Value Investors by Chan

We hear a lot about the most famous value investors. But there is a group of very successful value managers who fly under the radar, many of whom are profiled in Ronald Chan's Value Investors.

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Lunch With Francis Chou at the Richard Ivey School of Business

It was awesome to have the opportunity to listen to the wisdom of Francis Chou, who manages over $1 billion, in person at the Richard Ivey School of business via George Athanassakos’ value investing class. I learned many things during the course of the discussion and will share a few of the ideas here.

With regards to learning how to be better investors, Mr. Chou informed us that reading the autobiographies of great value investors and watching the actions of the best value investors is a great way to learn. He singled out an autobiography by Bernard Baruch as an example of an autobiography that he has read. An interesting anecdote for value investors is that Benjamin Graham caught the eye of Bernard Baruch in the 1920’s who tried but failed to bring the younger Graham on as his junior partner.

Mr. Chou doesn’t take a top down approach to stock analysis. From what I gathered, he is a microfundamentalist who looks for value opportunities all over the globe. Importantly, Mr. Chou does not take just one view on valuing a security but rather looks at an investment opportunity from several different perspectives. He told us that you can feel more certain about purchasing a company when all of the different views are consistently indicating value. As an example, his reply to the question of whether the housing market was undervalued in the US was that some housing value indicators seem cheap but if you look at the pricing from a historical rental to home price perspective, the housing market is not overly cheap.

Mr. Chou cautiously indicated that doubling down positions with investments is okay, but only if you are very certain of the company and the situation. He mentioned that value investors often buy in early and therefore feel like they should buy more if the stock has fallen below their entry price. He acknowledged that with excellent knowledge of the situation you could concentrate your holdings more on a few stocks in the same way the Buffet does, but suggests that you had better know the company as well as Buffet would before doing so. Tellingly, he left us with the advice that the first step to getting out of a hole is to stop digging.

In closing, I found Mr. Chou to be a rarity in the investment world. He is a very well read and successful value investor, but still very humble and generous. In my opinion, Mr. Chou is a refreshing role model for investors in an industry commonly motivated by greed and selfishness.

Francis Chou

Francis Chou is of a different background than the other value investors we've profiled here. He didn't have a lot of money to invest, and didn't have the chance to get a university education. As an immigrant to Canada from India, he had a Grade 12 education and was working as a telephone repair man when he discovered Security Analysis by Graham and Dodd. He started an investment club with 6 others and turned $50K into $1.5 million in the next five years. He has since gone on to turn that fund into a mutual fund and achieve %14 annual returns over the following 20 years.

What's most amazing about this record is that at most times, Chou isn't afraid to keep a great deal of his portfolio in cash. Like other value investors, Chou focuses on capital preservation, and at the same time wants to be able to take advantage of opportunities when they become available.

Again like other value investors, Chou won't invest in commodities, likely because the future prices of these companies' products are too difficult to determine.

Unlike standard mutual fund companies, which seem to be more like marketing companies than investment companies, Chou relies on word of mouth to find clients. That probably suits him just fine, as growing too large would probably hurt his returns.

For those interested in learning more about value investing, read The Intelligent Investor (Graham) and/or Security Analysis (Graham and Dodd).

Do we only hear about the lucky value investors?

Certain writers have taken exception to my stipulations about the successes of individual value investors. One such article, written by Frank Voisin, is listed here. In essence, he argues that of the thousands or millions of value investors who try their hand at investing, statistically there will surely be some winners...but that doesn't mean this (or any other) breed of investing works. But those arguments don't consider that there is a particular school of investors that does outclass the rest.

The argument stipulated by those who believe in efficient markets goes something like this: If 50 million people flip a coin twenty times, and get paid $1000 for every "head", there could be around 50 people that will have rolled "heads" all twenty times. Are such people particularly skilled? Should we copy their methods? Upon first glance, probably not.

But what if such coin flippers lived in the same neighbourhood? Or what if they all learnt how to flip from the same person? Wouldn't it be worthwhile to determine whether this group has some knowledge or skill which is allowing them to profit?

Warren Buffett makes such an argument in his article The Superinvestors of Graham and Doddsville. He shows us the investment returns of the people who studied with him under Ben Graham, demonstrating that the returns derived from this method of investing are no fluke. Below are the returns Buffett references from the investors he has personally worked with (despite the fact that there is little overlap between the stocks owned by these investors). I encourage you to read the full article here.

Paul Sonkin

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.

Where does Sonkin find value? 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

In addition, smaller companies are more nimble, and have better growth prospects (size can be a hindrance when trying to grow in percentage terms).

