Great Investor Lecture on Mar_27_2007

A Great Investor Discusses His Evolution

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March 27, 2007

Professor: Tonight‟s speaker is one of our most valuable. What is particularly important is that he is one

of the people who as much as anybody else has kept the discipline of value investing alive during the

years when it scarcely existed (at Columbia Business School). He started out with Walter Schloss whom

you read about in the outstanding investors of Graham & Doddsville. Who along with Ben Graham and

Warren Buffettt are the fathers of value investing? He was also, after going out on his own, an

extraordinarily effective producer of other value investors. Who has taken XX‟s class? Talk to people

who did. It is an extraordinary class.

He was also the person who recruited and trained Beth Lilly (Manager for the Woodland Fund) from a

fate worse than death, which is Goldman Sachs. In particular, he actually is the person who funded the

first revival of value investing here at Columbia. He gave the money to have the first value investing

breakfast to bring value investors back. He has spoken at every class since its inception.

Applause!

OPENING REMARKS

Great Investor (“GI”): Thank you.

It is always a pleasure to return to this class. I am a Columbia MBA myself and I graduated 37 years

ago. I have been a securities analyst my entire life which means I haven‟t had to work very hard for a

living. I met Walter Schloss after a great deal of effort to do so, early in the 1970‟s. And through him I

met a man named Sandy Gottesman, a very renowned value investor and currently a very large

shareholder and Director of Berkshire Hathaway. I worked for Sandy at First Manhattan, and it is from

Sandy that I learned much of what I know today.

I was instrumental in establishing the Graham & Dodd Program here. I also take some pride in helping

reengage Warren Buffettt here at Columbia Business School after a long period where he was estranged.

As the professor said, I talk every year for the course, and it is something I look forward to regularly.

Every year after I do so, I ask him for a report card, and he says don‟t change a thing.

PROFESSOR: But every year you do (change).

GI: I do it first of all just to keep him a little off guard and make him nervous about what I may say or

do. But I also try to keep changing myself. I try to keep learning. I constantly am thinking about what I

have done, how I practice what I do and how I could do it better and how I could avoid repeating

mistakes. To the extent that I am still active and still thoughtful, I change from year to year and I try to

impart some of that change in my remarks to this class.

Every year I have the challenge of distilling 37 years of experience into 1.5 hours. My first thought is

that if I could really do that, it doesn‟t say much for the thirty-seven years—it wouldn‟t have been much

of a career. It wouldn‟t be much, if it could be distilled (that easily). Distillation is very hard. You have

heard of the newspaper reporter saying to the editor, “I am going to write a 2,000 word article because I

don‟t have time to write a 500 word article.” In the class tonight I will try to distill in an hour and a half,

and the outcome will be the very high points and literally I will not provide a lot of answers to you. I

want to provide a lot of big questions for you to think about not just for tonight but for as long as you

are doing this kind of work.



I have said repeatedly to the Professor that I think the challenge of this course is to keep it at a high

enough plain. At the onset when we were creating the course, the risk was that we would have people

come from Wall Street who would tell very shallow, particular, antidotal experiences. I didn‟t think that

was of high enough quality for the caliber of Columbia and the aspirations of this business school.

So I try to keep my talk at the most general level. You may not agree with everything that I say, but I

hope you will never be able to come back to me and say that something you said to me was outright

wrong. There may be nuances but I am trying to get the most general points across.

This year at the professor‟s suggestion I attended his two introductory lectures. I heard what he said. So

I can dispense with introductory material. I do want to define value and what it means to me. Value is

the present value (PV) of the distributable cash flows. But we all know that is an easy definition to make

but a hard one to implement. The other definition of value is the price at which an equally

knowledgeable buyer and seller would negotiate a transaction freely and not under duress for cash.

In terms of value investing, I want to emphasize the idea of self-awareness—of knowing yourself,

knowing what you know, and what you don‟t know. The idea of a circle of competence is important.

There are areas where you know just as much as anybody else and there are areas that are not analyzable

by anyone.

The idea of value is something that you should always think of as a range. I see too often among

security analysts a false sense of precision. The idea that there are many more significant digits in their

work than there really are. Since studying here at Columbia and over the years I have been teaching this

class, I have become increasingly interested in the study of behavioral biases not only of other market

participants but also to help understand how I am thinking and why.

I know there is a behavioral finance program here at the business school. I think it is something that you

should take a passing interest in. Those are the opening remarks and I would now like to go quickly

through the handout.

HANDOUTS

The list of books that I suggest on the first page is--believe it or not--a carefully culled list. I read

constantly. I try to read as many investment books that may have something new or important.

I want to identify a couple of books I think are especially worth reading and worth having. The first one

is Value/Growth Investing published in England. There appears to have been a lot of cooperation with

Warren Buffettt and Charlie Munger. This is about the best single book I know on the kind of investing

that we will be talking about.

Title * = highly recommended Author Publisher

*Valuegrowth Investing Glen Arnold FT Prentice Hall

*Franchise Value: A Modern Approach to Security Analysis Martin L. Leibowitz John Wiley & Sons 2004

*Irrational Exuberance (2nd Ed.) Robert J. Schiller Princeton University Press 2005

*Inefficient Markets: An Introduction to Behavioral Finance Andrei Shleifer Oxford University Press 2000

Fooled by Randomness Nassim Nicholas Taleb Texere 2001

The Battle for the Soul of Capitalism John C. Bogle Yale University Press 2005

Fortune‟s Formula William Poundstone Hill and Wang 2005

The Theory of Gambling and Statistical Logic (rev. ed.) Richard A. Epstein Academic Press 1977

Fischer Black and the Revolutionary Idea of Finance Perry Mehrling John Wiley and Sons 2004

My Life as a Quant: Reflections on Physics and Finance Emanuel Derman John Wiley & Sons 2004



The John Bogle book, The Battle for the Soul of Capitalism (2005) brings home the enormous size,

behavior and influence of mutual funds. The book talks about the behavior and management of these

funds which you need to be aware of to understand valuation anomalies.

A few pages in I have a quote from Fisher Black from the book, Fischer Black and the Revolutionary

Idea of Finance by Perry Mehrling (2005).

“We might define an efficient market as one in which price is within a factor of 2 of value; i.e., the price

is more than half of value and less than twice value. By this definition, I think almost all markets are

efficient almost all of the time. „Almost all‟ means at least 90 percent.” (Fischer Black, 1986, Journal of

Finance 410).

He was a brilliant man—the originator of the Black-Scholes option model—and he had a number of

valuable insights. I excerpted this one. How he thinks of market efficiency. It is quite succinct and it

reminds me of what Buffettt said to me on more than one occasion when we were talking about the US

government bond market. He said the US govt. bond market is efficiently priced almost always. It is

almost never able to present an opportunity that he would consider worthwhile.

The Fischer Black idea that companies trade at ½ value and 2x value most of the time is something that

meshes nicely with my experience. You may have had people come to this class and tell you that they

can find stocks trading at half of value. From my experience I have almost never found a company

trading at ½ of value. Usually when my analysis leads me to believe that the company is trading at 50%

discount to value or less and I go back and do my analysis again to see where I made my mistake.

Except in times of extreme pessimism or extreme gloom and doom like year-end 1974, I can‟t think of a

time when there were a large number of stocks trading at ½ of value.

The Irrational Exuberance book by Robert Schiller is a must read, particularly the second edition. The

second edition is important because it updates the book from discussing the boom and bust in the stock

market to the boom and bust in the housing market. The real estate bubble. A good, easy read.

