words of investing wisdom - value investor · pdf filewords of investing wisdom finding an...

Finding an Edge

Field of Play

Uncovering Value

Research and Analysis

Portfolio Management

Learning Curve

Of Sound Mind

The Craft of Investing

Value Investor Insight 2Winter 2008 www.valueinvestorinsight.com

While we certainly believe there arecore principles upon which sound invest-ments are made, it’s equally clear that,like snowflakes, no two investing strate-gies are exactly alike. Equally talentedand accomplished investors can view thesame investment opportunity in preciselyopposite ways. That’s a central reason welaunched Value Investor Insight fouryears ago (and SuperInvestor Insight twoyears ago), to help inform the ongoingdevelopment of our readers’ own uniqueinvestment strategies with the experience,wisdom and ideas of a wide variety ofsuperior investors.

The differences in strategy and styleamong value investors are many: Someinvest primarily in small-cap stocks whileothers stick to large-caps; some investoverseas while others stick to U.S. mar-kets; some run concentrated portfolioswhile others are more diversified; someare activists while others never are; someare long only while others actively short.The list goes on.

At the same time, there are severalfundamental characteristics that value

investors tend to share as well. We’veidentified an even dozen:

» They tend to buy what’s out of favorrather than what’s popular.

» They focus on intrinsic company valueand buy only when there is a substantialmargin of safety, rather than trying toguess where the herd will go next.

» They understand and profit from rever-sion to the mean rather than projectingthe recent past indefinitely into the future.

» They understand that beating the marketrequires a portfolio that looks differentfrom the market.

» They focus on absolute returns, ratherthan outperforming a benchmark, and onavoiding permanent losses.

» They typically invest with a multi-yeartime horizon rather than focusing on themonth or quarter ahead.

» They pride themselves on in-depth andproprietary analysis in search of “variantperceptions,” rather than acting on tips orrelying on Wall Street analysts.

» They spend far more time reading thingslike business publications and financialreports than watching the ticker or televi-sion shows about the market.

» They focus more on analyzing and under-standing micro factors, such as a compa-ny’s margins and future growth prospects,and less on trying to predict the directionof interest rates, commodity prices or theoverall economy.

» They cast a wide net, seeking mispricedsecurities across industries and types andsizes of companies rather than acceptingartificial limitations on market capitaliza-tion or other criteria.

» They make their own decisions and arewilling to be held accountable for them,not seeking safety in what everyone else isbuying or decision-making by committee.

» They admit their mistakes and seek con-stantly to learn from them.

It’s in this spirit of continuous learningthat we offer this collection of wisdomfrom the pages of each of the 46 issues ofValue Investor Insight, celebrating boththe similarities and differences in how thebest investors apply their craft.

TOPICS INCLUDE:

John HeinsCo-Editor-in-Chief

Whitney TilsonCo-Editor-in-Chief

Words of

Investing WisdomA “Greatest Hits” collection of investing insight from Value Investor Insight

EDITORS’ LETTER:

03 Finding an Edge

“Efficient” MarketsConcept of Time

05 Field of Play

Circle of CompetenceDoes Size Matter?Sector InsightGoing Abroad

11 Uncovering Value

Where the Values AreIdea Generation

15 Research and Analysis

The Research ProcessAnalytical Rigor Management EducationDefining Value

23 Portfolio Management

Active ManagementBuying and SellingConcentrate or Diversify?Managing RiskGoing to CashThe Short SideActivism

33 Learning Curve

37 Of Sound Mind

40 The Craft of Investing

The Big PictureInvestor as ManagerFinding Motivation

http://www.valueinvestorinsight.com

Finding an EdgeW O R D S O F I N V E S T I N G W I S D O M


“EFFICIENT” MARKETS

So if the entire country became securitiesanalysts, memorized Benjamin Graham’sIntelligent Investor and regularly attend-ed Warren Buffett’s annual shareholdermeetings, most people would, neverthe-less, find themselves irresistibly drawn tohot initial public offerings, momentumstrategies and investment fads. Peoplewould still find it tempting to day-tradeand perform technical analysis of stockcharts. A country of security analystswould still overreact. In short, even thebest-trained investors would make thesame mistakes that investors have beenmaking forever, and for the sameimmutable reason – that they cannothelp it.

Seth Klarman, 3.23.05

Human beings are subject to wild swingsin their levels of fear, risk tolerance andgreed. That won’t change. I base mywhole approach on buying when othersare fearful and selling when others aregreedy. The reason Shakespeare is so rele-vant still today is that his plays were allabout human nature, and human naturenever changes.

Mark Sellers, 6.19.05

“Humans have a strong desire to be partof a group,” says Legg Mason equitystrategist Michael Mauboussin in a 2004research paper that dissects howinvestors make decisions. “That desiremakes us susceptible to fads, fashionsand idea contagions.”

VII, 9.28.05

On the behavioral-finance side, one ofmany inefficiencies comes from peopleanchoring on the past. People assumesomething is cheap, say, just because it

hasn’t traded at such a low valuation forfive or ten years. But that doesn’t matter,what matters is what will be.

Ric Dillon, 6.29.07

We always ask whether we ourselveshave any competitive advantage in ana-lyzing a particular company. Can weknow the business better because no oneelse seems to be paying attention? Is themarket’s view being distorted by somebehavioral or structural bias that wedon’t have?

Brian Bares, 9.30.08

The reason [GE traded at $55 in 2001]was because I’d estimate that 95% of thedollars invested in the U.S. stock marketwere either indexed or closet indexed –people had to own it to keep up with thebenchmark. If they thought it was over-valued, their response would be to maybebuy only a 3% position rather than the4% weighting in the benchmark. That’sthe type of irrational behavior that cancreate inefficiency.

Ric Dillon, 6.29.07

Investors overreact to the latest news,which has always been the case, but Ithink it's especially true today with theInternet. Information spreads so quicklythat decisions get made without particu-larly deep knowledge about the compa-nies involved. People also overemphasizedramatic events, often without checkingthe facts. It's the classic, “Are more peo-ple killed each year by sharks or by beingtrampled by pigs?” type of situation – thedramatic event can get more play than itdeserves. These types of overreactions arewhat we're trying to take advantage of.

John Dorfman, 10.31.08

One way of dealing with informationbeing more available is to stop playing thegame and seek out securities or assetclasses where there’s less information orcompetition.


Wall Street’s view is that if you don’tmake your projections, you’re a bad per-son. That’s because they don’t want to dothe hard work of making their own pro-jections to see if the company’s projec-tions make sense.

Richard Pzena, 2.22.05

Wall Street sometimes gets confusedbetween risk and uncertainty, and youcan profit handsomely from that confu-sion. The low-risk, high-uncertainty [sit-uation] gives us our most sought aftercoin-toss odds. Heads, I win; tails, I don’tlose much!

Mohnish Pabrai, 6.29.07

CONCEPT OF TIME

It’s still true that the biggest players in thepublic markets – particularly mutualfunds and hedge funds – are not good attaking short-term pain for long-termgain. The money’s very quick to move ifperformance falls off over short periodsof time. We don’t worry about headlinerisk – once we believe in an asset, we’rebuying more on any dips because we’refocused on the end game three or fouryears out.

Jeffrey Ubben, 1.31.06

I like to talk about the long term withmanagement because that’s how you real-ly determine if someone is going to createbusiness value. Most stocks are reason-ably priced in the short term – it’s thelong term where you’re most likely to put

Finding an Edge


Finding an EdgeW O R D S O F I N V E S T I N G W I S D O M


a different probability on something hap-pening than someone else does.

The human brain is incapable of concep-tualizing something vastly different fromwhat the situation is today. But thebiggest-money ideas are those where thechanges are far beyond what you canconceive today. The closer you can get toconceiving those types of changes andthe higher the probability they mighthappen, the more likely you are to findbig winners.

Lisa Rapuano, 9.28.05

Lack of visibility on timing is one of thebest things you can have as an investorwith a long time horizon. We love situa-tions where it’s very difficult to model thisyear’s earnings.

