I’m excited to share a conversation with Joe Calandro, Jr., author of "Applied Value Investing: The Practical Applications of Benjamin Graham’s and Warren Buffett’s valuation principles to Acquisitions, Catastrophe Pricing, and Business Execution".
Joe Calandro, Jr.’s Background:
Joe Calando, Jr. is the enterprise risk manager of a global financial services firm. He previously taught value investing and risk management courses in the MBA program at the University of Connecticut and worked as a financial management consultant with IBM Global Services.
Q. Let’s start by shedding some light on your background, how you became interested in value investing, and what you are doing now?
A. I came to value investing pretty late (that is, while I was in my mid 30’s), regrettably. My training was in economics and upon graduation I went into the insurance industry. After Hurricane Andrew in 1992, I was convinced the nature of the industry was going to change as a result of that catastrophe, which it did. So, given my background, I began studying derivatives and shortly thereafter I started trading. What you may find interesting is that I was taught to trade by someone who himself was taught by one of the traders Jack Schwager profiled in “Market Wizards.”
I did exceptionally well trading for 4-5 years even though it was not my full-time job: my returns were in excess of 50% with very low levels of volatility. If this performance continued I likely would have started a hedge fund, but it did not continue as I was caught in the Asian Contagion of the late 90s, which I didn’t see coming. Shortly thereafter I stopped trading to figure out what exactly happened, and why I had so completely missed it. As part of that exercise, I gravitated to Graham and Dodd, and I also started studying Austrian economics. That research forms the basis of what I am doing now.
Q. Can you give me an example of some of your best investments?
A. In the book I profile a value pattern that I call “base case value” which is simply net asset value reconciling with the earnings power value. Firms exhibiting that pattern, which sell at reasonable margins of safety, have proved highly profitable to me. In the book, I show examples of this type of investment.
I also look for margin of safety-rich franchise-based investments. For example, in February of 2009, I bought the stock of World Wrestling Entertainment (NYSE:WWE). At the time, it offered a 15% yield with no debt and is a “franchise,” or a firm operating with a sustainable competitive advantage. I bought it for $9.36 and I just sold it (in November of 2009) for $16.40. I sold it because my margin of safety disappeared; if I had stayed in the position I would have been speculating, which I will not do as I am a value investor.
“Value investing” in general has 3 core principles:
(1) The circle of competence, which essentially relates to an information advantage and holds that you will do better if you stick to what you know more about than others.
(2) The principle of conservatism. You will have greater faith in valuations if you prepare them conservatively.
(3) The margin of safety. You should only invest if there is a price-to-value gap: when the gap disappears you exit the position.
Q. You’re primarily in the corporate sector now; in your book you touch upon the failure of corporate M&A groups to apply value investing. Why do you think this is the case? What is your take on activist value investors?
A. That’s a good question and I don’t have a definitive answer for it. My take on it is that Corporate America hasn’t been trained in Graham and Dodd. For example, if you get away from Columbia and some of the other top schools, you really don’t have courses of study based on Graham and Dodd. I think this lack of education carries over to practice. If educational institutions aren’t teaching something, then executives are going to have a difficult time applying it. And if they do try to apply it, their employees and boards may not understand it. Hopefully, my book will help to rectify this over time.
Regarding activist investors, I think every investor should be active. If you allocate money to a security (either equity or debt), you have the responsibility of becoming involved in the respective firm because, as Benjamin Graham noted, you invested in a business, not in a piece of paper or a financial device. This is real money in real businesses so there is a responsibility that comes with investing.
Q. Can you give us a tour of the major insights you obtained from the Austrian School of Economics.
A. I have two big academic regrets: I did not study Graham and Dodd or Austrian economics until I was in my mid 30’s. One of the major theories of Austrian economics is its business cycle theory. Just the other day (11/6/2009), that theory was mentioned in the WSJ by Mark Spitznagel, who is Nassim Taleb’s partner, in his article “The Man Who Predicted the Depression.” As you know, Taleb has also spoken highly of Austrian economics as have other successful traders/practitioners such as Victor Sperandeo, Peter Schiff and Bill Bonner.
Austrian economics finds success with practitioners because, I think, Austrian economists are truly economists; they do not try to be applied mathematicians. Therefore, Austrians tend to see economics for what it is; namely, a discipline built around general principles that can be applied broadly to economic phenomena. As a result, Austrian economics is generally very useful in areas such as the business cycle and the consequences of government intervention, which are very pertinent topics today.
Q. What has the financial crisis taught you, how have you evolved as an investor?
A. The Asian contagion of the late 90s was my great awakening. As for the recent financial crisis, because of my prior experience in the late 90s I was not surprised by it. People familiar with Austrian economics or people who read “Debt & Delusion” by Peter Warburton were not surprised by it either. Interestingly, if you go back in history 100 years you will essentially see an economic shock of some kind every 10 or so years, and yet course work in financial history and economic history is in decline in most universities. This is a huge mistake, which hopefully will soon be rectified.