The Introduction to Behavioral Finance by Andrei Shleifer. This is a tremendous book. It is a collection

of his lectures.

The Box 4.1 King Kong: America‟s Largest Money Managers from John Bogle‟s book.

Every day we hear so much about how big the money management business is in aggregate. When you

look the mainstream institutional investors, the Fidelity, the Van Guards and so forth, basically they are

three quarters of the market. You can‟t underestimate how big they are, how important they are and

how they can move markets.

I have also excerpted from John Maynard Keynes about investor short-sightedness back in the 1930s.

You should read it. (Chapter 12 in the book, The General Theory of Employment, Interest and Money).

Warren Buffett excerpts from his 1990 Berkshire Hathaway Annual Report where I underlined one

section. “Over time, the aggregate gains made by Berkshire shareholders must of necessity match

the business gains of the company.” That is over the long-term and that is of course true for any

company. It is a very, very important idea. If we believe there is an intrinsic value that will accompany a

stock, and a share price that fluctuates around that intrinsic value over time, there will be swings of price

around intrinsic value. In the long run the returns of owning the stock will be equal to the growth in

value generated from the business.

As an aside there is a subset to this little excerpt from Warren. There are a couple of large institutional

investors (Sequoia, Fairholme, and Davis Funds) that I am aware of who hold Berkshire for their



clients. They argue that the stock is undervalued. I find that a very difficult case to agree with because

Warren says from this excerpt here and one of his important missions in life is to have a fair value for

Berkshire. He doesn‟t want big gaps up or down between price and value. The people who own this

stock and argue for its cheapness are arguing against the man himself.

The excerpts here I have from the Economist. You must appreciate that long-run profitability is

extraordinarily high and has been for many years—way, way above the long term norm and if you

believe in mean reversion, as I do, it is something to be well aware of. I also included a quote from an

interview in Barrons'.

Excerpt from interview with Jeremy Grantham on Feb. 6, 2006 in Barron‟s:

“Perhaps the most surprising thing to me is the inability of even market professionals to adjust for profit

margins. People will talk about the P/E being reasonable at 19 times without mentioning that it is 19

times the highest profit margins ever reported. The least we can do, as professionals, is to normalize

between economic boom and economic bust, between low profit margins such as those in 1982 that

were half normal and dramatic profit margins such as those in 2000 and today.

A lot of people think profit margins can be sustained. Profit margins are provably the most mean-

reverting series in finance, and if profit margins do not mean-revert, then something has gone badly

wrong with capitalism. If high profits do not attract competition, there is something wrong with the

system and it is not functioning properly.”

Annotation on Reversion to the Mean on Profit Margins

In the Wall Street Journal C-1 page on March 29, 2007:

Profit Pullback May Foretell Cost Cutting by Justin Lahart:

A month ago, former Federal Reserve Chief Alan Greenspan stirred markets when he remarked on the

possibility of a recession. Profit margins were “stabilizing,” Mr. Greenspan said, a sign that an

economy is in the late stages of expansion.

So what happens when they start to shrink?

When it reports its final estimate of fourth-quarter GDP today, the Commerce Department will also

report on corporate profits. Alliance Bernstein economist Joe Carson estimates pretax profits were 13%

above their year-ago level, which would market it the 19th quarter in a row that the broad measure of

profits has grown by better than 10%.

But that estimate also implies that fourth-quarter profits have grown by better than 10%.

But that estimate also implies that fourth-quarter profits were 4.7% below the third-quarter level. Such a

sequential decline is rare. And since the overall economy grew in the fourth quarter, that would mean

that companies saw a smaller portion of their sales fall the bottom line. In other words, profit margins

got smaller. One simple way to measure profit margins is to look at pretax profits as a share of GDP. In

the third quarter, this came to 12.4%--up from 7% five years earlier and at its highest level in over 50

years. Mr. Carson‟s estimate implies that it fell to 11.7% in the fourth quarter; it looks like its getting

slimmer.



Companies in their quest to stay on the right side of shareholders may react to even an incremental

decline in profit margins by cutting costs sharply. …If the cuts turn to jobs then Ben Bernake may need

to throw his inflation caution to the wind and cut rates.

Pretax profit margins as a percentage of GDP went from 8% in 2000 to 7.3% in 2001 during the last

shallow recession up to 12% in 2007.

--

Yes, P/E multiples are moderate by historic norms but the earnings part of the P/E are very high. This is

something I will take exception with GI when he talked about 7.5% returns on the stock market—

implied total returns on current valuations. I would say that is an optimistic assumption because

corporate profits as a percentage of GDP are at record highs. So the idea that corporate profits will stay

at the same percentage of GDP assumes that corporate profits will maintain their high levels. To me that

is a difficult assumption to make since they are at unprecedently high levels.

The other reason is that if corporate profits grow as fast as GDP, the risk assessment of owning equities

could change from the low risk assessment of today. Investor‟s appetite for risk could decline such that

they will not value equities as highly as they do now. You could get profits growing as fast as GDP but

prices fall. So there are two specific risks that you may not get a 7.5% implied rate of return.

This idea of investing for a 7.5% rate of return is something that I disagree with strenuously. The idea—

GI spoke about this earlier in your class: the idea--that the default option is cash or a piece of the index.

Many institutional money managers operate that way, but I would hope that when you manage your

own money, you wouldn‟t act that way. I can‟t imagine that any of you would say that if I can‟t find

enough investment ideas so, therefore, I will then buy an index fund with what is left.

That is the difference between the institutional mindset and the appropriate individual mindset. What is

the history of the stock market—a 9% rate of return with a 12% standard deviation? If someone said to

you that you could buy a treasury bill for 5% or you can buy the average stock with an expected return

of 7.5% with a expected standard deviation of 12% or 15%, I don‟t think very many of you and,

certainly I would not, find that an appealing choice. But institutions do that kind of investing all the

As you can see, the GI seemed accurate in assessing possible risks. This lecture given in

2007.



time. Because they are in the relative performance game. What they have learned is that the market goes

up over time, and they have to be fully invested all of the time. So, even for a small advantage that

entails some risk, they will invest in equities.

Another book that I talk about, The Fooled by Randomness, where the author talks about black swan

events. The idea that events can occur that you never think could occur. Just because you have not seen

a black swan doesn‟t mean it doesn‟t exist. So when people talk about the standard deviation of stock

market returns, they are looking at historical data—we could talk about the dotcom crash, the 1987

crash, we could talk about the bear market of 1973-74. But when we talk about risk in the stock market,

value investors don‟t talk about risk in the sense of volatility. Warren Buffett talks about risk as the

permanent impairment of capital. Many generations have learned that the stock market returns to some

sort of normalcy even after a serious downdraft. It has been a long time since a well-diversified investor

has suffered a permanent loss.

The risk, however, is that the game is more complicated than it seems or that history will tell you. I

hope all of you have read his new annual report and letter to shareholders. In it (2006 Annual Report to

Berkshire Shareholders) he talks about his desire to recruit a new, young investment professional. Here

is what he says, “It is not hard to find smart people, among them individuals who have impressive

investing records. But there is far more to successful investing than brains and performance that has

recently been good. Over time markets can do extraordinary, even bizarre things. A single big mistake

can wipe out a long string of successes. We therefore need someone genetically programmed to

recognize and avoid serious risks, including those never before encountered.”

Temperament is also important. Independent thinking, emotional stability, and a keen understanding of

both human and institutional behavior are vital to long-term success. I‟ve seen a lot of very smart

people who lacked these virtues.