Ken Shubin Stein, 2.28.06

Time is our friend. Today there’s so muchmoney chasing quarterly performance ordriven by program trading, index fundsor ETFs. That leaves a real opportunityfor fundamental investors like us who arelooking out two to four years to findinflections in businesses which aren’t cur-rently appreciated by the market.

Joe Wolf, 4.30.07

Time arbitrage just means exploiting thefact that most investors – institutional,individual, mutual funds or hedge funds –tend to have very short-term time hori-zons, have rapid turnover or are trying toexploit very short-term anomalies in themarket. So the market looks extremelyefficient in the short run. In an environ-ment with massive short-term data over-load and with people concerned aboutminute-to-minute performance, the ineffi-ciencies are likely to be looking outbeyond, say, 12 months.

Bill Miller, 6.19.05

Because enough people in the marketthink they’ll get fired for buying some-thing that might be a year away from get-

ting better, that provides real opportunityfor people who aren’t worried about that.

Jeffrey Bronchick, 1.31.08

I’ve read that the average holding periodon the New York Stock Exchange is ninemonths, which I don’t even considerinvesting. Over such a short period oftime you’re just betting on the overalldirection of the market or on the nextquarterly earnings.

Aaron Edelheit, 1.31.08

We’re catalyst-driven on both the shortand long sides, so we generally look outonly one or two years for the thesis toplay out. I was brought up in the businessto be skeptical of big, long-term discount-ed cash flow models, so that’s not animportant part of how we invest.

Steven Tananbaum, 9.28.07

Most investment institutions define suc-cess as having a good result in each andevery discrete time period, so it’s quitelogical that people in those institutionslook to buy stocks that will do well fromthe current moment in time until, say, theend of the year. As a result, favorableoccurrences such as positive earningsreports or value-realization events thatare highly probable, but not likely to

occur within the discrete time period, arediscounted at a fairly remarkable rate.Those kinds of inefficiencies, if anything,are more common than they were whenwe started out 13 years ago.

Murray Stahl, 11.21.07

The most important change in my 40years of investing has probably been ininvestors’ time horizons. Today themajority of investors – Ben Grahamwould call them speculators – are focusedso closely on this week, this month andthis quarter. Stocks are bought and soldon penny deviations from short-term esti-mates, which is mind-boggling. Crazy asit is, we can’t complain – it just createsmore opportunities for investors withlonger time horizons.

William Nasgovitz, 9.30.08

We have no problem buying things thattake a long time to play out. Call me lazy,but I don't want to worry about lastweek's same-store sales or next week'soil price.

Jeffrey Schwarz, 5.30.08

A[n] argument is made that there are justtoo many question marks about the nearfuture; wouldn't it be better to wait untilthings clear up a bit? You know theprose: “Maintain buying reserves untilcurrent uncertainties are resolved,” etc.Before reaching for that crutch, face upto two unpleasant facts: The future isnever clear [and] you pay a very highprice for a cheery consensus. Uncertaintyactually is the friend of the buyer of long-term values.

Warren Buffett (quote from Forbes),4.30.07

I have a ready answer when people askme why I’m such a long-term investor,which is because I failed miserably as ashort-term investor. I’m not against mak-ing money in the short term, I just don’tknow how to do it.

Thomas Gayner, 12.21.07

If I knew how to get rich quick,would I be sitting on a mountain-top all day?


Field of PlayW O R D S O F I N V E S T I N G W I S D O M


CIRCLE OF COMPETENCE

Stepping outside your areas of compe-tence is often a seductive siren song, butwe’ve learned from experience not to lis-ten anymore. Without the confidence thatcomes from experience and the ability torecognize patterns, the risk is higher thatyou’ll overpay or sell too soon in a panic.

Shawn Kravetz, 12.30.05

Over short periods of time, you can dothe wrong thing and make a lot of moneyand do the right thing and look like anidiot. We try to stick to what we do welland not get too caught up in what's“working” at any given moment. In thelong run, that sort of discipline will keepyou from blowing up.

Phillip Goldstein, 3.31.08

Most people say they want to stay withintheir circle of competence, and that’ssmart. But there’s no reason to say“Here’s my circle of competence and,guess what, it’s never getting any biggerbecause I’m not going to learn anythingnew.” We’re trying to understand newthings if we can.


The article closes with a telling anecdotefrom a Wall Street banker recalling a din-ner with Buffett in Manhattan: “He hadan exceptional ham-and-cheese sandwich.A few days later, we were going out againand he said, ‘Let's go back to that restau-rant.’ I said, ‘But we were just there’ andhe said, ‘Precisely. Why take a risk withanother place? We know exactly whatwe're going to get.’ And that is whatWarren looks for in stocks too. He onlyinvests in companies where the odds aregreat that they will not disappoint.”

VII, 12.22.06

DOES SIZE MATTER?

Our strategy from the beginning has beento focus on areas where we believe we canhave some advantage, where there is agreater prevalence of irrationality andhigher likelihood of mispriced assets. Forus, that’s not going to be investing inMicrosoft or in some quantitative strate-gy against a room of Goldman Sachs’Ph.D.’s with Cray supercomputers. Wehave to be guerrilla investors, lying in theweeds and picking off opportunitiesamong the obscure and mundane. Thatusually means small, ignored companiesthat no one else is talking about.

James Vanasek, 4.30.08

The core of our experience and successhas been in companies with market capsfrom between $200 million to around $2billion. Small-cap investing can be morelabor intensive due to the sheer number ofcompanies, but at the same time you canmore quickly know just about everythingyou need to know about a company tomake an investment judgment. I can’t saythat in looking at a company like AIG,for example.

Philip Tasho, 9.28.07

Our strategy works best with smaller-capstocks. Multiples tend to contract furtherwhen small companies mess up thanwhen large ones do, so there’s more roomon the upside when a small companygrows out of a turnaround. I’d also arguethat it’s generally quicker and easier for asmall company to be turned around,which improves your chances of invest-ment success.

Kevin O’Boyle, 11.21.07

Our sweet spot tends to be in the $2-3billion range, where the companies are

clearly established but can still be underthe radar. We also can get a lot morebang for the buck in companies that sizefrom the initiatives we see adding value.

In my experience, it’s harder for a $30 bil-lion company to add $10 billion in valuethan it is for a $3 billion company to add$1 billion in value. We’ve bought biggercompanies in the past, but I can’t saywe’ve been very good at it. It’s just toohard to have an informational edge.

Robert Lietzow, 2.29.08

We try to be cap-agnostic, but we dowant businesses that are easier to under-stand, and smaller to mid-size companiesare generally easier to understand. Theyhave fewer divisions and we can usuallyget more of our questions answered.

Steven Romick, 7.31.08

We want to maintain the discipline thatwe will invest in a company, regardless ofsize, if it meets our criteria. Part of that isbecause we learn from all the companieswe own. Part of that is because it keepsus fresh and engaged and not stuck in therut of looking at the same 100 companieseveryone else is. We also take the posi-tion that a penny more in return for ourshareholders than we would have hadotherwise is a penny worth having. Ifsmaller-cap companies can give us that,we’ll buy them.

Clyde McGregor, 4.30.08

SECTOR INSIGHT

Our “trifecta” is to identify companieswith increasing returns, growing cashflows and an ability to reinvest profitably,which is what we see in natural resourcestoday. The phenomenon of 300 millionpeople moving to the middle class inChina is going to have a dramatic impact

Field of Play




on the commodity intensity of that econ-omy and the world. I believe that’s theinvesting story of this decade and beyond.

Andrew Pilara, 4.30.07

The physics make sense to us that this isa resource that’s being used up. Everymajor field outside of Saudi Arabia is indecline. Those people who talk aboutthis endless supply of oil regeneratingand bubbling up from the center of theearth, where is it? We started workingthrough the alternatives: nuclear power,solar, wind, oil shale, coal-to-gas. I mademyself crazy one weekend trying to fig-ure out the potential for ethanol. All ofthese have their own problems – fromsafety, to capacity constraints, to cost, tolead times – and it’s going to be hard forany of these to compete with oil even attoday’s prices.

