Has the way you practice value investing changed as a result of the financial crisis?
We changed our focus on risk management. Many other value managers did as well, because they were blindsided.
There are three principles that I believe good risk managers and value managers should pursue to protect themselves from permanent impairment of capital and variance.
The first principle is that the quickest way to permanently impair your capital is to overpay for something. So you always want to have a margin of safety.
The second issue is that, you go wrong with your margin of safety because your intrinsic value is wrong. Something happens that surprises you. That is almost always – if it’s a permanent impairment of capital – a company problem, where a product doesn’t work or a competitor comes in, or an industry problem, like newspapers, where they get destroyed. Sometimes it’s a particular national problem, like in
For the sake of risk management, you’ve got to have at least 20 to 30 globally diversified positions. This second lesson of diversification applies because the risk of permanent impairment of capital tends to be unsystematic and specific to impairment of capital management and to variance management. We were very diversified.
The third rule is that, even within a diversified portfolio, if you have a total loss that affects 3% to 4% of your portfolio, you are asking for trouble. The thing that will convert temporary impairments, which are the macro fluctuations, to permanent impairments is leverage. We’ve always been extremely careful when it comes to leverage.
I think the value community has learned this lesson. The guys like Marty Whitman who got burned were in financial services, where there were enormous amounts of leverage. We’ve learned that if you want to do a stub, which is a highly leveraged position, you want a five- to six-times upside, because the downside is zero. You’ve got to start thinking in those terms. People have learned to think about leverage differently and to be warier of leverage, and only be willing to do it in a restricted part of a diversified portfolio.
The fourth thing we’ve learned is that when you build your portfolio you have to think about macro risks in terms of scenarios. Basically it comes down to two scenarios: You can have stagnation and deflation and a recession for extended periods with inadequate demand, or you can have inflation. You have to know, holding by holding, what your vulnerability is. For example, real assets – real estate, natural resources, and things like that – are going to do very well in an inflationary environment but are going to get killed in a deflationary environment. Fixed income is going to do very well in a deflationary environment and is going to get killed in an inflationary environment.
Which assets give you the best overall protection?
The assets that are most attractive are the franchise businesses that have pricing power, because you can pass along inflationary price increases and you are not subject to competition from excess capacity, the way you are in industries like autos and steel. You have much more control on the downside.
When you have a set of positions, you are looking for a discount to intrinsic value, but after you’ve built that portfolio you want to know that it is reasonably balanced. Fortunately, at the moment, the best bargains are in franchise businesses. You are getting 8% to 11% and in some cases 13% to 14% sustainable earnings returns. With no growth at all, you have a safe asset with really attractive returns in selective areas.
People have learned to look at their portfolios with this degree of balance as a result of this experience. Realistically, I don’t believe in inflation in this environment, but nobody can be absolutely confident of what will happen with respect to price expectations and inflation.
We’ve learned about diversification, the cost of leverage, looking at our portfolios from a macro perspective, and looking for balance in our exposure. The other thing we did inadvertently, when our macro exposure looks to be too much for the balance of our portfolio, is to think about buying hedges. The hedge that we’ve had is gold, which has protected us. The attractive thing about gold is that it has no industrial uses. It’s strictly something that, when everything goes wrong, it’s going to do really well. I think people have learned to appreciate that.
The other great way to hedge is to recognize that when the risks are the biggest is when nobody thinks there are any risks at all. When that’s the case, the implied volatilities in derivatives are going up, and you get really good prices on deep out-of-the money puts on overvalued indices like the Russell in the summer of 2007, and you get really good prices on credit default swaps. You can buy credit default swaps that are trading at four basis points, which implies one default in 2,500 years – in the most volatile region on Earth or on the most volatile commodity. Mutual funds really can’t use this strategy, but good value funds are thinking about hedges, which are really forms of insurance. For the last several months, hedges have been extremely expensive, but they are finally coming down in price.
In our mutual fund, gold is the primary hedge. We have some cash, which is clearly a safe asset carrying a low yield. Most of our risk management is that we are consciously moving our portfolio – because that’s where the bargains are – to the areas where we believe the macro risks are considerably more attenuated.
What surprised you in this environment?
The biggest surprise, in a funny way, is the way that franchise companies, like Deere, have weathered this period in terms of their profit performance. The auto companies got slaughtered, but Deere, which typically would have gone from making money to losing money, is maybe down 35% in earnings.
These companies increasingly make their money on services. The part of the package you need from Deere, if you own a Deere tractor, is service. If it breaks down, you need it fixed. Deere has a dense network of dealers with lots of parts availability and lots of capacity. You’re going to get much better service and you are going to get a higher price for that. That’s a competitive advantage that protects them against price competition. As the package of what these manufacturers offers moves in the direction of service, they are going to have more local monopoly power in different areas, because the services are locally produced and consumed.
For Part 1 of the interview, see: Robert Huebscher talks with Bruce Greenwald