--

GI: I think I understand what he is saying. He is saying there probably is some extremely low frequency,

high severity risks to stock market investments that nobody has recently lived through. Maybe no one

has encountered.

I have a list here; it certainly is not an inclusive list: major earthquake, bird flu, Martial Law, suspension

of civil liberties, nuclear attack. These are all unthinkable things but just because they haven‟t happened

in 25, 50 or 100 years, doesn‟t mean they can‟t happen or they won‟t happen. Whether you like it or not

when you invest in stocks, you are assuming these types of risks. My belief is that you should try to get

paid for that risk.

Annotation: Charlie Munger on page 73 in Charlie’s Almanac: Insist upon proper compensation for risk

assumed.”

If you can‟t…Warren Buffettt doesn‟t say run for the hills; he wants someone to think about it and be

aware of it (risk). He says the investments he likes to make are the ones where he would be happy

holding them if the stock market were closed. I think in the context of what he said in his letter here that

is something to think about. What does that mean? I don‟t have all the answers. Is Coca-Cola worth

owning if there was no opportunity to trade it? Those are individual choices but it is something to be

aware of.

I believe the institutional nonsense of accepting low returns and being invested all the time, being

exposed to risks, playing the relative performance game—all of that will come to an end when there is a

permanent impairment of capital--when something bad happens.



Investors will pull away from the market when they see that the returns are not adequate for the risks.

EVOLUTION OF GI‟S INVESTING STYLE

I want to talk about what I do and how my investing style has evolved. The professor has heard me

evolve and heard me change what I talk about. I am…nearly all value investors have a little element of

contrarianism in them. We lean against the tide. We like to buy when things are out of favor and sell

when they are in favor. Benjamin Graham used to write in a Latin phrase for it, “Nothing is ever as bad

as it seems, nor as good as it seems.” (From the 2nd

Edition of Security Analysis—“Many shall be

restored that now are fallen and many shall fall that now are in honor.” Horace--Ars Poetica). It means

in modern terms that there is a tendency toward mean reversion.

When businesses are doing well, they have a tendency to go back to their long term performance

measures and vice versa. (Competition enters, there is over-expansion, etc. Prices revert). Businesses go

back to their long-term norm. All businesses are cyclical to some extent. That is a deception that people

perpetuate on themselves—that is to say I am going to buy businesses that are not cyclical. One way or

the other all businesses are cyclical. Companies that report very smooth earnings are fudging the

numbers through accounting that would make the earnings smoother than the underlying business‟s true

earnings really should be.

I used to deal with severely depressed cyclical companies—steel companies, oil & gas companies,

businesses that would have wide ups and downs, and I would buy them when they were way out of

favor, when the businesses were doing poorly. And I would sell them when the prosperity would return.

It was a successful style of investing. I earned good positive returns but the volatility of those returns

was quite high. I have no problem with that kind of volatility but I wasn‟t getting high enough returns

for that volatility. It took me a long time to figure out. I had stocks where I made twenty times my

money but it took 25 years (a 9.648% CAGR). But that is ….getting back to Buffett‟s idea of the long-

term that the stock will track the underlying business in the long run. I decided after a lot of thinking

and a lot of analysis of what I could have done, should have done, might have done, and I decided that

there is a better way.

Annotation: Warren Buffett: “The chains of habit are too light to be felt until they are too heavy to be

broken.”

This is Warren quoting the English philosopher Bertrand Russell, because his words so aptly describe

the insidious nature of bad business habits that don‟t become apparent until it is too late. This is what

happened to Warren with the Benjamin Graham-inspired investment strategy of buying bargain (“cigar-

butts”) stocks that were selling below book value regardless of the nature of the company‟s long term

economics. This was something Warren was able to do with great success during the 1950s and early

1960s. But he stayed with this approach long after it wasn‟t viable anymore—the chains of habit were

too light to be felt. When he finally woke up in the late 1970s to the fact that the Graham bargain ride

was over, he shifted to a strategy of buying exceptional businesses at reasonable prices and then holding

them for long periods—thereby letting the business grow in value.

Annotation: Buffettt: “Turnarounds seldom turn.” The world is full of businesses with poor economics

selling at what seem to be bargain prices. Warren looks for a good business that is selling at a fair price,

or even better, a great business at a bargain price. Poor businesses tend to stay poor businesses.

In Warren‟s early days he was only concerned with the historical financials of a company, he didn‟t

really care about the products it produced. His mentor Graham believed the numbers reflected

everything there was to know; he didn‟t separate a commodity-type business such as textiles, which has



poor long-term economics, from a consumer-monopoly business such as Coke, which has great long-

term economics. But as Warren became active in running a struggling commodity type business, he

soon realized that it was the consumer-monopoly-type companies that had the competitive advantage

and were producing the superior results. Graham would buy anything as long as it was cheap. Warren

will only buy a consumer-monopoly-type company that has a competitive advantage, and he doesn‟t

have to wait for it to be selling cheap. A fair price is all he needs, if he holds on to it long enough.

An excellent example of this was his investment in Coca-Cola, for which he paid approximately 20

times earnings. The old Warren would never have made this investment because the Grahamian

valuation techniques would have deemed it way too pricey. But for the new Warren it was a more-than-

fair price that paid off for him in the billions. (The Tao of Warren Buffett pages 46-47)

CURRENT METHOD OF INVESTING

What do I do now? First of all, I deal with seasoned companies. By that I mean companies that have

been around for long enough to have a record that shows how the business behaves in various economic

environments—a business that has been through good times and bad, through recessions, inflations--and

see how the business performs. I look for companies that have a long enough track record so what you

are looking at present can‟t possibly be an aberration. Pretty much unavoidably these are pretty big

companies. These are big companies and they have been around long enough to be seasoned by my

definition, they are successful and they are not tiny, little companies. The insight that I bring to these

companies is that their stock prices—this is historically demonstrable--are much more volatile than their

underlying values.

And while I can‟t prove it, it would appear that stock prices are much more variable than the changes in

their underlying intrinsic values. I refine or restrict my list to companies with superior financial

characteristics. We will talk about what that means. But in general these are companies that are cash

generating, with free cash flow, businesses that are more than self-financing. They generate cash in

excess of their cap/ex and reinvestment needs. Because they are cash generating, they tend to have

lower debt.

I am also no longer interested in companies where there is a story or a narrative. I am not interested in a

company that is going to do something new and different. I am interested in its long record. I presume

that a company of a certain size has a long record. We will talk about specific examples in a few

minutes when we look at some Value Lines. I am not talking about long-term growth; I am talking about

long-term high profitability, consistent profitability and consistent cash generation.

Now, if I said to you, almost no company doesn‟t have some degree of cyclicality in its operations. Wall

Street because of its short-run obsession is very twitchy. You see these stories every so often like IBM,

an enormous company, reports earnings that are a penny or two higher or lower than expectations, will

move the stock price of these enormous companies 3% to 5% in a day. For sure, the value didn‟t move

5% but the price did. Not in a single day, but over a series of days, you can have the divergence between

price and value. The opportunities for value investors can and do present themselves.

Annotation: Warren Buffett: “We believe that according the name investor to institutions that trade

actively is like calling someone who repeatedly engages in one-night stands a romantic.”