Bruce Berkowitz, 4.28.06

Given energy’s commodity nature, it’s allabout how [energy-company] manage-ment allocates capital in a capital-inten-sive business. What’s interesting is thatthe survivors in the worst times are theones who are thriving now when timesare good. It gets back again to managingthrough tough times, which I find a fasci-nating process to study.


We’re very constructive on natural-resources businesses over the next five toten years. We look for situations wherethere is a steepening of cost curves andthe discrepancy between structurallyadvantaged assets and the marginal pro-ducer is increasing over time. We seethose in any number of different com-modities markets today. I’d argue that thecost or otherwise advantaged natural-resource company has a bigger andlonger-lived advantage versus its competi-tion than in almost any other segment ofthe economy.

MacKenzie Davis, 12.21.07

I believe the service companies are moreattractive than producers in the currentenvironment. Whether oil is $40 per bar-rel or $70 per barrel, I’d argue it’s notgoing to have that much impact ondemand for services. Many of the big oilcompanies have declining reserves andwill be desperate to add reserves. To dothat, they’ve got to spend on finding anddeveloping new production or gettingmore production out of what theyalready have.

Robert Robotti, 8.25.06

The lack of investment in developingenergy resources was so profound for solong that we expect to see inelastic, high-er prices for a very long time, regardlessof the fall in oil prices of late.

John Burbank, 8.31.08

The entire energy sector appears to beattractively priced right now, so our focusis on the stocks offering the best relativevalue and those that may have other cat-alysts than oil prices that will cause theshare prices to move.

Edward Maran, 10.31.08

We still don’t believe long-term, market-clearing oil prices have moved to a levelsubstantially higher than $40. I know itsounds silly because that’s barely half ofwhat prices are today. But if the oil com-panies themselves believed the long-termprice was much above $40, they would be

investing more in trying to find newsources of oil and gas. On the industrialside, companies are not making energy-saving investments that require $50-60oil to pay off. If these investments onboth sides were being made, we believeyou’d see tremendous oversupply –demand would fall sharply and supplywould go up significantly.

Bill Nygren, 7.28.06

I was surprised to read even smart peoplelike [Princeton economist and New YorkTimes columnist] Paul Krugman say oilcouldn't be in a bubble because there wasno stockpiling. That to me showed a dis-tinct lack of understanding of what wasgoing on. Companies were, in effect,stockpiling quite aggressively by notextracting oil that was economicallyviable. That stockpiling in the ground, soto speak, created a speculative bubblethat we expected to burst, set off by adownturn in the economy.

James Montier, 10.31.08

I love the videogame business. It’s a high-margin, high free-cash-flow business withremarkable installed-base growth. There’sa gigantic secular tailwind behind thisbusiness, which is unstoppable. We’re inthe midst of a massive change in theworld of media, broadly defined, andvideogames will continue to take timeaway from old media. People of the prop-er investment age don’t get it, so it’sunlikely for this change to be fully dis-counted in share prices.


Educational systems are generally gearedto educate the elite, not the masses. Butthe industrial economies of the past,where you just needed a few highly edu-cated people while the vast majority ofpeople were working on production linesor delivering stuff, are being turned ontheir heads. Now nearly the entire popu-lation needs training and education thatgoes past age 18. So there’s no questionthe sheer number of students is going to




increase dramatically, and somebody hasto house them. Even if you’re just aver-age, you’ll be getting students throughyour doors. If you’re very good, and even-tually people recognize that, that’s onlygoing to make the demand for your edu-cational services that much better.

Guy Spier, 4.27.05

I’m convinced television programming isgoing to go over the Internet, an open sys-tem that’s the most efficient distributionnetwork ever created. Everybody will beselling broadband access as a commodity.In such a world, a cable or satellite com-pany packaging channels with somechoice but not much and charging you40% off the top is insane.

At the end of the day, the cable companyis the middleman. In a digital world, mid-dlemen margins get crushed, because themarginal cost of transmitting a bit ofinformation is zero. If you’re a middle-man with a closed architecture, you’re introuble. You might not feel it in 2006 oreven 2008, but longer term you’redoomed.

James Chanos, 7.29.05

The secular trend in healthcare is cost-containment. How do you slow thegrowth in the total cost of healthcare as apercentage of GDP? The convergence ofsecular trends in healthcare will not bepositive for big pharmaceutical compa-nies. It has been and will be positive forcompanies like Aetna and UnitedHealthcare. The cost structures of compa-nies that have earned excess returns fordecades don’t reflect a lot of competition.That’s where the danger is when the secu-lar trends change – because these compa-nies have a culture that doesn’t knowhow to compete – but it’s also the oppor-tunity when someone comes in andchanges things.


Coach, which we originally bought in2002, is the poster child of tapping into

this global trend of consumers wanting totrade up in the quality and style of whatthey buy. Through strong or weakeconomies, we think that companies thatprovide affordable luxury, who give theaverage person the chance to indulge in aspecial treat, will be extremely wellrewarded in years to come.


There is something inevitable to me about“positional” goods. Once you’ve provid-ed for your basic needs, you start tomarch up the consumption curve and it isoften the more traditional brands thatattract the consumer as he reaches a newposition in life. The more you prosper, themore narrow the universe of itemsthrough which you can express yourprosperity.

Thomas Russo, 6.30.06

We believe the U.S. is already heavilyover-stored, so retail has become more ofa zero-sum game – one company’s successis at the expense of another. We alsobelieve that after 15 years of spendinggrowth, the American consumer is trulytapped out.

Jean-Marie Eveillard, 5.30.08

We think it’s hard to play where itappears the class-action lawyers have apermanent goal to destroy the industry,such as in tobacco or handguns. I’ve hadlong discussions with friends of mine, forexample, about Philip Morris [owned byparent company Altria]. I just can’t imag-ine all the prohibition against smoking inthe U.S. – in restaurants, bars, officebuildings – all the added taxes and all thelitigation risks aren’t going to be a prob-lem for the stock. Of course, my friendshave so far been right and I’ve beenwrong. These are just risks that we’vedecided to avoid.

John Rogers, 11.30.05

Another example [of a high barrier toentry business] would be the defense

industry. It’s very hard to get a govern-ment contract, not because the govern-ment doesn’t entertain new entrants, butbecause the rules of bidding require assetsin place in order to bid. If you wanted tocompete with Boeing on the B-1 bomber,you’d have to build an entire facility andhire all the necessary engineers and pro-duction people to assure the governmentyou could actually build a better B-1bomber – all just to enter a bid that youmay never win. That’s a positive situationfor a company like Boeing.


We’re focused on four sectors that haveexhibited unvarying demand regardless ofeconomic activity and that have key fun-damental strengths that help explain whythey’ve been around for hundreds ofyears. The inherent demand of people tosmoke, drink and gamble and of nationsto arm themselves is clearly strong andlong-lasting.

Charles Norton, 4.30.08

I first got interested in technology stocksafter watching things like MicronTechnology go from $20 to $40 to $20 to$40 to $20 to $40. The cyclicality inmany of these businesses can be more reg-ular than is often believed, so it’s possibleto buy on the down leg of a cycle becausethere will inevitably be an up leg.

We’ve also had considerable success inbuying technology companies that havegreat balance sheets. Companies like thishave the flexibility to invest in new initia-tives, buy new technology and invest inresearch and development. Even if theyaren’t profitable today, you have thepotential for a gold mine if the businessturns around.

John Buckingham, 8.31.07

We don’t do a lot in technology.Successful technologies change some-thing, creating an efficiency or demandthat wasn’t there before. But the very factthat the change happens means that




somebody else can come along andchange it again. If, because of the threatof technological obsolescence, I’m uncer-tain about a company’s cash flows sever-al years out, I’ll put a big discount onthose cash flows and conclude they’renot worth much. Because Wall Streettends to put a large value on the futurecash flows of technology companies, werarely find one that we consider veryattractive.

