believe are mispriced securities

but allocate less time to figuring out how big those positions should be within the portfolio. Both overbetting and underbetting are suboptimal, and lots of portfolios do one or the other.

The second component is behavioral. This covers much of what we’ve discussed. The idea is that we all operate with certain heuristics—rules of thumb—and that predictable biases emanate from those heuristics. Learning about those biases is really important but what’s even more important is weaving methods into your process to manage or mitigate the biases. Another piece of the behavioral component is what I call the “Mr. Market mindset.” This refers to the metaphor that Ben Graham used, and Warren Buffett popularized, to define a proper attitude toward markets. In short, Mr. Market is an accommodating fellow in the sense that he always provides bids and offers but also suffers wild emotional swings, from ebullience to depression. The important point to remember is that Mr. Market is there to serve you, not to inform you. You can take advantage of him when he’s foolish but it’s important to avoid getting swayed by his moods.

The final component is organizational. The goal is to minimize conflict between principals and agents. For an investment firm, this means always putting the interests of investors first. Naturally, a healthy business is essential to nurturing the profession of investing. But

markets must precede marketing in the minds of the individuals running the firm.

MOI: What is the key mistake that keeps investors from reaching their goals?

Mauboussin: The biggest mistake is a failure to distinguish between fundamentals and expectations. Using a metaphor from the racetrack, the idea is that you make money only when you find a discrepancy between a horse’s chances and the betting odds. What’s important is that almost everyone thinks that they are doing this, but very few actually do.

So when things are going well, people tend to buy and when they are going poorly, they tend to sell. They don’t separate fundamentals and expectations. These are really two distinct aspects of an investment, and they must be kept separate. Unfortunately, our emotions cause us to allow them to bleed together.

The biggest mistake is a failure to distinguish between fundamentals and expectations. Using a metaphor from the racetrack, the idea is that you make money only when you find a discrepancy between a horse’s chances and the betting odds. What’s important is that almost everyone thinks that they are doing this, but very few actually do.

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MOI: What investment-related resources have you found particularly useful?

Mauboussin: You mean besides The Manual of Ideas? My investment-related reading probably isn’t very different than most. I find the Economist useful and certainly try to listen to what great investors have to say. But most of the ideas I get are from reading outside the world of investing—even in tangential fields like gambling. There are lots of great ideas out there and the fact is, most of them relate back to investing in one way or another.

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Taking emotion out of the equation, or at least minimizing it as much as possible, is vitally important and difficult to do if you have investors peering over your shoulder in real time, questioning ideas.

Allan Mecham heads Arlington Value Management based in Salt Lake City, Utah.

The Manual of Ideas: Over the ten years ended December 31st, 2009, the S&P 500 delivered an underwhelming return of negative 9.1%, equaling a 1.0% annual loss. Bruce Berkowitz’s Fairholme Fund achieved a net annualized return of 13.2% during the same period, while your fund returned 15.5% annually net of fees. Berkowitz’s record has made him somewhat of a “rock star” in the investment business. How come you are still flying below the radar?

Allan Mecham: Ha! Good question… I’m eagerly awaiting The Little Book on Becoming a Hedge Fund Rock-Star. In all seriousness, it’s likely a combination of factors (Salt Lake City-based LLC, only $10+ million under management for the first five years with no serious marketing), but certainly my limitations marketing Arlington are partly to blame. Additionally, and probably the biggest reason for our obscurity, stems from

our fanaticism about accepting the “right” capital. Maintaining a culture that’s conducive to rational thinking and investment success has been the top priority since inception. We have turned down significant sums of money on many occasions because of this stubborn commitment. As I said in my most recent letter, we get far more satisfaction from producing top returns than from the size of our paycheck… though we’re hopeful this distinction won’t need to be highlighted for much longer!

Many potential investors require monthly transparency into the portfolio and are overly focused on short-term results. Accepting “hot” money would endanger the culture and my ability to perform. My partner Ben [Raybould] considers it his most critical job to cultivate and maintain a culture that minimizes emotional noise and short-term performance pressures, to which I must say he

has done a fantastic job. We believe patience and discipline are critically important to investment success. Taking emotion out of the equation, or at least minimizing it as much as possible, is vitally important and difficult to do if you have investors peering over your shoulder in real time, questioning ideas. That’s like telling someone what’s wrong with their golf game in the middle of their backswing — it’s the last thing you need when you’re trying to concentrate and execute a shot.

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Exclusive Interview with Allan Mecham

MOI: We could conduct this entire interview simply by revisiting quotes from your past letters, which are a tour de force. You recently didn’t hold back on your view of certain types of institutional investors: “Many times these gate-keepers of capital have expressed admiration for our results. Yet for them to invest we would need to not only continue to find undervalued stocks, we’d need to find more of them; additionally, we would need to identify overvalued stocks – and short them – as well as find ideas across the globe in both large and obscure markets. Such comments are flattering, yet we see nothing but wild-eyed hubris attempting to outsmart people, more often, in more ways, and in more markets, as opposed to sticking with what produced top-tier results in the first place.” Clearly, the proliferation of investment vehicles whose partners’ interests are at odds with those of the ultimate owners of capital has resulted in misallocation of capital. Do you see owners waking up to this inherent conflict and demanding a more sensible approach to investment? Is it feasible for a fund like yours to bypass the agents and go directly to the owners of capital?

Mecham: I think it’s possible to gain traction but I’m not optimistic about change on a large scale as there are multiple factors at play. Bypassing the agents is a laborious process that’s difficult for a two-man shop like ours. The fees throughout the financial system are crazy and make no sense when thinking about the industry as a whole. A lot of financial intermediaries and hedge funds operate using a form of the “Veblen” principle — where status is attached to the high cost and exclusivity of the product. The financial middlemen satisfy the clients’ emotional needs more than the financial needs. The comfort of crowds is strongly at play throughout the system. At the end of the day I think managers

The financial middlemen satisfy the clients’ emotional needs more than the financial needs. The comfort of crowds is strongly at play throughout the system. At the end of the day I think managers are giving clients what they want — peace of mind and smoother returns, albeit at the expense of long-term results.

are giving clients what they want — peace of mind and smoother returns, albeit at the expense of long-term results.

MOI: Short-term thinking seems to be alive and well in the investment industry despite overwhelming evidence that a longer-term perspective yields better results. You have alluded to the fact that good ol’ career risk may be the culprit: “Non-activity in the face of short-term underperformance is simply not tolerated, even though realistic assumptions (you can’t outsmart other smart people all the time) and basic math (lower frictional costs) confirm its worth. Most fund managers’ capital would not stick around long enough so they simply comply with more standard methods of operation in the spirit of keeping their jobs.” Incentives are one of the most powerful forces driving behavior, so it’s little surprise investment managers have adjusted to the prevailing industry incentives. What could be done to better align career risk with investment risk?

Mecham: I am a strong believer in the power of incentives. That being said, I’m not sure I have a silver bullet on how to solve the

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When looking at ideas, I have a Richard Feynman quote tattooed in the back of my brain: ‘Don’t fool yourself, and remember you are the easiest person to fool.’

problem. You need investors to think and act like owners, rather than short-term renters, and to judge performance over longer time frames. I remember reading a talk that Mark Sellers gave at Harvard a few years back. He basically said good investors have the right temperament by age 15, and there’s not much one can do to improve later in life. So I don’t think arguing the merits of one’s philosophy is going to gain a lot of traction — it seems people either get it or they don’t. If you could somehow get investors to accept annual reporting (which is arguably too often), or some type of soft or hard lock-up, that may help, but again, it’s a hard problem to solve as you’re dealing with human nature to a large degree.

We are fanatical about partnering with compatible investors — those who “get it” — and we still have soft lock-ups at Arlington Value Capital. The sophisticated family offices (and others) often ask, “What’s your edge?” I firmly believe it is our investor base — they act and think like owners rather than traders, which enables us to wait for exceptional opportunities. Such an investor base really adds value when you go through periods of distress and underperformance; precisely the time when you need confidence and stability is apt to be the time when investors are rushing for the exits and questioning the approach. Our investor base is unique: despite above-average volatility we’ve had minuscule withdrawals over the years. Part of the genius in the structure of

the Buffett partnerships (which has largely been maintained at Berkshire), is the culture and environment Buffett created and insisted upon; Buffett wouldn’t disclose positions and reported just once a year — he created an environment where nobody was questioning how or when he swung the investment bat.

MOI: Let’s switch gears and discuss the investment philosophy behind your track record. Help us understand the kind of investor you are, perhaps by highlighting a couple of examples of companies you have invested in or decided to pass up. What are the key criteria you employ when making an investment decision?

