Thursday, January 8, 2009

Interview with Bruce Berkowitz

Advisor Perspectives with an interview of Bruce Berkowitz on 12/24.
Based on your metric of free cash flow yield, how cheap or expensive is the overall market on a historical basis?

The last tough environment was in 1987, but that was a sudden shock and not a big event. Within a year the markets had recovered. In the Dot Com era the markets were caught in a mania, but the current crisis is much worse than what occurred at the end of that bubble, which was contained in the tech sector.

You would have to go back to 1974, when even the smartest investors were down 50% or 60%. I cannot say whether the market is as under-valued today as it was then, but certainly we are seeing valuations for companies in our portfolio that are comparable to those of 1974.

What are the lessons of the Madoff affair? Do you expect hedge fund liquidations to further reduce valuations in the first quarter?

Anyone who wanted to be liquid was already headed in that direction. If not, as investors withdraw funds, they will put pressure on the remaining hedge fund limited partners, unless the fund closes and does not allow redemptions.

I was extremely surprised that anyone would invest simply on a level of trust. I believe in “trust but verify.” Even businesses that might seem to operate simply on trust really employ a level of verification. For example, in the Diamond District in New York, millions of dollars may appear to change hands simply on the basis of a handshake. But, behind the scenes, there is a careful evaluation of the diamonds that were just sold. Those transactions take place at a single point in time and, if something goes wrong, the participants will never do another transaction. In Madoff’s case, investors continued to put money in over many years, without any verification.

There was a tremendous amount of social pressure to invest with someone who was perceived as brilliant and charitable. It was a social phenomenon.

You must have an independent source of verification. We have a large bank as a custodian, along with independent auditors and law firms. Our shareholders get statements provided by a secure independent third party. My money is in the fund too. We must avoid any possibility of collusion, which is why we rely on independent auditors.

What should investors expect from the market in 2009?

I don’t mind tough questions but this is an impossible question. There are two ways to invest – either predicting or reacting. I admit I have no skill at predicting. To predict would be foolish, so we react. We invest based on free cash flow relative to the price of a stock.

We could be bouncing around the bottom of the market. But I don’t know whether the true bottom will come in 31 days or 31 months. Prices today are as attractive as I have seen in my career and it will be worth the wait for the market to deliver the true value of these companies.