Please give me your thoughts on the interview in the comments section or feel free to e-mail me. I’m always looking for new investors to interview.

You can find more about the Tilson Dividend Fund here or learn more about the fund’s performance via Morningstar.

My questions are in bold.

Can you give us a brief bio of yourself and how you came to run Centaur Capital?

I started my career in the financial software business as a consultant deploying complex treasury and risk management systems for large banks and conglomerates, mostly in Europe. At the time, I thought that my natural career progression might be to become a risk manager for a large bank or insurance company.

Somewhere along the way I developed an interest in the stock market and discovered Warren Buffett’s Berkshire Hathaway letters and was immediately hooked. I also was a big fan of the Motley Fool website, and when I decided that I wanted to change careers to investing, I was fortunate enough to land a job there. I moved back to the States and started working for TMF as an investment writer in early 2000 – just in time for the bear market. I spent two years writing articles and research on investing for TMF, which enabled me to learn and refine my own investing approach.

In 2002, I decided that I was ready to start investing professionally, and moved to the Dallas area and started Centaur Capital Partners. I set up a private limited partnership and opened for business with less than $1 million under management, and it took several years to get to the point where Centaur Capital was a viable business. In 2005, we launched a mutual fund called the Tilson Dividend Fund (TILDX) in partnership with our good friends Whitney Tilson and Glenn Tongue at T2 Partners, and that has done well. We’ve now been in business for eight years, and while it’s not been without its challenges, overall I feel very fortunate to be where I am today.

A while back in 2007 at the Value Investors Congress, you gave a presentation (PDF) about how you think about asset allocation at Centaur. Is it largely the same today? Or has the financial crisis influenced your take on capital allocation?

That VIC presentation was primarily a discussion about portfolio construction, and it was really in reaction to what I thought was a growing pressure amongst value investors to run excessively concentrated portfolios. Keep in mind that this was 2007, and the market had produced a long stretch of good returns from 2003 to early 2007. The book “Fortune’s Formula” had become quite popular, and there were many discussions amongst investors about the potential for employing the Kelly Formula as some sort of secret sauce that would allow investors to increase returns by increasing concentration.

My own view is that most investors are better off running portfolios of 15-25 stocks because such a portfolio would ultimately be a truer reflection over time of an investor’s skill. In other words, a 15-25 stock portfolio has enough concentration to allow a skilled investor to really stand apart from the market, but is not so concentrated that bad luck, bad timing, or one or two mistakes can sink an otherwise competent investor. One of the points of emphasis in that presentation was that concentration shouldn’t be a constant, but rather should be idea and environment dependent. It has always seemed to me that each idea in the portfolio should be sized based on a careful assessment of the body of evidence available for that idea, with particular emphasis on risk factors. This would include factors such as how deeply the security appears to be under-valued, how predictable and reliable the business is, how it is capitalized, the quality and track record of the management team, and even how familiar the investor is with the idea. Also, it should be influenced by the presence of clearly correlated ideas in the portfolio.

I believed then and I believe now that using the flexible 20-stock model portfolio position sizing exercise that I described in the presentation is a very solid framework to start with. In looking back over that presentation today, I wouldn’t change a thing regarding the content of that discussion. But I’d sure like to have the stock picks back – I presented four ideas at that conference and three of the four performed very poorly in the bear market that followed.

How long do you study a potential investment before you decide to buy? After initiating the position, do you continue your research process on the name?

We generally produce a research document that covers all the important components of the investment, both qualitatively and quantitatively, prior to investing. For a simple idea, the document may well be five pages long. For a very complex idea, the report will be longer. But regardless of the complexity of the idea, writing a research document using a fairly standard template serves as both a form of checklist for us and ensures that we both understand the idea and can articulate why the idea meets our criteria for both value and safety. It also allows for a “quality check” in that it can be reviewed by a second analyst internally and even potentially by contacts outside of our shop that may be able to review our work and provide some insight back to us.

You have mentioned in the past that you are increasingly looking at macro data when making an investment. What kinds of macro indicators do you look at? Has there ever been a situation where a stock looked cheap but you did not invest because of the macro?

I wouldn’t say necessarily that we look at macro “data” when making an investment. It is more the recognition that an otherwise compelling idea can get overwhelmed if the larger forces surrounding that idea are negative enough. Going forward, we will probably be a little more cognizant of looking for the larger risks that could really hurt us as investors. As for an example, we basically decided in mid-2008 that we weren’t going to invest in any bank or other leveraged financial business given our concerns about the credit environment, and we sold the one stock he held at that time that qualified, which was American Express (NYSE:AXP). Granted, this was an extreme case, but it did help protect us from the worst of the permanent capital losses that many of our value investing peers suffered in banks and other leveraged financial stocks.

I suspect that our approach going forward when assessing ideas where we have identified a major industry or macro risk would be to use smaller position sizes, demand more compelling prices, or actively look for a way to hedge out any obvious macro risk that we identify if it can be done in a cost-effective way.

When you use valuation methods like DCFs, what kinds of factors do you look at when forecasting? Is it mostly things in the current-year, the past, or your own predictions? How far out do you model?

We use DCFs more as a sanity-check and to reverse engineer current market expectations than to try to produce any kind of precise valuation. When basing our views as far as what the future might look like, we try to look at a longer view of the company’s operating history (normally five to ten years) to see how the business has done over time. As an example, one of our larger current positions is Lab Corporation of America (NYSE:LH). Qualitatively, this is an outstanding business with tremendous barriers to entry. There is something of a Coke / Pepsi dynamic in the laboratory services industry, with competitor Quest Diagnostics (NYSE:DGX) the slightly larger company in the industry and LH being a strong number two in terms of revenues. LH has been a consistent but moderate grower over many years, with revenue growth in the high single digits and free cash flow growth at around 10% for the last five years. In looking at the recent stock price of around $72, when we plug the numbers into a DCF spreadsheet, we find that the market basically assumes that LH will never be able to grow its free cash flow at more than 2% annually going forward forever. Our view of the company’s growth prospects is significantly more optimistic than that.

So that’s our first sign that LH is a potential opportunity for us.

If I drop in even 5% average FCF growth for LH going out for ten years before dropping down to a terminal growth rate of 2% after that, my spreadsheet tells me the stock is worth $96. Because I’ve owned LH in the past and am extremely familiar with the business, I am very comfortable taking the view that the company will be able to grow its FCF much faster than the current market price is discounting. I don’t have to be super precise. When the stock gets to $85-90, it will be a closer call and I will probably respond by reducing our position size somewhat. So we try to use the full body of evidence we have available about a company, but in general we just don’t buy stocks that require heroic growth assumptions to justify the current price.

You operate largely as a generalist. Sometimes that entails investing in unfamiliar industries. Can you give an example of a case where this happened? What were some of the things you specifically did to learn the ins and outs of the business?

Yes, being a generalist means that one needs to have a framework for getting up to speed quickly when looking at a company or industry that is new for us. So we have learned to quickly identify the business model, which gives us a huge head start in terms of how to approach the research. There really probably aren’t more than a dozen or so basic business models in existence and most companies employ a variation of one of them. Then we start our study of the targeted business and some competitors, and we start reading annual reports, industry publications, and whatever we think we need until we feel we have a good handle on the business. One of the good things about this business is that knowledge is cumulative and the longer I’ve been investing, the more businesses and industries I’ve become familiar with and the faster I am able to get up to speed.

What is one company that you think you would be comfortable with buying and holding for 15 years? Why?

That’s an interesting question, and I’m going to have to answer it by changing your question a bit. We’ve come to believe that if your goal as an investor is to compound at high rates (our goal is 15-20%), that a “buy and hold” philosophy for 15 years simply isn’t likely to work except perhaps in very rare cases. To get that kind of return, you have to buy stocks when they are undervalued and sell them when they are fully valued. Therefore, to give you a stock that I’d be comfortable buying and holding for 15 years simply doesn’t reflect our philosophy, since over a 15-year period we’d expect to have the opportunity to buy a stock at discounted prices and sell it back at full prices multiple times. Of course we are prepared to wait a long time if necessary to get fair value for our holdings, and there are other cases where the performance of the company results in ever-increasing estimates of fair value such that we can hold on to the position for a long time. But we are usually hoping that we will be able to get full value for our stocks within 2-3 years of purchasing them.

So let me give you a list of companies that we admire and that we very much like to own when the stocks are cheap: Fairfax Financial (TSE:FFH), because we admire Prem Watsa. Berkshire Hathaway (NYSE:BRK.A / BRK.B) of course. In our current portfolio, I like Lab Corp (NYSE:LH), Dreamworks (NASDAQ:DWA), and a small Canadian company called Ag Growth International (TSE:AFN). In all of these, I either have a great deal of comfort and admiration for the management team, or else the business is extremely unique and enjoys a strong competitive advantage.

