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Forbes has posted a video and transcript of an interview with Joel Greenblatt.  Greenblatt is the founder of Gotham Capital, an adjunct professor at Columbia Business School where he teaches “Value and Special Situation Investing.”  He is the author of three investment books and, through Gotham, the advisor to four mutual funds, which select stocks based on Gotham’s proprietary system of ranking stocks according to value metrics (essentially an institutional version of the “Magic Formula” from Greenblatt’s The Little Book That Beats the Market)Greenblatt is also the co-founder of the Value Investors Club, a private forum for discussing value and special situation equity ideas.

In the interview, Greenblatt criticizes market-cap weighted indexes and the short-term focus of individual investors and money managers.  He also claims that an equal-weighted basket of value stocks can beat market-cap weighted indexes like the S&P 500 by 6-7% per year, which is what his Formula Investing Funds aim to do.  He also had this to say about value investing in general:

Most business schools do not really teach Benjamin Graham.  There are a few around the country that do.  But for the most case, people are still being taught the efficient market model, and all the math that goes along with that. We kind of feel the way Warren Buffett does: that’s good news for us.  That if everyone’s told you can’t beat the market – and this is the way to go about investing and it makes no sense to you and everyone’s being taught that – it gives a little more opportunity to value investors if you have less competition actually doing the work.

You can watch the video and read the full transcript here.

founded Gotham Capital, a private investment firm, in 1985. Since 1996, he has been a professor on the adjunct faculty of Columbia Business School where he teaches “Value and Special Situation Investing.” He is the author of three investment books: You Can Be a Stock Market Genius (Simon & Schuster, 1997); The Little Book that Beats the Market (Wiley, 2005) and The Big Secret for the Small Investor (Random House, 2011)

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Welcome back, ValueHuntr readers!  In the coming weeks, we will resume regular posts relating to the business of value investing.  In the meantime, we’ve kept some older posts that are still useful and relevant now.  For today’s post, we highlight a timely quote from the latest memo by Oaktree’s chairman Howard Marks.  In this memo, titled “How Quickly They Forget,” Marks comments on investor behavior, memory and risk-taking against the backdrop of today’s “low-return world.”

On risk, Marks had this to say:

Especially since the publication of my book, people have been asking me for the secret to risk control. “Okay, I’ll read the 180 pages. But what’s really the most important thing?” If I had to identify a single key to consistently successful investing, I’d say it’s “cheapness.” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It’s not the only thing that matters – obviously – but it’s something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity. When investors are serene or even euphoric, rather than discomforted, prices rise and we become less likely to find the bargains we want.

You can read the full memo here.

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We introduce a value-based investment model as alternative to the Capital Asset Pricing Model (CAPM) used by business schools, investment banks, and portfolio managers today around the world. We believe that the Capital Asset Valuation Model (CAVM) is a common sense approach to modeling risk-return in a way consistent with Graham and Dodd. We call it a model with some hesitation, as we only use simple algebra and common-sense to arrive at a solution. But the final solution may not come to much surprise many value investors.

Our Starting Point

In CAPM, expected return is dependent on beta, or price volatility relative to the general market as well as the average risk-free rate. It is inconceivable to us how expected returns can be measured as a function of past historical performance and the risk-free rate, as both are outside of the investor’s control.

Our starting point for the new model is recognizing that volatility is not equivalent to risk. To the contrary, as Graham points out in the Intelligent Investor, volatility is simply an opportunity to buy wisely when prices fall.

graham_quote

Our model defines risk as the probability of capital loss associated with a particular investment decision. Defining risk as the probability of loss allows us to define key points in what will become the equation for CAVM. The two key points are:

1) The expected return will be greatest when the probability of loss is zero.

2) The expected return will be zero when the probability of loss is 100%.

 

Derivation of CAVM Equation

Mathematically, the two points above can be plotted in a x-y axis, where y is the expected return and x is the probability of loss (risk).

 plot1

The max and min points on the plot can be incorporated into a linear relationship between expected return and risk, where as expected, investment returns will be a function of risk. This yields the following linear relationship:

Re = Rmax – (Rmax)*[risk]

Since risk has been defined as the probability of loss, then: risk = 1-p, where p is the probability of gain, or a gain confidence interval. The equation becomes:

Re = Rmax – (Rmax)*[1-p]               

 or

Re = Rmax*p

 

This simple equation makes sense. It tells us that the expected return on an investment will be the maximum possible return one can achieve on a particular idea multiplied by a confidence interval. We believe that confidence interval p is dependent on only two things:

1) The certainty to which the gap between value and price will close within the desired or expected time frame.

2) The certainty to which the value of the investment can be measured from the information available to us.

To add a time variable into our equation, we add variable T as one with inverse effect on the expected returns. Our equation becomes:

Re = Rmax*[p/T]

 

Value investors may also recognize that the maximum expected return Rmax occurs when the gap between intrinsic value and price is zero, such that:

Rmax = (IV-Price)/Price

Where IV is the estimated intrinsic value and price is the current price. This equation is zero when IV=Price, or when margin of safety (MOS) is zero.

We, as value investors, define margin of safety as:

MOS = 1-[Price/IV]

So that if price for an investment is for example $20, with an estimated IV of $30, the margin of safety would be 33%. This means that we as investors are paying 67 cents for every dollar of intrinsic value.