Ed Wachenheim, 2.29.08

Real estate is a natural for a value-invest-ing firm like Third Avenue. Real estatecompanies typically have identifiablehard assets that are relatively easy tovalue based on a sum-of-the-parts analy-sis to arrive at a net asset value you cancompare with the current stock price.

Michael Winer, 8.31.07

We’ve never been that fond of the hotelbusiness because the tenants move outevery night. That makes the businesssusceptible to economic swings in a waythat office buildings with long-term leas-es to credit-worthy tenants aren’t. Weprefer to see more predictable streams ofcash flow than lodging companies typi-cally have.

Michael Winer, 8.31.07

Gold kind of scares me because veryoften the people involved with it seem tobe slightly insane. My other problem is Idon't know how to value it. That said, Ican certainly see why gold could be con-sidered somewhat of an insurance policy,if not an investment in its own right. Anykind of systemic economic turmoil islikely to drive gold prices higher.


We don’t look at gold as a commodity,but as a form of insurance against whatPeter Bernstein calls extreme outcomes.In most circumstances in which world-wide equity markets would go down –and not just for a week or two – the price

of gold would go up, providing a partialoffset to the hits we’d take in our equityportfolio.


I find it almost sickening what has beendone to the country’s balance sheet,which is only going to get worse as thegovernment tries to spend its way out ofour many and varied problems. In thatkind of environment, we believe gold as astorehouse of value will come to evengreater prominence.


There's a saying that you should not con-fuse a clear vision with a short distance.We're willing to own gold even though itmay not act as a hedge in the near future,because we have a fairly clear visionabout what will happen to inflationthree, four or five years out, and it's nota pretty sight.

Charles de Vaulx, 11.26.08

I have always had an affinity for compa-nies that actually make things. We favorcompanies with transparent businessesthat we can understand fairly quickly andthose that have large and recurring main-tenance, repair and overhaul revenuesfrom an installed base, such as elevatorcompanies or aerospace-parts firms.

Alexander Roepers, 2.28.07

We don’t like businesses that are com-pletely reliant on human capital that canwalk out the door. We have no ruleagainst it, but you generally won’t find usinvesting in things like investment banksor consulting firms.

Donnell Noone, 4.30.08

We’ve invested for a long time in themutual-fund industry, for example, andclearly see it as within our circle of com-petence. Our experience with the long-term track records of companies like T.Rowe Price or Franklin Resources leads

us to believe they can more than deal withsome ups and downs.


My law of money management profitabil-ity says that because of fee structures, therate of return a money manager gets onits capital is, by definition, better than therate of return the client gets on his capi-tal. If you find stocks that are desirable,you’d be better off buying the moneymanager holding those same stocks thanbuying the stocks themselves.


GOING ABROAD

From day one we've had a significant por-tion of our assets invested outside theUnited States – it's currently about 30%of our gross exposure. This is probablytoo broad a generalization, but in ourview non-U.S. markets tend to be less effi-cient than the U.S. market. In an idealworld, I'd like to be more selective in theU.S. and take advantage of more oppor-tunities outside the U.S.

Lee Ainslie, 12.22.06

With the tremendous run in internationalstocks over the past three years, the valu-ation gap has clearly closed. But, in gen-eral, you still see less long-term commit-ment to owning equities by investors out-side the U.S. When markets run into trou-ble, you’ll see more wholesale selling ofequities by non-U.S. institutional holders.There may be some historical precedentto that, and we hope it continues.

Will Browne, 9.29.06

Over the next ten years it’s far more like-ly that the huge amount of capital ownedby the rest of the world will grow byinvesting somewhere other than the U.S.,whether it’s in infrastructure in China orthe Middle East, or to develop consumermarkets in places like India.





One benefit of being a global investor isin learning how a particular businessshould be valued – which is often proper-ly done in the U.S. – and applying that incountries where the valuation is different.


In general, we believe it’s prudent forlong-term investors to have a significantand growing portion of their portfoliosallocated to equities in foreign countriesthat are growing faster than the U.S. andwhose currencies will likely appreciateagainst ours. We’ve primarily been invest-ing in closed-end funds offering a doublediscount – trading at a discount to theirnet asset values and in what we believeare growth economies undervalued by thecapital markets.

David Nierenberg, 7.28.06

I’d argue that literally every investortoday has to be a global investor tounderstand what’s going on – certainly inmarkets like energy and commodities, butalso to take advantage of where we thinkthe best opportunities are going to be.


Another reason it’s important to be moreinternational in your outlook: if you’renot paying attention to what competitorsin emerging markets can do, you’re likelytaking on risk with U.S.-company invest-ments that you shouldn’t.

Robert Williamson, 8.31.08

One interesting aspect of what’s going onis the global nature of the credit explosionand now decline. Credit-fueled liquiditypushed asset valuations up dramaticallyacross assets and in just about every partof the world. When I first started in thebusiness, trends didn’t spread as quicklyor from market to market around theworld like they do today. I’d imaginethere’s no going back on that front.

Bob Wyckoff, 12.21.07

For the types of companies I generallyinvest in – sophisticated global companieslike Diageo, Nestlé, Pernod Ricard – theinformation is generally accessible andcomplete, so I don’t require a greater mar-gin of safety or lower multiples becausethey’re international. Also, partly becausethe field hasn’t been as crowded, I’ve hadas good, if not better, access to seniormanagement at non-U.S. companies.


Believe it or not, there are still countriesaround the world where accounting stan-dards are conservative. In the Anglo-Saxon world we're used to seeing over-stated earnings, but in places like SouthKorea, Japan, Germany and Switzerland,you can sometimes find earnings that aresignificantly understated.

Charles de Lardemelle, 11.26.08

Japan is particularly interesting right now.While corporate governance is improvingin the developed countries, Japan is prob-ably still the furthest behind. Some of thebest opportunities today, though, are incompanies that have a long way to go inimproving corporate governance.

Alexander Roepers, 2.28.07

We’re not afraid of political risks, whichwe generally think are exaggerated. Weinvested in Thailand after the coup. We’reinvesting in Turkey in the face of politicaluncertainty. It’s not a big component ofwhat we do, but there are always smallpockets of mispriced risk and politicaluncertainty can create very nice bargains.

Oliver Kratz, 6.29.07

We like to operate under the illusion thatif we see something that is out-and-outunacceptable being done, that there’s aclear rule book and well-defined avenueto complain about it. It’s not clear that’syet the case in China.


We take into consideration what we callattitudes toward capitalism. For example,there's a very low risk of being squeezedout at an unfair price if you own 13% ofa company in the U.K., but that couldhappen in Switzerland, where the lawsare less shareholder-friendly.

Álvaro Guzman de Lázaro, 11.26.08

In general, there aren’t many countries inwhich we wouldn’t invest. But if a coun-try is too economically or politicallytroubled or the rule of law doesn’t reallyprevail, we pass. The main country inwhich we won’t invest today is Russia.There’s still too much risk for foreign (oreven local) investors that you’ll think youown an asset and then Mr. Putin decidesyou don’t.


We haven't been traditional emergingmarkets investors because we do notchase growth or glamour, but we likenothing better than to invest in emergingmarkets on a contrarian basis. Strongeconomic growth is never steady, so youcan find nice opportunities to invest afterbooms have gone temporarily bust.


We’ve recently been very active in theMiddle East, which we consider to be thenew emerging-markets story today andthe third one-billion-plus population areaof the world that any global investorabsolutely has to understand.


We think Europe is particularly attractiveright now – it’s probably ten years behindthe U.S. in terms of rationalizing corpo-rate structures and activism is becomingmore accepted and will continue to pro-mote change there.

Barry Rosenstein, 3.30.07

We've found over the years that Europeanmarkets are much less efficient than those




in the U.S. Right now we have less than5% of our portfolio in the U.S., and it'sreally lower because our largest holdingthat trades there operates in the U.K.

Francisco García Paramés, 11.26.08

One of the keys to Warren Buffett’s earlysuccess was investing in high return oncapital consumer businesses that were rel-atively immature when he bought themand that grew enormously along with theU.S., the largest economy in the world.He owned companies like Gillette, WellsFargo and Washington Post Co. over aperiod in which consumer-products,financial and media companies grew frombeing a relatively small part of the S&P500 to a very large part of it. That’s a nat-ural evolution in any large, developingeconomy and we expect that dynamic tocreate value in India for a long time.