Mecham: It’s really quite simple. I need to understand the business like an owner. The firm needs to have staying power; I want to be confident about the general nature of the business and industry landscape on a longer term basis. I’m big on track records, and generally stay away from unproven companies with short operating histories. I also believe a heavy dose of humility and intellectual honesty is important when looking at potential ideas.

There’s a strong undercurrent constantly percolating to buy something — it’s fun, exciting and feels like that’s what you’re getting paid for. This makes it easy to trick yourself into thinking you understand something well enough when you don’t, especially if you are in the investment derby of producing quarterly and yearly

returns! When looking at ideas, I have a Richard Feynman quote tattooed in the back of my brain: “Don’t fool yourself, and remember you are the easiest person to fool.”

Ultimately, what tends to cover all the bases is the mentality of buying the business outright and retaining management. Critical to implementing this approach is, again, having a compatible investor base. “Whose bread I eat his song I sing”… An owner’s mentality forces you to think hard about the important variables and makes you think long term, as opposed to in quarterly increments. In fact, I think very little about quarterly earnings and more about the barriers to entry, competitive landscape/threats, the ongoing capital needs and overall economics, and most importantly, the durability of the business. Over the years I’ve come to realize the importance of management, so we look hard at the people running the business as well. And, obviously, the price needs to make sense.

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Oftentimes a key cog of value is in a form that’s difficult to measure… Sometimes it’s the location of assets that can be hugely valuable. Waste Management and USG both have assets that are uniquely located and almost impossible to duplicate, which provides a low-cost advantage in certain geographies.

The criteria bar is set high; we really try to avoid mediocre situations where restlessness causes you to relax investment standards in one area or another. We also stress test the business under various economic scenarios and look to a normalized earnings power. We passed up many seemingly attractive ideas over the years as we would ask, “What happens under 7-10% unemployment (when unemployment was in the 4-5% range) and 6-8% interest rates?” And we would ask, “Is the business overly reliant on loose credit extension and frivolous spending?” Many names didn’t hold up under these stress test scenarios, so we passed. We bought AutoZone [AZO] a few years back as it held up under various adverse macro scenarios, and in fact performed exceptionally well throughout the Great Recession. I constantly try and guard against investing in situations where the intrinsic value of the business is seriously impaired under adverse macro conditions. We prefer cockroach-like businesses — very hardy and almost impossible to kill!

MOI: You have said that “analysts tend to overweight what can be measured in numerical form, even when the key variable(s) cannot easily be expressed in neat, crisp numbers.” Can you give us an example of how this tendency occasionally creates an attractive investment opportunity for the rest of us?

Mecham: Sure. In a generic form, I think there are many instances where a company hits a speed bump and reports ugly “numbers,” yet the long-term earnings power and franchise value remain intact. Oftentimes a key cog of value is in a form that’s difficult to measure — brands, mindshare/loyal customers, exclusive distribution rights, locations, management, etc. Sometimes it’s the location of assets that can be hugely valuable. Waste Management [WM] and USG [USG] both have assets that are uniquely located and almost impossible to duplicate, which provides a low-cost advantage in certain geographies.

Reputation is valuable in business, though hard to measure in numerical form. Reputation throughout the value chain can be a strong source of value and competitive advantage. I think Berkshire Hathaway’s reputation is very valuable in a variety of areas, most obviously in acquiring other companies.

The various cogs of value differ between companies, but many times the key variable(s) are difficult to capture in a spreadsheet model and/or are not given the weight they deserve.

MOI: You wrote recently that your “appetite is paltry for risky investments, almost regardless of potential reward. Theoretically this stance is illogical as ‘pot odds’ can dictate taking a ‘flyer’ — where the potential payoff compensates for the chance of loss — however these situations are difficult to handicap, and can entice one to skew probabilities and payoffs.” You put your finger on an interesting phenomenon: Many investors systematically overestimate the probability and magnitude of favorable outcomes. We recall the countless times we have read investment write-ups that peg the expected return at 50-100%, yet virtually no investor manages to achieve even 20+% performance over any meaningful period of time. What kinds of situations do you consider too risky or, more appropriately, too susceptible to the skewing of probabilities and payoffs?

Mecham: I’m not sure I can categorize the situations… Any time you are paying a price today that’s dependent on heroics tomorrow — fantastic growth far into the future, favorable macro environment, R&D breakthroughs, patent approval, synergies/restructurings, dramatic margin improvements, large payoff from capex, etc. — you run the risk of inviting pesky over-optimism (psychologists have shown overconfidence tends to infect most of us), which can result in skewed probabilities and payoffs. We want to see a return today and not base our thesis on optimistic projections about the future. Many early-stage companies with short track records

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fall into the “too risky” category for us. Investments based on projections that are disconnected from any historical record make us leery. Investments dependent upon a continued frothy macro environment (housing, loose credit) are prone to over-optimism as well — how many housing-related/consumer credit companies were trading at 6x multiples growing 15%+ inviting IV estimates 5x the current quote?

Many times I think it can be a situation where you just don’t understand the business well enough and the bullish thesis is the nudge that sedates the lingering risks you don’t fully grasp. It’s important to keep the litany of subconscious biases in mind when investing. Charlie Munger talks about using a two-track analysis when looking at ideas. I think that’s an extremely valuable concept to implement when looking at investment opportunities. You have to understand the nature and facts governing the business/idea and, equally important, you need to understand the subconscious biases driving your decision making — you need to understand the business, but you also need to understand yourself!

MOI: How do you generate investment ideas?

Mecham: Mainly by reading a lot. I don’t have a scientific model to generate ideas. I’m weary of most screens. The one screen I’ve done in the past was by market cap, then I started alphabetically. Companies and industries that are out of favor

tend to attract my interest. Over the past 13+ years, I’ve built up a base of companies that I understand well and would like to own at the right price. We tend to stay within this small circle of companies, owning the same names multiple times. It’s rare for us to buy a company we haven’t researched and followed for a number of years — we like to stick to what we know.

That’s the beauty of the public markets: If you can be patient, there’s a good chance the volatility of the marketplace will give you the chance to own companies on your watch list. The average stock price fluctuates by roughly 80% annually (when comparing 52-week high to 52-week low). Certainly, the underlying value of a business doesn’t fluctuate that much on an annual basis, so the public markets are a fantastic arena to buy businesses if you can sit still without growing tired of sitting still.

MOI: You have stated that your “old fashioned style embraces humble skepticism and is wary of most modern risk management tools and ideas.” Give us a glimpse into how you construct and manage your portfolio — and how you protect it from the kind of upheaval the markets experienced in late 2008 and early 2009.

Mecham: There’s no substitute for diligence and critical thinking. It’s ingrained in my DNA to think about the downside before any potential upside. We try and stick with companies we understand, where we have a high degree of confidence in the staying power of the firm. We spend considerable effort thinking critically about competitive threats (Porter’s five forces, etc). We really stress long-term staying power and management teams with proven track records that are focused on building long-term value. Then we always “stress test” the thesis against difficult economic environments. As I said earlier, we try and guard against investing in businesses reliant on some type of macro tailwind.

If you have the above, combined with the freedom to take the long view, managing the portfolio is based more on intellectual honesty and common sense rather than any sophisticated “tools,” “models,” or “formulas.” If the financial crisis taught nothing else, it showed how elegant financial models that calculate risk to decimal point precision act like a sedative towards critical thinking and even

The average stock price fluctuates by roughly 80% annually (when comparing

52-week high to 52-week low). Certainly, the underlying value of a

business doesn’t fluctuate that much on an annual basis, so the public markets are a fantastic arena to buy businesses if you can sit still without growing tired of sitting still.

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Most investors are their own worst enemies — buying and selling too often, ignoring the boundaries of their mental horsepower.

common sense — “risk models” were like the bell that told the brain it was time for recess! I also think risk management by groups can have similar effects. Being diligent, humble and thinking independently are key ingredients to solid risk management.

MOI: What is the single biggest mistake that keeps investors from reaching their goals?

Mecham: Patience, discipline and intellectual honesty are the main factors in my opinion. Most investors are their own worst enemies — buying and selling too often, ignoring the boundaries of their mental horsepower. I think if investors adopted an ethos of not fooling themselves, and focused on reducing unforced errors as opposed to hitting the next home run, returns would improve dramatically. This is where the individual investor has a huge advantage over the professional; most fund managers don’t have the leeway to patiently wait for the exceptional opportunity.

MOI: What books have you read in recent years that have stood out as valuable additions to your investment library?