Combining the equations for Rmax and MOS provides us with an equation for Rmax solely dependent on MOS:

Rmax = MOS/(1-MOS)

So our equation for expected return becomes:

Re = [MOS/(1-MOS)] *[p/T]

 We believe, as value investors, that this is the equation every investor should be using as an alternative to CAPM. In fact, we believe value investors unknowingly make such calculation when evaluating potential upside vs. downside for each of their investments. The equation is simple, and implies that the only things that matter when making investment decisions are: the margin of safety (MOS), one’s confidence that our calculations are correct (p), and the time it takes for the price-value gap to close (T).

 

Thoughts on the Risk-Return Equation

There are several interesting thoughts that arise from the equation we have derived. Some are outlined below.

– Contrary to CAPM, risk decreases the probability of returns. Maximum expected return is only achieved by completely eliminating risk.

– The maximum risk on an investment is obtained on 3 different ways: margin of safety is zero, confidence interval p is zero, and time is infinity. Therefore, minimum risk comes from having large margin of safety, high confidence interval, and realizing value in the shortest time possible.

– Equation supports Buffett’s idea to investment in businesses whose “cash flows are highly predictable”. A highly predictable business would imply the investor has a high confidence interval p, since the probability of properly establishing an appropriate intrinsic value is high.

– Equation is valid in any type of investment scenario, e.g. stocks, bonds, real estate, etc.

– Equation is undefined as MOS = 1, so a margin of safety of 100% is impossible in the investment world (cannot invest at 0 cents on the dollar).

– Risk is independent of sector and/or diversification strategy. E.g. 1000 holdings will have equal expected returns as 10 holdings as long as the average margin of safety and average confidence interval is identical (though transaction costs would increase in proportion with the number of holdings).

– Investors concentrating in situations with high confidence intervals p (e.g. Buffett) have the ability to make high returns at lower margin of safety than average investor Investors with low p need to invest with higher MOS to make up for the difference.

– Portfolio of investors with identical stocks purchased at identical prices may pose widely different risks. First, MOS estimates will vary between investors. Second, investors may have different confidence intervals p because some the uncertainties of intrinsic value estimation will vary among them.

– Lower MOS will shift return line downward, diminishing returns for investors at identical risks.

 plot31

 

Challenges

– What confidence interval p corresponds to the average stock market investor? We believe that the average investor decision-making process on risk amounts to a coin flip, so we believe p = 50% is appropriate.

 plot2

 
– Confidence interval p is a “fuzzy” parameter which requires skill to evaluate:

1) The certainty to which the gap between value and price will close within the desired or expected time frame.

2) The certainty to which the value of the investment can be measured from the information available.

The skill to deal with these certainties (or uncertainties) can widely vary among investors.

 

 – Average S&P500 return of ~ 6% suggests average investor has historically purchased stocks with an average MOS of 10%.

 

CAVM in Practice: The ValueHuntr Portfolio

We calculate the average MOS for our portfolio both at cost and at the current market price. Our analysis indicates that MOS at purchase was 38%, and a current MOS of 29%.

 mos11

From MOS, we can then obtain the maximum return possible for our portfolio.  Assuming an average confidence interval p of 50%, we can then obtain the expected return of our portfolio.

 rmax1

At the time of our purchases, our portfolio had an expected annualized return of 43%. Our gains have since lowered the expected gains to roughly 26%.

 cavm-plot1

Afterthoughts on ValueHuntr Portfolio Analysis

– Importance of MOS is evident on the risk-return graph above. Even at 80% risk, expected return is still 10%.

– Steep value lines possible due to our focus on small caps, where big discrepancies between IV and Price occur more often than in mid- and large caps.

– Our expected return has gone from 43% to 24% due to investment gains. Ideally, we would re-balance our portfolio to shift to curve upwards by selling stocks with low MOS and buying stocks with larger return prospects.

– We assume that our ability to evaluate the certainty of investment returns given the information we obtain for our various companies is at par with the average investor. Hence, p = 50% (ability to evaluate risk amounts to a coin flip).

 

Any questions or comments regarding CAVM are welcomed.

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Today we examine the Capital Asset Pricing Model, which value investors tend to be skeptical of.

The CAPM assumes that the risk-return profile of a portfolio can be optimized. According to the theory, an optimal portfolio is one which displays the lowest possible level of risk for its level of return. Additionally, since each additional asset introduced into a portfolio further diversifies the portfolio, the optimal portfolio must comprise every asset, (assuming no trading costs) with each asset value-weighted to achieve the above (assuming that any asset is infinitely divisible). All such optimal portfolios, i.e., one for each level of return, comprise the efficient frontier.

Furthermore, because the unsystematic risk is diversifiable, the total risk of a portfolio can be viewed as beta. When the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio (see Figure below).

 capm

According to CAPM, beta is the only relevant measure of a stock’s risk. It measures a stock’s relative volatility – that is, it shows how much the price of a particular stock varies relative with how much the stock market as a whole moves. If a share price moves exactly in line with the market, then the stock’s beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose by 10%, and fall by 15% if the market fell by 10%.

A small and reprobate minority, value investors in the Graham-and-Dodd mould understand the shortcomings of the theory, and disregard both the conventional definition of investment risk and the standard practice of investment risk management.