The trading madness that goes with the mutual and hedge funds is almost boundless. They buy stocks on

a quarter-point drop in interest rates and a month later will sell the same stocks at a quarter point rise in

interest rates. They utilize a strategy called momentum investing, which requires them to buy a stock

when it is rising quickly in price and sell it if it is rapidly falling in price. (The Tao of Buffett)



What I do with these companies is to create a normalized financial model. You can look at IBM, and

you can see that it is a business that is so big that it really can‟t really change very much from one short-

run period to the next. You look at sales growth, the variability of sales growth around trend and if you

look at the cash generated per dollar of sales, if you look at the reinvestment needs of the business, you

can create a model that normalizes all these factors. You can then decide whether it is performing above

or below a normalized performance level. When these big, stable companies with superior

characteristics are performing at below normal or trend, for whatever reason, that is where opportunities

present themselves.

Now when I create a normalized financial model, the next thing I try to do is to try to break down the

components of the business. What is the present value and what is the future value? GI will tell you

how they are, of course, inter-related. I won‟t tell you precisely how I do it, but this is a way to think

about businesses. How much the price represents the present and how much is the future? All of us

value investors who come before you in this class will tell you that what we don‟t do is pay much for

the future. That is……

Benjamin Graham writes about not paying at all or anything for the future. He was paying a discount for

the present at a discount by buying below book value; below working capital (below net/nets). He

didn’t think in terms of franchises and growth. He didn’t want to pay for the future. The professor

demonstrated for you early in this class about high growth companies and their cash flows and how

much of their cash flows are far into the future. And that when you pay a high valuation for a company

that seems to be growing far into the future, you are getting little for the here and now of the total price

you pay. Sometimes 60% to 80% (of the market value of the company) represents the remote future so

that is not something value investors would do.

There is a highly regarded money manager with a wonderful performance record who manages a lot of

money (Bill Miller). He calls himself a value investor, and he owns stock like Amazon.com. You may

know whom I am talking about. He submits that he and his people working for him, who make long

very long run predictions of Amazon‟s cash flows and discount them back, they can tell therefore if

Amazon is undervalued. If I could meet him face to face, I would just say, “nonsense.” Not you, not

anybody. It may turn out that he is right and his projections of the cash flows are correct, but I don‟t

believe on any consistent basis he or anyone else can project cash flow for businesses 20 or 30 years in

advance on any consistent basis to buy stocks based on their valuation.

Annotation: Bill Miller, Mired in Worst Slump of Career, Embraces AES, Tyco

By Danielle Kost

March 30 (Bloomberg) -- The bad news streamed down via satellite to a private yacht cruising

somewhere off the Leeward Islands.

On board, Legg Mason Inc. money manager Bill Miller was bracing for the blow: The market, he knew,

had beaten him at last. His streak -- 15 years of besting the Standard & Poor's 500 Index -- had come to

an end. The final numbers showed he'd returned 5.9 percent in 2006, trailing a 15.8 percent gain by the

S&P 500.

There was little cheer at Baltimore-based Legg Mason when Miller returned from his late-December

sail. Miller says there was no buck-up message waiting for him from his boss, Raymond ``Chip'' Mason.

Nor were there condolences from his friend Warren Buffett.

Miller, the mastermind behind the $21 billion Legg Mason Value Trust mutual fund, says people often

ask if he's somehow relieved that his run, one of the greatest in the history of investing, is finally over.



``The answer is: No,'' Miller, 57, told Value Trust shareholders in a January letter discussing his 2006

performance. ``We are paid to do a job, and we didn't do it this year -- which is what the end of the

streak means -- and I am not at all happy or relieved about that.''

Losing Picks

`Ì got asked, `How do you go about analyzing your mistakes?' Miller says. `Ì said, Ì don't. I don't

analyze my mistakes.' We will analyze spectacular errors, but not garden variety errors.''

Miller has picked some doozies in his day. In the center of his bookcase sit framed stock certificates of

past bloopers, including Enron Corp. and WorldCom Inc.

Value Trust pick Sprint Nextel fell 10.4 percent in 2006. UnitedHealth Group Inc., another of his

favorites, lost 13.5 percent. A third choice, Amazon.com Inc., sank 16.3 percent last year. Miller's bets

on homebuilders soured in 2006, too.

His recent showing was a rare misstep for Miller, who posted an average annual return of 16.2 percent

from 1990, when he became sole manager of Value Trust, to 2005.

Buffett's League

His record puts him in the same league as his friend Buffett, whose Berkshire Hathaway Inc. delivered

an average annual return to shareholders of 18.8 percent from 1991 to 2005. Buffett, unlike Miller, beat

the S&P 500 in 2006, with a 24.2 percent return.

`Ìt still would be hard not to see Miller as one of the best investment managers of his generation,'' says

Christine Benz, director of fund analysis at Chicago-based Morningstar Inc. ``Many of the best

managers run into periods of weakness.''

Such assurances don't change the fact that Miller is mired in the worst slump of his career. He's the first

to say his streak was partly luck anyway. For starters, his run reflects a fluke of the calendar: If Pope

Gregory XIII hadn't tweaked the Julian calendar in 1582 to shorten the average number of days in a

year; Miller wouldn't have beaten the S&P 500 for 15 years. Sometimes, he scraped by in the final days

of December. In 2005, for example, he beat the index by a mere 0.4 percentage point. Two weeks later,

Value Trust's return sank below that of the S&P 500.

Luck or Skill?

In his January letter to investors, Miller said that if beating the market were purely random, like tossing

a coin, then the odds of beating the S&P 500 for 15 consecutive years would be the same as the odds of

tossing heads 15 times in a row. Using the actual probabilities of beating the market in each of the years

from 1991 to 2005, he put his odds at 1 in 2.3 million.

``So there was probably some skill involved,'' Miller said. `Òn the other hand, something with odds of

1 in 2.3 million happens to about 130 people per day in the U.S., so you never know.''

--

I want also to talk about and to get back to this Fischer Black idea to refine my thinking of a Margin of

Safety and the kind of companies I am interested in. I used to say….I don‟t find companies trading at

half of value. I used to have a cut off for a margin of safety of about 30%. I could find enough

investments with a 30% margin of safety to put to work the amount of money I was managing. But as I

looked at these better companies, these superior financial companies, I began to understand that they

don’t get as cheap as lesser companies do. Warren Buffettt says he would rather pay for a great

company at a good price than a good company at a great price. That is what I think he is talking

about. If I wait for a really great company to trade at two-thirds of value then I will never buy anything.

As Fischer Black says most companies‟ trade between ½ to 2 times value most of the time (90%). I

would submit that really superior companies—Coca Cola, P&G—may be selling, when they are really



cheap, at a 10% discount to intrinsic value and most of the time they sell above (Mr. GI said below, but

that is probably a misstatement) intrinsic value.

I brought along another book here called, Dr. Z Beat the Race Track. I actually bought this when it was

new in the 1980‟s. There is a very interesting chapter in here called, Stock Market Efficiency Concepts

to the Horse Racing and Betting Markets. There has actually been exhaustive, rigorous, statistical

research on horse race betting and what it proves is there is a body of research that bettors in aggregate

do know how to pick winners. They…but the horse racing game is a negative expected value game.

If you take the track take and breakage, it is a negative 20% expected value game, where the stock

market is a positive expected value game. The people who bet favorites actually lose much less money

than people who bet long shots. Favorites do win. Extreme favorites with odds of 1-10 and 1-20 are

actually under bet to the extent that even with the track take you make a little bit of money in the long-

run by betting on them. The idea, though, is that at the horse track and the stock market too,

investors underestimate the probability that good horses will win and overestimate that long shots

will win. This idea of betting on favorites and the consequences of betting on favorites is something that

I find interesting and applicable to stock investing.

Finally, we talked about understanding that great companies do not get as cheap as lesser companies,

and now we look at the margin of safety. I have what I hope is a helpful rule with this matrix here that I

made up. There is a point here at the end—try to bear with me.