Sonkin adds another reason. Smaller companies are easier to understand. Their business models are far more simple, and thus value can be found without having to understand several lines of business or complex financial statements.

As we've seen with other value investors, Sonkin also looks for stocks that have been beaten down. He screens for stocks that are at lows, looking for stocks that have been neglected or punished by the market. Like Greenwald says, "If it ain't broke, don't buy it"

Schloss

You'll note that for this value investor description, I use only one name. It's not because this investor is trying to make headlines with a one-name moniker like Madonna or Cher. Rather, I'm trying to do a 2 in 1 here, by covering both Walter and Edwin Schloss. Walter is yet another successful value investor who trained under Ben Graham. Edwin joined his father Walter's partnership in the 70s.

Walter and Edwin practice a brand of value investing that's very basic to grasp. They look for cheap stocks, and sell them when their value has been realized. No hedging, no bonds, no convertibles, no indexes...nothing complex. Yet following this simple strategy, they have been able to beat the S&P by about 4% per year for over 50 years. Four percent may not sound like much, but over that time period it would turn $1 into $662 as opposed to $118...big difference!

There are a few neat things about how the Schloss' operate. First, they don't charge a fee for assets under management. They only get paid off of the profits they make for their clients. I love it!

Second, they don't disclose to their clients as to what stocks they own. The knowledge of the stocks they own can sometimes strike fear and uneasiness in their clients and they would rather do without!

Third, the way they find their stocks is by looking at what's been beaten down. They like stocks that have disappointed other investors who have then gone on to punish the stock. Then, they are interested in the replacement value of the assets. If the assets are selling on the cheap, good things will happen.

Bankruptcy Pays for Michael Price

Most of the value investors you hear about are super old. This is mainly because, to have proven yourself successful as a value investor, you've had to put in years of patience and shown that you can beat the market over long periods of time. Michael Price was fortunate enough to be recognized as a great value investor by the time he was 40.

After graduating from college, Price worked for 13 years for Heine Securities. When Max Heine died in 1988, Price assumed direction. A few years later, he sold the company to Franklin Resources, and soon started his own smaller company. He has kept his fund private, so as not to succumb to the quarterly pressures inherent in public companies.

One area where price has made a killing is on bankruptcies. For those diligent enough to study a company in or entering bankruptcy, an investment does not correspond to a random spin of a wheel.

As outlined by Bruce Greenwald, there are four main stages to most bankruptcies:

1. Before filing for bankruptcy: Here, the company may be desperate for cash to keep afloat, and thus may be willing to grant equity or debt at attractive prices. If an investor is confident the company will eventually return to normal, there are large gains to be made here.
2. The filing itself: Many funds are forbidden to own securities in companies that involved in such reorganization, and thus many of these securities can be acquired at fire-sale prices
3. A reorganization plan: Two-thirds of each class of security holders must approve the plan for it to go through, so controlling one-third of the votes of any class garners some control, which can result in payoffs if used well.
4. Liquidation or re-emergence of the firm: Either liquidation, whereby stakeholders are paid with senior debt holders first in line, or re-emergence, where debt is substantially reduced, and the company is now in a position to be more profitable than it was before.

A lot of people invest in bankruptcies looking for dead-cat bounces or other random movements in prices. But there is value to be found for those willing to put the effort into doing the work!

Seth Klarman...the only OTHER guy to beat the market?

When I was doing my MBA, my finance professor was extolling the virtues of Efficient Market Hypothesis (EMH) when a student asked, "But what about Warren Buffett? Doesn't he serve as evidence that markets are not efficient?". My professor stated something to the effect that Buffett's pretty much the only guy that can beat the market. Fortunately for us, that's not the case. Fortunately for this prof, the professor market is not efficient either and therefore he still has a job.

Seth Klarman is an example of another value investor who has consistently beaten the market. Since the inception of The Baupost Group in the early 1980s, Klarman has been generating returns of nearly 20% per year. What may be most amazing, is that he has done this with his first priority being risk, not returns! In this regard, he follows the oft-referenced first rule of investing: "Never lose money", and pays equal attention to Rule #2: "Don't forget about Rule #1."

In order to find value, Klarman likes to look for motivated sellers. Such sellers may be present for a variety of reasons. The stock may be:

• Dropped from the index. Many fund charters preclude them from owning shares.


• A spin-off. Large funds will pull the trigger on a sale of these often smaller IPOs.


• Involved in a bankruptcy proceeding. Again, certain charters my restrict ownership of these shares.