One of the things that value investors often talk about with shorting is how it gives you potentially unlimited losses. How do you manage risk with shorts?

Shorting is a very tough business, and we continue to learn new lessons every year. I have come to the belief from talking to several guys who are more experienced than myself on the short side that the best way to manage risk is to keep position sizes small and have a slightly more diversified short book. We also limit the size of our overall short exposure. Unlike the long side, where we have no individual position loss limits, we have historically used a position loss limit on short positions, though over time it has probably hurt us as much as it has helped us.

Can you give an example of a past investment mistake? What do you think happened? What did you learn?

Sure. Rather than give you a specific mistake, I’ll give you a category mistake that we’ve made more than once and that I therefore think is one that investors are extremely vulnerable to. The mistake is one of commitment bias, where for example we will decide that a given idea is very compelling but due to its potential risk is justifiable only as a small position. For example, every once in a while we find ideas where there is a very wide range of possible outcomes, but where either the potential magnitude of the return in the good case scenario is very high or we think the probabilities are favorably skewed in our favor. On balance, we’ve done OK with this kind of idea. The problems have come when we’ve initiated the position at an appropriate position size (say, 1% of the fund, or 2% or whatever) but then the stock declines either because of some new development or for another reason. We’ve often added to the stock and built them to inappropriately large position sizes simply due to the lower price, rather than sticking to our initial game plan of limiting our bet. Because of this, we’ve occasionally made what would have been a small loser into a bigger loser.

Another and similar mistake is reacting immediately to a sharp decline in an existing holding on negative news without taking adequate time to fully review the new information to ensure that making the additional deployment is justified by the new development. We try now to be rigorous in ensuring that each incremental add to an existing position is truly justified by the existence of a widening discount to our expected range of fair value and not due to some embedded commitment to the name.

What are some of your favorite books? Investing or non-investing related.

I kind of like to follow good writers around. For financial-related books, I always like to read anything by Roger Lowenstein, with particular nods to his biography of Warren Buffett as well as his book Origins of the Crash that described the causes of the tech and large cap bull market of the late 1990’s. I think Michael Lewis does fantastic work – his latest of course is The Big Short, but I also loved Liar’s Poker as well as his non-financial books The Blind Side and Moneyball.

How do you look at the market cap of a company? Are you less willing to invest in large caps? Do you see more opportunities in one than the other?

No, we don’t care what the market cap is. We are looking to get the best combination of value and safety out of our investment dollars as we possibly can. I do think that large cap, high quality stocks are as cheap now relative to the rest of the market as I’ve ever seen them, and that being the case our portfolio is more heavily weighted to large company stocks than it has been for most of our history.

Can you give us a company that you think is undervalued/attractive right now? What is your thesis there?

Sure. Lab Corp is our biggest position, and I’ve already explained our thinking there. Let me give you an esoteric one. This one is a small position for us, because the stock trades on the pink sheets and isn’t very liquid. Therefore, I’m not making a recommendation, only naming a stock that I personally think is undervalued and attractive. The company is Mass Financial Corp (PINK:MFCAF), and it trades in the U.S. on the pink sheets under the ticker MFCAF. MFC is a merchant bank specializing in a combination of traditional financing services and proprietary investing, primarily involving commodities and natural resources. The business is run by Michael Smith, who is also the chairman of the company formerly known as KHD Humboldt Wedag and is now called Terra Nova Royalty Corporation (NYSE:TTT).

MFC was spun out of KHD in January 2006, and had negligible book value at the time of its spin-off. The stock trades for $9 and change, and has a market cap of approximately $200 million. In the last four years, MFC has averaged over $40 million in net income and over $50 million in free cash flow. Here’s the book value per-share at the year-end each of the last four years, starting basically from zero at January 2006 (note that the book value per share figures are adjusted for a 9% stock dividend issued in late December 2009):

December 31, 2006 $2.43
December 31, 2007 $4.39
December 31, 2008 $5.71
December 31, 2009 $9.72

Going back further, prior to folding MFC into KHD, Michael Smith ran the company (then called MFC Bancorp) from 1984 to 1995, and during that stretch he grew book value from $1.49 per share to $17.09 per share, which is a pretty impressive performance. Overall, we think that MFC is a very intriguing investment at a discount to book value given the impressive track record.

The downside to an investment in MFC is that there is never really any way to know what Michael Smith is up to. Smith’s policy is to report financial results every six months, and only issues press releases when a material development occurs. In addition, the company’s disclosures are not as highly detailed as one might like regarding its merchant banking and direct investment activities. Nevertheless, the performance of the company speaks for itself, and MFC has an extremely strong and liquid balance sheet and uses very little leverage in its activities, making the historical performance that much more impressive. A couple months ago, MFC took over a majority interest in a micro-cap Canadian listed company called Canoro Resources (CVE:CNS), which has some very interesting oil and gas assets in India. As I mentioned, MFC is a small position for us, but I like having it in the portfolio.

Zeke, thank you for taking the time to interview with Street Capitalist

Up 21% in a little less than a month! Too bad I didn’t buy it back then.

Monsanto (NYSE:MON) has been a real innovator in their field, here is how they define their business:

Monsanto Company (Monsanto) along with its subsidiaries, is a worldwide provider of agricultural products for farmers. The Company’s seeds, biotechnology trait products, and herbicides provide farmers with solutions to produce foods for consumers and feed for animals. The Company operates in two segments: Seeds and Genomics, and Agricultural Productivity.

The thesis you often hear from agriculture bulls of the company is that if the developing world truly does continue its pace of development, we’re going to need more food to nourish those people and that food is going to be grown with the help of Monsanto’s products. Then, if there is a bull market in agricultural commodities — Mosanto’s products will be needed in order to help give farmers the ability to increase their yield and sell for higher prices.

So then what has been the bear case?

We just got out of an agricultural commodity boom and one of the things Monsanto did was steadily increase pricing on their products as the prices of commodities continued to rise. This made a lot of sense when prices for commodities were high, they were able to capture the benefits from the increased yield in their crops. But Monsanto did not adjust pricing as commodities started to fall. That caused a drop in sales which led to an increase in inventories.

Now, I haven’t had a chance to do much valuation work on Monsanto. I know the company on a more qualitative basis. But, Glenn Busch from ValueInvestingCenter has taken a stab at valuing the company:

The Seed and Genomics division is by far the largest division at Monsanto CO. (MON) based on revenues; it accounts for 62% of Monsanto’s revenue. In fiscal year 2009 the Seed and Genomics division had $7.29 billion in sales. For fiscal year 2009 the Seed and Genomics division had a Gross Margin of 61% and an Operating Margin of 22%. In 2008 Seeds and Genomics had an operating margin of 18%. The increase in margins has been due to the launch of newer- higher margin products. Margins are expected to continue to increase further based on more launches of higher margin products like Genuity VT Triple Pro Corn.

For the discounted cash flow that I will run on this division I will use an operating margin of 20% even though recent margins have been higher and are expected to increase further. I will use current interest expenses and taxes but I will use normalized Statement of Cash Flows line items. For growth rates, I will use the median analyst estimate of 10% and the lowest analyst estimate of 6%. I will use 10% as the discount rate because Monsanto CO. (MON) is a large multi-national company with minimal debt and a leader in its field. Currently, Monsanto Co. (MON) has 545 million shares outstanding and to keep it simple I will not factor in any share buybacks.

Below is the range of values for the Seed and Genomics division.

6% Growth = $51.00
10% Growth = $59.00

With Monsanto Co. (MON) currently trading around $57.00 we’re pretty much getting fair value for the Seed and Genomics division and everything else free.

Valuing Monsanto Co. (MON) (Value Investing Center)

According to Busch, one of the problems was in Monsanto’s agricultural products division. Monsanto produces a herbicide called Roundup, which featured lower adoption rates due to a flood of competitors (they lost patents) and some customers over pricing. They’ve had to reduce prices to clear out excess inventory which has carried over into their margins. Here is Glenn’s take on the division:

I will value the worst case scenario like a perpetuity using a discount rate of 10%. I’ve chosen to value the worst-case scenario like a perpetuity because Roundup is still the largest selling glyphosate product on the market. Glyphosate is also the largest herbicide in use and has been this way for a long time. Monsanto lost its U.S. Patent in 2000 and still has maintained a high level of Roundup sales. I would expect Monsanto to continue to sell more Roundup than what I’m basing this valuation on.

Below is my value for the worst case scenario.

$3.90

Valuing Monsanto Co. (MON) (Value Investing Center)

So in Glenn’s low case, Monsanto is worth $54.90 all together versus a current price of $57.32. Not a bargain, but it could be if we see another AgBoom because Monsanto could simply increase the prices on their products and reap the benefit. Glenn talks about this towards the end of his write up, which you should read to get the whole picture. I’ve only excerpted part of it.

