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Interview with an Aspiring Value Investor (Part 2)

This is the second part of my interview with Miguel Barbosa of Simoleon Sense:

1.       Given your background, how do you look at real estate?

 

I know this is going to sound a bit strange to people who only started looking at real estate during the boom, but I look at real estate more like a bond than a stock. In other words, instead of thinking of real estate as a rapidly appreciating asset, I look at rental income as being similar to coupon on a bond. When my family invests in real estate, we don’t think about how much more we are going to sell it for in the future. What we try to figure out is how much we can rent it for, what kind of yearly increases we can negotiate, and how much time and capital need to be put in on an ongoing basis. Obviously, during the boom people weren’t interested in stable tenancies and leases that protect against the downside. They looked at real estate as if it were as liquid as stocks and thought properties should appreciate as fast as equities often do after a market correction. However, in periods when there is not excessive speculation and leverage entering the real estate market, these assets are slow growth vehicles. In theory, they should not grow any faster than the rate of increase in rents. Accordingly, when commercial real estate and housing finally do bottom, people should not expect values to recover for many years. Anyone who is holding onto a piece of real estate until the market “comes back” will likely be waiting a long time unless the Fed is able to create another asset bubble.

 

2.       What has the financial crisis taught you, especially when it comes to investing? How have you evolved as an investor?

 

I think when I look back on this period of my career, I will be very thankful that I cut my teeth in such adverse market circumstances. It’s much better to learn certain lessons now (when there are only a few zeroes involved) than when the stakes are much higher. The crisis has just reinforced my view of the role of a manager. As Howard Marks so eloquently says, the duty of a money manager is to protect capital and manage risk. It is really that simple. If you focus on a margin of safety, have disciplined buy and sell requirements and strategically hedge downside risk, you are fulfilling your fiduciary duty as a money manager. Along the same lines, it is imperative to remember that leverage is a killer. The common denominator in every bubble I have ever examined is excessive leverage. I am currently reading a book called Funny Money (by Mark Singer) that is about the oil lending boom in Oklahoma and Texas that led to the notorious failure and bailout of Continental Illinois. This episode represented the beginning of the too big to fail era among banks that obviously still exists today and basically defined what moral hazard would look like going forward. I’m sure you will not be at all surprised to learn that root cause of the bank’s flameout was too much and too rapid lending combined with inadequate analysis of credit. Does that sound familiar?

 

3.       What financial issues concern you the most?

 

Oh my, I really don’t want to depress the readers! Anybody who follows me knows that I am quite bearish in the short run but am also legitimately concerned about the long run ability of the US economy to remain vibrant and innovative. I think we have structural imbalances that need to be addressed and it makes me sick that the leaders of this country seem unwilling to face these issues. You have to remember that I am not an economist so this is not my specialty. However, it seems to me that America became a “too much and too many” country over the last 30 years or so. We have too much debt, too many stores, too many banks, too many dodgy loans, too many cars and too many big houses. We use too much energy and we pollute too much. Unless the Fed and Obama can find a way to prolong the necessary day of reckoning, I believe we may soon find ourselves living in a “too little and not enough” country. In retrospect it will be clear that we saved too little, put too little money into Social Security, invested far too little in education and did not do enough to address climate change and health care reform. I really hope that I am wrong but I am not as optimistic as Buffett is that future generations of Americans are guaranteed to enjoy a better standard of living than we do.

 

4.       Do you have an opinion about inflation/deflation?

 

I think this is probably the most fascinating debate going on right now and the eventual outcome will likely be the main determinant of what asset classes perform and underperform over the next decade. My current view is that at least temporarily we have seen a bizarre combination of commodity price increases, severe credit contraction and wage deflation. This seems to me to be a particularly insidious cocktail and is why Main Street is struggling so much. In the short run, despite the Fed’s attempts to pump liquidity in the system I see deflation as a much more relevant risk. But in the long run it is hard for me to see the Fed exiting their money printing in a smooth way that somehow prevents inflation and simultaneously avoids stifling a recovery. The Fed is kind of like a bull trying to walk out of a china shop. Yeah, maybe it doesn’t break all the plates but it sure leaves some collateral damage in its wake. I guess I don’t share the blind faith that the Fed can be precise in its monetary policy. So, I’m not sure if Marc Faber and Jim Grant are right about the possibility of hyperinflation, but it is hard for me to see how the dollar and our purchasing power are not the eventual casualties of the Fed’s doubling of its balance sheet.

 

 

 

5.       Where do most value investors screw up?

 

 

I like to think that the recent turmoil in the markets will separate true value investors from what Klarman calls value pretenders. The latter are investors who only knew appreciating markets, never really considered intrinsic value and thought that buying dips was the same thing as value investing. In a Darwinian kind of way this crisis could have a silver lining, at least in terms of separating the truly skilled from those who benefitted from the rising tide.

 

When it comes to legitimate value investors, I think there are two common mistakes. The first is thinking that a stock can really be market agnostic. When there is either excessive euphoria or extreme fear in the markets, stocks that should not be correlated to one another seem to move in the same direction. The appropriate lesson is not to become a closet macro fund and try to time economic cycles. The answer is to be like Klarman: focus on company specific analysis but make sure that the macro environment is not unambiguously going another direction. Second, I think that value investors are often too quick to trust the markets to close the gap between intrinsic value and price. I am not suggesting that we all become technical analysts, but it is important not to forget that certain exogenous forces can have a tremendous impact on the markets. Last year we saw what forced and panic selling can do to stock prices and this year we have seen how Federal Reserve liquidity injections can turn a market speculative just about overnight. So I think it is useful to be at least aware of ways that overall market distortions can affect the process of value realization, especially with the number of players out there who have the incentive to manipulate the market.

