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.


The New Warren Buffetts

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.





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.


(Written by Levi Folk for the Financial Post)

Security Analysis, the original book on value investing by Benjamin Graham and David Dodd, published in 1934, was inspired by the market crash of 1929. The book said investors were on solid ground if they owned shares in “net-nets” –companies whose liquidation values exceed by a wide margin their market capitalizations net of all liabilities.Net-nets were a proven strategy for protecting capital and achieving long-term gains.

Marty Whitman, chairman of Third Avenue Management and manager of the Third Avenue Value Fund, is the closest thing we have to Benjamin Graham today. Coming off an uncharacteristically difficult year, Whitman is finding bigger discounts in the market than at any time in his 50-plus year career.

A vociferous critic of Generally Accepted Accounting Principles (GAAP), Whitman makes refinements to the Graham and Dodd concept of net-net.

First and foremost, companies must be well-financed in keeping with the core tenet of Third Avenue’s “safe and cheap” method of value investing.

The goal is to own companies that are going concerns, not ones destined for liquidation. This difference is a crucial point of distinction between the focus of equity investors, who are often wiped out in liquidation, and bond investors, who have rights to the assets of a company in liquidation.

The second adjustment is to the assets themselves. Graham and Dodd focused exclusively on current assets when calculating liquidation value whereas Whitman includes long-term assets that are easily liquidated.

For example, roughly one third of long-term assets of Toyota Industries Corp. are investment securities, including a 6% position in Toyota Motor Corp. (TSX: TM), says Ian Lapey, portfolio manager at Third Avenue and designated successor to Whitman on the Third Avenue Value Fund.

These securities are therefore included in Third Avenue’s calculations of net-net.

Closer to home, oil and gas producer Encana Corp. (TSX: ECA) has proved reserves of oil and natural gas that are not included in current assets, says Lapey.

“They are liquid in that there is a real market, current commodity prices notwithstanding, for high-quality proved reserves of oil and gas.” Encana is a top holding in AIC Global Focused Fund, sub-advised by Third Avenue and managed by Lapey.

The third adjustment is the inclusion of off-balance-sheet liabilities. Here, U. S. banks’ structured investment vehicles readily spring to mind.

The fourth and final adjustment to Graham and Dodd is the inclusion of “some property, plant and equipment” for their liquidated cash value and associated tax losses that often produce cash savings.

Hong Kong real estate companies, such as top holding Henderson Land Development Co. Ltd. (HK: 0012/),are required to mark property values to market prices, so liquidation values are easily ascertained.

“In most time periods, the market for fully leased office buildings is quite liquid,” says Lapey, justifying their inclusion in net-net calculations of these companies.

Sycamore Networks Inc. (NASDAQ: SCMR) is the most compelling example of a net-net situation in the United States offered up by Lapey.

The telecom equipment company has more cash — US$935-million in all — than the total value assessed to it by the market, in light of its US$800-million market capitalization and US$38-million in total liabilities.

“We feel that there is value to their technology that is being recognized by some of the large telecom carriers,” says Lapey of Sycamore Networks, but he acknowledges its current weak earnings power. Lapey is also attracted to the one-third of outstanding share ownership by management because it presents an important alignment of their interests with those of Third Avenue, who are by and large passive investors.

These large valuation discounts in the market are reassuring words for investors from the one of the finest practitioners of Graham and Dodd.

“We are holding these companies trading at huge discounts,” says Lapey, “and if these companies were to sell assets or sell the whole companies we think the result would be a terrific return for our investment.”

Most analysts feel they must choose between two investing approaches customarily thought to be in opposition: “value” and “growth”. But the Warren Buffett Letters (available in our resources section) make it clear that the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.


Buffett’s 1992 letter points out that although growth often has a positive impact on value, such effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless growth. For these investors, it would have been far better if Orville Wright had failed to get off the ground at Kitty Hawk: the more the industry has grown, the worse the disaster for owners.


So growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.


What kind of businesses are these in which growth hurts or benefits investors? Bruce Greenwald, director of the Heilbrun Center for Value Investing at Columbia Business School, provides an enticing answer:


If a firm operates with no competitive advantages, or with no barriers to entry in any given industry, returns above the cost of capital will attract new entrants whose competition will eliminate those higher rates of return. Without barriers to entry, competition will sooner or later force the rate of return downward until it equals the cost of capital. Since the most common competitive condition is a level playing field, for most firms return on capital is nearly equal to cost of capital. For these firms, growth adds zero to shareholder value. For firms that are on the wrong side of barriers of entry, outside and looking in, the cost of capital exceeds return on capital, so growth destroys shareholder value. Only in markets where a company enjoys a sustainable competitive advantage, protected within its franchise by barriers to entry, will returns on capital be greater than the cost of capital.


So the basic relation between value and growth comes down to this: Only growth created through a competitive advantage creates value.

 According to modern investment theory, diversification is a central feature to proper investment strategy. The theory holds that it is possible to diversify away the risks of holding securities by spreading this risk among many uncorrelated holdings. It’s a theory that has been widely followed, but one that has been tested by the recent financial meltdown in which stocks, bonds, commodities and real estate have all dropped in unison.


For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, “risk” is theoretically the standard deviation from the average return. Hence, diversification is not necessarily a way to reduce risk, but rather to lower volatility. We explore the flaws in this theory through two thought experiments.


Our first thought experiment consists of two investors with widely different portfolios. Investor A is aware of modern investment theory and is sure he can lower his investment risk by holding 3 uncorrelated investments: a real estate property, a stock, and a bond certificate. On the other side, investor B has decided to invest only in 3 real estate properties. Which investor has the riskier portfolio?