Well, I, for one, am more or less willing to throw in the towel on behalf of Inflation. For the near future at least, his adversary in the blue trunks, Deflation, has won on points. Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor. Even three months ago, I was studiously trying to stay neutral on the “flation” issue, as my colleague Ben Inker calls it. I, like many, was mesmerized by the potential for money supply to increase dramatically, given the floods of government debt used in the bailout. But now, better late than never, I am willing to take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and inflation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or flat prices are the prospect for the immediate future…

At GMO, our asset allocation portfolios, however, are merely informed on the margin by these non-quantitative considerations. They draw their strength from our regular seven-year forecast. Today this forecast (see Exhibit 1) suggests that it is possible to build a global equity portfolio with just over the normal imputed return of around 6% plus infl ation. With our forecast, this can be done by overweighting U.S. high quality stocks and staying very light on other U.S. stocks. At a time when fixed income is desperately unappealing, this, not surprisingly, results in our accounts being just a few points underweight in their global equity position, which is suddenly a little nerve-wracking as the growth of developed countries slows down. A little more dry powder suddenly seems better than it did a few weeks ago, but then again, prices are 13% cheaper. I regret not having seen the light a few weeks earlier. Running at the same rate of change in attitude as both the market and general opinion is both frustrating and unprofitable. But even as global equities approach reasonable prices, I would err on the side of caution on the margin.

Let me give a few more details: just behind U.S. high quality stocks, at 7.3% real on a seven-year horizon, is my long-time favorite, emerging market equities at 6.6%. This is now above our assumed 6.2% long-term equilibrium return. Additionally, my faith in an eventual decent P/E premium over developed equities exceeding 15%, perhaps by a lot, is intact. Emerging equities’ fundamentals also continue to run circles around ours. EAFE equities at 4.9% are a little expensive (6% or 7%) but make a respectable filler for a global equity portfolio. Forestry remains, in my opinion, a good diversifier if times turn out well, a brilliant store of value should inflation unexpectedly run away, and a historically excellent defensive investment should the economy unravel. Otherwise, I hate it.

Summer Essays: Finance and Portfolios (Morningstar)

I’ve posted recently that I am also seeing value in large cap stocks many of which seem to have strong exposure to emerging markets and franchises that should be able to withstand tremors in the global economy. Grantham’s point about deflation is interesting. Unlike with inflation — where certain businesses can simply raise prices, deflation creates a downward pressure that is harder to tackle. I’ve noted in the past that Seth Klarman believes in deflationary environments we should seek a wider margin of safety. So if you used to buy at 60 cents on the dollar, maybe you start buying at 40-50 cents.

Sorry about taking so long with the Red Robin post, I am still getting together the charts/models to present.

This paper seeks to answer several questions: Why in the past have governments defaulted on their debts? When have deeply indebted countries kept faith with their creditors? Under what conditions do governments opt for inflation rather than default? And, in the light of our historical findings, is Greece really the crest of a wave of sovereign debt crises about to crash down upon the developed world?

Reflections on the Sovereign Debt Crisis (Scribd)

Here are some of the charts that I found interesting:

Chancellor ends his paper with a brief look at the Japanese savings rate, which appears to be coming down. He thinks that going forward, the past wont be indicative of Japan’s future:

The situation going forward looks rather different. As the population ages, Japan’s household savings rate is in steep decline. Pension funds have become sellers, rather than buyers, of JGBs. The capacity of both the Bank of Japan and domestic commercial banks to acquire yet more government bonds is limited. Japan’s political system has failed to address the chronic crisis in public finances. Huge deficits have become entrenched at a time when the cost of financing the national debt has consistently exceeded the country’s growth rate. In short, Japan is stuck in a debt trap.

Furthermore, Japanese debt is relatively short term. The face value of bonds that have to be rolled over this year is equivalent to nearly half of Japan’s GDP.29 Unless Japan changes direction, its public credit will come under threat.

As always, try to read the full paper. It’s pretty short at 10 pages and an excellent read.

Seth Klarman almost doubled his hedge fund’s assets to $22 billion in the past two years as the industry shrank by sticking with the off-the-beaten-path investments he’s pursued since starting out in 1983…

While Klarman didn’t post the gains that made Paulson famous, he was able to raise almost $4 billion in 2008 when firms including D.B. Zwirn & Co. and Peloton Partners LLP liquidated funds. Baupost was the ninth-largest hedge-fund firm as of Jan. 1, according to AR magazine, Pensions & Investments magazine and data compiled by Bloomberg. He oversees more money than better-known managers such as Ken Griffin and Steven Cohen.

Klarman Tops Griffin as Hedge-Fund Investors Hunt for `Margin of Safety’ (Bloomberg)

I really think Baupost’s performance during the financial crisis was exemplary of value investing at its best — going into the crisis, many fund managers were overly concentrated in long positions. Even the famed long/short funds, which were supposed to use shorting to hedge against market downturns were simply not short enough to make a difference.

Most long-only value funds ran into the same issue. This stems mainly from an unwillingness to take large cash positions when the market gets frothy. That kind of value investing cuts both ways, taking a few concentrated positions will usually allow you to outperform major indices, but it also means that during a downturn your portfolio may get hit with higher than average volatility. As a result, some value funds would actually underperform the S&P 500′s already dreadful performance.

Most people like to knock Baupost’s performance in the 90′s, for not outperforming the S&P but I think that misses the point. What Klarman and his team have put together at Baupost is a fund that can achieve great absolute returns. For some entrepreneurial investors seeking massive John Paulson-like returns, this might not mean much. For college endowments though, having the benefit of limited losses, or actually appreciating in a down year must be a tremendous asset and shows the kind of niche that Baupost can serve.

The other thing that stands out about Baupost is their willingness to travel across all asset classes in search of returns:

A value investor who looks for securities he considers underpriced, Klarman, 53, said he’s best at “complicated” situations where fewer investors compete for assets. Over the years, Baupost has invested in Parisian office buildings, Russian oil companies and real estate that the U.S. government disposed of following the savings and loan crisis of the early 1990s, said Thomas Russo, a partner in the Lancaster, Pennsylvania-based investment firm of Gardner Russo and Gardner…

“He specializes in illiquid, complex assets,” said Russo, who has known Klarman since 1984.

Baupost gained an average of 17 percent annually in the 10 years ended in December, a period in which the Standard & Poor’s 500 Index fell 1 percent a year. The hedge fund has returned 19 percent a year since it was started, even as it held more than 40 percent of its assets in cash at times.

More recently:

Among the money-making bonds Baupost purchased, according to an October 2008 shareholder letter, was debt issued by Washington Mutual Inc., whose bank unit failed in 2008 and was bought by New York-based JPMorgan Chase & Co. Baupost also acquired bonds of CIT Group Inc., a New York-based lender that emerged from bankruptcy in 2009. The fund was part of a group of creditors that made a $3 billion loan to CIT in July 2009.

Klarman, in a May 18 talk to financial advisers in Boston, cited another Baupost purchase during the crisis to illustrate the way he thinks about investing. In a series of “what if” exercises, the firm calculated how much bonds of Ford Motor Credit Co. would be worth under different scenarios, including an economic depression in which loan defaults rose eightfold. The conclusion: the bonds, then selling for about 40 cents on a dollar, would still be worth 60 cents.

Stein goes on to outline some of Klarman’s more macro views. His fund is bearish and worried about inflation. Baupost’s US equities weigh in at only $1.7B versus their $22B in AUM, or a about only 7.8%. In addition, like many others, Klarman is apparently a big fan of Jeremy Grantham’s research at GMO:

Klarman’s views on the U.S. stock market echo those of Jeremy Grantham, chief investment strategist at Boston-based Grantham Mayo Van Otterloo & Co., who recommended investors buy stocks in March 2009 after more than a decade of saying they were overvalued. Grantham’s latest forecast, posted on the firm’s website, predicted U.S. large cap stocks would return 0.3 percent a year, adjusted for inflation, over the next seven years.

Klarman called Grantham “a very smart person” whose forecasts he watches carefully. In an e-mail, Grantham called Klarman “just about the smartest guy around.”

How does Baupost hedge against such possible scenarios?

Klarman buys put options and credit-default swaps, which he calls “cheap insurance,” to protect Baupost against risks such as a steep fall in the stock market or a surge in inflation. He currently has a put, or an option to sell a set amount of a security by a specific date, that will pay off only if interest rates go dramatically higher, he said in his Boston speech. In an October 2008 letter to shareholders the firm said it benefited from credit-default swaps, without saying what the swaps were meant to protect against.