Q. Do you really think the world would have fallen apart if the banks weren’t bailed out?
A. No, I don’t think that the world would have fallen apart, but that is just my opinion. I would have continued paying my mortgage and most other people would have too. The FDIC insures all deposits if a bank fails up to a specific amount so, in general, people would have had savings to fall back on until the volatility dissipated, assuming of course they had savings. One of the great wrongs of the booms that preceded the latest crisis was the incentives it created to consume at ever larger levels of debt. Of course, statements like this don’t generate news; people saying that the economy is going to collapse generates news, and we heard an awful lot of things like that, including from some people who clearly should know better.
Q. I know you are experienced with trading, what “trading related” books would you recommend for value investors?
A. Jack Schwager’s books: “Market Wizards,” “New Market Wizards,” and “Schwager on futures: fundamental analysis” are great trading books. As is George Soros’ “The Alchemy of Finance,” and Victor Sperandeo’s “Trader Vic – Methods of a Wall Street Master.” Three more recent trading books that I like are: “Trading Catalysts” by Robert Webb, “World Event Trading” by Andrew Busch, and “Way of the Turtle” by Curtis Faith.
Q. One of the best things about your book is that you go case by case and tell us about making adjustments to balance sheets. That is, you essentially help us become better analysts. How else can we become better analysts?
A. Balance sheet analysis is a key investment activity. In school, you are taught discounted cash flow and it seems so simple, but when you go through it in practice you quickly encounter substantial assumptions that are required to make that approach work. I was never taught how to practically address those assumptions, so I learned how to the hard way. Conversely, Graham and Dodd provide a framework to address assumptions up front in every valuation, which is important because, like it or not, when you value a business you are addressing these assumptions, either explicitly or implicitly.
You will make better adjustments if you understand accounting (financial and managerial), strategy, and operations management. There isn’t a silver bullet with this activity, or anything else for that matter. When you read books like “Margin of Safety” by Seth Klarman, “Security Analysis,” “The Intelligent Investor,” and Buffett’s Shareholder letters you see very carefully that they have thought through the assumptions in their valuations very carefully. They aren’t assuming anything away, but rather addressing issues head on, which I think is a key factor of their success.
Q. Which one of the cases in your book is your favorite or a must read?
A. That’s a great question, and I would say the Geico case in chapter 3. I’ve studied numerous acquisitions and I’ve never seen one quite like GEICO. It had absolutely everything going for it: assumptions were conservative, value drivers were clear, the strategy was rational and consistent, and there was a clear margin of safety. On the flipside, I also recommend studying the GenRe acquisition which was the exact opposite of Geico. By studying both of these cases you will get a flavor for what makes the modern Graham and Dodd approach so powerful from a variety of perspectives.
Q. Have you thought about writing another book, if so what cases are worth studying going forward?
A. I really haven’t thought about writing another book. What will determine that is people like you and your readers. If there is a demand for another one then I will have to seriously consider it. Believe me, my editor is also thinking about this… [laughter]
Q. In the last chapter you say something like, “Most of us are taught to look up to great people but are not taught to be like them”. This chapter takes a managerial approach to understanding business and links it to value investing: what motivated you to include this material in the book?
A. Let’s start with one of Ben Graham’s famous sayings: “investment is most intelligent when it is most businesslike.” That sentence has always stuck with me.
I was at a conference in the late 1990s and Tom Peters was speaking. Typically, I don’t go to guru-based conferences because they tend to be light on content, but Peters said something that caught my attention: he recommended taking a 10th grade history book and then removing the “nuts” (such as Hitler, Mao, Stalin, etc.) and seeing who is left. From there, he recommended asking yourself if schools teach students to be like these people (such as Ben Franklin, Thomas Edison, Albert Einstein, etc). I started thinking about this and felt the same premise applied to investing and business. For example, I was trained in economics but what I learned did not help me develop investment skills like Soros, Buffet, Mitchell Julis, or Seth Klarman. The same holds for business. So the key insight I took away from this was the need to focus on cross-discipline analysis, which is important for both investors and business people. For example, do you think Warren Buffett has been so successful just because of his investment prowess? Similarly, is Bill Gates so successful just because of his knowledge of programming? Clearly not, both achieved remarkable levels of success based on how they applied a variety of skills over time. The last chapter of my book presents a practical way of thinking about this for both investors and businessmen.
Q. What is it like teaching students about value investing?
A. It’s interesting what you see when you stand at the front of the room. Some of the students “get it” immediately, but many of them do not. I don’t have an explanation for why this is; in fact, I asked Seth Klarman why many people do not seem to “get” Graham and Dodd, and he reminded me of something Warren Buffett once said: value investing is like an inoculation, it either takes immediately or it doesn’t at all.
Another reason could pertain to the circle of competence; for example, if I assign a case study to a class of 30 students most of them are not going to be familiar with the company being valued so it will be outside their circle of competence, and as such they will struggle with adjustments and the valuation.
A third reason could be behavioral. Value investing is based on conservatism but many people (students included) are aggressive. You see this very clearly when evaluating some of their adjustments.