 

Shortcomings of CAPM

There are two problems we see with the conventional risk-return relationship proposed by CAPM.

The first one is that the expected market rate of return is usually estimated by measuring the geometric average of the historical returns on a market portfolio (i.e. S&P 500). CAPM assumes that expected market return always follows past performance, which is a dubious assumption (as shown in the housing bubble burst of 2008).

The second problem is that the risk free rate of return used for determining the risk premium is usually the arithmetic average of historical risk free rates of return. In a similar fashion as the expected return, the average risk-free rate is somehow dependent on past performance, which is not a sensible assumption to make.

Several other assumptions are:

a) The model assumes that asset returns are (jointly) normally distributed random variables. It is however frequently observed that returns in equity and other markets are not normally distributed. As a result, large swings (3 to 6 standard deviations from the mean) occur in the market more frequently than the normal distribution assumption would expect.

b) The model assumes that the variance of returns is an adequate measurement of risk. This might be justified under the assumption of normally distributed returns, but for general return distributions other risk measures (like coherent risk measures) will likely reflect the investors’ preferences more adequately.

c) The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets (homogeneous expectations assumption).

d) The model assumes that the probability beliefs of investors match the true distribution of returns. A different possibility is that investors’ expectations are biased, causing market prices to be inefficient.

e) The model assumes just two dates, so that there is no opportunity to consume and rebalance portfolios repeatedly over time.

 ValueHuntr Portfolio According to CAPM

We have used CAPM to measure the expected performance of our ValueHuntr Portfolio. The analysis, as shown in the figure below, indicates that our portfolio is one with high risk. CAPM estimates our expected return at nearly 5% due to a volatility of 10% above the market average beta of 1.

 capm_valuehuntr

Obviously, we believe these results do not accurately reflect the prospects of our portfolio, as the volatility of our holdings tells us nothing about risk. Tomorrow, we will introduce a simple relation developed by ValueHuntr to be used as an alternative to CAPM.

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There are several documents written by Ben Graham that are currently stored at the New York Research Library, and amongst them is a microfilm document titled “The Renaissance of Value”, written in 1974 by Ben Graham and which I have just obtained for our readers.

 

The document discusses several questions posed by Graham, one being the following: to what degree should the valuation techniques presented in Graham & Dodd’s Security Analysis be modified to account for recent developments?

 

According to Graham, the midpoint of the value range has typically been found by applying an appropriate multiplier to estimated future earnings, which is not the best technique to use (This technique is still used today). Instead, the earnings figure taken should be what Graham calls “normal current earnings” and all the future prospects – favorable or unfavorable, specific or general – should enter into the multiplier. This procedural change obviates the necessity of establishing a future value, and then discounting the same to its present worth.

 

In this document, Graham also corrects some of the formulas he proposed in Security Analysis. For example, Graham had previously suggested that the intrinsic value could be approximated by a formula that employs a single variable G, representing the expected growth rate over the next seven to ten years. The formula read:

 

Value = “current normal earnings” x (8.5+2G)

 

However, Graham states that this formula had the great defect of failing to allow for changes in the basic rate of interest. To account for this, Graham re-states his intrinsic value formula as:

 

Value = “current normal earnings” x (37.5+8.8G)/AAA rate

 

With the AAA rate at 5.39% today and a historical GNP growth rate of 4%, Graham’s equation indicates that the current multiplier for the market should be 13.5. With operating earnings at $49 for the S&P500, Graham’s formula seems to indicate a fair value of 661 for the S&P500 benchmark relative to its current value of 831. At ValueHuntr, we do not believe in a single formula for valuation estimates, but it is an interesting exercise.

 

Additionally, it is clear that Graham saw no systematic way of reducing multipliers to allow for investments in companies with a below par debt position. His advice to analysts is to rather avoid attempting a formal valuation of such companies. In other words, analysts should limit their appraisals to enterprises of investment quality.

 

In general, “Renaissance of Value”, as Graham noted in 1974, involved the reappearance of sub-working capital opportunities. It seems that 2008 was a year which Graham would hail as the “Re-Renaissance of Value”.

 

A scan of the microfilm document has been posted in our resources section. Click here to read.

 

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Yesterday we wrote about the 1989 Fortune article titled “The New Warren Buffetts”, which identified the best young investors at the time. The article included the names of what seemed to be unknown and obscured investors at the time.  However, today they are among the best investors around. Investors highlighted in the article included value investing luminary Seth Klarman, hedge fund manager Eddie Lampert, and TV personality Jim Cramer.

 

Today, we identify the most promising young investors (under 45). This new generation of investors never had a chance to personally meet or study under Ben Graham, but some have been lucky to work with some of Graham’s former students. In other words, the investors we highlight today may be considered Graham’s grandchildren, but they are not necessarily dogmatic Grahamites. Some of them may not even see themselves as value investors, but they do follow two fundamental principles of value investing:

 

1)     Stocks are not just moving tickers; they are businesses whose fundamentals have an impact in long-term stock performance.

2)     Great investments are those purchased at bargain prices relative to their true worth.