When Klarman can’t find investments he likes, he holds cash. “We prefer the risk of lost opportunity to that of lost capital,” he wrote in his 2004 yearend letter to shareholders. In 2007, Baupost gained more than 50 percent, even as it held more than 40 percent of its assets in cash.

Klarman Tops Griffin as Hedge-Fund Investors Hunt for `Margin of Safety’ (Bloomberg)

Using the cheap insurance strategy sounds really sensible to me. Fairfax took the same approach when they purchased credit default swaps to protect against the financial crisis and they paid off handsomely. For more ordinary investors, derivatives like CDSs are probably inaccessible.

There are still some ways of insuring against disaster. One would be using out the money puts on things like the S&P 500. This kind of approach makes it so you are betting on what are initially perceived to be improbable events. Klarman’s fund used this very approach in their early days, against frothy indices like the Nikkei. To learn more about this approach, be sure to read Michael Lewis’ awesome book The Big Short because sections dedicated to Cornwall Capital outline this style of investing.

There are downsides to this approach though. First, you will incur frictional costs whenever your hedges don’t work out. Second, they require you to identify the right kinds of things to hedge against. You end up having to pay attention to whether the market is overvalued or not. This should not be so hard if you are a disciplined investor because you’ll end up seeing your range of opportunities dry up. If you are the kind of investor that keeps making excuses to allow you to buy overvalued stocks, this strategy is not for you.

Seth Klarman and his fund continues to impress me with how they have taken Benjamin Graham’s ideals and adapted them to the modern world. It’s true, for most investors, some of his strategies are out of reach. But some of his ideals – like going to cash when things are overvalued, or taking a real bottoms up approach with your analysis and looking for catalysts in your investments are all things you can incorporate into your process right now.

Today there are a number of news releases that are pointing to a rebound:

Freight companies’ shares rose early Thursday after strong results from several companies in the sector showed a pickup in demand, which bodes well as an early sign of recovery for the economy as a whole.

The companies had been seeing a slow recovery as the economy started to improve. Pricing pressures and slumping freight demand hurt the companies in the last year and a half. But results from several of the companies, including United Parcel Service Inc. (UPS), in the last two days have offered new optimism for the freight-transport sector and sent shares soaring. Several companies posted gains in some of their metrics, such as revenue or volumes, that hadn’t been seen in nearly two years.

UPS is often viewed as a key barometer for global trading activity, and the freight sector as a whole offers a glimpse into how the economy is doing because it moves manufactured goods before they are sold.

“Seeing transport volumes pick up is a sign the economy isn’t far behind,” FBR Capital Markets analyst Christian Wetherbee said. A pickup in freight volumes points to improvement in manufacturing activity, along with coming improvement in retail sales, he said, which will eventually translate into gross domestic product.

Freight Companies’ Shares Rise As Results Show Demand Returning (WSJ)

Here is a closer look at UPS (NYSE:UPS):

United Parcel Service Inc. said its first-quarter earnings jumped a better-than-expected 33%, in another sign of improvement in shipping, a bellwether of the broader economy.

Disclosing its results two weeks early, UPS said on Wednesday that growth was powered by a “significant acceleration” in international shipping with daily volumes up 18% in the quarter compared with a year ago. U.S. daily shipping volumes rose less than 1%, but that is the first increase in U.S. volume reported by the company in two years.

UPS said international sales jumped and the U.S. had its first year-over-year gain in two years. Above, workers load packages in Louisville, Ky.

“We expected the first quarter to be the most challenging of 2010 as the economic recovery gathered steam through the year,” Kurt Kuehn, UPS’s chief financial officer, said in a statement. “As it turned out, revenue was stronger than we expected due to international volume gains, increased yields in the U.S. and growth in forwarding and logistics.”

Kevin Sterling, a transportation analyst with BB & T Capital Markets, said: “What I find encouraging is that the growth is top-line driven; it’s revenue driven. Really, I think it speaks to the economy gaining steam,” he said.

Mr. Sterling said that overall, international freight shipments are up 35% compared to a year ago, and up between 6% and 8% over 2008.

UPS Posts Strong Results (WSJ)

Railroad company CSX (NYSE:CSX) also reported strong results:

Railroad operator CSX posted double-digit increases in sales and income on gains in productivity and volumes. Above, a CSX locomotive at the Barr Rail Yard in Riverdale, Ill., in January.

CSX Corp., the first major U.S. railroad to report first-quarter results, cited the economy’s “gradual and steady” gain for a 24% profit rise that topped Wall Street expectations.

The Jacksonville, Fla., railroad operator said its freight volume rose 5% overall and climbed in most categories, compared with the depressed year-earlier period, with big increases in shipments of metals, fertilizers, autos and auto parts.

A 27% increase in metals shipments was driven by “rebounding steel consumption consistent with the ongoing economic recovery,” the company said in a statement. But its big coal-transportation business remained weak as volume shrank 13% in the quarter due to high coal stockpiles at U.S. utilities. Last month, CSX said it expects its coal shipments this year to rise a bit despite weak first-quarter trends.

The transport sector is poised for a rebound this year, with freight traffic on U.S. railroads up 2.2% in the quarter, according to figures complied by the Association of American Railroads. Still, traffic remains well off 2008 levels, indicating a slow turnaround is underway.

CSX Profit Jumped 24% On Revenue Gains (WSJ)

The railroad traffic specifically can give us an idea of how construction and new builds are progressing in the US via their activity in steel transportation. However, it is worth noting that coal demand and overall traffic still remains lower than before. So while we are gaining momentum in the recovery, we aren’t quite there yet.

If you think about it, Berkshire Hathaway (NYSE:BRK.B) must give Buffett a number of indicators for how the consumer economy is working. Besides Burlington Northern’s railroad traffic data, his various operations give him data on t-shirt sales, jewelry, furniture, fast food, energy consumption, and more. I’d argue that some of this data is probably more helpful than the kind the Federal Reserve gathers.

For us mere mortals without billion dollar conglomerates, we can rely more on transportation data for an approximate take on the economy since many businesses rely on trucks and rail freights to move goods from one point to the other in the supply chain.

Jim Grant of Grant’s Interest Rate Observer on Alan Greenspan’s testimony:

-Alan Greenspan has a tendency to need to be liked. Encouraged tech bubble and mortgages at bottom of interest rates. He is a momentum, Wall Street driven guy.
-He claims to be against central planning, but he was a central planner as Fed Chairman by fixing the interest rate because he told us how he fixed it and how long.
-That is the origin of this debt bubble
-A reason the banking system was undercapitalized was because people came to trust the Fed. as a great savior. He would be there in times of stress and sorrow with a rate that would make everything right. So people took an extra element of risk.
-Other countries have done it better
-Brazil has a charming regulatory idea that owners of banks are responsible for solvency. If you are a director/shareholder of a bank that fails, your entire net worth is at risk. As it was in the partnerships of Wall Street.
-Greenspan came to Washington as an acolyte of Ayn Rand and left as a panderer to power.
-He turned a blind eye to the Fed’s regulatory powers.

-Back in 2002, Grant’s called a housing bubble, but 2002 was not the top.

-Wall Street is a probabilistic world. You get an idea, you seek evidence for it. You accumulate evidence, and see something, building a position in the process
-Greenspan operates not in a world of practitioners but in the cosmos of theoretical economists. He disdains people who had a clue and says they had no business being right. Marine biologists, hedge fund guys, who had an open mind saw the crisis. If you have a closed mind, you pay the price in the private sector which he seemed to have favored during his time with Ayn Rand.

I have to say, Grant makes a number of excellent points. Economists and more largely, academics, tend to form into close minded tribes where they start seeing only one perspective. Good investors need to be able to question the world around them and have open minds about everything. The world around us is filled with uncertainties and is constantly changing. A closed mind will only help you lose your shirt when the market turns against you.

Burry outlines his initial worries about the housing market:

I had begun to worry about the housing market back in 2003, when lenders first resurrected interest-only mortgages, loosening their credit standards to generate a greater volume of loans. Throughout 2004, I had watched as these mortgages were offered to more and more subprime borrowers — those with the weakest credit. The lenders generally then sold these risky loans to Wall Street to be packaged into mortgage-backed securities, thus passing along most of the risk. Increasingly, lenders concerned themselves more with the quantity of mortgages they sold than with their quality.

Meanwhile, home buyers, convinced by recent history that real estate prices would always rise, readily signed onto whatever mortgage would get them the biggest house. The incentive for fraud was great: the F.B.I. reported that its mortgage fraud caseload increased fivefold from 2001 to 2004.

At the same time, I also watched how ratings agencies vouched for subprime mortgage-backed securities. To me, these agencies seemed not to be paying much attention.