I labeled this margin of safety with three pre-conditions for an emergence of a margin of safety. I have

a three by three matrix here. Across the top we have the recent delta of value: -, 0, + then Down we

have price: +, 0, -

Delta of Value Down (-) Flat (0) Plus (+)

Price UP NO NO Yes-special case-Possible.

Flat NO Possible Possible

Down Possible Possible Possible but unlikely

Now we will try to fill in some of these boxes.

Price up and value down-NO.

Price is flat and value down-NO.

If the price is rising and the value is rising this is a very interesting and special case-Possible. This is the

hardest opportunity for a value investor like me to identify. What this is if you think about it… If a

value is created, even though the value is rising and the price is rising, it means that the price is not

rising enough. It means an under-reaction to good news in the case like the introduction by Apple of the

IPOD. Just about anybody could figure out that was a pretty important plus to change the value of

Apple. But few people—none I know--would realize how big the IPOD would become. Apple’s stock

went up. In fact, it did not go up enough, nearly enough. It took a little while for the adjustment to take

place.



A simpler example of an adjustment to good news would be a relatively small oil company finding a

relatively large oil find. Investors are slow to recognize how significant the discovery really is relative

to the size of the company. Other natural resource companies could be like that—a coal mine, a gold

mine. This is the possible one—under-reaction to significant good news. And that falls into the circle

of competence category. It means that if you are not a real expert on the field, you are just a generalist;

you are not going to be able to assess how significant the IPOD will be. You won‟t identify it. You are

not going to be able to say, you know Apple’s stock has already tripled, but it is still cheap; it is not

adequately discounted the tremendous change value the IPOD created. OK, let‟s fill in the rest of the

boxes……

Price flat and value falling-NO.

Price flat and value flat-Possible. That is the hundred dollar bill that has been lying on the ground

because nobody else saw it and it has been there for awhile. So that is a possibility but not likelihood.

But it is possible that there can be a margin of safety if the market for whatever reason has been asleep

and has not appreciated the value that has been in existence for awhile.

The price is flat and the value is rising-Possible. That is a delayed reaction to significant positive change

in value. Something has happened that is positive, that has enhanced the value, and the market for

whatever reason is slow to digest. It under-reacted. Here it doesn‟t react enough. One reason this can

occur is because there could be an external distraction—a global event, a war, an assignation. There is

something that distracts people, so the stock market….so opportunity exists but people are slow to deal

with it.

Down here at the bottom. Price is falling and the value is falling-Possible. This is genuine overreaction

to bad news. This is when there is genuine bad news, and the market gets panic stricken. The price goes

down more than it really should. A good example of this many years ago was Texaco losing a lawsuit.

Texaco filed for bankruptcy after losing a lawsuit. The stock and the bonds sold off very sharply on that

news and the drop in prices created tremendous opportunities. There was a period of panic where people

said, „Oh my gosh, they filed for bankruptcy.‟ The investors‟ way oversold the stock. Yes, the news was

Value and Price moving higher but the

price is not discounting the increase in

value fast enough. Apple Computer, Inc.



bad, yes they had a $10 billion dollar judgment against them, but the reaction in the market was

excessive.

This one down here is possible: price is falling and the value is flat. This is what I categorize where the

news is perceived as bad news so the price goes down, but it really isn‟t. The value is unchanged, but

there is a misinterpretation to the news. Price falls and a valuation disparity occurs because value

remains unchanged so a value disparity occurs.

Finally, the last box I call possible but unlikely. This is where value is rising and the price is falling.

That is an unlikely set of circumstances. It can happen. Again, it could be a big external distraction.

There is good news about the company but the news in the world is so bad. Or the more subtle way is

the short run/long run trade-off. Sometimes companies will make announcements where they make

changes for the improvement of the company (more marketing expense, more R&D) but in the short run

it will depress earnings. And unfortunately, investors sell on that news because they are not interested in

long-term investing, in investing for the future particularly if it has a short run negative impact on

earnings and cash flow.

Anyway, we can have all types of hypothetical situations why these situations might arise. But the

punch line for all of this is that of the nine boxes, there are six that are preconditions—logically they are

preconditions—for the appearance of a margin of safety. And what you should remember and take away

from all of this: Five out of six of these involve a share price that is going nowhere or is falling. GI

has talked about that. Go through this rigorously and logically and you have to be looking at stocks

that are flat or are falling. This is the exception up here (both share price and value increasing-IPOD

example). This is the special case, the circle of competence, where you know you know something. For

example a drug company discovers a new drug; you have enough knowledge to say that I know more

than the market does that is a monster discovery that is worth a lot more than the market is attributing to

it now. Even though the stock went up a bunch, it has not gone up nearly enough. If you have this type

of specialized knowledge that is an area where you can hunt.

I am saying for myself and for the most of you it is rare that we find situations where we can say, “Yes,

the price has risen a lot, but I know because of my knowledge of the industry and company the price

hasn‟t gone up nearly enough and, in fact, its margin of safety is there.

SEARCH: The punch line again are stocks that are going down or are not going up. That is where you

should be hunting.

VALUE LINE HANDOUTS

Now I want to talk about the Value Line handouts. I will start out by saying that if you are not familiar

with Value Line, it is absolutely essential. The amount of information that is available in this one page is

just astonishing. It is necessary and it is almost sufficient for the type of investing that I do. It is amazing

the amount of information in these pages.

I want to start out by talking about Coca-Cola and Nokia. Coca-Cola is everybody‟s poster child for a

great company. It is a high profit margin company, essentially unlevered, generates lots of cash, raises

the dividend every year, and net repurchasers of stock most years. We all know that Coca-Cola has had

slowing growth, but again looking over at the little box over on the left column on Coke you see for the

last five to ten years the growth rates and cash flow have been growing 5% to 7%. This stock is trading

at 20 times earnings.

Now let‟s look at Nokia. These are great big companies—Coke has $113 Billion market capitalization

while Nokia is $85 billion. Nokia‟s price is higher now, but look at the numbers on Nokia. When Wall



Street talks about Nokia, they compare it to Motorola and what is going on with China. This narrative,

this story that we are going down market with headsets; they are getting smaller and cheaper, and the

margins are getting smaller and smaller. There is always a story. The financials tell the story. This fits

the character…these are seasoned companies, not a flash in the pan. This goes back to 1996. But look at

these numbers. Look at the little box over here of annual rates of growth of sales, cash flow and

earnings much higher than Coca Cola. It has similar returns on equity—earning 30%, 40% ROE with no

debt. Pays a dividend every year, the dividend has been rising—22% compounded over the past 5 years.

The company has a significant share buy back every year, and it trades at 15 times earnings.



This is the first step that I recommend to you in terms of finding stocks to research. When I find a

company with these characteristics which are extraordinary, I look deeper. You can spend some time

going through Value Line by hand or do some screens; there are not many companies with these types of

characteristics. Extraordinary! To tell you the truth, I don‟t know how they achieve this. But it is sure

something I would like to know.

This is not a fluky thing; this is not a flash in the pan. This is not a brief hula-hoop type of thing (a one

trick pony or a company with a hot product). They (Nokia‟s Management) are doing something very

right. There is some moat here. Prima Facie evidence suggests that there is really something good going

on here. Compare the numbers to Coca-Cola.