Mecham: I enjoy all the behavior psychology stuff and would recommend Predictably Irrational [by Dan Ariely], Nudge [by Richard Thaler], How We Decide [by Jonah Lehrer], and Think Twice [by Michael Mauboussin].

The Big Short [by Michael Lewis] is a good book and a very entertaining read. Roger Lowenstein’s new book, The End of Wall Street, is very good as well. I’d also recommend The Relentless Revolution [by Oldham Appleby]. I like reading history of all sorts and think it’s beneficial to investing.

MOI: Allan, thank you very much for your time.

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…the bias blind spot is simply that we don’t see the biases at work in ourselves, but clearly see them in others.

Value investing strategist James Montier serves on GMO’s asset allocation team and is the author of Value Investing and The Little Book of Behavioral Investing.

The Manual of Ideas: How did you become interested in behavioral finance and value investing?

James Montier: It all started way back, well over twenty years ago when I was at university. One of my tutors was concerned that I had too much faith in the classical approach of economics, and suggested I read some papers by some of the earliest advocates of the behavioral approach, and I was smitten. When I actually starting working in markets the first paper I wrote was on excessive volatility in the bond markets (i.e., the fact that the long bond moves more than is justified by the change in future short rates). I returned regularly to the themes of behavioral finance many times over the years, but in the period of the TMT bubble I got really interested in applying the insights of psychology to investment (what I call behavioral investing) The more I understood about the behavior mistakes to

which we are all prone, the more I found myself naturally drawn to value investing as a way of mitigating those mistakes.

MOI: You have been a member of GMO’s asset allocation team since joining the firm in 2009. What research topics are you focused on at GMO?

Montier: I’m one of the portfolio managers in the asset allocation department. My interest is in unconstrained global asset allocation, effectively a value-based approach to multi-asset allocation. We are a very research driven organization; so all the portfolio managers are highly involved in the research. My work these days covers a wide range of topics from high-level ideas spanning philosophy, process and construction, to investigating forecast robustness and down to individual trade ideas like European dividend swaps. I also

write white papers occasionally on investment topics that pique my interest such as tail risk protection.

MOI: In The Little Book of Behavioral Investing, you observe that we all seem to have a “bias blind spot.” Could you explain this concept, and what can investors do to eliminate or mitigate this weakness?

Montier: Sure, the bias blind spot is simply that we don’t see the biases at work in ourselves, but clearly see them in others. So when I’ve taught behavioral investing I often hear people talking about Bob the trader, or Bill the portfolio manager as examples, but rarely do people have

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Exclusive Interview with James Montier

The best rule of thumb is that if you feel confident you are probably overconfident. I have regular debates with one of my colleagues on this subject. He is a great believer in having confidence behind an idea. I am much more skeptical. The evidence is overwhelming; we are generally massively overconfident, so erring on the side of caution makes sense to me.

the self insight to know that they themselves are making exactly the same mistakes.

As to eliminating or at least mitigating, being aware of their existence is a pretty good first step. Keeping a diary of your investment ideas is a powerful aid memoir when it comes to behavioral biases, as you can see what you were thinking in real time, and then evaluate your process in the cold light of day provided by the distance of time. The downside of this approach is obviously that it takes time to build up a catalogue of mistakes to learn from.

MOI: Behavioral finance can seem daunting at times, with numerous studies, theories and inferences. How should one approach the subject? What are the limits and drawbacks, if any, of behavioral finance?

Montier: It can appear that behavioral finance is an unwieldy beast, with a theory to explain almost every observed action. However, I think a number of authors had done an excellent job of trying to explain the salient aspects and insights of the field to investors. I’m thinking of books like Jason Zweig’s Your Money &

Your Brain, or Richard Peterson’s Inside the Investor’s Brain (and Little Book of Behavioral Investing written by someone whose name has escaped me). It is also worth noting that the late great Amos Tversky (one of the great founding legends in the field of decision-making biases) once said that he wasn’t suggesting anything that second-hand car salesmen hadn’t known for years. Once you invest time in understanding how we make decisions, you will see examples in all walks of life, which makes it all the more real.

I think the most useful application of behavioral investing is to understand the major biases that are likely to appear in the investment process, and then try and work out which ones you personally are most likely to make. Then safeguards (or checks and balances) can be put in place to try and prevent you stumbling into these pitfalls.

For instance, let’s say you are particularly prone to empathy gaps (i.e., not being able to imagine how you will feel and act under a different set of circumstances, say like the market being down 50%), you can force yourself to do your

research work on normal days when nothing much is happening, reach your conclusion on intrinsic value and an appropriate margin of safety. To ensure consistency with this effort, you can place limit orders with brokers, such that you buy when the stock or market reaches the level your work suggested.

MOI: There appears to be a fine line between confidence and overconfidence. Can we ever make the distinction a priori?

Montier: The best rule of thumb is that if you feel confident you are probably overconfident. I

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I believe most investors would be best off thinking about the three or four things they really need to know in order to make a good decision (such as intrinsic value, margin of safety, an assessment of fundamental risk) rather than getting bogged down in the details.

have regular debates with one of my colleagues on this subject. He is a great believer in having confidence behind an idea. I am much more skeptical. The evidence is overwhelming; we are generally massively overconfident, so erring on the side of caution makes sense to me. That said, investing is a very fine balance between humility and arrogance. You need a certain amount of arrogance to be willing to take positions that are contrary to everyone else, but you must also have the humility to keep looking for the evidence that shows you are wrong in your arrogance.

MOI: “Never invest in something you don’t understand” is one of your seven immutable laws of investing. How should investors go about expanding their circle of competence over time?

Montier: There is so much jargon in finance that it is often hard to see what is actually going on. I place a lot of faith in simplicity, as Einstein said “if you can’t explain it to a five year old, then you don’t understand it.” When making an investment you should be able to understand the basic idea behind the investment in a few lines. One of my colleagues who invests in distressed debt is an expert at distilling the complex into the simple. After all, in his world everything is about the detail, but when he talks to those of us outside the area, what he actually does is very simple, and the investments he uncovers can be explained in very simple terms.

In terms of expanding the circle of competence, learn from the

best you can find. But above all remember the overriding power of simplicity. Never feel afraid of asking a question, no matter how daft it sounds. Confucius said, “To ask a question is but a moment’s shame; to live in ignorance, that is lifelong shame.” In investing it can be disastrous not to ask a question.

MOI: Aristotle has written, “It is the mark of an educated man to look for precision in each class of things just so far as the nature of the subject admits…” You have often talked about the dangers of seductive, but irrelevant details in modern risk management. While researching an investment, when should we say “enough is enough”?

Montier: It is easy to get suckered into excessive detail in our industry. I’ve worked with analysts who can take a computer apart in front of you, and tell you what every little bit does, but they don’t have a clue about valuing shares. In essence, I believe most investors would be best off thinking about the three or four things they really need to know in order to make a good decision (such as intrinsic value, margin of safety, an assessment of fundamental risk) rather than getting bogged down in the details.

However, to do this you have to be prepared to say “I don’t know,” and that is never an easy admission. It makes for very poor dinner party conversations. But it allows you to focus on things that will really determine the success or failure of your investment process.

MOI: How do you define good investment judgment?

Montier: The longer I’ve spent in this industry the more I have come to realize that common sense just isn’t so common when it comes to investing. Good judgment really seems to come hand in hand with experience. For instance, there was a great research paper written by Stefan Nagel and Robin Greenwood, which showed that it was the younger fund managers who really bought into the TMT bubble, while the old grey beards where much more skeptical. People only really seem to learn when they themselves have made the mistake and accepted it as such. I’ve spent a lot of time trying to help people learn vicariously, but nothing can replace the power of lesson learned the hard way.

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…it is easy to put a high multiple on peak earnings because everything is going right in the world. However, when the world is going to hell it is hard to put a high multiple on trough earnings (that’s if you can convince yourself that these are trough earnings). People love extrapolation and forget that cycles exist.

MOI: Explain the concept of “killing an idea.” What if you can conjure up a scenario that would “kill” an idea, but you conclude it is still a good risk-reward — is this ever be a legitimate conclusion?

Montier: “Killing the idea” is an attempt to keep confirmatory bias in check. We humans have a bad habit of looking for all the information that shows we are correct, rather than looking for the information that might show we are wrong. So “Kill the idea” for us is when someone presents an idea, the rest of us must try to spot its weaknesses. Of course, few ideas are so good that they can’t be killed in extremis. For instance, very few ideas can withstand nuclear war! However, the point of killing an idea isn’t that we won’t put a position on, but rather than we are aware of potential weaknesses and have tried to think of them ahead of time, such that if they come to pass we can react. It is perfectly legitimate to kill an idea and then conclude it is a good risk-reward, it just needs to be sized appropriately. You don’t want all of your fund in such an investment.