• In the wrong hands. For example, banks owning foreclosed real estate.

By taking advantage of sellers who are selling for non-economic reasons, one can buy at a discount and thus generate excess returns.

Robert Heilbrunn: To P/E or not to P/E

Robert Heilbrunn's potential to know a bargain when he saw one became apparent when he hired Benjamin Graham to advise him on his portfolio for $25/month. For this sum, Heilbrunn was able to work with Graham and understand his methods of valuing various securities. Together, they bought a slew of bonds and stocks trading at large discounts, and subsequently sold them at their intrinsic values for a profit.

Heilbrunn later made an innovation to the field that is often used today: focusing on where a single stock trades in comparison with itself! Usually, analysts compare a stock's P/E or P/B with other companies in its industry or index. This can often hide stocks trading at discounts if the entire industry or index is depressed. Heilbrunn, therefore, was interested in what a stock's P/E (among other things) was in comparison to its historical ranges, rather than just against other companies.

Later, Heilbrunn invested his money not in companies, but in other value investors. He was able to retire comfortably by investing funds in Warren Buffett (only one year after he had formed his partnership), Walter Schloss, and Graham himself.

Glenn Greenberg Says Concentrate

Glenn Greenberg's not telling you to pay close attention. Nor is he suggesting you should pasteurize your fruit drinks. Greenberg is saying he disagrees with the oft-used expression "Don't put all your eggs in one basket" when it comes to investing.

Since 1984, Greenberg has outperformed the S&P 500 by almost 10% per year. One of the chief reasons he attributes to this is a strategy of anti-diversification! For example, he will not buy a stock unless he is willing to commit 5% of his portfolio to it.

This forces him to know all the companies he buys very well. He attends their meetings, reads trade journals, and knows his companies better than the sell-side analysts. Sounds like a pot-shot at sell-side analysts; how does he know how much they know? Well Greenberg started out as one in 1973.

Following a brief elementary and highschool teaching career, Greenberg completed his MBA at Columbia and joined JP Morgan as an analyst. Greenberg saw first-hand the follies of the industry, as his firm could not buy enough Avon or Polaroid shares, despite the fact that they were trading at over 100 times earnings!

Needless to say, the Dow Jones declined 40% over the next two years. These events laid the foundations for Greenberg to be skeptical of prevailing wisdom and to make sure he understands a company extremely before he buys an individual stock. Keeping his portfolio at between 8-10 companies allows him to do just that.

Mario Gabelli

Many a market connoisseur can name two value investors. No points for guessing who those two are. But to the chagrin of Efficient Market Hypothesis (EMH) proponents, there are many value investors who have seen much success. Mario Gabelli is one such investor.

Gabelli was schooled in the Benjamin Graham tradition of value investing. Graham manually searched through flurries of financial data to find companies trading at discounts to their current assets minus their total liabilities (what he termed net-net companies). With today's databases of information and computational speed, such companies are identified before they become grossly undervalued.

So Gabelli created Private Market Value (PMV), which Bruce Greenwald calls a "value metric that is less easily uncovered than net-net but no less discriminating in its ability to identify underpriced securities".

The idea behind PMV, as defined by Gabelli, is to determine the value an informed industrialist would pay to purchase assets with similar characteristics. The principle behind PMV is that because the market price is determined based on the last trade, it's not necessarily a good gauge of what a knowledgeable buyer would pay for the company. PMV seeks to exploit any such differences, with the idea that eventually a catalyst will come along and bring the market price to PMV levels.

Warren Buffett Invitational

Last week, a friend of mine mentioned that my blog has become 'coma-inducing'. This was a clear signal to me that I'm finally reaching my target market: the finance industry! On that subject, today's post is about a recent trip I undertook to meet Warren Buffett.

A couple of months ago, Warren Buffett was kind enough to invite a group of us to Omaha to meet with him at Berkshire headquarters and subsequently dine at one of his favourite restaurants, Piccolo Pete's.

Those of us who have been following Buffett's comments for several years did not hear anything from him that we haven't heard before. He was the man we've come to know through reading his annual letter to shareholders and watching or listening to his commentaries. Nevertheless, it was an eye-opening experience. The most striking thing about him was his humility, evidenced primarily in the way he carried himself. He drove a couple of us to the restaurant, didn't bring an entourage with him, and didn't leave until all our questions were answered.

We had originally planned to chip in a few bucks to buy Buffett a token of our appreciation for taking the time to meet us. But then we decided that would just be silly. What can you get for a man who can have anything, but wants nothing?