I once heard someone say that for every2X kilometers you are away from whereyou are investing, you should divide thequality of your assessment in half. Weagree with that.


For better or worse, the Anglo-Saxonbusiness model puts the interests of share-holders first. We are less comfortable inmarkets where loyalties are more divided.


My feeling is that it’s beyond my skill set totry to buy local companies outside the U.S.Some people will make a lot of moneydoing that, but not me. What I am doing isbuying companies like GE and Citigroupand Diageo, who already have tremendousexpertise and operations outside the U.S.to take advantage of international growthand development opportunities.


We keep heading more toward directinternational investing, but worry thatwe’re going to end up being the patsy. Welooked at South Korea, but kept askingourselves what edge we really had there.How do we understand the culture, themanagement?


The fundamentals of value investing –which to my mind are based on commonsense – still work, and work equally wellacross borders. We look at stocks exactlythe same way, whether in Hong Kong orJapan or Paris. People always ask, “Butdon’t you want to invest like the locals,understanding the local idiosyncrasies?”and my answer is simply no. We neverbuy stocks based on what we think otherinvestors are going to do.


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Uncovering ValueW O R D S O F I N V E S T I N G W I S D O M


WHERE THE VALUES ARE

When you've been around as long as Ihave, you realize that value manifestsitself in different ways at various times inthe market.

William Fries, 10.31.08

We don’t have a discernible edge deter-mining whether IBM’s earnings are goingto beat the Street by a nickel. But thereare a wide variety of situations in whichthere are dislocations – like mergers, spin-offs, short-term bad news, legal issues –where we think we understand why theremight be a huge disconnect between sup-ply and demand for a given security.

Jon Jacobson, 2.28.06

It’s often when companies are in the midstof change – buying or selling divisions,installing new management, reorganizingor restructuring. Change brings uncer-tainty, so many investors want to wait outthat uncertainty until the situation is eas-ier to analyze. We think that uncertaintyis what creates opportunities.

Peter Langerman, 12.30.05

The hedge-fund industry grew up bypreying on the inefficiencies created bythe mutual-fund mentality of only depart-ing from a benchmark index weightingwith reluctance. Events that transformcompanies can complicate things whenyou’re focused on, say, having an 8%weighting in industrials. That’s why thesetypes of companies can often be mis-priced. There’s also change going on andthe market can be remarkably slow inshifting its focus from how things havebeen to how they will be.

Gary Claar, 3.30.07

Management changes can help a lot withtiming. If a board of directors is seriousabout restructuring, they’ll often hiresomeone from a best-in-class company tomake it happen. Those people aren’tcheap, which shows the board is serious,and the fact that the person is willing tocome indicates they think they can addvalue. An executive from a first-classcompany taking over a laggard can meanan opportunity is ripe for the picking.


Just missing a product cycle is generallyfixable. So are problems that result froma company outgrowing its infrastructure– it’s a high-class problem to have, butcan result in some real earnings trouble.Botched acquisitions can also create inter-esting opportunities if we believe thedelayed cost savings or strategic benefitswill eventually increase earnings.


Companies in severe financial stress tendto be overlooked and underloved,because they have a risk or fundamentalprofile that many equity investors are notcomfortable with. We also like what wecall “crossover” equities, where a transi-

tion between value and growth share-holders causes them to fall out of focus.

Mitch Julis, 3.31.06

I look for companies that may be losing abit of money, break-even or even a bitnegative cash flow, but where two tothree years out you can get $1 worth ofearnings power for every $5 in stockprice. Most investors worry about nextquarter, not what will be in two to threeyears, so that’s why these stocks can be socheap relative to the longer-term earningspower. Companies eventually get pricedon earnings power, not current earnings.

Matthew Feshbach, 5.22.05

We focus first on good businesses, withhigh returns on capital, barriers to entryand significant free cash flow generationover a cycle. If you're right about thebusiness, time should be your friend, socatalysts are not important.


In general, the best thing for us is to findcompanies that have really stumbled, butwhere you can look at their past andunderstand why they are going to earnsomething much better in the future.That’s opposed to looking at a companylike Amazon.com, for example, whichmight be a great business, but whereunderstanding exactly what the model isgoing to be in the future isn’t easy. It’s alot easier to look at the prospects for arailcar manufacturer, whose business hasbeen the same for decades.


In my experience, stocks begin to fall outof favor when companies miss Wall Streetestimates and then really get hammeredwhen actual earnings decline. That’s

Uncovering Value




when prices can be least efficient, as themarket extrapolates short-term trendstoo far into the future and also ignorescompanies that may still have a few dis-appointing quarters ahead.


Dreman Value Management has researchthat shows something like 40% of allearnings announcements are “surprises.”Overreactions to those surprises happenall the time, which often creates greatbuying opportunities.


Most of the time we’re picking up thepieces after a high-growth company hitsthe wall at 80 miles per hour, havingmade at least one too many investmentsto try to sustain an unsustainable growthrate. Public markets can actually conspireto screw companies up. When you’regrowing fast, you get this big P/E andpretty soon you have the wrong investorswith ridiculous expectations. You try tomeet those ridiculous expectations and dothings contrary to shareholder value.


If you look at technology-driven growthindustries over the past two centuries –steam engines, railroads, telephony, elec-tric power, the Internet – people becometoo excited about growth and overinvestin it. When the bubbles burst, marketsovercorrect on the downside, even thoughthe fundamental growth drivers may stillbe as present as they were before. We loveto find jewels buried amid the rubble afterthat kind of explosion occurs.


We are often looking for broken growthstories, when a once-great company is nolonger considered to be great. The markettends to overreact in these cases, asgrowth and momentum investors moveon to the next new thing and the share-holder base turns. Since I wasn’t in thestock before, I’m not disappointed if

something is no longer a high-flier. All Icare about is the future potential relativeto what I have to pay for it.

Alan Schram, 1.31.07

[W]e basically spend our time trying touncover the promising turnarounds,dullards and assorted investment misfitsin the market’s underbrush that are large-ly neglected by the investment communi-ty. One of the key metrics we assign toour companies is an “analyst ratio,”which is simply the number of analystswho follow a company. The lower thebetter – as of the end of last year, about65% of the companies in our portfoliohad virtually no analyst coverage.

Carlo Cannell, 3.31.06

Most companies expand during goodtimes and wind up over-leveraged andwith too much capacity when the busi-ness goes south. We like to see the oppo-site, companies today investing on thecheap in additional capacity for whenthings turn up.


My returns have actually been slightlynegatively correlated to the S&P 500.The reason is that most of my companieshave zero momentum, zero hype, aren’tusually in cyclical businesses and have noanalyst coverage. Why would they movein step with the market?


Any time we see a headline saying com-modity X is trading at a 30-year low,we’ll be sure to look closely at the indus-try for the company or companies stilldoing okay, which are most likely to leadthe way off the bottom. Conversely, if wesee stories about commodity X trading ata 30-year high – much more likely today– we’ll look at companies that aredependent on the commodity and havehad input costs driven through the roof.The more dependably cyclical the indus-try is, as the commodity price trend

reverses itself the true value of the compa-ny is likely to come out.


We often return to stocks that face a cycli-cal business downturn, but investors areoverreacting to the prospect of a tempo-rary dip in earnings. When the Fed is rais-ing rates, for example, investor reaction isusually negative out of all proportion toeconomic reality. We bought banks,thrifts and mortgage companies in 1990,1994 and 1999 as investors followed con-ventional wisdom and sold them.

Wally Weitz, 8.29.05

An area we try to mine is busted IPOs.Buying at the IPO often means you’rebuying from smart sellers, but we’dmuch rather buy from dumb sellers –which is more likely to happen after anIPO company disappoints in some wayand the people who bought in the initialoffering bail.