By mid-2005, I had so much confidence in my analysis that I staked my reputation on it. That is, I purchased credit default swaps — a type of insurance — on billions of dollars worth of both subprime mortgage-backed securities and the bonds of many of the financial companies that would be devastated when the real estate bubble burst. As the value of the bonds fell, the value of the credit default swaps would rise. Our swaps covered many of the firms that failed or nearly failed, including the insurer American International Group and the mortgage lenders Fannie Mae and Freddie Mac.

Michael Burry: I Saw The Crisis Coming. Why Didn’t The Fed? (NYTimes)

Most people have read Charlie Munger’s Psychology of Human Misjudgment, but they often miss how to incorporate those ideas into the investment process. I think that Burry here demonstrates an ability to implement those ideas into an investment thesis. With such perverse incentives and a break down of agency, lending standards were bound to collapse and cause problems after the teaser rates ran out.

Burry goes on to criticize Greenspan:

Since then, I have often wondered why nobody in Washington showed any interest in hearing exactly how I arrived at my conclusions that the housing bubble would burst when it did and that it could cripple the big financial institutions. A week ago I learned the answer when Al Hunt of Bloomberg Television, who had read Michael Lewis’s book, “The Big Short,” which includes the story of my predictions, asked Mr. Greenspan directly. The former Fed chairman responded that my insights had been a “statistical illusion.” Perhaps, he suggested, I was just a supremely lucky flipper of coins.

Mr. Greenspan said that he sat through innumerable meetings at the Fed with crack economists, and not one of them warned of the problems that were to come. By Mr. Greenspan’s logic, anyone who might have foreseen the housing bubble would have been invited into the ivory tower, so if all those who were there did not hear it, then no one could have said it.

As a nation, we cannot afford to live with Mr. Greenspan’s way of thinking. The truth is, he should have seen what was coming and offered a sober, apolitical warning. Everyone would have listened; when he talked about the economy, the world hung on every single word…

It did not have to be this way. And at this point there is no reason to reflexively dismiss the analysis of those who foresaw the crisis. Mr. Greenspan should use his substantial intellect and unsurpassed knowledge of government to ascertain and explain exactly how he and other officials missed the boat. If the mistakes were properly outlined, that might both inform Congress’s efforts to improve financial regulation and help keep future Fed chairmen from making the same errors again.

Michael Burry: I Saw The Crisis Coming. Why Didn’t The Fed? (NYTimes)

“you’re a doctor, ipso facto a lousy investor.”

That was one of the first messages Michael Burry received when he started his value investing thread on Silicon Investor, back in 1996. Now however, Burry is a pretty well-regarded investor, having made it big with inventing the credit default swap trade as a means of profiting from the financial crisis and being prominently featured in The Greatest Trade Ever by George Zuckerman and The Big Short by Michael Lewis.

What I wanted to find out is how Burry went from being a medical resident to being regarded as one of the greatest investors in recent history. Burry’s story is pretty inspirational to investment bloggers — he started out in relative obscurity, posting his ideas on message boards and eventually his own site, until he built a strong institutional following. Eventually, his amateur analyst work attracted the likes of Joel Greenblatt’s Gotham Capital and White Mountains Insurance Group (NYSE:WTM). With their money, he started Scion Capital and built a market beating track record. In recent years, Burry unwound his fund in favor of managing his own money.

We are lucky in a way that the internet archives of Burry’s posts are still readily available. These archives let us see how Burry invested and the evolution in his process from about 1996 to 2000. I am sure that his approach changed while he was running Scion as well, but I still think the information here is really insightful to young investors.

1. I’ve read way too much

The first thing that strikes you about Burry is the fact that at the time of his initial post, he has read a lot:

Ok, how about a value investing thread?

What we are looking for are value plays. Obscene value plays.
In the Graham tradition.

This week’s Barron’s lists a tech stock named Premenos, which
trades at 9 and has 5 1/2 bucks in cash. The business is
valued at 3 1/2, and it has a lot of potential. Interesting.

We want to stay away from the obscenely high PE’s and look
at net working capital models, etc. Schooling in the art
of fundamental analysis is also appropriate here.

Good luck to all. Hope this thread survives.

Mike

(Silicon Investor)

Look at the type of value investing that Burry is referring to. Remember, most people mistakenly believe value investing is just copying whatever Warren Buffett does, but value investing is actually more diverse than that. The Graham tradition refers to Benjamin Graham, Buffett’s teacher, and indicates a more quantitative approach to investing. Graham targeted net-nets, stocks trading at 2/3 their net current asset value. He sought hard assets and did not mind investing in terrible businesses as long as the liquidation value was in tact and protected.

Burry later notes that he is an MD, not an MBA. He picked up most of his knowledge by reading. I believe that if you want to be successful in investing, it is important to be willing to learn and explore new concepts on your own.

This must have been especially true for Burry because when he started posting he was just an outsider. He was no Wall Street analyst and lacked the same resources as many institutional investors. But, Burry made up for his lack of professional knowledge with his drive and determination to learn. Here are some of the books he recommended:

Re: books

To get started, I’d suggest the following four books:

The Intelligent Investor by Graham
Common Stocks and Uncommon Profits by Fisher
Why Stocks Go Up and Down By Pike
Buffettology by Buffett and Clark

If you read these books thoroughly and in that order and never touch another book, you’ll have all you need to know. Another book you might want to consider is Value Investing Made Easy by Janet Lowe – a quick read. I have a fairly extensive listing of books on my site, with my reviews of them, and links to purchase them at amazon.

http://www.sealpoint.com/

My problem is I’ve read way too much. One book stated, “If you’re not a voracious reader, you’ll probably never be a great investor.” But sometimes I wish I had a more focused knowledge base so that my investment strategy wouldn’t get all cluttered up.

Re: Security Analysis you can get a lot of the same info in a more accessible format elsewhere, but everyone says that Buffett’s favorite version is the 1951 edition. Yes there are differences, and the current version has a lot of non-Graham like stuff in it.

Good Investing,Mike

(Silicon Investor)

From the period of 1996 to 2000, Burry wrote 3,304 posts or about 2.3 posts per day. He didn’t let the criticism of more experienced investors get to him, on occasion he was lambasted for being a doctor or not a financial professional. But he kept posting anyway. Many of these posts give us a glimpse of his thought process and the kinds of questions he asked. We can see that he mostly used the site as a sounding board to gauge investment ideas and learn from more experienced investors. His constant asking of questions and stock analysis posts are demonstrative of his intellectual curiosity and how he tried to continuously improve his own abilities as an analyst.

2. There’s a way to win at everything. It just has to be found.

If you go back and read Michael Burry’s posting history, you will see that his investment style was influenced by Graham and Buffett but also had a number of unique qualities. Note his use of technical analysis:

As I’ve brought up on this thread before, I was a growth/technical analysis investor for quite a while. I studied TA pretty extensively. Hence, when I felt the market getting toppy last December and became a student of value investing, I found it hard to leave TA completely behind. Mainly I use it only to avoid falling knives and to find buy points at very solid support. I try not to use it to sell stocks
because my horizon remains long-term. With the market this toppy though, I find it hard to ignore when TA says sell after a fast rise. It’s the old take the money and run. It has helped me tremendously, and I have been hurt when I ignore it completely. The four companies I hold now I’m not even charting, though I would do so if one or more gains 40-50% in a few weeks, as WHX has done.

Mike

(Silicon Investor)

Most value investors I think would cringe at the very thought of using TA, but Burry found a way to incorporate it into his approach. Part of this has to do with the fact that he actually starting his trading not in stocks, but in coffee futures:

Jim, I guess I still watch the charts a bit. After all, I cut my teeth trading coffee futures. About 8 trading days ago it broke a significant downtrend on decent volume when it moved to the high 40s. At the point, I wished I had bought more in the low 40s. Today it just popped its 200 day, after trending along it for a few days after trendline breakout. This all occurred in a setting in which the years-long stock chart tested a years-long uptrend and the support held. Maybe TA is only useful because others use it. I don’t know. But it’s interesting to watch, and I believe in it to the degree it reflects crowd psychology. Despite SLOT’s volatility, I’d be surprised if it goes back to sub-50 now.

And yes, I’m waiting for the 80′s at least before I sell, no matter what the chart does. It’s as sure a bet as Apple at 34, Oracle at 23, American Power at 27 (presplit)…

Mike

(Silicon Investor)

Was Burry a futures trading guru? Not quite:

Re: coffee futures, let’s just say I got out with the shirt still on my back.

Mike

(Silicon Investor)

Off-topic

In futures, I learned a lot about TA. The frustrating thing was it worked. You could actually predict the moves. But slippage ate away everything. I was up big at times, never down big. I left with 98% of my original capital as soon as I realized I would have to quit my day job to do it right. The friend that got me into it did quit his day job and is doing ok. There’s a way to win at everything. It just has to be found.

