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My name is Ben and I am a generalist equity research analyst for Right Wall Capital. Right Wall is a small, long-short equity, financials-focused hedge fund located in New York City. Prior to working at Right Wall I worked as an analyst at Blue Ram Capital, another long-short equity hedge fund... More
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Inoculated Investor
  • Interview with an Aspiring Value Investor (Part 1) 0 comments
    Sep 8, 2009 12:56 AM | about stocks: GFG-OLD, WFC, HAR

    And the subject of the interview is.....well, me. I want to thank my good friend Miguel Barbosa of Simoleon Sense for giving me the opportunity to share my views regarding value investing with his readers. Miguel came up with some fabulous questions and I hope I was able to do them justice with my responses. I am very excited about this unique opportunity to share the lessons I have learned and describe both my background in and passion for investing. For those of you who are relatively new to value investing I like to think it offers a valuable review of some the most basic tenets and principles.

    Due to the length of the post I am going to split it up into two separate parts. As always, feedback is welcome and appreciated. Hope you enjoy.

    1.       When did you first become interested in allocating capital?


    The funny thing about me is that I was a value investor before I had ever heard of value investing as a discipline. In my former life I was a commercial real estate professional and one of my duties was to be a steward of my family’s capital. In that role I analyzed hundreds of opportunities to purchase existing buildings or develop new properties. I think it is a testament to my discipline that from 2003 to 2007 there was only one deal that I actually advised my family members to invest in. During that span I had dozens of what turned into contentious discussions with real estate brokers who were desperately trying to convince me that this was a great time to buy and that paying a 4% cap (which is like an earnings yield on a stock) for a Walgreens in Indianapolis made ultimate sense. I feel bad for the people who were swindled by these brokers and bought near the peak of the bubble. Luckily, even before I had heard of Ben Graham I understood that the return you receive has to compensate for the risks you are taking.


    When it comes to stocks, the indoctrination into value investing that has led me to want to manage money professionally all started when I read Ben Graham’s The Intelligent Investor. I know it sounds almost cliché, but there is something about the investment philosophy that Graham details in this book that just clicked with me. If you look at my blog site, I have two quotes from prominent investors that articulate my attraction to value investing better than I ever could:


    Seth Klarman (Baupost Group): “It turns out that value investing is something that is in your blood. There are people who just don’t have the patience and discipline to do it, and there are people who do. So it leads me to think it’s genetic.”


    Mohnish Pabrai (Pabrai Funds): “Warren Buffett has said many times that people either get value investing in five minutes or they won’t get it in five years. So, there is something in the human brain--that for some of us--makes all the difference in the world right away and the patience it requires is part of the wiring process.”


    2.       Currently you work as an analyst and run the Inoculated Investor Blog. Why did you start the blog? Where do blogs like yours fit in among the financial journalism and equity research spaces?


    Well, my days as an official analyst are over, at least until I graduate from UCLA with my MBA. However, I plan to continue working on the blog as much as I possibly can. The reason I started the blog was that I literally had a running dialogue about the markets and economy in my mind. It was actually driving me a little crazy and I badly needed an outlet. Fortunately for me I was able to launch the site with content that was quite unique. I attended this year’s Berkshire Hathaway annual meeting and I was literally the only person out of the thousands there who was crazy enough to try to write down every word that Buffett and Munger said. As a result, my meeting notes were more complete than those of others and after I posted them the entire value investing portion of the blogosphere was linking to me.  It was a very good way to start off my blogging career.


    Since then I have focused solely on adding value to my readers. My goal is to try to make what can be very difficult material accessible to non-professional investors as well as people who work in the markets. I think my particular niche lies directly in between the financial articles you read in the Wall Street Journal and the equity research created by analysts.  I often find the articles in the financial publications to be incredibly cursory and that the research barely scratches the surface. On the other hand, in depth company specific equity research is really only compelling to professional investors.  So, as opposed to using my blog as a glorified version of Twitter, I try to walk the line between boring readers with too much detail and offering insight that any novice could come up with. For example, I often post links to other sites with commentary so that I can expand on the topics covered by others. But I also have a section of my site that has samples of the actual equity research I presented to my bosses. I like to think that this makes my site somewhat unique.