We like looking at multi-segment busi-nesses where it’s a bit more complicatedto analyze all the parts and there’s not anobvious answer to the question of whatthe entire company is worth. In this con-text, we pay a lot of attention to private-market values and trying to understandhow underperforming segments shouldbe valued.


Holding companies are particularly inter-esting now because for some odd reasonthe discounts to the sum of the parts usu-ally increase in bad markets, even as eachpart individually becomes more underval-ued. That provides two layers of under-valuation.


First and foremost we want to invest inbusinesses that have the fundamentalability to earn attractive returns. There




may be a core business that fits thatmodel and management has tried toexpand beyond that and the strength ofthe core business is being obscured.

Michael McConnell, 7.31.07

Wall Street’s focus on steady growth inquarterly earnings is [ridiculous]. I wantto go into companies where on a reliablebasis over a long period they keepincreasing net asset value. That’s what wepay attention to.

Marty Whitman, 5.22.05

In general, we're far more interested incyclical companies that are well-capital-ized, that don't lose money at the bottomof the cycle and whose peaks and troughsare both higher over time.


We find opportunity in looking at the dif-ferent values ascribed to different assetclasses. If the debt markets would provide100% financing of a company’s totalmarket value, that usually means theequity is undervalued.


One general thing we’ll do is focus onareas that are not being talked about.We’ll look at each other and say, “Ihaven’t heard anything about agricultur-al-equipment manufacturers. I wonderwhat’s going on there?”

Donnell Noone, 4.30.08

Music to my ears is when something isconsidered dead money and people say,“It looks okay, but I’ll come back to itlater when this or that issue resolvesitself.” That to me shouts, “Look here.”


Historically, value investors have foundopportunity in declining businesses withcompanies that could milk cash flow andmake smart investments elsewhere. The

idea, properly so, was that you could geta free call on any new-business upsidebecause the stocks were so cheap. Thisisn’t happening any more in areas ofrapid technological change because thecash flows evaporate faster than you everdreamed.

James Chanos, 7.29.05

I’m looking for steady cash flows, rein-vested on owners’ behalf by honest andable management. Steady cash flowscome from businesses that, for one reasonor another, enjoy the perception of indis-pensability for their products.


If you’re looking, as we are, for extraordi-nary returns – from companies whosestocks can go up 10x rather than 2x – it’sfar more likely to happen because the com-pany’s earnings turn out to be so much bet-ter than anyone expected than because youfound a temporary 50-cent dollar.


In such a value-focused world, we need tobe all the more contrarian in our views. Italso requires additional research focus onunique, future-potential situations thatmight traditionally have been calledgrowth ideas. This is just a practicalresponse. As defined in classical Grahamand Dodd terms, a bargain-basement stockhas a market capitalization lower than its

net working capital – current assets minuscurrent liabilities. The approximate num-ber of companies selling at a discount tonet working capital today is zero.


IDEA GENERATION

There’s no magic bullet to finding ideas –the tools available are there for everyoneto use. Good ideas generally come fromindividual curiosity and then creativityaround what could be done with the busi-ness. The real value we can add is havingconviction about what we think prospec-tive earnings power is and why.


There’s a clarity that comes with greatideas: You can explain why something’s agreat business, how and why it’s cheap,why it’s cheap for temporary reasons andhow, on a normal basis, it should be trad-ing at a much higher level. You’re neversitting there on the 40th page of yourspreadsheet, as Buffett would say, agoniz-ing over whether you should buy or not.

Joel Greenblatt, 10.31.06

Another thing Peter Lynch did really wellwas figure out how else to make moneyon a good idea. Look down the industrystructure and figure out the other waysthat this particular information can gen-erate an edge. In our portfolio today, weidentify a theme – say consumer-drivenhealth care – and then we try to figure outwhere all the opportunities are.


Say you’re interested in copper. You maystart with the mining companies, thenmove to refiners, then intermediateprocessors, then metal-bender manufac-turers and on up the line. If one area ofthe business looks lousy, you may want tolook at the companies that buy fromthose people. You may look at the com-petitors or the alternatives to copper.Thirty-five companies down the road,you’re likely to be in a completely differ-




ent business and industry and you’ll comeacross something that looks interesting.


Our best ideas tend to come from what Icall “old research, new events.” That’stypically the good company you’ve stud-ied carefully and would love to own at theright price, that gets marked down after ittrips or its industry goes out of favor.

Ricky Sandler, 8.25.06

It would be unusual for someone to callus with an idea that we don’t alreadyhave some knowledge of. As a result, thevast majority of our ideas come fromthinking through the ramifications ofindustry developments or the recognitionof changes within a market.


The majority of our investments are origi-nally driven from the top down. We’llidentify an industry that has underper-formed for the past five or ten years thatwe believe is due for a cyclical regressionup to the mean. Then we systematicallyreview the micro-caps in the industry, sort-ing them based on financial measures andsubjective assessments of management toidentify the companies we’ll bore into.


Time is a precious resource and if youmake it your task not to “miss” anything,you set yourself up for failure. There aretoo many opportunities out there and, bydefinition, you will miss many of them.That’s why we narrow where we want tolook first by the themes we consider mostcompelling. We’re not necessarily seeingthings others don’t see, but we will have avery different view on the magnitude ofthe trend or the speed at which it happens.


I’d say most of the ideas that have mademoney for the portfolio have been theresult of some form of reasoning by analo-

gy. One example: Applying well-under-stood U.S. investment ideas to marketsoutside the U.S. During the time when one-newspaper towns in the U.S. were anotherversion of Buffett's toll booth, there were anumber of European newspapers that weredominant local monopolies which werestill trading at attractive multiples and Iwas able to do very well with them.

Guy Spier, 4.27.05

We use a lot of grapevine ideas, askingpeople what they’ve finished buying thatmight be interesting. Why not look atwhat other great investors have found?


We learn a lot from other investors. I goto idea dinners and regularly talk to a lotof people I respect in the business. I’m notafraid of ideas owned by other people,but you obviously need to do your ownwork and make sure they fit what you do.


Our best source of ideas is probably otherinvestors we highly respect. I don’t have aproblem sharing ideas and research – weget as much as we give and we obviouslyonly buy things that make sense for usafter doing a lot of work.


I don’t talk much to other fund managers,but I do have a network of investigativereporters I know who call me from time totime to discuss long or short ideas they’vecome across, which can be helpful.

Francois Parenteau, 7.31.08

We follow management teams we knoware good. We talk to operators we respectabout what other companies or business-es they think are doing interesting things.We might look at something because it’s aproduct we use.

Mario Cibelli, 6.30.06

Bloomberg lists on a monthly basis thehighest-ranked and lowest-ranked stocksby sell-side analysts. I look at the lowest-ranked for buying opportunities and thehighest-ranked for selling opportunities.


One fruitful screen over the years hasbeen for what we call low-P/E outliers –companies with the lowest 1% of trailingP/Es in the market, but with debt that isstill less than equity. That causes us tolook at things most investors will notlook at, which is a good thing.


We don’t do traditional screens and areactually looking for situations in whichthe publicly available information that acomputer can analyze is giving false sig-nals. For example, we bought auto-insur-er Progressive [PGR] in 1999 when theirearnings looked bad because they werespending heavily on a direct-to-consumerstrategy like Geico’s. A computer wouldsee that as a negative earnings trendresulting in a too-high multiple, but itdoesn’t know how to judge whether cer-tain spending might generate big returnsin the future.

Boykin Curry, 3.31.08

We do exactly one screen, which is to seg-ment our potential opportunities by mar-ket cap. Starting with a rank-order valua-tion screen is more likely to lead you intoless-than-optimal businesses, which wecan’t afford to be in with such a concen-trated portfolio.


It’s hard to have unique insights in thisbusiness, but they often just come fromworking on something that leads you tosomething else. I work with two analystsand every once in a while we’ll say,“Let’s brainstorm about new ideas,” butI can’t say we’ve ever come up with anidea that way.