 

This group is smart and confident enough to ignore short-term market fluctuations for the sake of long-term return. A lot of them already enjoy great success, but for one reason or another they may not be well-known outside the investing circles. Some will fail. But the odds are that, just as those highlighted in the original 1989 Fortune article,  a few will go on to investing fame, and most likely lead their clients to great fortunes. Our picks are:

 

 

David Einhorn, 39, Greenlight Capital

 

Einhorn, a soft-spoken poker guru, is President of Greenlight Capital, a “long-short value-oriented hedge fund”, which he began with $1 million in 1996. Greenlight has historically generated greater than 25% annualized net return for partners and investors. Einhorn is also the Chairman of Greenlight Capital RE, Ltd, a Cayman Islands-based reinsurance company and one of its major shareholders.

 

He has been a critic of investment-banking practices, saying they are incentivized to maximize employee compensation. He cites the statistic that investment banks pay out 50 percent of revenues as compensation, and higher leverage means more revenues, making this model inherently risky.

 

In May 2002, Einhorn made a speech about a mid-cap financial company called Allied Capital, and recommended shorting it. The stock opened down 20% the next day. Starting July 2007, Einhorn became a short seller in Lehman stock. He believed that Lehman was under-capitalized, and had massive exposures to CDOs that were not written down properly. He also claimed that they used dubious accounting practices in their financial filings.

 

In May 2008, Lehman CFO Callan had a private call with Einhorn and his analysts to give Callan a chance to explain discrepancies Einhorn had uncovered between the firm’s latest financial filing and what had been discussed during its conference call about that filing. Ms. Callan is said to have fumbled some of her responses to questions on Lehman’s asset valuations. When Einhorn went public with the conversation, the declining Lehman share price took a further knock and Callan was fired a few weeks later. Lehman went bankrupt in September 2008.

Einhorn is a graduate of Cornell University, where he graduated summa cum laude with a BA in Government. He currently serves on the board of the Michael J. Fox Foundation.

 

Paul D. Sonkin, 39, Hummingbird Value Funds

 

Paul D. Sonkin has served as the Chief Investment Officer to Hummingbird Value Fund, L.P., a Delaware limited partnership, since its inception in December 1999. The fund has achieved a 17% annual return since inception. Mr. Sonkin also serves as an adjunct professor at Columbia University Graduate School of Business, where he teaches courses on securities analysis and value investing. From May 1998 to May 1999, Mr. Sonkin was a senior analyst at First Manhattan & Co., a firm that specializes in mid and large cap value investing. From May 1995 to May 1998 Mr. Sonkin was an analyst and portfolio manager at Royce & Associates, which practices small and micro cap value investing.

 

Mr. Sonkin was the youngest investor profiled in the book “Value Investing: from Graham to Buffett and Beyond” written by his former professor at Columbia Business School Brunce Greenwald.

 

According to Greenwald, Paul Sonkin isn’t going to impress anyone at cocktail parties by discussing the companies he owns. He would probably impress with his returns, however.

 

Sonkin finds value in small-caps and micro-caps: companies so small, that value can often be found for one of several reasons:

1) Many funds can’t own them
2) Fewer analysts following the company

Sonkin often indicates that he likes small companies because they are easier to understand. Their business models are far simpler, and thus value can be found without having to understand several lines of business or complex financial statements.

 

Whitney Tilson, 42, T2 Capital Partners

 

Whitney Tilson is the founder and Managing Partner of T2 Partners LLC, a $100 million hedge fund based in New York City. Mr. Tilson was one of five investors included in SmartMoney’s Power 30, was named by Institutional Investor as one of 20 Rising Stars. T2 Partners has achieved an annual return of 8.6% since inception, compared to -1.4% for the S&P500 and 1.7% for the Dow. Mr. Tilson received an MBA with High Distinction from the Harvard Business School, where he was elected a Baker Scholar (top 5% of class), and graduated magna cum laude from Harvard College, with a bachelor’s degree in Government.

 

Prior to launching his investment career in 1999, Mr. Tilson spent five years working with Harvard Business School Professor Michael E. Porter studying the competitiveness of inner cities and inner-city-based companies nationwide. He and Professor Porter founded the Initiative for a Competitive Inner City, of which Mr. Tilson was Executive Director. Mr. Tilson also led the effort to create ICV Partners, a national for-profit private equity fund focused on minority-owned and inner-city businesses that has raised nearly $500 million.Before business school, Mr. Tilson was a founding member of Teach for America, a national teacher corps.

 

Mr. Tilson is also the co-founder, Chairman and co-Editor-in-Chief of Value Investor Insight an investment newsletter, and is the co-founder and Chairman of the Value Investing Congress a biannual investment conference.

 

 

Karen Finerman, 43, Metropolitan Capital Advisors

 

In 1992, while still in her late 20s, Karen Finerman co-founded hedge fund outfit Metropolitan Capital Advisors. Before launching her hedge fund, she was a lead research analyst for the risk arbitrage department at Donaldson, Lufkin & Jenrette, and before that a trader at First City Capital, a risk arbitrage fund for the Belzberg family.

 

Metropolitan Capital Advisors is a special-situations, long-short hedge fund which Ms. Finerman assembled with her partner Jeffrey Schwarz. The fund, currently has $400 million in assets and has produced 14% percent annualized returns since its 1992 inception.