According to modern investment theory, investor A is more diversified, and therefore holds the less risky portfolio because his deviation from average return would ultimately be lower than the more correlated portfolio of investor B. This may be true, but let’s now imagine the portfolios look as follows:


Investor A


1. A stock whose company has no competitive advantage

2. A real estate property currently under water

3. Bonds of a company which cannot meet its future obligations


Investor B


1. Three real estate properties below fair value


Now that the content of each portfolio is known, I would argue, as most sane investors would, that the probability of permanent loss are higher in investor A’s portfolio. Thus, investor B’s portfolio is less risky.


This is the obvious flaw that haunts the diversification strategy most funds employ today, where holding hundreds (and sometimes thousands) of positions is considered less risky than concentration regardless of the fundamentals of each individual investment.


Unfortunately, these misguided definitions of diversification and risk are also employed in hedging strategies. For example, funds employing the so called “market-neutral” strategy aim to decrease risk by maintaining a balance between long and short positions. Though these funds may be better immunized from wild market volatility, this does not mean that the probability of capital loss is lower than any other strategies. In fact, the “a market neutral” strategy is used not to decrease investment risk, but rather to minimize redemptions, since investors are more likely to pull their money out of these funds when volatility is greater.


This takes us to our second thought experiment. Consider a portfolio that holds two stocks: one that pays off when it rains and another that pays off when it doesn’t rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. But the payoff in either case will always be 50% lower than the return we would realize on rainy days by concentrating on stocks that pay off only when it rains, and so on for shiny days. This thought experiment indicates that volatility is reduced, but above-average returns are more difficult to obtain. Many investors fall into this trap.


Since value investors tend to reject modern investment theory, it is not surprising that many also refuse to diversify. So how should value investors manage risk?


1.                 Forget about volatility


Volatility is not risk. In fact, volatility is what allows value investors to purchase companies at bargain prices. Unless you are a hedge fund trying to keep investors by making the market rides easier on their stomachs, volatility is not where your focus should be.


2.                 Don’t swing at every pitch


The standard response of value investors regarding diversification has been best expressed by Warren Buffett in his frequently cited baseball analogy. Buffett argues that great hitters such as Ted Williams were able to achieve high batting averages because they swung only to the pitches they were sure they could hit. Ted Williams stated:


My first rule of hitting was to get a good ball to hit. I learned down to percentage points where those good balls were. The box shows my particular preferences, from what I considered my “happy zone” – where I could hit .400 or better – to the low outside corner – where the most I could hope to bat was .230. Only when the situation demands it should a hitter go for the low-percentage pitch.





Similarly, investors are more likely to invest successfully only in situations where the probability of return is high. This may mean investing only within a circle of competence (investing in understandable companies), staying on the sidelines during bullish times, and purchasing heavily during periods of uncertainty.

Those who invest in hundreds of opportunities at a time, as most funds do, are bound to be obtain returns almost identical to the general market. In this case, investors may be better served by simply buying the S&P500 index.


3.                 Place bets according to odds


It has been mathematically proven that the best gamblers are those who bet heavily when the odds are in their favor, and who stay on the sidelines when the odds are against them. Similarly, value investors tend to bet according to the likelihood of a positive outcome. In probability theory, the Kelly criterion is used to obtain the optimize size of a series of bets.  In the simplest cases, it can be shown that the size of each bet or investment is proportional to the difference between the probability of winning and that of losing. For example, if an investment has a 60% chance of success – or 40% chance of failure – the size of the optimum bet should be 60%-40%, or 20% of the total portfolio.


4.                 Remain pessimistic: challenge own judgement


So how do value investors evaluate the probability of success for their investments? They tend to do so by continually focusing on what can go wrong with an investment rather than what can go right. Focusing on the negative prospects of each investment serves as a check in situations where the prevailing market sentiment is irrational (tech bubble, credit bubble, etc.)



Value Investing Collection

Our electronic collection of rare value investing articles, lectures, videos, and books is now open to the public. All the scanning and copying was paid for by your small donations. Visit our resources section to access the collection, and help us grow it.


We were recently able to obtain copies of some of Ben Graham’s original lectures (dated 1932 to 1947) while he was teaching at Columbia University, and we thought we would share some common themes among them.


According to Graham, analysts who value companies based upon the capitalization of its earning power must make certain adjustments for the asset picture. However, asset valuation is more reliable than earnings-based valuation because the assets tend to move slower than earnings.


In general, Graham points out that if the earning power value exceeds the asset value, the value of the business should be marked upwards, but that some reduction should be made based on its assets. He suggests that to value these cases conservatively, analysts should take off a quarter of the difference between earning power value and asset value. The other case is that the asset value exceeds the earnings power value. For this case, companies should not be valued upwards because the assets have no earnings-generating potential, with the exception of cases where working capital exceeds earnings power. From experience, Graham points out that when this exception is validated, the analyst should add half the difference between earnings power value and working capital to correct for the eventual impact of this excess working capital on the business once it is put to work.


Additionally, Graham explains the two fundamental approaches that analysts may use to pursue the valuation of securities. These are:


1)     The conventional – that is based primarily on quality and prospects.

2)     The penetrating one – that is based on value.











Lastly, Graham insists that analysts should stay away from the game of expectations – the idea that because the prospects of a company are good then the company should be bought. He is most skeptical of this frequent Wall St. activity because “it tends to be the most popular form of passing the time for security analysts”. Graham stresses throghout the lectures that this behavior is naïve, at best.


More of these documents can be found in our resources section. To support the collection and publication of our library of documents, go here.