MOI: Investors often fall for cyclical stocks exactly when their valuations start to imply strong growth far into the future. Why is it so hard for investors to apply a high multiple to trough earnings and a low multiple to peak earnings?

Montier: The short answer is human nature. The longer version is that people like to do things that are comfortable, and dislike doing things that are uncomfortable. So

it is easy to put a high multiple on peak earnings because everything is going right in the world. However, when the world is going to hell it is hard to put a high multiple on trough earnings (that’s if you can convince yourself that these are trough earnings). People love extrapolation and forget that cycles exist. The good news is that you get paid for doing uncomfortable things, when stocks are trough earnings and low multiples their implied return is high, in contrast you don’t get paid for doing thing that are comfortable.

tales. However, when one does the analysis in the cold light of day, the implied growth is often all but impossible to achieve (and that simply is to justify the current price, let alone any increase).

MOI: In addition to your books, investors may find your commentaries on the GMO website. What other resources on behavioral finance or value investing would you recommend?

Montier: If I had to suggest just three value investing books I would encourage people to go and read Graham and Dodd’s Security Analysis. it never ceases to amaze me how few people have actually made the effort to read this foundational work. I love Seth Klarman’s Margin of Safety. It is all about understanding yourself and others and keeping it simple. Howard Marks’ The Most Important Thing is best modern book on investment I’ve read — the insights are timeless.

On the behavioral front I’m a huge fan of Dan Ariely’s books. Daniel Kahneman has a book coming out later this year, which I’m excited about.

A Selection of James Montier’s recent writings: • A Value Investor’s Perspective on Tail Risk Protection• The Seven Immutable Laws of Investing• In Defense of the “Old Always”• Is Austerity the Road to Ruin?• Strategic Asset Allocation Is Not Static Allocation• Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt

MOI: What is the single biggest mistake that keeps investors from reaching their goals?

Montier: The most common mistake I come across is the one you alluded to in the previous question, a habit I have described as “overcapitalizing hope.” The sex appeal of growth stories is another prime example of this problem. Growth is exciting and seductive, it short-circuits our abilities to rationally assess because it appeals to the brain’s love of tall

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The trend of the market is up, not down. Shorting stocks puts you against that trend…

Guy Spier has been running Aquamarine Capital Management since 1995. Investors include friends and family, high net worth individuals, and private banks. The fund has market-beating returns, and has received mentions by Lipper and Nelson’s world’s best money managers. The investees can be obscure or they can also be very well known. The fund has also done well owning the shares of less understood, but very high quality, cash generative businesses.

MOI: Your fund has outperformed the market indices by a wide margin since inception, posting a cumulative net return of 115% from September 1997 through June 2009, compared to cumulative returns of 9% for the Dow Jones Industrial Average, 0% for the S&P 500 Index and -13% for the FT 100. Do you use short-selling or leverage in the portfolio and how concentrated is your fund typically?

Guy Spier on short selling: I do not use short selling. The fund has not shorted a stock since the 2002 to 2003 time frame. At that time I did short three stocks, on which I broke even on two and made money on one of them. The experience taught me that I was not going to be using short selling going forward for a slew of reasons. The first is the straightforward logic of the matter. The trend of the market is up, not down. Shorting stocks puts you against that trend and thus makes it more difficult to make money. Other

The Investment Process… than a time period like the one we’ve gone through, short selling will tend to be a difficult strategy to make money with.

This results in two things. First, it means that if you are going to short, you have to make each short position a small proportion of the portfolio. Most of the people I respect who do short make their short positions no more than 1% or 2% of the portfolio, which means that in order to derive advantages from it, you need to short a lot of stocks. The other effect is that you have to be super vigilant. When you have shorts in your portfolio, you have to be watching them all the time, looking for indications of something that will cause the stock to go up on you many multiples and thus eat away much of the value in your portfolio.

That is not the way that I want to run money. What I found when I was short the three stocks was that I was doing things, and having to pay attention in ways that I don’t think my brain is wired for. As you know, and many of your readers know, much of investing is finding a way to invest successfully to play the odds which are in tune and in congruence with

Second, the mathematics of shorting – when you short something and it goes down, it becomes a bigger and bigger part of your portfolio, thus creating increasing risk as things go against you, making it an unbalanced and unstable thing to manage. By contrast, when you go long something and it goes against you, it becomes a smaller and smaller proportion of the portfolio, thus reducing its impact on the portfolio. So there is a tendency for long positions to self-stabilize in a certain way – they have a stabilizing effect on the portfolio, whereas short positions have a destabilizing effect on the portfolio.

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Exclusive Interview with Guy Spier

…short selling falls into a category of trade that… has been described as picking up pennies in front of a steamroller.

…leverage can prevent you from playing out your hand because exactly the time when markets go into crisis is when your credit gets called.

the way your own nervous system is wired. I think that there are some people out there who have nervous systems that are wired to do shorting very well. I take my hat off to them, but I am not one of those people.

I would also add that short selling falls into a category of trade that Nassim Taleb has described very well in Fooled by Randomness. It has been described as picking up pennies in front of a steamroller. There are many trades that appear to be profitable on a cash basis, meaning that one can go for years picking up the pennies, showing an income, while pretending to one’s self, or one’s risk managers, or investors that the risk of a loss on that trade is minimal to zero. The practical reality is that one can go for long periods of time on those trades and can do just fine until a big bath happens that eats away all of the previous profits that were gained. I would argue that short selling is one of those kinds of trades and the big bath is exemplified by the experience that people had in the recent Volkswagen/Porsche pair trade. The price of VW went up many, many, many times and resulted in a huge loss for the people who were

in that position, potentially wiping out many years of shorting gains.

I see a lot of these kinds of opportunities, and the right thing to do is just to say “no.” I think one of the hard things about these types of trades is that they are extremely attractive. They are dressed up to look extremely sexy for the kinds of people that are thinking about investing in funds like mine. I think that often investment managers consider doing them not because they believe in the trade themselves, but because they know it will be attractive to certain types of investors who perceive the trade as being smart. I think that the best thing to do is walk away from them.

Guy Spier on leverage: I was actually levered to 110% of the value of equities, so 10% levered in 1998, as I purchased more securities during the Asian crisis. I was very lucky, because everything worked out for me and I made a little bit more return as a result. Since then, the fund has never been leveraged for a very good reason. Most of the people that you and I know, the readership of your fine publication, will be in trades that will make them money provided they can play out their hands.

We know that leverage can prevent you from playing out your hand because exactly the time when markets go into crisis is when your credit gets called. I am aware of funds that had their credit lines pulled at the most inconvenient times and suffered catastrophic losses which would not have been suffered had their credit not been pulled.

It is worth saying that except in the case of a very large fund that can arrange for some kind of long-term loan from their broker, the loans tend to be overnight. You get money overnight and the trades can usually be liquidated within a very short period of time.

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A checklist pulls us away from the kinds of actions that we would take if we were in either fight-or-flight or greed modes.

Good investment ideas usually take months, if not years, to play out. I would argue that levering up an investment portfolio, even if it is composed of liquid securities, is a profound mismatch of assets and liabilities.

I think that the experience of Bear Stearns and Lehman Brothers exemplifies this case. They were borrowing money short-term and the investments they were making were liquid, so from the perspective of the lender they were not bothered because they knew they could force the brokerage firm to liquidate in order to pay their short-term funding. The reality was that the bets that they were making needed time to play out and to the extent that those firms didn’t have the time to let those bets play out, they suffered insolvency, and that is not something that I am about to do for my investors.

Guy Spier on concentration: The portfolio was extremely concentrated in that about six positions were as much as 85% of the total value of the fund. I think that part of the reason for my substantial decline in 2008 was the fact that risks that I was not aware of cropped up in the portfolio and impacted some positions substantially. If I were able to go back in time and look at the information I had, I am not sure I would not have owned the things that I owned. However, I think that one of the ways I could have protected my investors from such a substantial decline is to have less concentrated positions. Going

forward a 5% position will be a full position. An idea will have to be something absolutely extraordinary to become a 10% position and many positions in the portfolio are currently 2-4%.

MOI: When it comes to stock selection, you have talked about the importance of checklists. Why are they so crucial, and what are some of the key items on your checklist?