Ms. Finerman received a B.S. in Economics, from the University of Pennsylvania’s Wharton School in 1987, with a concentration in Finance. She is the Chairwoman of the Development Committee of the Michael J. Fox Foundation for Parkinson’s Research and serves on its board. She is also a Trustee of the Montefiore Medical Center in the Bronx, N.Y. where she serves on their Investment Committee.

 

Curtis Jensen, 36, Third Avenue Funds

 

Alongside Martin Whitman, Curtis Jensen is Co-Chief Investment Officer of Third Avenue Management. He also manages the Third Avenue Small-Cap Value Fund and several sub-advised portfolios. Additionally, Mr. Jensen is Co-Manager of Third Avenue Variable Series Trust.

 

Mr. Jensen received an M.B.A. from the Yale School of Management, where he studied under Third Avenue Management’s founder, Martin Whitman. He joined Third Avenue Management in 1995. Previously, Mr. Jensen held various corporate finance positions with Manufacturers Hanover Trust Company and Enright & Company, a private investment banking firm.

 

Jensen’s work at Third Avenue Management takes on a number of roles that have grown as the company has become a major Wall Street investment firm. “The first and probably biggest piece of it is working as an analyst,” he often says. In an interview with the Yale School of management, Mr. Jensen outlined his responsibilities at Third Avenue:

 

 

“Whether it’s property-casualty reinsurance, semiconductors, oil and gas, we need to figure out the businesses we’re invested in, or looking to invest in. The second piece would be as a portfolio manager. I manage one of our funds here. So that’s taking those ideas and constructing a portfolio out of the ideas, and managing that portfolio on a day-to-day basis. For us, we tend to be very long-term oriented in our investing. There is no furious buying and selling of securities here”

 

 

Since its inception, Third Avenue Management’s returns have been among the highest on Wall Street. The six-year old International Value Fund has earned more than 20% per year, while the flagship Value Fund has averaged more than 16% returns since 1990. Jensen manages the firm’s Third Avenue Small Cap Value Fund, which has consistently outperformed the S&P 500, delivering annualized returns over five years of just over 19% and about 12% per year since the fund was founded in 1997.

 

 

Mr. Jensen currently serves on the Board of Opportunities for a Better Tomorrow, a nonprofit organization, which provides academic support, job training and life skills primarily to disadvantaged and at-risk youth.

 

Thomas S. Gayner, 45, Markel Corporation

 

Tom Gayner is the Executive Vice President and Chief Investment Officer Of Markel Corp and President, Markel Gayner Asset Management, Inc., the investment subsidiary Of Markel Corp since December of 1990. The asset under management is about $2 billion. Over the last 10 years, Mr. Gayner has averaged an annualized return of 14.3%.

 

Since 1990, Gayner has served as president of Markel Gayner Asset Management; he also served as a director of Markel Corporation from 1998 to 2003. Previously he had been a certified public accountant at PricewaterhouseCoopers and a vice president of Davenport & Company of Virginia.

 

As the CIO of Markel Corp, Tom Gayner is certainly a value investor. He thinks stock is part of a business and the business is worth what the present value of the future cash flows are. He often says that his portfolio operates with a Margin of Safety and that he has also relatively concentrated portfolio. As Buffett, he believes that he can earn the best returns by concentrating his focus and portfolio in promising areas where he has the best understanding and knowledge.

 

Gayner serves on the Board of Directors of The Davis Funds in New York City and First Market Bank and Colfax Corporation, both in Richmond, VA.

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I recently came across a 1989 Fortune Magazine article titled “Are these the New Warren Buffetts” which highlighted some of the best young investors at the time.  The article highlights what seemed to be obscure investors at the time, some of who are well established names today. The list includes Seth Klarman (Baupost Group), Glenn Greenberg and Jason Shapiro (Chieftain Capital), Eddie Lampert (ESL Investments), Jim Cramer (CNBC), among others.

 

The article demonstrates the importance of developing a reputation for brains, ethics, and great returns during the early stage of one’s career. Equally important, it shows that the best investors are those who develop a consistent and conservative investment strategy and resist the temptation to deviate from it over the long haul.

 

The investors highlighted in the 1989 article are now 20 years older, so tomorrow we will be posting our version of “The New Warren Buffetts”, where we will highlight the best young investors currently around.
 
 

 

The original 1989 article is included below.

 

 

fortune_logo

ARE THESE THE NEW WARREN BUFFETTS?

The dozen young investment managers you’ll meet here are brainy, ethical, and good at making money grow consistently.


By Brett Duval Fromson REPORTER ASSOCIATE Susan E. Kuhn

October 30, 1989

 

(FORTUNE Magazine) – Wouldn’t you like to become partners with someone who would double your money every three to four years ad infinitum? To put it another way, wouldn’t you like to invest with the next Warren Buffett? Riches come to investors who, early in their lives, find great money managers. Buffett is certifiably one of the greatest. His early clients are now worth tens of millions of dollars (see box). He achieved that by compounding money consistently and reliably at about 25% per annum. The young investors you will meet here show signs of comparable talent. But even if they can return only 20% a year — most have done at least that well so far — $10,000 invested with them today would be worth $5.9 million in the year 2025. What reveals their potential? ; Strong investment performance, of course. But that is not conclusive, especially among young managers who generally lack a ten-year record. More important are certain character traits. Buffett himself starts with ”high-grade ethics. The investment manager must put the client first in everything he does.” At the very least, the manager should have his net worth invested alongside that of his clients to avoid potential conflicts of interest. Those profiled here have put the bulk of their assets with their customers’.