 

6.       You have a reputation as a diligent & structured investor. Tell us about your use of checklists.

 

I am a huge fan of checklists. I soon need to sit down and write down every metric that I evaluate about a specific company. Right now my checklist exists in my mind and on an Excel spreadsheet template that I use for just about every company.   Don’t get me wrong, this is not a DCF model with specific assumptions about growth and an arbitrary terminal multiple. I clearly understand the false precision that comes with such models. I just like to aggregate all the quantitative information--from margins to insider ownership to valuation metrics—in one place. It really helps me frame the company before I engage in a longer write up in which I include the qualitative factors as well. The benefit of this strategy is that it forces me take a very comprehensive view of a company. For example, let’s say a company has an interesting product or division that you think is under appreciated by the market. Without calculating the operating margins for each subsidiary you might not notice that this very profitable division is being dragged down by a low margin business that just sucks up capital. So, even though the number of items on the checklist can lead to a bit of informational overload, I firmly believe that it helps me avoid overlooking important characteristics.

 

7.       What single trait is most important to cultivate in order to be a successful investor?

 

Without question being a successful value investor requires a certain temperament. It is very hard to be greedy when others are fearful. Humans are not wired to be contrarians. We like the safety of the herd. Value investors measure the magnitude of an opportunity based on how sick they feel when they make the actual investment. The more consternation establishing a position causes, the better the returns are likely to be. Accordingly, developing an even temperament in which you don’t get excited when stocks are going up or get downtrodden when your positions are moving against you requires a significant amount of discipline.  While I do think some people are predisposed to being able to control their emotions and stick to their investment philosophies, it absolutely takes practice. Even some of the best investors became paralyzed during the free fall in equity markets during the early part of this year and the ones who have been the most successful loaded up on stocks they had strong convictions about during that period. So, as Warren Buffett has said: “By far, the most important quality is not how much IQ you’ve got. IQ is not the scarce factor. You need a reasonable amount of intelligence, but temperament is 90% of it.” Along the same lines, I don’t know if I can take credit for making this up but my mantra is to be passionate about the markets but to invest dispassionately. I think if I can follow that I will end up being an accomplished investor.

 

8.       What is the hardest bias for you to overcome?

 

In my case, I am constantly fighting to avoid becoming a victim of confirmation bias. I am definitely guilty of searching out information that agrees with my philosophies and views on the markets. I also often too easily dismiss opinions that are contrary to mine and too readily accept those that mesh with my views. Accordingly, I make a concerted effort to read anything I can find that offers the other side of an argument. Even though it feels just as painful as being outside of the herd, it forces you to understand the contrarian position in a way that can help you make better decisions.

 

9.       Where do you see yourself after business school?

 

My goals are very simple. After I graduate I hope to have the opportunity to work for a value fund in which I have access to a portfolio manager who is willing to be my mentor. I anticipate that my research skills will get better with more practice. However, I have never had the luxury of being able to watch a skilled value-focused manager navigate the markets. It is not hard to analyze individual stocks. Managing my own portfolio is a challenge, but nowhere near as nerve wracking as managing other peoples’ money. Thus, if I am lucky I will be able to find a job with a value manager in which I can spend a lot of time observing and learning how to run a portfolio day to day. Eventually my goal is to be a portfolio manager myself and the dream is to run my own fund. I am aware that I am probably many years from reaching that milestone and have more to learn than I can possibly even describe. But I look at business school as a conduit for developing relationships that will help me along the way. I also plan to continue doing a significant amount of company specific research outside of the classroom so I can continue to further my skill set.

 

10.    What message/advice would you give to readers of SimoleonSense?

 

My advice to readers is to look in the mirror before you decide how to allocate your precious capital. Investing is black and white in one way: either you have the skills and time to become a professional investor or you don’t. Honestly, while I hope I am qualified I am still working every day to figure out which camp I fit in. The truth is that it is OK if you don’t have the time, the temperament or the skills. You have plenty of wonderful value managers that you can entrust with your money. You can also buy an index and do better than most mutual fund managers. Managing a portfolio of individual companies is a full time job. Please, never forget that. The attention to detail and time required to follow and understand a portfolio of stocks are not trivial. If you cannot perform deep and comprehensive bottom’s up analysis on specific companies I would suggest that you are better off letting someone else manage the equity portion of your portfolio.  I worry that CNBC and Jim Cramer lead far too many people to think this is a game that anyone can play. It is unquestionably not. Just like you wouldn’t want someone performing open heart surgery on you after watching a TV show about doctors, you should not be trying to pick individual stocks after doing a minor amount of research. Let someone who will act as your fiduciary do that for you. 

  1. Thank you very much for taking the time to interview with us.

Thanks for the wonderful opportunity to present my ideas. I hope everyone finds my responses valuable. I look forward to having another chance to share my thoughts with your readers.


(Dislcosure: No Positions)