Guy Spier: Those readers who have seen my two or three presentations know that I have talked about checklists. All of these ideas have emerged from conversations with Mohnish Pabrai, who noticed an article by Atul Gawande in The New Yorker with profound implications for investors. I’ll share the basic insight that I have had as a result of these conversations: I think that we just have to acknowledge that there are some individuals out there — I think Warren Buffett in the investment world is one, Ajit Jain in the insurance world is another — who have a very particular ability to rationally analyze a situation in spite of crazy things going on in the world.

Most of us do not have that specific wiring. In spite of that, we can still improve our decision-making an awful lot by using checklists. The main way that I see it is that the investment world, either by design or by nature — and I think it is a combination of the two — throws up plenty of information that is designed to trigger one of two areas in the brain.

One is the threat detection fear mechanism, which throws up a very primeval response that has evolved within us for a very long time. It is one of the oldest parts of our brain — the fight-or-flight response. When we see something that makes us fearful, and we don’t have time to act, analyze and make weighted judgments, we have to decide either to run or to stay. We all know days in the market where that part of an investor’s brain is dominating and in which share prices can move around rather dramatically when compared to what appears to be very small amounts of news. So that is one sort of mode that the markets can be in, which is really the psychological mode of the majority of the participants in the market.

Then there is another side, which is irrational exuberance, as Alan Greenspan has described it, where the part of the brain that is being triggered is, as I’ve seen it described in various articles, the pleasure center of the brain. It turns out that the part of the brain we stimulate by the expectation of future profits is not that far away or dissimilar to the part of the brain

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…in terms of building checklists, there is no question that the place to go is past mistakes.

that is stimulated, or lights up in CAT scans, when cocaine addicts either contemplate or are taking cocaine. These are very powerful centers.

Whether it is the fight-or-flight or the expectation of pleasure centers, the effect of both is to short-circuit rationally considered thoughts. They undermine the path of the brain that can make weighted, careful judgments about probabilities and about expectations. My perception is that it is the rational neocortex from which flow the very best investment decisions. Unfortunately, the world in which we operate is a minefield of opportunities to get caught up either by the fight-or-flight or by the pleasure center. So to the extent that somebody will talk about an investment being good when one is trembling with greed – I would not subscribe to that because trembling with greed implies that your greed and pleasure mechanisms in the brain are dominating the rational side.

I think that somebody like Warren Buffett is naturally wired not to be in either of those two extremes and spends his time in the happy middle. I think that what the rest of us human beings can do to train ourselves to be in that happy middle is use checklists. A checklist pulls us away from the kinds of actions that we would take if we were in either fight-or-flight or greed modes. So that is the basis for checklists.

The example I have given in talks is an airplane that is crashing. There

is no question that checklists have been extremely helpful in reducing airplane accident rates. What it does is it brings the brain back to the place where one can make rational decisions.

the needs of the business and on capital allocation decisions. His whole investment, in fact, would have gone to his former wife if she had won the lawsuit. The whole company would not have belonged to him. So his emotional ties to the company were predicated on the outcome of the court case. His desire to make money for the company’s shareholders would have been hugely diminished if his wife had ended up controlling the company. So one of the items in my checklist is whether the CEO is going through major divorce proceedings, in which case I would tend to weigh that very heavily.

To give an example of checklist items that don’t come from individual or personal mistakes is the example of Coca-Cola and its ownership by Berkshire Hathaway. There was a period earlier this decade when Coca-Cola was trading at a multiple which was as high as 40 to 45 times earnings. We all know that Warren Buffett did not sell. I think that there is at least one statement in the public domain where he said that if given the chance to revisit that decision, he would have sold Coca-Cola.

MOI: What advice would you give other investors on building an effective checklist? Is it primarily a product of past investment experience, i.e., mistakes — and if so, how does one differentiate between mistakes that should go on the checklist versus others that are simply unavoidable?

Guy Spier: Obviously, in terms of building checklists, there is no question that the place to go is past mistakes. Not only one’s own past mistakes, but also to look at other investors’ past mistakes and see what those mistakes were. It seems to me, and it is a process that I am still going through, that the more specific the checklist item is the better.

I can give an example of an investment that I made where the CEO of the corporation was going through a divorce — a long, protracted and bitter divorce. In retrospect, when I look at what went wrong in that investment, I can see very clearly that the fact that he was going through this divorce meant that the CEO was much less able to focus both on

…checklists are not wish lists.

I ask myself to what extent he was unable to make that choice at the time and execute a sale because he had already made public statements in the annual reports and elsewhere that Coca-Cola

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was an inevitable and permanent holding of Berkshire Hathaway. Making such a public statement is a very powerful driver of commitment consistency bias, which may have affected his ability to make rational decisions.

So what would go on the list? You would ask yourself the question, “Have I made public statements about this?” Obviously, the note to self is, don’t make public statements about positions you own that will predispose you towards owning them or not owning them or being able to sell them or not.

There is another example from Berkshire Hathaway, which is the acquisition of Cort Furniture, which did not turn out to be the phenomenal acquisition that some commentators suggested it was. It seems that one of the reasons is that Cort was in the business of renting furniture to people who had a temporary need. Cort benefited dramatically from the Internet bubble in which many companies were setting up offices that needed to be furnished rather quickly and had large amounts of money to spend. In the aftermath of the Internet bubble, the demand from that portion of the market was extremely attenuated and Cort’s earnings power was diminished significantly.

The basic insight that seems to have not been applied in the Cort acquisition, which has gone onto my checklist, would be, “Am I investing in an industry or a company that is benefiting from

another industry that has just experienced a dramatic boom?” Another way of saying the same thing would be, “Am I investing while looking in the rear view mirror rather than looking at the road ahead?” Whether they are yours or somebody else’s, I think that mistakes are the most fruitful place to look for checklist items.

It is important to note that checklists are not wish lists. Obviously, we are looking for certain kinds of businesses and certain types of investment. That is what we are navigating for. The checklists are very specific items that are designed to bring our brains away from the influence of greed and fear. I would argue that I am not sure a mistake that is unavoidable is a “mistake” in terms of your question. I think that there are so many ways where one can go wrong. In retrospect we can see what we should have known. It is hard to control for the unknowable, because it is by definition unknown. The more one can throw onto an investment checklist, the better.

It is worth pointing out that no investment is going to pass every single investment checklist item. What the investment checklist will do is to throw up the issues that one should be focused on. Then an investor can try to weigh them to decide if they negate the benefits of the investment or not. One of the things that the checklist has done for me is to bring up the basic question: “Are we stretching to make the investment?” In this way investing is very similar to

…no investment is going to pass every single investment checklist item. What the investment checklist will do is to throw up issues that one should focus on

golf. In golf, one never hits a good shot if one is stretching or pushing oneself. The best golf shots come when we are acting well within our capacity. To that extent, a term that I do not think should apply to investing is, “I spent time getting comfortable.” The investment should leap out to you. If you are trying to get comfortable with something or it takes too long for you to get comfortable with it, then it is probably not a good investment. You shouldn’t have to get comfortable. That implies to me that I would be stretching.

MOI: What is the single biggest mistake that keeps investors from reaching their goals?

Guy Spier: The biggest mistake is when we as investors stop thinking like principals. I think that when we think as principals, when we apply Ben Graham’s maxim that we should treat every equity security as part ownership in a business and think like business owners, we have the right perspective. Most of the answers flow from having that perspective. While thinking like that is not easy, and most of the time the answers are not to invest and to do nothing, the kind of decision-making that flows from that perspective tends to be good investment decision-making.

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I’ll just give you examples from my own life and from people close to me of the ways in which that perspective can be deformed by the environment and circumstances. It can be deformed by having the wrong investors — investors who see you, the investment manager, as a proxy for their desires.

I had an experience with an investor who was admonishing me for holding too high much cash. The investor claimed that they were not paying me to hold cash balances. Well, that created a pressure on me to get fully invested. The person making the investment wanted me to show that cash was being put to work. I was responding to the situation rather than to the logical and rational dictates of having a prudent amount of cash. I was responding to the actual demand of the client. To the extent that I did respond to that pressure, I was acting less like a principal and more like somebody that was putting together a marketing story.

In another example, to the extent that I have been associated with the for-profit education industry, I have received questions as to why I don’t market my fund as a global education fund. Again, if I were to do so, I would no longer be acting as a principal trying to maximize the return on investment for my shareholders, but I would be seeking to market the fund by appealing to a particular niche audience. That could result in some substantial misallocations of capital.

I think that this mistake comes in varied forms and it influences all of us. When we talk about creating the best environment for making investment decisions — a lot of that entails investing within the right structure, the right incentive structure. It also comes from having the right investors as partners and aggressively moving away from and not engaging with people who show themselves to be the wrong type of partner because they are focused on the wrong thing. I think that everything falls from having a principal’s perspective.