Buffett says he would invest only with someone who handled his mother’s money too (as he did). Brains help, but above a certain level they are not the salient distinction among investment managers. Says Buffett: ”You don’t need a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ.” The size of the investor’s brain is less important than his ability to detach the brain from the emotions. ”Rationality is essential when others are making decisions based on short-term greed or fear,” says Buffett. ”That is when the money is made.” More often than not, the best money managers, like Buffett, are ”value investors,” intellectual descendants of the late Benjamin Graham. He emphasized buying securities of companies selling for less than their true worth.

The dozen young managers presented here are Graham’s grandchildren, in a sense, but they are not necessarily dogmatic Grahamites. A few dredge for average companies at rock-bottom prices — Graham’s specialty. Others follow Buffett’s approach and buy great companies at reasonable prices to hold for a long time. Two practice arbitrage, buying stock in companies about to be taken over or restructured in publicly announced deals. One prospers by selling overvalued companies short. Most do some of each, especially in a market where value is increasingly hard to find. Surveying these relative rookies, a reasonable man should ask, ”How will they do in a bear market?” Probably better than other money managers because they comprehend the basic rules of investing: No. 1, Don’t lose money. No. 2, Don’t forget the first rule. Each searches intently for discrepancies between a security’s price and its worth, whether measured by asset value, earnings, cash flow, or dividend yield. If they are wrong about a security — and everyone is sometimes — the difference between price and value provides a margin of safety. The best way to spot a potentially outstanding investment manager is to ask another one. Each of the 12 presented below was named by his or her peers as someone they would entrust money to. They tend to handle money for the rich and the famous; each has at least one investor whom any reader of Fortune would recognize — if the clients allowed their names in print. With the ) exception of the two who manage mutual funds, the required minimum ranges from $250,000 to $5 million. Most of these promising players will succeed. Some will fail. But the odds are that at least a few will go on to investing fame and their clients to fortunes. In order of how long they’ve been managing money on their own:

The Bargain Hunter It hardly seems possible that Michael Price is only 38. He has been picking stocks at Mutual Shares, the estimable no-load mutual fund based in Short Hills, New Jersey, for 15 years. He came to investing immediately after graduating from the University of Oklahoma. ”I was a mediocre student,” he says. Perhaps, but Price gets nothing but A’s for his work on Wall Street. If you had invested $10,000 with Mutual Shares ten years ago, you’d have $62,289 today. Before taxes but after all fees and expenses, that works out to a 20% average annual compound rate of growth. ”I like cheap stocks,” says Price. ”I’m basically a guy who looks at a company’s balance sheet and asks, ‘What is the company worth? Give me a number.’ If the answer is, ‘Substantially more than the price,’ then I get interested.” Price usually holds about 350 securities in his $5.7 billion portfolio. He spreads his holdings because many of his picks are small-capitalization issues whose prices would surge or collapse if Price bought or sold heavily. His largest holding, however, is TIME WARNER, parent of FORTUNE, which he bought at an average of $60 a share starting in November 1986. Time was languishing because the government had nailed Ivan Boesky and scared away many a speculator investing on takeover rumors. Price saw a good media business at a cheap price and accumulated 1.9 million shares. Time Warner traded recently at around $135.

A Freudian Grahamite Randy Updyke remains virtually unknown, even to his peers. Perhaps that’s because he is a solitary soul who rarely talks to other money managers. ”Investing is about survival,” he says. ”I stay away from the herd.” And how. When the bright lights of Philadelphia get too distracting to him, the 46-year-old Updyke removes to his ranch in Idaho or his plantation in South Carolina. Solitude seems to serve him well. If $100,000 had been invested in his partnership ten years ago, it would be worth about $850,000 today. That works out to a 24% average annual compound rate of return. Updyke is a decidedly unconventional investor: He combines the teachings of Benjamin Graham with those of Sigmund Freud. ”I like to buy things for a lot less than I think they are worth,” he says. ”But to me the psychology and mood of the market are more important than anything.” Updyke uses a variety of gauges to measure its state of mind — for instance, whether corporate insiders are buying or selling. If he thinks the market or a sector of the market is headed south, he unloads stocks en masse (some 60% of his portfolio was in cash before the October 1987 crash). ”I don’t care how good the fundamentals are. Very few people make money in down markets,” Updyke says. What does he think of the market’s prospects? Recently, 32% of the $225 million currently under his management was in cash.

The Passionate and the Skeptical Warren Buffett would be proud of the two young men who run Chieftain Capital Management. They scout for a few excellent companies selling for reasonable prices and loose their arrows only at robust businesses with top-notch management. This style has served them and their small tribe of investors well over the past 5 1/2 years. If you had invested $100,000 with them early in 1984, it would be worth $409,000 today. That’s a 28% average annual compound rate of growth. Glenn Greenberg, 42, and John Shapiro, 36, work as a team, much as Buffett does with his partner, Charles Munger. Greenberg, son of Hall of Fame slugger Hank, is usually passionate one way or the other about a stock. Shapiro is more the detached skeptic. Their stock selections are joint decisions. Says Greenberg: ”That way we avoid blaming each other for our losers. We try to be competitive with the rest of the world, not with each other.” This duo likes to be wedded to their stocks for years. That is why they check them out thoroughly before investing and then put as much as 20% of their money into a single investment. Their biggest position is in BURLINGTON RESOURCES, an oil and gas producer spun off by the Burlington Northern railroad in late 1988. They bought in at an average price of $27. It traded recently at $47.