Nokia Coke

P/E 16x 20x

Return on Total Capital 36% 28.%

Return on Equity 36% 30.5%

Debt as % of Capital 0.5% 6.0%

Growth 10-yr/5-yr in Book Value 21% / 19% 12.5% / 12.5%

Sales 18.5% / 14% 4.0% / 3.0%

Cash Flow 18.5% / 11% 7.5% / 7.5%

Dividends 33.5% / 22.5% 10.0% / 9.5%

Buy backs >5% < 5%

I would argue that the financial performance is just as good and the growth seems to be faster, and the

stock is cheaper. This is the type of company that could reward work particularly if we could

develop an understanding of what it is that creates its competitive advantage. My superficial

understanding of Nokia is that what they make are commodities. The financial performance says their

products are not commodities. There is something else going on.

Now let‟s turn to Cisco (CSCO). We talked about Cisco here a year ago.



This turned out to be a very successful investment for us a year ago. This is more interesting because its

financial performance is more volatile than Coca-Cola or Nokia’s, and its share price is more volatile--

much more volatile. In this case volatility creates opportunity. In 2000, Cisco traded at $82 and in 2002

it traded at $8 (a decline of 90.3%). Somewhere in there, almost certainly, it was overvalued and

undervalued because companies don‟t fall 90 percent without creating some kind of investment

opportunity. The investment characteristics are extraordinary—very high returns (20% to 25% returns

on total capital. Debt 3% of total market capital. Huge cash generation and in the recent years an

enormous buyback. When we talked a year ago, Cisco was generating $500 million a month of free cash

flow and it is using it to buy back stock.

Now what I want to point out also about Cisco, Nokia and Coca-Cola and bring up Intel to your

attention—all of these companies operate without debt. Nokia has no debt and $12 billion in cash.

Coca-Cola has nominal debt and $3.5 billion in cash. Cisco has $19 billion in cash with $6 billion in

debt. I am a long way out of corporate finance at Columbia Business School, but I would certainly argue

the case that these are not efficient capital structures. Not only are they operating with 100% equity but

they are actually operating on 100% equity and lots of excess cash. The opportunity in these companies

is for them to recapitalize themselves. I am not saying they should go to the razor‟s edge and operate

like an LBO, but there is no reason for Cisco to have $19 billion in cash.

Another thing you should be aware of—look at Nokia—these huge returns for Nokia are after spending

11% of revenues on R&D. In the case of Cisco, they spent even move (14%) on R&D. So these

discretionary cash flows, these are all things we value investors are trained to look at. These are very

substantial cash flows. Not many people come before you and talk about these kinds of companies--TV,

cigarettes, tobacco--yes, that is true, but these numbers speak for themselves--extraordinary financial

characteristics. People say well I don‟t understand it. There could be a paradigm shift. But I say, “What

the hell do you know about Kraft?” I know a little bit about package cheese business. They are afraid to

come to grips with this. When you look at these seasoned companies you are entitled to presume that

something good is going one here. It seems unreasonable to expect that it is all going to go to hell five

minutes after you purchase it.



We talked a little about volatility. Companies that are highly profitable—the revenues may fall from

time to time. These create tremendous investment opportunities. Wall Street is always ready to say the

sky is falling at the first sign of a revenue decline. Almost every company has fixed costs that they can‟t

cope in the short run with on a revenue decline. Intel has a bad year and revenue falls and earnings fall

a lot. Wall Street gets very worried.

Then we will talk about another company that the professor and I have talked about—Analog Devices

(ADI). If you look along the top of the page here, it traded as low as $26 per share. How did that

happen? Well, it happened because the company reported earnings that disappointed people and the

management guided future earnings down a few pennies and the stock goes down 20% in a day. Again,

look at the financial characteristics of this company: No debt, $2.24 billion in cash (or $6 to $7 per share

in cash with no debt), return on total capital 14% to 15%. This company is spending 20.8% of its

revenues on R&D. This is not a business that is being milked for cash. This looks like a business that is

being nurtured. Even after that R&D and cap/ex and you are still seeing enormous cash generation.

When the stock was $26 and it had $7 per share in cash, the operating business was $19 per share. Look

at the free cash flow, year after year. This is a business; this is a specialty integrated circuit

manufacturer that custom designs its products. When you see companies like this, you should say to

yourself, WOW, there is something really interesting going on here. I would like to find out what is

going on here. What it is about this company that enables it to earn these kinds of returns?

I included IBM; as I said earlier, look at the revenue growth, the cash generation, the degree of leverage,

the consistency of the net profit margins and the relative consistent ROE. This would not be a difficult

company for you to model.



For you to do a mean reversion model about what normalized profit should be. Look, for example, this

volatility has dampened down somewhat. But even in the last year or two, it has traded down in the low

$70s and $100. I submit to you that opportunities arise in a company like IBM. Because the value of

IBM is not changing to the same degree as the price of IBM. If you separate in your mind the difference

between price and value, you will think IBM is the quintessential aircraft carrier, whatever metaphor

you want to use, and it will not change much from quarter to quarter. The value is not changing a lot

here. Even if the company invented something new it couldn‟t possibly be big enough to have much of

an impact because the company is so huge. The stability of intrinsic value and the share price volatility

is what gives us the opportunity.



I included here one of my favorite companies, Timberland (TBL), the footwear company. Again, I am a

broken record here—extraordinary financials here, no debt, high return, huge cash generation, major,

major share buybacks going on. This is an interesting company because there are two classes of stock.

There is a family that has control of the company. They do not have to worry about being taken over.

Nonetheless, they are using the cash flow to buy back stock and increase their own ownership. When

you look at 1997 and the ten years since then, one-third of the shares have been bought back. The

conventional wisdom is that this is a crummy business—to be in the shoe business—every kind of shoe

business has gone broke in the US. Look at these numbers; something really good is going on inside of

Timberland here, and you ought to find out what it is.



One other thing, I want to talk about another type of investment, Lancaster Colony (LANC). This is a

company you probably never heard of. It has three businesses and I don‟t know how they all came into

the business. They have a perfectly good business, a mediocre business and a bad business. The bad

business makes floor mats for the after-market for autos, and, as you can guess, that is a bad business; it

is a commodity business. I don‟t know why they are in it; they don‟t earn any type of returns. On the

other hand, they have a branded packaged salad dressing and these products are sold under various

names without the customer being aware of the corporate name, but the salad dressing business is a

phenomenal business—very high profit, high cash generation. And it creates through Lancaster Colony

a business where the management has only good decisions every year they say, “What should we do

with this business? Should we raise the dividend? Should we buy back some stock? Should we make a

small acquisition? Oh, let‟s do all of that. And next year they have the same problem and they do it

again. And so it is very prosaic, it is not exciting. Value-Line doesn‟t get excited about it, but every year,

there is value accretion through dividend increases, share buy backs. As in many such companies, this

has a strong family ownership with large inside ownership.



Finally, last year when I was here, we spoke about the overvalued side, Urban Outfitters (UGIN), and

now we will look at Nordstrom, Inc. (JWN). Look at JWN’s financials. These are good financials-26%

return to total capital, 31% ROE. I am not going to say anything bad about JWN, but if you look at the

profit margin over this cyclical recovery which has risen from 2.2% to 7.9% and Value Line is

projecting it to continue. My experience is that these are mean reverting kinds of numbers. It is quite

reasonable to me that a consumer driven business in a strong consumer cyclical recovery will have a big

margin expansion. It is also quite conceivable to me that if the economy goes down, the profit margin

will revert. One of the guests who will be speaking here later is Lew Sanders. Now Lew is, I don‟t know

him, but I know what he does and what his analysts do for him as least as I understand—is that the

typical research analyst does not factor in mean reversion in projecting the future. I don‟t know whether

JWN’s profit margin which already is by far at a record will go higher. It may well, but I see it as an

investment…This is a Jeremy Grantham idea. The P/E multiple (19) does not seem very high, but its

profitability is at a record, cyclical high. To say that the P/E is reasonable on record high cyclical

earnings, almost by definition suggests there is no margin of safety here and, in fact, there might be

danger to the contrary.