    3.       Mark Sellers stresses the importance of clear writing as proxy for clear thinking. You’re a fantastic writer- How does this skill translate into thinking through investment ideas?


    What I love about Seth Klarman and Howard Marks is how articulate they are. Something about the way they talk about value investing resonates with me. Along with Buffett, they are my role models as a writer. For me writing is the best way to present my ideas. I readily admit that I am nowhere near as articulate or persuasive when I speak about investing. It is something that I obviously hope to get better at. I have seen firsthand that the way portfolio managers talk about their investment philosophy and discipline can dictate whether investors are comfortable or not.


    Until I am fortunate enough to have investors of my own, my focus will be on presenting my ideas in written form. As an equity research analyst, you are only as good as your written research. You have to be able to present your ideas and recommendations concisely without sacrificing the obviously necessary depth.  PMs are often very busy and you must avoid wasting their time or even the best idea will get pushed aside. For me, I sometimes don’t even know how I feel about a stock until the write up is complete. Until that point everything is so abstract and the information is so segregated in my mind that I don’t have a complete picture. But, once all of my research is aggregated I feel much more comfortable making recommendations and explaining the investment thesis.


    4.       Which investors do you admire? Besides these investors who else has influenced you?


    I have already discussed this to some extent but I am happy to elaborate. In my young career I have been most influenced by Buffett and Klarman. I actually launched my blog with a post in which I discussed my vision of the optimal portfolio. Ideally, it would contain some Buffett stocks (great companies at a fair price) and some Klarman stocks (fair companies at a great price). I think these men frame value investing in a way that no other people can. It is not a surprise that the best quotes I have ever read regarding investing come from these two luminaries. I also lump Howard Marks in that group even though Oaktree does not focus on equities. The fact that Marks’s words strike me as so profound even though he invests in another asset class is more proof that value investing is a universal discipline that does not necessarily require a specific context. It also shows that the language translates well across asset classes and can even teach some very valuable life lessons.


    5.       What is it that you like about value investing specifically? In other words, what about it attracts you?


    This is an easy one for me. Anybody who knows me is aware that I am a little cheap. I have been so ever since I can remember. While that translates into plenty of backhanded complements in my social life, I think it makes me uniquely predisposed to value investing. I am just not geared toward taking large risks or investing based on an optimistic future. I know that humans are terrible at forecasting and I would rather focus on what a company is worth right now rather than what it could be worth if all these assumptions prove to be right. I think that is why Graham’s analysis was so intriguing to me. He searched for $.50 dollars almost exclusively by focusing on the balance sheet and refused to pay up for growth. I am generally very cautious when it comes to money and Graham’s investing style that focuses on a margin of safety is perfectly suited for a careful and deliberate person like me.   


    6.       What’s your approach to fundamental analysis? What’s your edge?


    The development of my edge is a continual process but based on early returns I would suggest that my edge is made up of my willingness to dig and to look where few others are looking. Regarding the former, I don’t look at companies as single entities. Most companies have a number of different operating units or products that have different costs and margins structures. Accordingly, as I dig my goal is to understand each individual business component in terms of what drives profitability, what generates costs and what the opportunities or headwinds are.  More and more I have become a margins guy in that I assess the quality of a business based on the operating margins it produces. There is no question that for the company as a whole free cash flow is paramount to me. However, before I can determine whether cash flows are sustainable, I need to understand a company’s competitive advantage. This is an element that I believe can be evaluated using operating margins. Thus, I think it is the granular knowledge that I require in order to be comfortable with an investment that distinguishes me from investors who focus mostly on earnings.