Seeking Subtle Signs of Value at 32, Seth Klarman is already a legend among colleagues and competitors. ”Seth is as good as they come,” says his former boss, Michael Price of Mutual Shares. Certainly no one in his generation has a better investment record. From his offices at the Baupost Group just off Harvard Square, he invests for a small group of affluent families who snagged him to run their money soon after he graduated from Harvard business school in 1982. A $100,000 stake entrusted to Klarman at the birth of Baupost today is worth on average $500,000 — a 28% average annual compound rate of growth. Klarman’s exceptionally quick and subtle mind allows him to see value in many different guises. With stocks high, he looks for ”market-insensitive opportunities.” By that he means companies whose financial performance depends on bankruptcies, announced mergers, liquidations, restructurings, or spinoffs — corporate events largely independent of the vagaries of the financial markets. For example, he bought the senior bonds of the ailing discount chain PAY’N SAVE for 62 cents on the dollar. They yield 23% to maturity in 1996 and are backed by assets far in excess of bondholders’ claims. Klarman also has clear ideas about what isn’t value. A vocal critic of junk-bond financing, he says he would never buy a new issue of a highly leveraged company. Klarman’s insistence on protection from market fluctuations served his clients well in the October 1987 crash. For the fourth quarter of 1987 his portfolios broke even, and for the year as a whole they earned an average of 20%. Says Klarman: ”I focus on what could go wrong. Before buying, we always ask ourselves, ‘What would we pay to own this company forever?’ ”

A Scientist on Wall Street At Fidelity Investments, where he runs the Capital Appreciation Fund, they hail Thomas Sweeney, 33, as the second coming of Peter Lynch, legendary manager of Fidelity’s Magellan Fund. This shy workaholic lives across the street from his downtown Boston office to put in 80 hours a week more conveniently. In almost three years of steering Capital Appreciation, Sweeney has sailed right by Lynch’s more celebrated ship. That is no mean feat, even if Sweeney’s $2.4 billion fund is one-fifth the size of Magellan. Anyone who invested with him 2 1/2 years ago has seen the stake double. Average annual compound rate of return: 28%. Sweeney picks stocks like a scientist. Says he: ”Where I came from — Wappingers Falls, New York — business was looked down on. Smart people were supposed to go into the sciences.” He almost became a geneticist, and calls his approach ”pattern recognition,” after a discipline geneticists use to predict behavior under specific conditions. His favorite pattern? ”People always panic,” he says. ”If you study this phenomenon over time, you see that eight times out of ten you make money by buying into a panic.” Sweeney was eyeing Monsanto in early 1988, but the price, about $86, was too high for him. In September a federal court ordered the company to pay $8.75 million to a woman hurt by a Copper-7 intrauterine contraceptive device manufactured by a subsidiary. The news prompted a wave of selling by those who failed to recognize that the company was fully insured. Sweeney bought 940,000 shares at an average cost of $77. He sold in 1989 at $110 a share for a 65% annual rate of return. He has recently loaded up on electric utilities, especially those with extra generating capacity and high- powered cash flow that are near regions lacking adequate sources of energy. One of his favorites is DQE INC., formerly Duquesne Light Co.

Turning Value Upside Down You have to marvel at shortseller Jim Chanos. After all, he makes money on a stock only when it goes down — and the Dow has gone up 250% since the bull market began in August 1982. Even more amazing, the Milwaukee-born Yale graduate has kept his sense of humor. ”I’m a great market timer,” says Chanos, 31. ”I wrote my first short recommendation on August 17, 1982.” Pointing to a combat helmet on a shelf in his Manhattan office, he adds, ”On really bad days, I put it on and hide under my desk.” He is too modest. If you had invested $100,000 with Kynikos (cynic in Greek) Associates back in October 1985 when it began, you’d have $173,119, an annual compound rate of return of 15.7%. That may not sound so hot until you understand that people who invest with Chanos think of his services as insurance against a bear market. Says Chanos: ”The difference between my policy and Aetna’s is that their clients pay for the insurance and my clients get money from their insurance.” As long as he earns more than the riskless rate of return on T-bills, his clients are satisfied. Chanos is in truth a perverse kind of value investor. Using the same techniques as the others, he looks for overvalued stocks. He stays mainly in large-capitalization issues. That way there is more liquidity and thus less chance of a short squeeze, which would force him to liquidate his position because he could no longer borrow shares from brokers. Last winter Chanos made a big bet against HARCOURT BRACE JOVANOVICH, the troubled publishing company that was trying to sell its Sea World amusement parks to avoid drowning in debt. Chanos figured HBJ wouldn’t get as much as management hoped to. Lo and behold, when it finally sold the parks to Anheuser-Busch in September, the price was some $400 million less than most analysts anticipated, and HBJ shares tumbled. Chanos sees no reason to take his profit yet. Says he: ”We think the common is worth zero.”