I cite that as an example of a good company has its own cyclicality. Everything is booming, the

valuation is reasonable, but beware of such companies.





SELLING

Finally, concluding remarks. I want to talk about selling. And here I even disagree with the great

Warren Buffettt. He writes that his favorite holding period is forever. Other people, some with and some

without, mimic those words. I have decided it is worth some discussion. We are buying companies with

a margin of safety. We are buying businesses with an underlying intrinsic value where we believe the

underlying intrinsic value is rising. We buy into the business at a discount from its present intrinsic

value and what we hope will happen is that the intrinsic value will rise and the margin of safety or

discount to value will shrink--ideally, will go to zero. I did some numbers. Let us say we buy a business

where the intrinsic value is $100, and where we believe the intrinsic value is growing at 10% per year

and today you are able to buy that business at a 30% discount—at $70. You hold it for three years and,

in fact the intrinsic value compounds at 10%, so that is a factor of 33%.

And let‟s assume that you are fortunate enough that whatever caused the margin of safety to dissipate

occurs, and the stock rises. So in three years, you make the 10% compounded over three years, and you

make the accretion of the discount. You multiply that out and in three years it is $133. At that point by

definition it is trading at intrinsic value and the margin of safety is gone. You have identified the margin

of safety, you capitalized upon it and you earned a very high return. But now that you own it at fair

value, you can continue to hold it if you so choose—it is a free country—but you are not a value

investor at that point. You are—if you are in the business of holding things at fair value—that is not

what we are talking about. Now, I am going to qualify that a little bit and say don‟t ever assume a high

degree of precision of what fair value is. If you say you are trading at 100% of fair value give or take

10% or some variation. But when people say, well, my greatest success has been when I bought some

stock and held it for a long time and that has been successful.

I will submit to you roughly Warren’s table where every year he talks about his holdings, his biggest

marketable securities and it shows his historical costs. There are some very high appreciation in those

positions, but if you take the effort to try to figure out when he bought those stocks and what he paid for

them, you will see that the long-term compounding is almost always, 15%, 14%, or 12%--something

like that. The longer you hold it....this gets back to his statement that long-term price appreciation



equals the long-term value creation of the business plus the accretion of the margin of safety. Now

in the case of Warren Buffettt, the big difference that he has between you and me is that Berkshire

Hathaway is a corporation and his tax rate on long term capital gains is 35% while yours is much lower.

George Bush says it is 15%. But if you are Berkshire Hathaway or a corporation, the deferral of a 35%

tax rate is very valuable. Especially when Warren‟s opportunity costs are so low. He is going to be

loathed to realize big gains when he is already sitting with $45 billion in cash.

So when he says my favorite holding period is forever, that is a unique circumstance and it applies to

almost nobody else I know. My advice to you is that if you buy something at a discount to value and the

discount goes away and you earn the excess return that is your reward for your analytical skills. You

should harvest it and move on. Well, what if I just keep holding on and compound it? At that point all

you are hoping for is that the business continues to accrete intrinsic value at the rate that it has been. Do

not forget at that point it can go too overvalued or it can go back to a discount. If you are buying

something at a sizeable discount, and you have earned the accretion of intrinsic value and the

vanishing of the margin of safety, that is what the game is all about.

FINAL THOUGHTS

I used to describe myself as contrarian but I tried to think of something more flattering. I describe

myself as independent and skeptical and I suggest that you should think of yourselves that way.

Contrarianism sometimes involves a knee-jerk reaction. That is not right. I want you to be skeptical. The

professor said it that when you think you have identified an investment opportunity, why is it apparent

to me and no one else? What am I missing, how am I able to see something such that other people can‟t

see it?

Over a long period of time on Wall Street I have come to appreciate that the smartest people, the most

successful people talk the least. I have an anecdote to relate from a close personal friend, a professional

investor and former business partner, who told me how he went down to Princeton, NJ to meet with a

friend who manages a hedge fund down there. And the HF manager said how much money he was

managing and how well he was doing. But he went on to say how this really was a hedge fund Mecca.

You would not believe what is going on. Much of this is so far under the radar, you would never hear of

or about it. I know of two people now who started with a hedge fund and as their fund grew with good

performance, they returned money to investors, and then came the clincher. You don‟t know the names,

but I know for a fact that each of them has over $10 billion dollars.

Now I tell that story and you can take that at face value. But then ask yourself, who are the people who

are so available; who are always being interviewed in Barrons’; always writing a report on CNBC or

there on Bloomberg. Money managers who tell you that they like growth stocks, the yen is going to go

up and the dollar is going to go down. Ask yourself why is he telling me this? Why should I believe him

that he has any insight? All of these insights if they were accurate are money making insights. If I know

something for sure there are plenty of opportunities on Wall Street to place a bet and I will make money

from it. I don‟t need to tell you about it. So I would be skeptical of me and everyone else who comes

here.

Ask yourself, why is he telling me this; what is in it for him?1 Now, the simple answer in most cases is

that almost every value investor wears multiple hats. He is a portfolio manager, a stock picker and a

marketer. He is always looking for more money to manage. He talks a lot to find people and encourage

them to focus on his successes and ignore his failures.

1 As always, incentives matter.



To the extent that by talking so much tonight I may have undermined my own case, but I did bring a

visual aid. Anne is with me, and it has been in the family a long time. Many years ago I read this on

Wall Street, and I asked my wife for a Christmas present.

This is in the introduction of The Great Crash by

John Galbraith, “The Wise on Wall Street are Nearly Always Silent. The

Foolish Thus Have the Field to Themselves.”

I think that is something I will close on. APPLAUSE.

QUESTIONS

Question: Do you use the Kelly Criterion to size your position? How do you size up your edge and your

odds?

GI: Good question. The answer is no I don‟t. Since reading that book I have gone back and read the

original which is this thick (2 inches) which talks about information theory. The honest answer is that

over my career, I have not been good at sizing my positions. I have always tended to buy as much as I

can. I think probably some type of position optimization like the Kelly Criterion is something I should

consider. A lot of people talk about it. It is a buzz word, but I don‟t know how many people actually put

it to use.

It is information theory that has to do with noise and signaling. There are ways to filter out the signal

from the noise. The Kelly Criterion is a way of optimizing your positions based upon your ability to

estimate the probabilities.

Question: Some companies are subsidized for their R&D. How do you analyze that?

GI: The answer is on a case by case basis. The productivity on R&D is a difficult matter for an outsider

to assess. I don‟t know if all the companies. I point it out to you as an example. I am fascinated by these

companies that are earning high profits, generating extraordinary amounts of cash after large R&D

expenditures. I am old fashioned but the old rule of thumb I grew up with was that companies that spent

10% of their revenues on R&D was a lot. Now there are companies that spend 20%.

Question: How would you look at the risks of a major nuclear strike?

GI: I don‟t know, but Warren has certainly…let me tell you about his letter. There is not a single word

that he has not labored over for months. There is a message. That is his megaphone to get out to the

world. So when he talks about risks to the stock market that has never been encountered before that is

worth thinking about. I don‟t know how to cope with that. I have been interested in index options and

index puts. Insurance has been very cheap, but that would not be of much use to him given the enormity

of the assets he is involved in.