Mike

(Silicon Investor)

We know that right off the bat, Burry had read a number of value investing texts. However, he chose to incorporate things he had picked up previously with his new, value oriented approach. I think that his willingness to create his own systems and methods for investing highlight his ability as an investor. He wasn’t just a mindless drone that would follow whatever he read in books.

Take this rule about new lows, it shows that Burry was able to think critically enough to come up with his own investment rules:

As you know, I have a simple philosophy: sell on new lows.
There are two reasons for this:
1) Many people do this. It’s a self-fulfilling prophecy. I try to do it quicker.
2) If I know something is a fundamental value and it breaks to new lows, the selling is irrational by definition and I don’t want to be in the way of irrational selling. Better to wait for the buyers to show where they are willing to step up and give support.

I suffered for several years trying to be stubborn in the face of irrational selling and all it got me was a lot of 50% haircuts on stocks that had already been too cheap. One of the biggest lessons I’ve learned was that PE 8 stocks can become PE 4 stocks and stay that way for a long time. AT&T’s long-distance business is getting close to trading for 1X EBITDA, yet everyone looks at it like this big albatross around T’s neck. Maybe in the future I’ll get the long-distance biz for free. All we need is another $15 billion in lost market cap.

That said, I love your rhetorical questions. Why do you think AT&T is getting hit?

Mike

(Silicon Investor)

To me, that is an important aspect of learning investing. Most people will read a book about Warren Buffett and begin to think that there is only one way to really do investing. That kid of thinking really limits you. And Burry brings this up in the context of the tech bubble:

OK, here’s where I go and offend a lot of people. Religion? Style? What’s the difference? I’m sitting here fully expecting AMZN to go to 10. Don’t expect incredulity from me just because I haven’t seen it happen before. At some point, I did give up on my tech ban. Reason being that they are businesses like any other, and I couldn’t justify not valuing them. It’s fashionable for value investors to steer clear, certainly because of Buffett’s influence. But it is possible to invest intelligently there, IMO. I can’t just stick my head in the sand and say Microsoft didn’t make a lot of really intelligent investors very wealthy. Ratios bite. That’s gotta be lesson number 1 in tech value investing. I learned it with one stock – Creative Labs. Applying a little bit of Buffett to tech isn’t heresy or impossible, IMO…

Mike

(Silicon Investor)

Burry’s willingness to analyze tech companies is more evidence of his propensity to think independently. He makes a great point, totally ignoring tech on the basis of Buffett saying “tech is too hard” is probably a bit of an over generalization. If you look at some of his other posts, he gives some insights into how he evaluates tech stocks:

I just go for what has value. To me, ignoring tech doesn’t make sense. I’ve done well with Apple, Oracle, American Power this year. IMO, applying traditional value criteria to tech is deadly, because there is usually a reason it looks like a value, and it is too technical to understand.
So in tech I look for:

1) Big, Buffett-like established companies with tremendous
cash-generating ability that are out of favor despite a franchise on something
2) Small techs trading at about cash with no debt. They usually do well in my experience.

In tech, good management is rare and when it is present limits become merely a figment. But for an outsider to somehow judge this before the Street does – I don’t know that it is possible.

(Silicon Investor)

To Burry, you don’t need to ignore all of tech. Actually, when you look at established tech businesses, they are really some of the best. They tend to have clean balance sheets and are usually almost debt free, making the capital structure very straight forward. For a new investor, a mature tech company is probably easier to analyze than a bank.

Burry breaks tech into two piles. The Buffett businesses are ones that have wide moats and earn a lot — think Microsoft or Ebay (which Scion Capital has owned). The Graham businesses are likely small cap / micro cap stocks that the market has forgotten about, you will often see some of these tech companies on the net-net list (Adaptech comes to mind).

Here is how he described Apple:

I like AAPL because it IMO is now a bona fide value stock on an enterprise value/ratio basis, and is generating tons of cash. I see loads of opportunity, an extremely strong balance sheet, and little downside. And I see a huge contrarian play because a generation of security analysts have been trained to think that whatever is wrong with this world, AAPL is a part of it.

What the price will do in the next 12 months, I don’t know. Whether day traders will ever mature, I don’t know. Whether value will even become more important over the next year, I don’t know. I just see an absolute value in AAPL at recent prices.

I do feel the greatest margin of safety was back at 34 when no one ever thought it would move, but that there remains a margin of safety for longer-term holders.

(Silicon Investor)

If you were willing to overcome your biases against tech stocks, you would have seen a no-brainer value investment with Apple. Around the time of Burry’s post, Apple had about $4.5B in cash and marketable securities, with only $300M in debt. If you had taken Apple’s market cap, added the debt, and backed out cash, you would have ended up with the operating business being valued at only 10% of sales. That is absurdly low. The thing is, I am sure many investors missed this because they chose to ignore all tech stocks.

In The Big Short, by Michael Lewis, Burry argues in favor of creating your own investment style:

Burry did not think investing could be reduced to a formula or learned from any one role model. The more he studied Buffett, the less he thought Buffett could be copied; indeed, the lesson of Buffett was: To succeed in a spectacular fashion you had to be spectacularly unusual. “If you are going to be a great investor, you have to fit the style to who you are,” Burry said. “At one point I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his rules… I Also immediately internalized the idea that no such school could teach someone how to be a great investor. If it were true, it’d be the most popular school in the world, with an impossibly high tuition. So it must not be true.”

The Big Short (Michael Lewis)

Basically, Burry did not reject Buffett, but he understood the limitations that came with Buffett’s teachings. He didn’t have Buffett’s resources or talent for influencing management teams. As a smaller investor, he realized that he had to create his own approach so that he could invest effectively.

3. What everybody else was doing was insane

“The late nineties almost forced me to identify myself as a value investor, because I thought what everybody else was doing was insane.”

Michael Burry (The Big Short)

I am a huge believer in having investors study historical financial crises and panics since markets naturally have a tendency to become bubbles. Investors who have never really experienced a bubble will usually relax their investment standards after having a string of homeruns. This almost always leads to disaster, which we saw it in the most recent crisis. Many fund managers lamented that they had strayed a little too far from their core competencies and their investments suffered.

I was really curious about why Burry decided to do the credit default swap trade while so many other investors had missed it. Part of the reason Burry was able to see the mortgage bubble may have been a result of having honed his investment abilities during the dot com bubble. If you look through his posts, he knew the markets were being irrational:

A very, very close friend of mine whom I work with and talk with 6 hours a day has in the last 3 weeks quintupled his net worth on a single stock. Today he crossed $500,000. He’s not an insider at a company or anything. He’s just a resident phsyician who’s buying what everyone else is buying, and he’s telling me the same thing: fundamentals don’t matter anymore; who wants to talk about fundamentals?

Paul, if doctors make lousy investors, what does it tell you when doctors are making excellent investors – in droves?

Mike

(Silicon Investor)

Here is an interest exchange that Burry had with Reginald Middleton, who at the time was selling financial models that projected Microsoft to be worth north of $500 per share:

Reginald,

You appear to be arguing that junk bonds and technology equity investments have more value because they have been yielding higher returns over the last 7-10 years, thus counterbalancing the risk to a sufficient degree to call these value plays. This is the logic of a growth investor. What if you buy junk bonds just before the next crisis? Or if you buy A junk bond and the company deteriorates or is cannibalized by the people that sold it to you? You’ll be sitting on a big fat capital loss. This risk is high, hence the name.

How about the Nifty Fifty and the 72-74 crash? Good companies that didn’t see a return to their previous levels for over 10 years. In the inflationary environment of the mid 70′s to early 80′s this was devastating for holders of these growth stocks (which had been deemed “safe” due to their previous returns during the 60′s bull and size/history).

This is why we use AAA corporate bonds and gov’t securities as benchmarks for a safe return. Hold until maturity and you are guaranteed (as best as can be expected — if you don’t trust the gov’t, check out AAA bonds oneself) at least a modicrum of insurance against inflation. I am not arguing that your model doesn’t do this implicitly.

In sum, if you buy at the top, where’s the value? This is what Margin of Safety is meant to address, and why many people distinguish value investing from growth investing.

Mike

(Silicon Investor)

Finally, there is this:

Jim, I overheard two conversations today. Both were about investing – one involved the med center librarian, the other a janitor. Moreover, the friend I describe with the half-mill is not the first overnight success story. As I might’ve mentioned before, my two best friends and my younger brother’s two best friends all became multimillionaires this year. But you know, even though I’m here in Silly Valley, I’m on the fringe – that same guy who made half a mill went on a date with an HP IS employee who said it’d take 2 mill to buy her house. When informed of his goal of 3-5 million in a few years, she scoffed and said “That should last 2-3 years.” Then she asked what doctors are making in the Valley. He said “$100 to $120k.” She actually sniffed.