Finding and valuing investments is very much like creating an argument. For example, my valuation might argue for the presence of a margin of safety in a particular security, but I have to be critical of that margin and question it continuously. Simultaneously valuing a business and questioning the assumptions of that valuation is very difficult to do. I don’t think I had an appreciation for how difficult it was until I began teaching.
Q. How can a young analyst (say one of your students) build a circle of competence over the years?
A. One of the best ways to start is by reading, “One Up On Wall St” by Peter Lynch. It’s a great book, and although Lynch isn’t a Graham and Dodder he is a fellow traveler. The thesis of his book is to start with things that you really understand and by so doing Lynch describes how to develop a circle of competence. I strongly recommend this book to beginning investors.
When a beginner starts investing, they should do so with a small amount of money because they are going to be wrong (possibly very wrong). Therefore, learning from each failure is critically important; I suggest that every investor conduct a post mortem on each of their investments (both failures and successes) and by so doing they can refine their circle of competence over time. This is important because the circle of competence is essentially what you are offering people as an investor so the sooner you start developing one, the better.
Q. How would you recommend that a small investor approach analyzing investments that require professional input (to adjust line items)?
A. Good question and the way to do so stems from the circle of competence. Let me give you an example; when I was valuing Sears for my book I talked with members of my family who are commercial contractors and in the real estate industry. Now, I couldn’t value every Sears property or hire appraisers but I could talk with people I knew on a general basis to get a feel for what those adjustments could be. The people I talked with provided me with general ranges that I used for the adjustments in my valuation. So people within your network can be of tremendous help with this.
Q. Outside of investing what other topics make you a better investor?
A. I was recently a guest lecturer at a university and the professor latched onto my trading background; specifically, he said that everyone who is in the risk management business, including investment, should have a background in which they experienced a significant loss so they understand first hand what it is like, and how it can happen. I never thought of that, but clearly having traded and seeing what an external shock can do gave me a greater appreciation for what could happen prior to the recent crisis.
Becoming involved with various aspects of a business has certainly helped me. I have worked predominantly in insurance but I have worked in many different areas such as finance, risk, underwriting, claims, and consulting, which have all helped me in some way.
Reading is also very important. I mostly read about finance and economics, but I also study probability, science, philosophy, and history. There really isn’t any limit to what you can learn and therefore how deeply you can expand your knowledge base or circle of competence. To me, a circle of competence can be applied not only to investments, but also to careers, business and a host of other areas. The same applies to the other value investing principles of conservatism and margin of safety.
Q. You have met many of the top value investors. What is the key trait that separates the “best from the rest”?
A. Their discipline, they are fanatical about discipline. They never lose sight of their circle of competence, of who they are as investors, or of what they are trying to accomplish and their long term track records bear this out: Buffett, Gabelli, Klarman, and Julis have been doing this for many years and yet they remain extremely successful, and as such are role models for us all.
Q. What is the number one mistake that investors make?
A. They are looking to make a 10,000% return. You see these junk mailings every year – local dentist makes a 10,000% return using some type of system. In fact, there are no such systems; there are only ways of investing and ways of speculating. Furthermore, randomness tells us that given the amount of people looking to hit the proverbial “long ball” each year someone will get lucky. However, if that’s your motivation for investing then you’ll have more fun in a casino or at a horse track than in the markets. Value investing is not gambling or even speculating, it is leveraging an information advantage via the circle of competence to identify and buy under-priced businesses.
Another area where some investors slip-up is thinking that investment is easy. Incredibly, Warren Buffett has in some ways fostered this type of thinking by talking about making “gut” investment decisions. That may be true at the moment of decision, but it doesn’t take into account all of the work Buffett did before making the actual decisions. As I hope my book shows, there is a lot of work that goes into value investing, and it is not easy. Nevertheless, it can be very enjoyable and rewarding.
Q. I think all of the value investors you have mentioned would have the same career regardless of their pay. This isn’t a case where many smart minds studying to become doctors decided to start hedge funds. I also have to say, these guys regardless of their intelligence like to think and value companies. Whereas the efficient market hypothesis often times prevents even smart guys from thinking for themselves.
A. You make a good point: loving what you do is a great way to be successful in investing, or anything else for that matter.
Regarding efficient markets, value investors have been attacking that theory pretty much since it was introduced. Hopefully, the experience of the recent credit crisis will put an end to that theory once and for all. I think Soros’ theory of reflexivity is a much better, and more practical, theory of market behavior and as such I would like to see researchers (academic and practitioner alike) take more of an interest in it.
Q. What advice would you give to a young guy who has just picked up "The Intelligent Investor"?
A. Follow what you love to do, develop a circle of competence, and start implementing it. If you do not have money to invest, paper trade and keep a diary. It is better if people find their passion early when they have few responsibilities; if that passion is value investing, and if you are willing to study and work diligently, then as you develop there is no reason why you can’t follow in Graham and Dodd’s, and Buffett’s footsteps.
Q. Thank you for taking the time to answer our questions.
A. You're welcome, I enjoyed it.