MOI: How do you generate investment ideas?

Guy Spier: My answer is “all of the above.” The nature of a good investment idea is that it puts together new facts in old ways or old facts in new ways. You need to have the mental flexibility and creative ability to see something new and see why it fits together in a certain way. I think that the answer in my case is to look at everything, to do everything in a certain way, and to reserve a lot of time for thinking.

I read other managers’ letters. I look at the positions they own. The lists of portfolio securities that other managers own are very useful because it means the investment has already passed a very important filter. I think that whenever something in Seth Klarman’s portfolio is trading below the price that he paid for it, it is worthy of looking at, and at the same time, it performs another

function. To get better at investing you want to study the moves of the masters.

I also read a number of industry publications. The publications vary at any time depending on the particular industries that I am interested in and what subscriptions I have decided to subscribe to. One subscription that I have right now is to The Nilson Report on the credit card industry. Based on my interest in following the U.S. banking sector I recently subscribed to The American Banker. I also recently subscribed to The Oil and Gas Journal. These are all interesting journals that don’t necessarily throw up investment ideas per se, but they throw up background information. While a lot of this information is available on the web, it is very nice to look at it in the form of a publication.

So, wide reading, including the daily newspapers, is important. I like to screen for companies, but increasingly I have found that your service and other people present me with screens that perhaps provide a shortcut. Having said that, it is also worth saying that I don’t think there is any shortage of ideas for anyone who is interested in investing. It doesn’t take a moment of browsing on the Internet before you have 30 ideas to look at.

… whenever something in Seth Klarman’s portfolio is trading below the price that he paid for it, it is worthy looking at.

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The real question is, as I look at the ideas, why am I discarding them and what personal biases am I engaging in as I discard them? I think something I have seen in a number of portfolios, including my own, is that the contents of the portfolio are a reflection of the particular biases of the person running the portfolio. To the extent that those biases or the model of the world that person has is faulty, it can lead to either phenomenal returns if the stars are aligned or it can lead to very bad returns if the stars do not align.

As I look at other people’s portfolios, I look to understand what their biases are and what particular chinks in their armor they may have. They may have a predilection for small-cap stocks or they may have a predilection for niche companies with niche ideas. Ultimately, what I can say for myself, I have had a bias towards low-capital invested, high-ROE businesses. In general, that is a bias that has probably been very productive. However, there are environments, particularly the one that we have just been through over the past 18 months, where that has probably hurt the portfolio more than it has helped the portfolio. So the way in which we go about generating ideas is obviously both important and critical and I think that ultimately it is a journey to explore our own personal biases.

MOI: Please share with us your thesis on global for-profit education. Which countries are particularly good places to invest in this growing trend?

Guy Spier: The thesis on the global for-profit education business is a very simple one. We have an educational infrastructure whose legacy was the industrial revolution. This has been valid whether we talk about China, Brazil, the United States, or Western Europe. The basic outlook was that the vast majority of people being educated would go to work in factories. They didn’t need more than a certain level of education. These educational systems would then skim off the very best who would go off to be lawyers, doctors, and accountants – white-collar suited pen pushers.

The IT and post-industrial revolution that we have been through and continue to go through over the last 30 years has been one in which the need for relatively low skill levels has attenuated and the need for people with high skill levels has grown dramatically. Whether it is people who can do research into biochemistry and biotechnology or whether it is people who are developing gaming software for the gaming industry. Obviously the people who design computer chips or computer programmers need to achieve a certain skill level.

In every growing part of the global economy, you have the need for highly skilled workers, and the

infrastructure is just not set up to generate the number of people we need. For various reasons, the private and the state sector are very slow in responding to those needs. What has jumped in to fill the gaps are the for-profit institutions, which are very responsive to the needs of people who need to improve their skill sets and to prove their marketability in the workforce. That creates the demand for education.

I should add that in emerging markets the demand is dramatically heightened by the fact that these economies are trying to grow at a rapid rate, and most of the growth comes from the sectors which require skilled people. I would argue that in places such as China and Brazil there is a dramatic shortage of skilled people.

… the need for relatively low skill levels has attenuated and the need for people with high skill levels has grown dramatically.

Global For-Profit Education…

Then we come to the supply side. It turns out that the supply of educational services is profoundly constrained for a number of reasons. I think that this relates to the work that I did in the credit rating business, and there is much that is similar. First of all, the education business tends to be highly regulated. In most countries around the world, you cannot just go and set up a post-secondary college and expect to be allowed

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to stay in business. There are regulatory requirements which have to be met, and the tendency in all regulated businesses is that the leaders and the largest companies tend to dominate the regulatory process. There is a good aspect to the regulatory process in that it raises standards in the industry and it ensures that you do not have charlatans and fly-by-night companies engaging in the industry. At the same time, it has an anti-competitive effect. Now, from the consumer perspective, that is not good. From the perspective of an investor in those industries it is very good.

The other side of the story, which is not regulatory, is equally important. There is a reputational and branding effect which takes place when an educational institution has been around for some time, in which the very fact that you have attended and studied at a certain place gives you credibility in the marketplace. There are a limited number of brands that people can carry in their heads. We all know that when it comes to the United States, it is extremely unlikely that any university would displace Harvard, Yale, or Princeton. This branding effect also extends to the kinds of colleges that are offering for-profit degrees in that when they establish a brand, it becomes very marketable. The students who are going for higher education to improve their skill sets are not going to attend any institution. They are going to attend an institution with a good brand.

[Regulation] raises standards in the industry and ensures that you do not have charlatans and fly-by-night companies engaging in the industry. At the same time, it has an anti-competitive effect. From the consumer perspective, that is not good. From the perspective of an investor in those industries it is very good.

There are two final elements to the thesis. First, the return on investment to the student is extremely high. This is something that has been studied across economies and has been shown to be the case across many different economies. The payback of any degree, even if you spend $20,000 to $30,000 per year on a two-year degree — which is not as effective as a four-year degree — is usually within two years. Somebody earning $50,000 will end up, after they have finished their degree, earning $60,000 or $70,000. Thus, they can pay off the cost of the education very quickly.

The ROI on a degree has not been definitively studied, but I estimate to be well in excess of 50%, and the institution is only capturing a small proportion of that return on investment. Then when it comes to the institutions themselves, it turns out that you can have very high operating leverage, very high returns on invested capital, and very high returns on equity in these businesses because your customers benefit and because there are barriers to entry, both regulatory and other. That means that if you are established in the business, you can make very high returns. The key is to buy these companies at reasonable valuations and to buy companies that don’t run into regulatory problems — that have a long hill to slide down.

MOI: Do U.S. giants such as Apollo Group have a chance of becoming leaders in overseas markets, or do you expect “locally grown” companies to dominate?

Guy Spier: I should say that I have not been particularly focused on the U.S. for-profit education sector, even though it is the most developed in the world, because my perception is that the companies have had extremely rich valuations.

I also think that since the U.S. market is so large and so full of opportunity, the majority of companies have focused, probably rightfully, on the domestic market. The result has been that the international markets have been wide open for other companies to pursue.

I can think of at least one non-U.S. company that has a substantial chance of becoming the dominant player in the for-profit industry over the next 20 or 30 years. But there are some very good United States-based companies that I believe will do extremely well. I have visited the operations of Laureate Education [taken private in CEO-led buyout

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in 2007] in a number of different countries. They do an outstanding job of running a campus and they also have a global vision.

I think that another company that is developing steadily internationally is Kaplan of the Washington Post [WPO], although they have been slower than Laureate to move internationally. The Kaplan testing service exam preparation service is already very international, so they have a good basis upon which to expand their operations.

A third company, DeVry [DV], has started to gingerly expand into international markets. They recently bought a company in Brazil and they have had their international medical school, Ross University, which is based in Dominica. They also have means for exploring expansion through Becker Review. The guy who runs international development is named Sergio Abramovich, who is a very interesting guy to get to know. So they are developing, but I would still argue that all those companies, except for Laureate, are very much American in their focus and that creates great opportunity for non-American companies to pursue international opportunities.

MOI: For-profit education providers have enjoyed significant pricing power despite the fact that many companies derive a majority of revenue directly or indirectly from government-supported loan programs. Do you expect tuition price increases to continue to outpace inflation?