If you look at Berkshire Hathaway, he is in a position of maximum defensiveness. He has got a huge

amount of cash; his bond portfolio is high quality, extremely short duration. He is pulling in his horns

in terms of the reinsurance that he is writing. He is short the US dollar. What more can he say? Given

the enormity of his business, he has done just about everything he can to say, I am hunkered down and

prepared for something bad to happen.



Now in the case of …this idea…look at his holdings and ask yourself about these mega disasters what

would happen to the IV of those businesses. His current theme for decades has been I have positions in

companies I am happy to hold if the stock market closed forever.

Q: You spoke about the default option—cash vs. an index?

GI: Yes, the default option is cash. For a rational individual the default option is cash. Most portfolio

managers are under pressure to mimic the market. Incumbent to this was the Magellan Money Manager

who was fired because he raised too much cash and it caused the fund to fall behind their

competitors/index. It is better to fail conventionally than succeed originally.

Q: Who is on the other side of the put buying to hedge portfolios?

GI: The answer is that I don‟t know. I spent quite a bit of time two or three years ago trying to find out.

I have been around Wall Street a long time and I have a lot of friends and I called everybody I could

think of to see if they could put me in touch with people inside their organizations who could give me an

education.

And I found it difficult to find such people. Finally I did come up with a few people from Morgan

Stanley. What he said is that what you are talking about is the way I manage my own money. There is a

fair amount of money managed in Europe this way where there is a perpetual insurance policy in the

form of index puts to offset the loss.

What I have heard from reading the economist, in a low volatility market, big pools of money have been

selling risk. They cliché is it is like scooping for nickels in front of a steam roller. The idea of making

the bet is that I will write the insurance on very low frequency, high severity risk. My hunch is that a lot

of hedge funds are doing it.

I have a friend who is a really cantankerous, twisted person who always can find things that are wrong

and bad and he is so valuable that there is a consortium of hedge funds in Greenwich that gives him

office space for free and he sits there. His compensation is to give them short ideas. And what he has

told me is that hedge funds are a misnomer. Hedge funds are leveraged mutual funds. There is not a lot

of hedging. I suspect there will be a lot of consequences. The idea that the lending institutions have been

spreading their risks around the world to hedge funds, I don‟t know if that will have a happy ending.

Again, the idea of writing insurance, a man I used to work for in insurance used to call these high

severity and low frequency risks, “tic, tic, tic, BOOM!” You underestimate the risk that is unlikely but it

occurs.

Sometimes you hear of ads in the newspapers like Barrons, investment strategies that have 99% success

rates and these are the ones to suck in subscribers. Almost certainly what they are talking about is

writing out of the money options. Tic, tic, BOOM. 90% you collect your little premium and then you get

wiped out.

End.

What Graham would say about the above approach:

Graham‟s Advice on “Relatively Unpopular Large Companies”



Few books have been able to withstand the test of time in better form than

The Intelligent Investor [1]

. Written by Benjamin Graham in 1949 as a guide to investing

principles designed to be accessible to the general public, The Intelligent Investor clearly

presents not only information regarding sound selection of securities but, perhaps more

importantly, the correct mindset that separates true investors from speculators. For decades,

Warren Buffett has recommended that readers pay particular attention to Chapters 8 and 20

covering how investors should think about market fluctuations and margin of safety.

In Chapter 7 of The Intelligent Investor, Benjamin Graham presents three recommended fields

for “enterprising investors”:

1. The Relatively Unpopular Large Company

2. Purchase of Bargain Issues

3. Special Situations or Workouts

At the market lows in 2009, it is reasonable to assume that even someone as conservative as

Ben Graham would have found ample “bargain issues” available for purchase. However, the

very strong bull market over the past year erased many deep bargain opportunities. There are

always special situations, but this is not a field that many investors feel comfortable with.

Unpopular large companies, however, will always be with us for a variety of reasons. Certainly

there is no shortage today of large companies that are disliked or even despised by politicians

and the general public.

Why Large Companies?

There are certainly many unpopular companies of all sizes, many of which trade at depressed

levels, so why should investors focus on larger companies? The following excerpt from

Chapter 7 provides the rationale:

If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent

growth or are glamorous for some other reason, it is logical to expect that it will undervalue — relatively, at least

— companies that are out of favor because of unsatisfactory developments of a temporary nature. This may be set

down as a fundamental law of the stock market, and it suggests an investment approach that should prove both

conservative and promising.

The key requirement here is that the enterprising investor concentrate on the larger companies that are going

through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in

many cases may later increase their earnings and share price, they entail the risk of a definitive loss of profitability

and also of protracted neglect by the market in spite of better earnings. The large companies thus have a double

advantage over the others. First, they have the resources in capital and brain power to carry them through

adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable

speed to any improvement shown. (Fourth revised edition, 1973: page 79)

http://www.amazon.com/gp/product/0060555661?ie=UTF8&tag=theratwal-20&linkCode=as2&camp=1789&creative=390957&creativeASIN=0060555661



Essentially, the argument is that if an investor can identify strong enterprises with a record of

meaningful profitability, a temporary setback may provide an opportunity to make a bargain

purchase if Mr. Market has misunderstood the situation and assumed that the difficulties are

permanent rather than temporary. By looking at larger companies that have the financial

strength to withstand a potentially protracted period of adversity, the investor can hedge against

the risk that would exist in a smaller enterprise that may face similar headwinds but fail to

make it to an eventual upturn.

Unpopular Sectors Today …

There are always several sectors facing economic or political headwinds but two in particular

seem to be potential opportunities for investors today:

1. Oilfield Services. Due to the disastrous oil spill that is still underway in the Gulf of

Mexico, few industries are facing as much near term uncertainty as those involved in

the oil and gas industry. The companies that are directly involved include BP,

Transocean, Cameron International, and Halliburton all of which are down sharply over

the past month. Beyond those companies directly involved, oilfield service and

equipment companies have been punished in general. These companies have various

degrees of exposure to offshore drilling. Within the offshore oriented firms, there are

different exposures to shallow vs. deep-water along with regional differences as well.

Despite the tragic situation in the Gulf of Mexico as well as the near certainty of higher

regulatory costs going forward, America and the rest of the world will be heavily

dependent on oil for at least twenty years and probably much longer.

2. Medical Device Industry. The new health care law has broad implications for all

businesses involved in the delivery of health care. Medical device companies will soon

be facing a 2.3 percent excise tax on gross sales of most medical devices. The largest

companies are obviously expected to bear the most significant cost [2]

given the fact that

this is a gross receipts tax. The other major headwind facing the industry is that

consumers of medical devices (ultimately the insurers) are putting increasing pressure

on suppliers to hold the line on price increases. On a positive note, a larger potential

market will exist for medical devices based on the aging population and a larger number

of individuals having health coverage under the new system.

These are just two examples of industries that are not popular with investors today for very

different underlying reasons. There are many companies in both industries with long records of

high profitability. The difficulty is always separating the companies that may be facing long

term decline from those that will recover once near term issues are resolved.

In the coming days, we will present some potential ideas from these industries. The idea is not

to necessarily identify companies that qualify for immediate investment, but to examine

unpopular situations based on how they might have looked to Benjamin Graham. Some

companies may be interesting but are not depressed enough to offer a margin of safety today. It

is still a good exercise to examine as many companies as possible so one is able to act promptly

if market prices eventually offer a better entry point.

http://www.medcitynews.com/2010/03/medical-device-tax-would-mostly-target-the-biggest-companies/

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