Research and AnalysisW O R D S O F I N V E S T I N G W I S D O M


THE RESEARCH PROCESS

Before I even look at a financial state-ment, I try to find out as much as I canabout the history of the company, tounderstand how it has arrived at its cur-rent predicament. (If we’re looking at it,it’s usually a predicament.) I’m trying tofind evidence of similar issues in the pastand what happened, to help judgewhether current problems are control-lable and rectifiable.


One of the first questions we ask about apossible investment is “Why is it mis-priced?” If you don’t have a reason, there’sa good chance it isn’t really mispriced.

Jeffrey Tannenbaum, 7.31.07

Peter Lynch’s greatest influence, whichstill pervades Fidelity, is that you pick upthe phone and call companies. At the endof the day, if you haven’t spoken to a fewcompanies in existing positions or onnew ideas, you go home a failure.That’s a good discipline – you shouldspend your day talking to operators,not to Wall Street.


One lesson is how important it is toget out there are talk to people. If youspend all your time with your modelsand spreadsheets, you’re likely tomiss something important. You needto understand how the economicswork for the people who are makingthe actual decisions and when youcome across something you didn’tknow that has broad application, itcan be very useful.


One thing we try to do is find the“guru.” Getting to the truth can really beaccelerated by finding the handful offolks who truly understand a business orindustry.


Julian Robertson was always adamantabout seeking out the opposite point ofview and then being completely honestwith yourself in deciding whether youranalysis overrides that. That’s somethingwe try to practice every day.


If we’ve spent time with a Wall Street ana-lyst to understand why he or she disagreeswith our opinion on a company, that willgenerally make us more confident whenwe ultimately make a buy decision. It’snot that we’re smart and analysts aren’t,but usually that they operate with a muchshorter time horizon.

Christopher Grisanti, 10.31.07

There’s a virtuous cycle when peoplehave to defend challenges to their ideas.Any gaps in thinking or analysis becomeclear pretty quickly when smart peopleask good, logical questions. You can’t bea good value investor without being anindependent thinker – you’re seeing val-uations that the market is not appreciat-ing. But it’s critical that you understandwhy the market isn’t seeing the valueyou do. The back and forth that goes onin the investment process helps you getat that.


We spend time early in our researchprocess speaking with competitors, theone group with a vested interest in tellingus why our thesis is wrong. I’d muchrather hear why our thesis might bewrong at this point than for the market totell us after we own the stock.


It’s very common to drown in thedetails or be attracted to complexity,but what’s most important to me isto know what three, four or fivemajor characteristics of the businessreally matter. I see my job primarilyas asking the right questions andfocusing the analysis in order tomake a decision.


We have a disciplined process, but ithas to be open to serendipity – oftenit’s the footnote in the trade journalwhere you see something interestingthat eventually becomes an idea.


Our research process brings usdown to 50 or so companies about

Research and Analysis

“Looks like another case of media overload sir.”




which we’ve affirmatively answered thequestion, “Would we want to own thiscompany?” It’s only then that we turn tovaluing each company.


One of my clients has only oneBloomberg terminal in his office, sittingin the corner, and people get ridiculedwhen they use it too often. His point isthat they don't need it – their business isinvesting and they should work out thevalue before seeing if there's a sufficientmargin of safety to invest at the currentprice. If there isn't, the work hasn't beenwasted because there one day might be.


We’re constantly trying to triangulate andconfirm what we hear or see elsewhere. Ifreturns on invested capital tell us it’s agreat business, we also want to hear fromcustomers about why they value the com-pany as a supplier and expect to continueto do so. If the company expects toincrease market share, we want to heardirectly from competitors why they don’tthink that will happen. Taking short cutsin due diligence, for whatever seeminglydecent reason, is just a recipe for disasterin our view.


In studying the common traits of thosemost successful at games of skill – acrossdisciplines – researchers have found aclear tendency to focus more on processthan individual outcomes. Poker legendAmarillo Slim has described it this way:“The result of one particular game does-n’t mean a damn thing, and that’s whyone of my mantras has always been‘Decisions, not results.’ Do the right thingenough times and the results will takecare of themselves in the long run.”

VII, 1.31.06

Pilots do the same thing thousands andthousands of times in their lives, but theystill go through the physical pre-flight

checklist to eliminate what could be a cat-astrophic error if they try to circumventit. Investors are well served by havingsimilar types of checklists and stickingwith them.


The best investors often employ checklistsfor each idea, to ensure that no data-gath-ering shortcuts are made. General impres-sions also should not be mistaken forfacts: “As the saying goes,” says LeggMason’s Michael Mauboussin, “the plu-ral of anecdote is not evidence.”

VII, 10.31.06

ANALYTICAL RIGOR

Everyone tends to see the same things,read the same newspapers and get thesame data feeds. The only way to arriveat a different answer from everybodyelse is to organize the data in differentways, or bring to the analytic processthings that are not typically present.


One of the best lessons I learned early onwas to look at companies as companiesfirst – to understand what they want toachieve and the likelihood they canachieve it. People too often focus onstocks first and think they can generate anedge in how they’re looking at valuation.In the end, static valuation is relativelyefficient and it's what companies do thatdrives their futures.


One of the biggest things we strugglewith in training people is driving homethe fact that you cannot have an opinionabout an investment unless you reallyunderstand what the consensus is andare then able to articulate why the con-sensus is wrong.


As Jeremy Siegel writes in his well-researched The Future for Investors:

"The long-term return on a stockdepends not on the actual growth of itsearnings, but on the difference betweenits actual earnings growth and thegrowth that investors expected."Something to consider every time youbuy a stock, especially if you’re bettingon “sweeping trends.”

VII, 7.29.05

We spend a lot of time trying to figure outhow competitors would attack the busi-ness of the company we’re interested in.The harder that is, the more interested weare. We try to avoid markets perceived tobe so attractive that capital could startpouring in at any time.

Mario Cibelli, 6.30.06

I’m a big believer that a company’s suc-cess is about execution and the hundredsof little things that one company does bet-ter than another. We want to understandthat for the companies we invest in: is theparty line what’s actually taking place inthe branches? In bad companies, there’san enormous difference.

Thomas Brown, 10.28.05

There are characteristics that have beenproven over long periods to be associatedwith above-average rates of return: lowP/Es, discounts to book value, lowdebt/equity ratios, stocks with recent sig-nificant price declines, companies withpatterns of insider buying and – some-thing we’re paying a lot more attention to– stocks with high dividend yields.


True sources of sustainable competitiveadvantage fall into four categories[according to The Little Book ThatBuilds Wealth]: 1) Intangible assets, suchas brands, patents or regulatory licenses;2) High customer switching costs; 3)Network economics, in which the valueof the product or service increases withthe number of users; and 4) Cost advan-tages, stemming from scale, location or




unique processes. Such attributes can pro-vide the competitive barriers to entry andpricing power that allow companies togenerate high returns on capital over longperiods of time.

VII, 5.30.08

I think the number one variable in theinvesting equation that Wall Street over-looks is margin leverage. Most investorsfocus on leverage from sales growth,which is relatively easy to figure out andeverybody looks at that. But in the greatorganic growth stories, a lot of the shareprice upside has come from these compa-nies increasing operating and net marginsas they grow. Margin leverage tends to goalong with a company having an endur-ing competitive moat.

Arne Alsin, 11.30.05

Our favorite way to get paid is to findcompanies with below-normal margins forreasons that are fixable and in their con-trol, and to which the market is not givingthe benefit of the doubt. In those, you getpaid two ways – if you’re right, both theearnings and the multiple improve.

Stephen Roseman, 9.29.06

Our experience shows there’s a positivecorrelation between improvements in acompany’s return on invested capital andits stock performance. More than any-thing, we’re looking for inflections inbusinesses where some sort of structuralchange will drive returns on invested cap-ital to be materially higher.

Joe Wolf, 4.30.07

An area on which we spend a lot of effortis to define how big the runway of oppor-tunity is in the business. We’re not look-ing for short-term or arbitrage opportuni-ties, but cases where we can see a reason-able probability of a huge upside, whichwe’re not paying for.