    Additionally, I am not foolish enough to think that I can add a whole lot of value to an analysis of Microsoft. I see huge companies that are well covered by the sell side and are widely owned and researched by institutional investors as basic proxies for the S&P 500. In other words, these stocks are by in large going to move with the market, barring extraordinary company specific news. While large cap stocks can become mispriced, I think it is better to fish in a pond that is more likely to see lasting and significant dislocations between intrinsic value and stock price. Therefore, I like to look at spin offs and companies that are not covered by many sell side analysts. Plus, I have no problem investing in small and mid caps as long as there is ample liquidity in the stock. If you take a look at the companies for which I have research posted on the blog you will see my bias. Hurco, Movado, Ceradyne, IPC Holdings: these are not necessarily household names but they are still successful companies that at certain times have generated attractive returns on capital. So, this is where I think investors are most likely to find compelling value.


    7.       Give us an example of your best and worst investments? What did you learn?


    Since I am not a portfolio manager, I think it is more appropriate to discuss my best and worst recommendations. As an analyst my job is not to invest for myself but to come up with ways in which my fund or other investors can make money. First, my best recommendations have come in the regional banking sector. The two short calls that proved to be the most prescient were on Wachovia and Guaranty Financial. For those who are not familiar with these banks, Wachovia was forced into the arms of Wells Fargo as the share price neared $0 and Guaranty recently filed for Chapter 11 and the remnants were picked up by Spanish bank BBVA. These stocks were trading in the mid teens and my analysis of their balance sheets and credit deterioration led me to believe that both had the potential to go to $0 (and in fact they both basically did). Neither of these were obscure names. Wachovia was a household banking name and Guaranty had attracted famous investors such as David Einhorn and Carl Icahn. What I learned from my experience with these companies was that if you can develop an edge in a certain industry you can take advantage of the market not fully understanding the prospects or fundamentals of certain stocks. During the boom years investors did not focus on bank credit or capital, they just saw the prices going up, solid ROEs and stable dividends. Accordingly, when things got bad very few people had the experience or the ability to scrutinize the balance sheets of these banks. As a result they either did not sell quickly enough or bought after dips and got clobbered in the end. This showed me that investment opportunities can be hiding in plain sight. It also taught me to never trust that the $100 bill lying on the sidewalk is not actually there just because the Efficient Market Theory says that someone would have picked it up if it were there.


    On the flip side my worst recommendations had to do with underestimating the extent of the financial crisis and consumer spending downturn. I remember after the $120 a share Harman buyout by Goldman and KKR fell apart I thought the broken deal could lead to an interesting opportunity. The stock was around $70 and looked like quite the bargain when compared to buyout price. Well, the stock is $27 now as companies who rely on auto sales have been absolutely crushed. My biggest mistake was becoming anchored to the $120 offer price as if that were a measure of intrinsic value. I now understand that the presence of excessive leverage (hence the term leverage buyout) can skew the price of any asset. Additionally, despite the fact that I had a negative macro outlook, especially when it came to discretionary auto sales, I thought Harman had a stable business model that would not be harmed by the coming recession. Accordingly, I failed to adequately follow Klarman’s strategy in which he invests bottom’s up but worries top down. As a result of this and other similar mistakes I am now fully aware that even value investors cannot completely ignore what is going on in the broader economy. In other words, there are very few companies whose fortunes are completely independent of the business cycle or wholesale movements in the stock market.


    8.       How do you look at risk & uncertainty?


    To me, risk is nothing other than the potential for permanent capital impairment. Risk is not volatility. If a stock goes down 50% it likely is not more risky than it was at the higher price. If your favorite cereal is on sale for 50% off at the grocery store you don’t refuse to buy it because the price has fluctuated.  As long as you still like it you should be comfortable buying twice as much. In this way stocks aren’t a whole lot different from boxes of cereal. My goal as an analyst and investor is to avoid situations that involve obvious risk or capital impairment but to take advantage of uncertainty. Uncertainty comes about when market participants have very little visibility into a company’s future and it can lead to severe dislocations between price and intrinsic value. Whether fear is caused by potential government regulation, concerns about demand, or changes in management, value investors who have in depth knowledge regarding companies can often find ways to benefit from uncertainty. What you don’t want to do is buy something that looks certain because you are likely to pay a premium price.

    (Disclosure: No positions)

    Stocks: GFG-OLD, WFC, HAR
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