Thursday, February 24, 2011

GuruFocus Interview With Prof. Bruce Greenwald

Back to your comment, what’s the best way, do you think, to distinguish the ones that are temporarily sick from the ones that are terminally ill?

The first judgment that you have to make is that is it a franchise business or is it not. And the reason that judgment is so important is, that if this is a franchise business, then the growth is valuable, and temporary slow growth may give you a bargain. If it’s not a franchise business, you don’t care what the growth is, the growth neither creates nor destroys value, and that, too, will give you a view into where the opportunities are, because if it’s been growing and now it’s stopped growing, and people are upset about that, because the growth in the long run doesn’t create value, you don’t care about that at all. So the first thing you have to understand is, is this a Buffett franchise type business? And the answer to that is that typically, they’re going to dominate niche markets, and if it’s not a franchise business, you’re crazy to pay for the growth, and you only are going to get the earnings in the asset value. So if it’s not a franchise business, you look at the earnings, you look at the asset value, and if the earnings value is close to the asset value, and there are some other filters that you can look at, and this is not a destructive management, and together that average value is way below what the company is trading below in the marketplace, then that’s a company where the disease is not coming. So then if it’s a franchise business, the nature of the terminal disease is different. If it’s a franchise business, the terminal disease is where the franchise is either shrinking or going away, by competition. And the newspapers are an example, I think Apple (AAPL) is going to be an example of that, so I think in that case whether the disease is terminal or not is if the company continues to enjoy the standard competitive advantages. Do they dominate their particular local markets in geography, do they have customer captivity, or is that going away, and if they have propriety technology.

Okay. This comment makes lots of sense, but it’s kind of different from what Warren Buffett said. Warren Buffett said “I’d rather buy a good company at fair price, than a fair company a good price.”

Our only variable is what Warren Buffett thinks of is a fair price. His idea of a fair price, by the way, is a price that gets him a return going forward on that investment without any improvement in the multiple of somewhere between 13 and 15%. By normal standards, when the average market return is 7-8%, that’s a really good price, he’s looking for a very good price. They call it a fair price because the multiple may be fairly rich, it may be 13, 14 times earnings. But the value of the growth may bring his return up to 13-15%. So when he says a fair price he’s talking in terms of normal value metrics, and there the reason that you prefer that to a poor company at a really good price is that because the good company can grow through reinvestment and things like same-store sales growth, your return will come in the form of capital [gain], not distributive income, and that, after tax, is much more valuable.

Moving on to another topic, back to 2008, we know that many famed value investors lost lots of money, some lost about 50% of their fund. Why do you think this happened?

I think that there are two reasons why this happened. One is that some of them were not careful about what were franchises and what were not. So they looked at the financials and they said “look at how much money these guys are making” and they ignored the fact that none of them were dominating any particular market, and they bought them because they were cheap but not on a sustainable earnings basis, they were cheap on a temporary earnings basis that wasn’t going to continue.

A perfect example of this is banking. There are three basic activities that banks are involved in. They do backoffice processing, and that’s a big competitive market, no one’s got any advantages there. Second thing is that they deploy assets in public markets, and they do investment banking operations. There are no competitive advantages in that, there are lots of smart people competing, and when they stretch to get extra returns from that they almost invariably do it by taking those outside risks, and they almost always pay for it later. But they don’t really make money there, even though in good times it looks like they’re making money there.

The real way they make money is that they dominate local markets, like M&T Bank (MT) up in Buffalo, and they have better information about local borrowers. That’s the way to make money, and people forgot that, and everyone forgot that. All these banks, like AIG (AIG), looked like they were making money by superior performance in financial markets, and we know that that’s not sustainable. And so the first thing is that they made a mistake by overestimating the earnings power of a lot of businesses, that they shouldn't have, and that’s one big source of loss.

A second source of loss is that you can convert a temporary loss into a permanent loss. Many went bankrupt, and they never had a chance to recover. So, I think it’s those two things that got people in trouble. Where they were careful about assets, and Buffett got in trouble, and he’ll admit it, on the Irish banks and the oil companies.

So you think that because these investors don’t think long term or long business cycles?

Right, I wouldn’t even say long business cycle, I would say that they look at earnings that are not really sustainable without a franchise, and they bought companies that they thought were franchise companies, on the theory that those earnings were sustainable, when I think when they looked carefully they would have seen that they weren’t. And they bought companies that did come back, and as a lot of you know, a lot of companies did come back, but some went bankrupt before they could.

Do you think that [macro] factor[s] should play a [role] here in value investing? Some value investors after the 2008 crash put more attention on [macro]-economic environment.

I think that in terms of doing macro forecast, all the evidence is that no one does that well, and you’re not going to make money by forecasting the economy. But, if you want to worry about risk, you certainly should have a sense on when the macro environment is very uncertain, like it is now and in 2007, and when the macro environment is much more stable. And there, I think, you should make a judgment. I don’t think that people should look at macro as a way to make money, but if they consider their risk posture, I think they’ve got to buy more insurance or be more careful in a macro environment that’s dangerous. That’s what they want to assess, not if the market is up or down, just if there’s a high level of uncertainty or not. And typically, the most dangerous kind from a macro perspective are not just when the market is all high and all expensive, but also when you look at the implied volatilities and the derivatives they’re incredibly low, so no one thinks there’s going to be any problems. Like housing was going to go up forever. And I think you’re not going to make money on a bet, unless you’re lucky, that housing is going to plant. But in that environment you know that sooner or later you’re going to get into trouble with the market, and insurance in a former derivative is being sold quite cheaply.

So if we cannot predict the [macro] economic trend, but what about the overall market valuations? Warren Buffett uses the ratio of total market cap over GNP, which is the single most important indicator of the market. Also we know that Professor Shiller used an adjusted P/E ratio.

Any of these measures will do fine. They’ll tell you when markets are out of the normal range of where they are because profits are characteristically over a very long period of time get a constant portion of GDP, and therefore the value of those profits should bear a constant relationship to GDP, and therefore P/E levels of those profits should be roughly stable, which is Shiller’s point, and therefore you can compare profit to GDP or you can use Shiller’s P/E and you’re going to come up with similar answers. And because Shiller also uses the average earnings over many years, it would be constant relative to GDP. I think that’s certainly something you want to worry about, but again, you’re not going to predict one year ahead using that, but I think what you will be able to predict is when there’s a higher probability you’re going to get into trouble, and there you should take a more defensive posture.

So we can use this as a long term indicator of market valuation, maybe make some strategic change on portfolios?

Yes, I think that’s right. And derivatives, the VIX is pretty low at the moment, this is a slightly scary moment.


Another question, for your personal portfolio, what sector/industries do you hold?

Let me give you one stock when I think about what’s the obvious industry to look at: health insurers in the United States. You want the health insurer with the strongest competitive advantage, which is related to local economies. Most locally concentrated company is Wellpoint (WLP), and it’s traded for a very good price.

Do you have it in your personal portfolio?


You think that the reason you own it is because it has a strong local position?

It has a powerful local position, only in 17 states. The management buys back a ton of stock, that they sold their sub-scale subscription drugs service at a very good price to the industry leader and distributed most of the money to shareholders. It’s a cheap price, and you can’t do better than that in an industry that sooner or later is going to grow.

The P/E ratio is only at 10.

It’s actually a lot lower than that because they have a lot of cash embodied in the balance sheet.