Mr. and Mrs. Aggressive In a windowless lower Manhattan office, a young married couple with matching desks furiously buy and sell stocks. ”Sell at three-quarters,” she says to a broker at the other end of her line. ”Terrific. I want to participate,” he says to his broker. Karen and Jim Cramer, 31 and 34, are the quintessential Eighties couple, equal partners in work and at home. So far, the Mr. and Mrs. have succeeded in both venues. They recently celebrated 12 months of excellent financial performance — and their first wedding anniversary. Their investors are toasting both. Someone who placed $100,000 with them in April 1987 would now have $165,000 — an annual compound rate of return of 23%. The Cramers divide the labor. He generates most of the investment ideas; she handles the trades, using techniques she learned at the feet of master trader Michael Steinhardt, head of Steinhardt Partners. Their strategy is nothing if not aggressive. They place about 50% of their $19 million portfolio in stocks chosen with an eye to long-term value. A current favorite is WILLIAMS COS., a natural-gas pipeline and telecommunications company. The Cramers bought 65,000 shares at an average price of $39. It traded recently for $42 a share. They commit the other half to intraday trading. ”Our goal is to make money every day. That is why we trade,” says he. ”I never want to write a letter to our investors saying that we didn’t participate this quarter because we think the market’s too high. That’s none of our business.”

Pairing Value with Arbitrage Two years ago, at 25, Edward Lampert left the safety of Goldman Sachs to go out on his own. He had a bright future in arbitrage there, but after meeting dealmaker Richard Rainwater, a Goldman alum, on Nantucket, he decided he wanted more than becoming a Goldman arb. Says he: ”I wanted to set up my own business to invest in undervalued securities as well as arbitrage situations.” Rainwater, maybe seeing a bit of himself in the young man, helped him get started in April 1988. ESL Partners of Dallas started with $29 million under management. Lampert’s strategy gives him enormous flexibility. Says he: ”Arbitrage helps our value investing. If we can earn 20% to 25% annualized returns in arbitrage, then for the long term we can buy only stocks that we think will earn comparable rates of return. Conversely, if deal stocks get overpriced, we will begin investing in companies with good long-term prospects at low prices.” Like Buffett, he doesn’t talk about his current holdings in case he decides to buy more. His results, however, are eloquent. Had $100,000 been placed with Lampert a year ago April, it would be worth $165,000 today. That’s a plump 44% average annual rate of return.

Mr. Preservation of Capital This teddy bear of an investor is living his boyhood dream. As a boy in Glencoe, Illinois, John Constable, 33, took Warren Buffett as his hero. ”It amazed me that by simply thinking and being careful you could make money in stocks,” he says. Constable followed his dream to Harvard, where he took night-school extension courses and worked all-day as a block trader for the university’s endowment fund to pay tuition. He went on to apprentice at some of the most successful value-oriented investment shops, including three years at Ruane Cunniff & Co., managers of the redoubtable Sequoia Fund. Constable went out on his own in August 1988. He has $28 million under management. As befits a value player in a pricey market, Constable is cautious. He owns a few stocks involved in publicly announced deals where he can make, say, 10% in 90 days if the deal goes through. But he prefers to buy ”wonderful companies” like NESTLE for the longer haul. He owns 160,000 shares, bought at an average cost of $24. Why? ”It was one of the world’s superb food companies selling at 9.5 times earnings,” he says. Nestle traded recently at $25 a share. In large part because Constable has kept 30% of the money entrusted to him in T-bills, his limited partners are only 16% richer than a year ago. That’s not quite up to his 20%-a-year target, but he’s prepared to wait patiently for the day when prices come down and he can accumulate an entire portfolio of Nestles. His clients aren’t restless. ”First and foremost, my investors want preservation of their capital,” he says.

A Formula for Deals Like his friend Eddie Lampert, Richard Perry, 34, is a veteran of Goldman Sachs’s arbitrage unit. He too chose to leave Goldman because of its size; there are 132 partners. ”I wanted something smaller, where a few partners could work closely together,” he says. After asking the advice of his uncle, James Cayne, president of Bear Stearns, he established Perry Partners in September 1988 with $50 million to invest in publicly announced risk arbitrage deals, including mergers, tender offers, and bankruptcies. His investment approach? E(V) = P(UPx) + (((1-P) (DPx))) / (1 + COF). That simply means he values a deal by calculating the odds that it will go through, how long it will take, and what the investment is worth with and without the deal. Why all the effort to quantify? Says Perry: ”There are no lay-ups in the arbitrage business. This helps us maintain clear, high standards for buying a deal.” It seems subjective, but so far it seems to work: $100,000 invested with Perry ten months ago is worth $120,000 today, an annual compound return of 24%. Like his confreres, Perry is having a devil of a time finding great value in the stock market. One of the few good deals he found recently was NWA, the parent of Northwest Airlines, which became the object of a takeover attack this past spring. In June he bought 82,000 shares at $115 a share. Using his special equation, he estimated an expected annualized return of 27%. When he sold in July at $121, his return was 50%. Today, however, deals are pricier, and he does not anticipate such quick profits. He is buying one deal for every five he looks at. Says Perry: ”To be consistent over a long time, you have to know when to say no.” Mr. Buffett would approve.

 

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