Guy Spier: It is true that the for-profit education providers have enjoyed significant pricing power. It is worth saying, as an aside, that education is a fantastic example of a Giffen good. Those of us who are economists will know that a Giffen good is something where the higher the price goes, the more we want of it. Examples usually given are luxury goods such as a Rolls Royce or a Rolex watch. Warren Buffett, in his own inimical way, has described this as when you go and buy a diamond ring for your fiancée. You don’t want to come home and say, “Honey, I took the low bid.” That is true when it comes to certain brands of chocolates, it is true in the case of high-end jewelry, it is true in the case of certain luxury goods, and it is also true for education. It is true in any place where price becomes an indicator of value. Where someone is engaging in a purchasing decision where there is a huge amount of uncertainty, they don’t know much about the product they are buying, and they very much want to get it right. Price becomes one of the ways in which you discern that a purchasing decision is a good thing. This creates an incredibly strong business advantage for companies and enterprises that are leaders in their field.

I have absolutely no doubt that the “Harvard Business Schools” of the world will continue to lead the industry in terms of price increases. As more and more people get rich around the world, they will all want elite educations. So as long as there is an increase in demand for their services, as there is today, the “Harvard Business Schools” of the world will be able to increase their prices at a greater rate than the rate of inflation. Those elite private universities create the pricing umbrella for the for-profit industry to move underneath. So if Harvard is raising its prices 10% per year, it is perfectly possible for a for-profit university to raise its prices 5% or 6% per year, and I absolutely expect them to do that.

It is true that much of the revenues in the United States come from government-supported programs, but ultimately the decision to take on the debt and the decision to attend an institution is taken on by the student themselves. If the companies were pricing their education above the value that their educational services would deliver to the student, then one could expect that the price rises would not continue, but that is not the case at all. In fact, studies would suggest that the value of an education is going up, not down.

One of the statistics you can look at to support this is to look at different economies and look at their salaries per degree. What is the salary of the non-college graduate workers? What is the salary of a college graduate?

…for-profit education providers have enjoyed significant pricing power. […] education is a fantastic example of a Giffen good.

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What is the salary of a master’s degree graduate? The gap between educated and non-educated is increasing. In a knowledge-based world, degrees which help you work with knowledge become more valuable because you can add more value in the workplace. Therefore, the people who are offering these degrees can charge higher prices. I don’t expect that process to end any time soon.

investing country and assume that the same conditions exist in the country where the investment is being made. I have seen that going both ways. From the United States investing out, there are assumptions that investors have made about how the managers of the foreign company will allocate capital. There are also assumptions about what kind of standard managers hold themselves to. Not all managers of companies want to be remembered for being the best capital allocators. In some countries, being rapacious and greedy is considered a normal standard. Russia might be an example of that. At the same time, there are some countries such as Switzerland, where I would argue the ethics of drawing a modest salary and really acting for best interest of the shareholders are possibly even higher than the very high standards that already exist in the United States.

The reverse is also true. For example, Korean investors think that the United States is a very risky place to invest because they make assumptions about the way Americans act. I think that the key danger is that we make many assumptions that have to be checked and revised. One of the ways to do that is to spend some time in the country where the investments are being made. One of the rules that I have is that I want to be able to read the source documents in the language in which they are produced. I think there is a lot of subtlety that is missed when one reads a translation.

Transaction costs in international markets have been going down over time, so I don’t think that they should be a big concern. I have been a buy-and-hold investor, and my average holding period is in excess of three years. To the extent that the transaction costs a bit higher, it has not been a deterrent for me.

MOI: Is globalization irreversible?

Guy Spier: The global economic downturn has made protectionism more popular. We absolutely know that. We see that in a number of different ways, and we all know as free traders that this is unfortunate but true. The anti-globalization and the anti-world trade movement is a strong movement. People who feel like their jobs have been lost and their livelihoods have been lost to workers from other countries have a specific and very genuine grievance which is something that all globalizing economies have to deal with.

To deal with it doesn’t mean to ignore it. To deal with it means to find a way to buffer the effects of the jobs of these people going overseas. Of course, in theory a laid-off autoworker can become a creative web designer. However, the truth is that a laid-off auto worker may only be good at making cars. I have absolutely no doubt in my mind that this is one of the reasons why we pay taxes — to ensure that people who are laid off through globalization have opportunities to retrain and have opportunities to go into new professions and new jobs and be productive human beings.

International Investing…

MOI: You have invested globally for a long time — what are the main pitfalls to global investing and how big a role do transaction costs play when investing locally in emerging markets?

Guy Spier: I have been investing internationally for a very long time – since I started investing. The main insight I would pass along is that I try to see the world as borderless. I think this is a better way to see things. I am not too concerned as to where a company is based. I am more concerned to find the business qualities that I need to find in order to make an investment.

While it is easier in the United States, I think that an investor is crazy to stop the search for great investments at the borders of the country that they happen to be living in.

I think that the most profound pitfall and thing that one has to get over when investing beyond your borders is not to take the conditions that exist in the home

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In terms of whether globalization is irreversible, I would argue that it is absolutely irreversible in the same way that the phone created irreversible changes, and the Internet created irreversible changes. I would argue that much of what is driving globalization is actually the implementation of these new communications technologies around the world.

One great example that I heard was of the remote Indian village in which there are no telephones. One day you install one telephone and the effect of that telephone is profound even though there is only one. Suddenly farmers can phone hundreds of miles away and discover the prices for their produce at markets. Suddenly, middlemen have a much diminished opportunity to engage in taking middleman profits. Farmers are able to discover weather patterns and storm fronts and thus plan when they plant and how they manage their fields. It is the subject of a talk that I have given. Once you have that convenience, you are not going to give it up at almost any price. Once you have lived in a concrete and steel constructed house, you are not going want to go back to living in a mud hut. Once you have had the benefits of speaking on the telephone to your loved ones, you are not going to want to go without that.

I would argue that globalization is inevitable and irreversible. It is similar to thinking that southern Manhattan once had fields and crops planted there. Over time there

was an increased concentration of offices and residential activity in southern Manhattan, and the fields moved away from Manhattan such that you don’t have any planted fields within at least a ten-mile radius of Manhattan, let alone southern Manhattan. The process by which southern Manhattan developed was inevitable and irreversible. Much as the probability that southern Manhattan would be ploughed over and turned into fields is extremely low, I would argue that the probability that globalization is reversible is equally as low.

For those of us that are big Buffett fans, that is a huge advantage. It helped me to understand why I am different than Warren Buffett. I think it is a valuable read in that regard. It helps to place his mind in the center of the decisions he has made. The book lets you look at the kind of emotional life that Buffett had growing up. I do not think his phenomenal track record could have come about without that emotional makeup.

There are three books that I have read not so long ago on complexity theory. I think that they are extremely valuable. One is by John Gribbin.8 Even though I studied economics and I felt I had a good grasp of the kind of economics taught academically, I feel that the study of complexity theory as applied to the global economy is actually a much better model for understanding how the global economy evolves.

One of the books is by Benoit Mandelbrot 9 who is famous for the Mandelbrot set. He also wrote a book about the fractal nature of financial markets. Mandelbrot is obviously a very modest guy because his fractal approach to financial markets predicts that sooner or later something like what happened over the last 18 months was going to happen. Unlike other commentators, who get in front of the TV cameras and say “I told you so,” he has not done that. He is a true scientist.

…globalization is irreversible… in the same way that the phone created irreversible changes, and the Internet created irreversible changes.

MOI: What books have you read in recent years that have stood out as valuable additions to your investment library?

Guy Spier: I sent Alice Schroeder’s book7 out to a bunch of investors. I think that it is a very valuable book to read. I know that it has been controversial, but setting that aside, I think that Alice probes into aspects of Warren Buffet’s mind and psyche to reveal more of his personality with all of the foibles of the human being behind Warren Buffet.

And Finally…

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Lastly, an investor of mine gave me one of the two books by Atul Gawande who is focused on the very small things that make hospitals better. One of the books is actually called Better. The other book is called Complications. Atul Gawande gives a sense of how you can be extremely knowledgeable and totally focused on the right outcomes and still fail by a wide margin to get close to the ideal that you would like. Of course, this has massive lessons for investors.

I recently took up bridge, so I have been reading a lot of bridge books. I am looking forward to going outside Borsheim’s at the next Berkshire Hathaway meeting and playing bridge with whoever is willing to play me. I don’t think that it is a coincidence that Buffett chose to put an area to play bridge outside of Borsheim’s rather than chess or table tennis or any one of a number of other things. It is not just that Buffett likes bridge. He likes an awful lot of things. I think that he is sending a message, in his inimical way, which is not to force it down anyone’s throat. But by placing an area to play bridge right outside of Borsheim’s, Buffett is saying that bridge is more than just a great game, it is something

…by placing an area to play bridge right outside of Borsheim’s, Buffett is saying that bridge is more than just a great game — it is something that has really helped him develop his mind.