Jim, I’m reversing my position on your QQQ short, although I’m not yet doing it myself. Never, ever have I heard stock discussion permeate the medical center like this. This is new to me in the last few weeks.

Mike

(Silicon Investor)

Unlike most people at the time, Burry realized that he was living in a bubble. It didn’t make sense. Hearing about janitors, librarians, and co-workers, making such outsized returns with little actual investment analysis must have been jarring. The thing is, Burry not only realized that there was a tech bubble, but he sought to profit from it.

Shorting is a somewhat debated topic among value investors. They often complain that shorting saddles investors with potentially unlimited losses and runs counter to the fact that stock markets generally rise. I thought examining Burry’s perspectives on short selling would be insightful:

I’ve brought this up before, but since there’s a new group hanging around,

Does anyone have any rules for shorting based on a value basis?

I’m currently short KO on a value basis and am looking to short G next. (My AXP and WFC shorts are not value-based).

Mike

http://siliconinvestor.advfn.com/readmsg.aspx?msgid=1213782

Even though his shorts were more based in TA, Burry gradually refined his approach to incorporate more fundamental analysis:

I mentioned that I pick stocks to short based on valuation, not ratios (I ask you to find the correct free cash flow — I bet most people don’t kow they’re working with negative net working capital, either).

But I ENTER based on technical analysis. KO could go up or down. The odds are down, technically, but that’s what buy stops are for. This isn’t a long term short by any means. Research on shorts show that profitable shorts make money with small gains, not by waiting for businesses to bankrupt. The small gains are usually there for the picking. Another indicator — if it’s mentioned in Barron’s as a buy three different times — set me onto Wells Fargo.

What’s there to understand about Coke? The business is a KISS model. This gets to my value/short strategy. When people start claiming a business deserves a special valuation above all reasonable
fundamental analysis (because of the “franchise”, because there’s so little institutional ownership for a big cap growth stock, because Buffett’s in it, because global expansion will provide endless opportunity, because ROE is so damned high, because it’s nearly a monopoly, because Buffett’s in it…), that’s a short, IMO.

I just read a bunch of Graham, and he doesn’t deal with shorts (I assume it would be “speculation”), but EMT isn’t all that its panned to be either, IMO.

Just trying to think independently,
Mike

(Silicon Investor)

With further refinement, Burry started to create screens to pick up possible shorts. Here is one:

A study came out on shorting late last year. It basically said ignore the momentum plays because they move irrationally and fast. Look for companies with immense debt, crummy balance sheets and declining sales. And then hold for a while. This is just so against my nature, if not all human nature.

I screened for negative sales growth plus LT Debt>>equity, and PSR>20. The screen works, in a sense — you get all kinds of companies trading for less than a buck, and a lot of low cap oil&gas explorers. Nothing marginable, so hence they are not shortable. If you leave out the balance sheet problems you get a bunch of development stage cos, esp. biotech. But it seems to be on the right track. I’ll keep trying.

As long as you put tight stops on the shorts, there’s no unlimited risk. Problem is, how much do you believe the stock will go down? I’m only aiming for 10% in a bull market (which usually happens either quickly or not at all given my technical entry) so I need tight stops. Got stopped out of all mine today except IBM. This is why I’m looking for a value-based alternative.

Good investing,
Mike

(Silicon Investor)

Even though he was trying, he could not totally come up with a pure value approach to shorting. In this post, Burry describes how his process is still driven by TA, but that he is closer to figuring out a value based strategy:

Re: stops and shorting

Effectively, you need to use technical analysis. My shorts, though fewer in number by far, have been more successful than my longs — what that says about me I don’t know. Alternatively, you could just use percentages, but to me that’s a shot in the dark. Or if you know the company intimately, you could just waitbecause you know it’s going down.

Using TA, you can find, say, when a company is bumping up agains some significant overhead resistance, hitting a trend channel boundary, or hitting a Fibonacci number on a retracement during a downtrend. There are lots of other examples. Then, you just set a mental stop to get out if the scenario doesn’t play out technically. My futures experience led me to study TA intensely. I can’t help but use it for position entry in stocks.

To answer someone’s question, shorts do not free up cash. They are always borrowed (you are shorting stock that your brokerage borrowed for you from another investors margin account), and hence in your margin account. But it’s not like you can keep 100% shorts and then still have 100% cash to play with.

BUT this is TA. Stops are not a part of value investing as I understand it. Hence my search for a value-based strategy.

Shorts take a lot of maintenance as I practice it.

I may have found something, and am currently researching it.

Mike

(Silicon Investor)

This is where Burry’s past experience with trading futures was probably helpful. By using frequent stops, he limited the possibility of unlimited losses from a short position. Since he is incorporating shorts into his portfolio, Burry allowed himself to actually profit from the fallout of the bubble popping. Most other investors, who chose not to short, were left putting more and more of their portfolio into cash. Cash is not necessarily bad, while it does not earn returns or compound, in the short term it doesn’t decline.

One of the books that Burry recommends for learning short selling is The Art of Short Selling by Kathryn F. Staley. Here is what he had to say:

For the last week I’ve been carrying “The Art of Short Selling” around with me just about everywhere. Every time I get a break, I just open to a chapter. Doesn’t matter if I’ve already read it. I just read it again.

If there’s one thing that keeps hitting me in the head about that book and its cases is that there’s a lot of time to short and still come out ahead. The problem with net stocks is that they appear as if they require constant capital infusions, which makes them good shorts. But they’re getting these infusions at will. That makes now now a good time. When the capital spicket is turned off, the stocks will react downward, but won’t fully account for how bad the news is then. They’ll be terminally wounded but the price won’t reflect it. That’s when IMO you’ll be able to grab a lot of the net stocks on their way to zero. But before that, a lot of smaller companies will pitch themselves to larger companies. So the wild card is that they get taken over by a bigger, stupider, more capital-rich, company, a la Yahoo of GeoCities, which stands out as the single most characteristic action of this era. The AofSS describes this risk as the thing that keeps ss’s sweaty-palmed and awake at night. I think for good reason.

For my next, more certain short, I’m taking a long, measured look at Pre-Paid Legal (PPL). I posted why over on that thread. I think I finally understand that one.

Mike

(Silicon Investor)

Increasingly, we see Burry progressing towards shorting on the basis of fundamental analysis:

Shorting stocks where I can see the bad news confirmed in the numbers. Amazon.com (short at 82 5/8 again today) is pursuing some creative financing to get the cash to keep going. Selling euro-dominated bonds follows an Australian issue follows equity-linked debt follows who knows what.

Exodus (short at 129) is in a capital-intensive business with high start-up costs and business inputs that have short half-lives. The barriers to entry are minimal in the long run. Exodus’ major shareholders have sold big-time. The company should be raising its needed additional capital by selling inflated shares but instead is borrowing $1billion plus at 10%+ rates. Intel is one of the many targeting this same market.

Pre-Paid Legal (short at 24 3/4) I’ve gone through before (I shorted it from $37ish down to 24ish last year). Cash flow continues to lag far behind reported net income, membership retention stinks, and the CEO is engaging in borderline stock promotion while he steadily sells. Many in the investor community misunderstand this stock.

(Silicon Investor)

You can see the improvement and progression in his process. You will note that the analysis is more sophisticated here. It is much more value based, akin to an approach that you might see touted by a guy like Jim Chanos or other noted short sellers. With Amazon, Burry found the overall business model to be a bit suspect and disliked the complex financing. Exodus was a weak business that required large amounts of capital investments and financing that could only be raised at 10%+. Conversely, he was able to see larger businesses like Intel pose as competitive threats with the benefit of a cheaper cost of capital. Pre-Paid Legal, which astoundingly still exists today, is often a favorite among shorts. The mis-match between cash flow and net income is found in a lot of fraud businesses and is one of the indicators for trouble that you will find in forensic accounting books.

I talked about Burry’s willingness to modify Graham’s teachings to fit his own style and the time period. I think that shorting is simply an extension of that. In one instance, after being criticized by another investor, Burry outlines his philosophy on shorts:

Craig,

I wouldn’t go far as to say shorts are not part of a value investing strategy. To each his own, but one might argue that with bonds providing a weak counterweight to stocks over the last few decades, hedging with shorts might be something Graham would have considered by now had he been alive. He definitely was into market timing, and it wouldn’t surprise me to learn that he felt that shorts had a place in a rich market as a hedge against a majority long equity position. And re: Paul’s remark about hedging and shorts never coming up, I submit that Graham’s Bonds/Equity 25/50/25 theory was meant to be the equivalent of a mild hedge strategy. As for me, I’ve come out ahead on my shorts over the years, but I much favor longs, and in a fairly priced or evem overpriced market will still overwhelming favor longs…

Good investing and keep contributing,
Mike

(Silicon Investor)

Later, he cites the Rediscovered Benjamin Graham book’s material in order to argue that going long value stocks may not be enough if we are faced with a downturn:

“I’d like to think that if I own real absolute value stocks it won’t matter if the big indexes drop 50%. But that might be wishful thinking. ”

Jim, in that Rediscovered book, Graham makes it quite clear that value stocks will be punished every bit as much and probably more in a market downturn, according to his research. He of course advocates raising cash or adjusting to bonds if one thinks the market is too high. In another area, though, he talks of the tremendous values that can be found even in a high-priced market. I find this book fascinating — lots of stuff I hadn’t read before.