8 John Gribbin: Deep Simplicity: Chaos

Complexity and the Emergence of Life

(Penguin Press Science).

9 Benoit B. Mandelbrot: Fractals and Scaling In

Finance: Discontinuity, Concentration, Risk.

that has really helped him, I believe, develop his mind. I think it can develop all of our minds in a way which is helpful to investing.

MOI: Guy, thank you very much for taking the time to interview with us.

We remain indebted to David M. Kessler for transcribing the interview

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…if you were focused on safe and cheap and forgot about everything else your portfolio would have nothing but Japan in it. It is very, very cheap.

Amit Wadhwaney is the co-founder of Moerus Capital Management and has managed foreign stock portfolios since 1996. He has been particularly interested in emerging economies where he has long believed that market inefficiencies favor bottom-up value investors. Amit formerly was a founding

manager of the Third Avenue International Value Fund as well as the Third Avenue Global Value Fund and the Third Avenue Emerging Markets Fund. Earlier in his career, Amit was a securities analyst and subsequently Director of Research for M.J. Whitman. He holds an MBA in Finance from the University of Chicago, a B.A. with honors and an M.A. in Economics from Concordia University in Montreal (where he also taught economics) and B.S. degrees in Chemical Engineering and Mathematics from the University of Minnesota.

The Manual of Ideas: How do you approach Japan? What is different about your approach and why do you see value in Japan?

Amit Wadhwaney: Now, a couple of things. Japan, if you were focused on safe and cheap and forgot about everything else your portfolio would have nothing but Japan in it. It is very, very cheap. Numerically it’s very cheap. And companies are often flush with cash. It is neglected, it is disliked, it meets many of these criteria that draw people — some would say suckers — like us. There’s a whole collection of value investors there gnashing their teeth and wondering, what is it that we do and have done?

First, before last year, before 2011, disproportionally to my mind value

existed in the domestic companies — disproportionally, by a big margin. Exporters were battle-hardened. Locally, Japanese companies have been constantly coddled, and the local companies tend to operate quite differently.

going to make money here? That’s the question everybody asks. So having been worried about that same question some years ago earlier, having watched — you must understand, my history with Japan goes back to the early to mid 1990s. And Japan has been a place where you invest and you wait and wait and wait and suddenly make money, lots of it and very fast. It’s always been this sort of hockey stick phenomenon. It’s like watching paint dry.

Now, this time may be different. I don’t know, I can’t tell you. But the way I’ve approached this is you buy things, you put yourself in the path of some kind of change, change which may come from the companies themselves doing the right sort

So our focus was on domestic companies. They all met the safe and cheap criteria. Now, the question of course you ask is after some years of requisite impatience and nothing happening, how are we

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Exclusive Interview with Third Avenue’s Amit Wadhwaney

For example, for companies to hang on to cash in a period of deflation is a very rational response. It’s a logical safety blanket. Logical, completely logical.

of thing. So we don’t buy perfect companies. Let me be very clear about this. Are these great capital allocators? Often not.

Let me give you an example of one of our holdings which we have, which has done everything right except for one of the most important things. Mitsui Fudosan [Tokyo: 8801] is a magnificent real estate company, almost near trophy real estate. A great balance sheet, growing the top rapidly. It’s building. They’re building buildings; they’re doing all the right sorts of things. However, what’s the rub? The rub is the following. You’re building buildings there with cap rates of 5% when you can repurchase shares at high single digits like 9-10%. To my mind it’s not a very big leap of imagination that gets you there. Yet, for the last number of years they visited us here, for the last number of years we asked them, “Why do you not do that?” They said, “No, no, no, we have to grow the business.”

So the business is growing. It is cheap. And it may stay cheap for a while. However, value is building. We are waiting for the lightning bolt to hit there.

MOI: So what do you say to people who when you tell them about your approach to Japan and then they say, “Well, yes, I get what you’re saying but how do you get over this corporate governance?”

Wadhwaney: Please. You have terrible corporate governance in other places, too. Japan’s been, I think, singled out. Japan has been pushed into a crisis. They will change. They will change. Japan’s response to the tsunami and Fukushima was shockingly slow. You’re actually seeing change, I think, flowing from that now. I’m a patient investor. Again, we don’t have a huge amount in Japan. Some people are very Japan sensitive so they won’t buy it if you have an index rating. Again, we bought what we could buy which was interesting to us. We are very patient. We are seeing industries reconfigure, restructure themselves. We are seeing gradually eke out more and more and more.

The response of Japanese companies has not been entirely irrational. For example, for companies to hang on to cash in a period of deflation is a very rational response. It’s a logical safety blanket. Logical, completely logical. Because it enhances

the probabilities of survival. And they did that. They have very conservatively figured balance sheets to cope with this kind of deflation, the spiral the country went through. They also worked hard on their costs. There’s a lot of good that’s gone on in the process.

The arguments against Japan revolve around the lack of M&A market. Because if there was a very active M&A market you would seriously start to see a change happen in terms of valuations being recognized.

MOI: So this argument about corporate governance then in your view does not reflect the specific opportunities that often pose exceptions to that overall negative view?

Wadhwaney: Oh yeah, there’s lots of reasons to avoid Japan. Lots of reasons, heavens. The graphics, the slow responses to crises, the civic economics. Maybe civic

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A company we bought, Otsuka [Tokyo: 4768]. Otsuka trades at a very modest multiple of operating earnings, which it has grown over the years.

economics. A lot of stuff that they could do. A lot of the damage is self inflicted, quite clearly. The lack of active M&A market. But by the same token the steps are slow — baby steps, evolutionary steps is a culture not characterized by a lot of people wish to be outliers in their conduct.

Let me tell you yet another worry I have. Japanese companies being increasingly seized by the fear that Japan is so permanently ex-growth given the fact that there are too many of these cash balances, given the fact that there are fewer and fewer growth opportunities in Japan, we start making crazy acquisitions outside Japan at very high prices. That is, for me, a much more scary thing than the other ones you mentioned so far. That scares me because Japanese companies historically have not been the stingiest of acquirers. They have not been willing to engage in some knock them out, drag them out, got to fight to save the last nickel. They just have not. They don’t have it in them. They prefer to be viewed as friendly. Friendly takeovers sometimes are expensive takeovers, unfortunately.

MOI: Now, some people would also say that if they can get over the corporate governance then often would cite it as but it’s bad, there are graphics and the economy. How do you perhaps realizing that that doesn’t present a hurdle for you, how does that perhaps filter down to the selection of the specific companies? So I’m thinking are there any themes in terms of more

export-oriented companies, more certain sectors? How does that enter if at all?

Wadhwaney: Well, the hurdle of getting into Japan is overcome by looking at two times earnings for companies. I’d rather be two times earnings for companies. Insurance companies, I used to certainly love the idea of owning insurance companies at fractions of book value, fractions of embedded value, as opposed to buying them at multiples and multiples of book value in China because China had growth, this had none. So that’s one hurdle. I have a much bigger hurdle to deal with in the case of these growth markets, or at least once growth markets. They are repricing, too, as they should.

I wouldn’t say export companies have particularly been a theme for us. The most recent purchase of ours — actually two of them — would be Daiwa Securities [Tokyo: 8601] which was largely domestic. In fact, unlike Nomura, they have so much smaller global ambitions so they’re not going to do silly things like buy Lehman Brothers and then find out everybody runs away after they buy them and stuff like that, all that stuff. They’re much more local, they’re much more focused on things like their asset management business locally. That gives me a source of comfort.

So companies that have really narrowed their focus, where they’re very good and very big players, is of some interest to us. A company we bought, Otsuka [Tokyo: 4768]. Otsuka trades at a very modest

multiple of operating earnings, which it has grown over the years. This is a company which is a systems integrator. It’s a company which is kind of like Ingram Micro in the U.S., for example. They’re very big, very big. And Japan has been itself a slow innovator in terms of its installed computer base. It’s much, much, much slower. They’re very good at what they do. It’s a company which was set up by a Ricoh copier repair guy who basically got into these and saw this huge opportunity to help automate, modernize small to medium enterprises in Japan which were very, very slow. They’ve actually been growing and growing very rapidly at the expense of the mom and pops. And even in this horrible market they’ve been growing rapidly.

The surprise — what probably will surprise people more is the rate of earnings growth happening in Japan. That’s not what we focused on. We focused on cheapness, bought our stocks and what happens, happens. I’m incapable of forecasting the future.

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