Mike

(Silicon Investor)

Eventually, Burry was able to incorporate short selling as just another weapon in his arsenal for value investing. Later, you can really see how improved his level of analysis has become. Take this post on WorldCom:

To answer whether this is a good business (and not just apparently cheap based on traditional superficial measures) I coincidentally just did a new return on capital calc on WCOM today, based on its latest results. Largely, I go by Stern and Stewart’s version when doing this. In terms of earning cost of capital, Worldcom is doing a poor job.

In fact, it is not earning its cost of capital. After accounting for past pooling acquisitions, and breaking down Worldcom’s cash flows, I figure the company is going to earn, optimistically, $8 billion in cash earnings on invested cash thus far somewhat above $90 billion. Even looking ahead and taking analysts estimates into consideration, I’m seeing at best a 10% return here and hence WCOM is not earning whatever its cost of capital may be – I’m estimating at least 12%.

Right now, it trades above its capital even though it is not earning the cost of its capital. Not good. This may change as WCOM finds a way to leverage its investment into further profits down the road. The latest quarterly report provides a hint of this. But it has said it will have massive capital expenditures in the future – and current cash levels imply additional borrowings to do it. All this will dilute returns further.

I think with T and WCOM, we’d have to find a way to analyze the current levels of investment and somehow come to a conclusion that future earnings will grow quite significantly off this base alone. One wonders what degree of empire building is going on – what is motivating management? Right now, T seems to have the greatest potential because of its cable assets, but it is potential. Management has to execute. Plans to spin off or merge with BT tell me that management is responding to the wrong inputs right now. Ebbers’ Sprint plan told me he is responding to the wrong inputs as well…

Following up on my examination of Worldcom, I concluded that Worldcom would have to start showing it didn’t need more acquisitions. Its acquisitions to date seem to have been borne of empire-building rather than shareholder reward. And the market is knocking it down drastically on news of its latest acquisition. Certainly it appears that the “story” phase for the stock is over, and the proving time has begun. But Worldcom is still trying to finish the story. I’m still staying away.

Good investing,
Mike

Part I (Silicon Investor)
Part II (Silicon Investor)

As many of you already know, WorldCom had engaged in massive accounting fraud. Some of this was covered up through their clever use of accounting with acquisitions. Each deal boosted their reported earnings whereas it was obvious to Burry that they weren’t even out earning their cost of capital. Being able to pick up on small details like this must have been helpful later on when he had to analyze complex subprime-mortgage backed securities.

4. The Big Short

Burry was relentless about seeking out value. That meant buying undervalued tech stocks and shorting the ones that had shoddy fundamentals and were irrationally bid up. To me, when we read about Michael Burry netting huge from credit default swaps against mortgages, we are just seeing an extension of his process.

Value purists may disagree with using credit default swaps because they are derivatives, but Burry’s wasn’t a purist. He isn’t the first value investor to get attracted by insurance. Warren Buffett has had a long history of involvement in the reinsurance business. For Buffett, insurance is all about taking premiums for well priced policies and investing them in the market to compound returns. For Burry, it was more of the opposite. He was being presented with premiums that were so low, relative to the huge payoff, that the CDSs were actually undervalued and worth investing in. His CDS positions may have costed 5% annually but had the potential to deliver 100:1 payouts.

What is funny is that in his SI posts, you could see that Burry was already suspicious about the possibility of a housing bubble back in 1999 with a post about Washington Mutual:

…with equity/assets of under 5%, WM is not in the strongest shape should its fundamentals deteriorate, i.e. real estate deflate. Out here in Silicon Valley, everyday life feels like a bubble. People can hardly comprehend when I tell them about 90-92 and the foreclosures – not when 2br/1b’s are going for 5-600k. I just can’t help but think that it will get even uglier before it gets better.

Mike

(Silicon Investor)

Burry constantly frets about the potential downside and isn’t deluded into thinking that markets will remain stable. In his posts he brings up cases where investors are afflicted by delusional euphoria. The Nifty-Fifty days, the early 90′s real estate foreclosures, investor behavior during the tech bubble, the ever appreciating home prices in California; he comes off as almost always vigilant against the the possibility of another disastrous bubble around the corner.

In the Michael Lewis article, Betting on the Blind Side, Lewis describes how Burry learned about mortgage bonds:

In early 2004 a 32-year-old stock-market investor and hedge-fund manager, Michael Burry, immersed himself for the first time in the bond market. He learned all he could about how money got borrowed and lent in America. He didn’t talk to anyone about what became his new obsession; he just sat alone in his office, in San Jose, California, and read books and articles and financial filings. He wanted to know, especially, how subprime-mortgage bonds worked.

Betting on the Blind Side (Vanity Fair)

Going back to Burry’s past, we know he had a penchant for self-teaching. The way he learned about subprime-mortgage bonds was probably similar to how he learned about investing. Simply by self teaching. My guess is that most investors did not bother wading through subprime mortgage bond prospectuses. At most, they may have double checked the rating on the bond by calling up the people at Moody’s or S&P. For Burry though, we know that when he learned something, he sought complete understanding:

The problem is, I don’t believe anything unless I understand it inside out. And even once I understand something, it is not uncommon that I disagree with accepted view (even if it’s a Nobel laureate). So I struggle pretty mightily with my own perceptions and definitions every once in a while. That’s where I am now.

Mike

(Silicon Investor)

That drive to figure out the ins and outs of every subject must have contributed to the fact that he was willing to sit down and understand all the granular details of a subprime mortgage bond. I doubt listening to a ratings agency or the common market sentiment was enough. He had to personally understand everything. And that singular focus led him to see that subprime mortgage bonds were really a sham:

But as early as 2004, if you looked at the numbers, you could clearly see the decline in lending standards. In Burry’s view, standards had not just fallen but hit bottom. The bottom even had a name: the interest-only negative-amortizing adjustable-rate subprime mortgage. You, the homebuyer, actually were given the option of paying nothing at all, and rolling whatever interest you owed the bank into a higher principal balance. It wasn’t hard to see what sort of person might like to have such a loan: one with no income. What Burry couldn’t understand was why a person who lent money would want to extend such a loan. “What you want to watch are the lenders, not the borrowers,” he said. “The borrowers will always be willing to take a great deal for themselves. It’s up to the lenders to show restraint, and when they lose it, watch out.” By 2003 he knew that the borrowers had already lost it. By early 2005 he saw that lenders had, too…

In his quarterly letters he coined a phrase to describe what he thought was happening: “the extension of credit by instrument.” That is, a lot of people couldn’t actually afford to pay their mortgages the old-fashioned way, and so the lenders were dreaming up new financial instruments to justify handing them new money. “It was a clear sign that lenders had lost it, constantly degrading their own standards to grow loan volumes,” Burry said. He could see why they were doing this: they didn’t keep the loans but sold them to Goldman Sachs and Morgan Stanley and Wells Fargo and the rest, which packaged them into bonds and sold them off. The end buyers of subprime-mortgage bonds, he assumed, were just “dumb money.” He’d study up on them, too, but later.

Betting on the Blind Side (Vanity Fair)

My guess is that most of Wall Street did not bother to wade through the hundreds of pages that comprised a subprime MBS. Unlike Burry, who sat in an office and learned these bond deals by himself, most of Wall Street likely deferred their judgement to the ratings agencies or sell side contacts. Ultimately, those groups lacked any substantial knowledge about these securities, their models were flawed which made their opinions flawed. So when investor groups came to them to get their opinions, they were almost always given the wrong answer.

Going through all of Burry’s posts, you will see that he was constantly analyzing stocks. To the point where he was at least posting a few ideas every week, in addition to his day job. To me, that is the definition of deliberate practice for an investor. You really have to get into the habit of frequently analyzing and valuing companies. In one post, Burry mentions that he has built a watch list of over 80 companies that he would be ready to pounce on if they ever hit his target price. That level of work, with a tendency to think independently, should help improve anyone’s investing.

This quote by Michael Burry in The Big Short says it best:

I have always believed that a single talented analyst, working very hard, can cover an amazing amount of investment landscape, and this belief remains unchallenged in my mind.