Robert Jaffe, 12.22.06

The most important thing I figured outearly on was the benefit when investing inturnarounds of focusing on companiesthat operate in growing markets. If acompany has market growth as a tail-wind, it’s quite a bit easier for manage-ment to execute an operational turn-around.


I like to see multiple levers in an invest-ment that will allow me to win. I thinkyour margin of safety is directly correlat-ed to the number of levers. It could be theability to double sales over four or fiveyears. It could be margin leverage. Itcould be leverage from undervaluedassets that management can use to unlockvalue. It could be a huge cash positionthat might be used to buy back stock, paya dividend or invest in growth.

Arne Alsin, 11.30.05

Many times companies find themselves inwhat the market considers predicamentsbecause they have been far-sighted andare spending on future opportunities. Thegood thing about that type of spendingfrom a shareholder’s standpoint is that ifthe company is right, you benefit, and if itturns out to be wrong, it stops spendingthe money and you also benefit.


Stock prices go up for two primary rea-sons. The first is investors’ willingness topay a higher multiple for a company’searnings or cash flows. That’s what tra-ditional value managers look for –undervalued securities that will be morerichly rewarded in the future. We’re try-ing to find that as well, but we’re alsolooking for evidence of fundamentalturnarounds and the additional stock-price upside that comes from higherearnings expectations.

Ronald Mushock, 10.31.07

If something is cheap but the businessdynamics aren’t great, time can be your

enemy unless you see a clear catalyst forvalue to be recognized.


Discounted cash flow to us is sort of likethe Hubble telescope – you turn it a frac-tion of an inch and you’re in a differentgalaxy. There are just so many variables inthis kind of analysis – that’s not for us.

Curtis Jensen, 5.22.05

We rarely use discounted cash flow to cal-culate target prices. We just don't thinkit's worth the effort except for very stablebusinesses such as toll roads or utilities.


People often say they emphasize the qual-ity of management or the competitivemoat of a company, but the problem withsome of those generalizations is that com-panies with those attributes are very oftennot attractively priced.

Ric Dillon, 6.29.07

MANAGEMENT EDUCATION

The power of self-interest in business andeconomics is, of course, well established.“It is not from the benevolence of thebutcher, the brewer, or the baker that weexpect our dinner,” wrote Adam Smith inThe Wealth of Nations, “but from theirregard to their own interest.”

VII, 6.19.05

There is no way to make a good deal witha bad person. It’s the character of the peo-ple you go into business with that will fun-damentally determine your investmentreturns and your ability to sleep well andeat well in the meantime. If you’re notcomfortable with the people involvedbecause of their prior conduct and howthey’ve treated shareholders, you’re proba-bly not going to be comfortable with yourinvestment results. I take it to heart anduse it as a screen for potential investments.





We tend to be more about the jockeythan the horse. It’s important to under-stand how people are going to behaveunder stress. You don’t have to predictthe future if you know the company hasthe assets and management to do well indifficult times. I believe that’s when theseeds for exceptional performance areplanted.


I’m at a stage in my career where I’d sayhuman behavior is the most importantdeterminant of a business’s long-term suc-cess. I don’t care how smart an analystyou are, you can’t really know what’sgoing on inside a business. We want toinvest not only in highly capable man-agers, but also those with clear trackrecords of integrity and acting in share-holders’ best interest. I’ve found thatwhen a manager puts his hands in share-holders’ pockets once, he’s much morelikely to do so again.

Charles Akre, 11.30.06

You can’t overstate the importance of theCEO in judging an investment. My bestideas, by far, have been in situationswhere a new CEO takes over an under-managed franchise. If we only focused onone thing, that would be it.

Kenneth Feinberg, 5.31.07

Julian [Robertson] was maniacal on theimportance of management: ‘Have youdone your work on management?’ Yes,sir. ‘Where did the CFO go to college?’Umm, umm. ‘I thought you did yourwork?’ He wanted you to know every-thing there was to know about the peoplerunning the companies you invested in.


We don’t ascribe to the view you should-n’t meet with management to avoid being“sold.” A personal connection gives us abetter understanding of what’s going on,allows us to judge management moredirectly and even can give us some influ-

ence – all of which we consider necessaryto invest with conviction.

Randall Abramson, 12.21.07

Making judgments about management isimportant to us and something I thinkvalue managers tend to underweight. Youcan analyze something statistically, but ifyou expect to own it for 10 years, man-agement is going to make thousands ofdecisions you can't predict and may nevereven know about, which collectivelymake earnings compound at a rate moreor less than they would have otherwise.Those things can add up over time to thedifference between a Staples and anOffice Depot.


[The importance of handicapping man-agement’s skill] really depends on the typeof investment we’re making. If a compa-ny is under-earning against its industry orhistorical levels and the challenge is to getthings back to normal, my perspectivewould be more like Rich Pzena’s – that ifcurrent management can’t figure it out,someone else will. But in a situationwhere the business is growing and man-agement’s ability to reinvest capital is crit-

ical to the thesis, knowing and believingin management is very important.

Alan Fournier, 2.28.07

Excellent management is usually criticalto successful turnarounds. While man-agement changes aren’t always neces-sary, we often view management changespositively. You’re much more likely toget a frank, thorough appraisal of whathas gone wrong and why, so you’ll prob-ably understand the situation better. Myconfidence also increases when a strongnew manager has been attracted to agiven situation and is highly motivatedto perform.


We'd rather analyze the company, itsopportunities and issues, and how it hasallocated capital in the past, without firstbeing fed the party line. When we domeet with management, it should be aneducated discussion between two knowl-edgeable parties.


[The ideal turnaround CEO] is a first-time CEO, between the ages of 48 and

“When I said none of us were infallible, I didn’t mean you sir.”




52. They have 25 to 30 years of experi-ence, but have never had a #1 spot.They’re seeking out a challenge, haveeverything to prove and – while they’vesurely done very well – probably haven’tyet had the huge payday, which theybadly want.

Lloyd Khaner, 4.28.06

For asset stories, we want at least to seecompetent management that won’t messup the value of the assets we’ve identified.With cash-flow ideas, we’re depending onfuture execution to deliver the cash flowthat at the moment is just a number inour model, so first-class management ismuch more important.

Chistopher Grisanti, 10.31.07

We sometimes buy companies with badmanagement, if that fact is more thanaccounted for in the price. At a cheapenough price on a decent business, I’mwilling to ride out any problems untilsomebody, if not current management,figures out how to turn things around.

Robert Olstein, 9.28.05

The hardest thing is to find managementthat actually objectively behaves in share-holders’ interest as opposed to their ownlong-term interest. It’s not what they say,it’s what they actually do. TakeSPX Corp., the industrial com-pany that came out with thiselaborate description on howthey were focused on EVA[Economic Value Added] …until they didn’t hit their tar-gets and then the boardchanged the criteria and gavemanagement their bonusesanyway, saying “it wasn’t theirfault, the economy was bad,why should they get penalizedfor that?” So you’re lookingfor managements and boardsthat actually act in sharehold-ers’ interest, and there aren’tmany of them.


I started my career doing criminal defensework and learned a lot from having myclients lie to me and having to see throughthat. That’s been invaluable in dealingwith corporate America.

Edward Studzinski, 4.30.08

Investors face a variety of risks, which wecan more or less address in how we con-duct our analysis and make our invest-ment choices. But the risk that can reallyset you back – and is more difficult tocontrol – is if you have a managementthat takes these great cash flows andexpropriates them more for their ownbenefit than for the benefit of the compa-ny. That, I think, is the biggest risk publicequity owners face.


AOL was run at the peak of the Internetbubble by a coterie of relatively youngmanagers who had, thanks to theirefforts and in no small part to whatturned out to be a fantasy-land economyand stock market, become fabulouslywealthy. As wealth is often a strong con-tributor to self-esteem, it’s safe to saythis tight band of executives – busy intheir spare time acquiring yachts andfractional jet ownership and third homes

– held their particular views on business(and pretty much everything else) in veryhigh regard. The problem was, the worldwas changing. Money was no longerfalling from the sky from newly publicdot-coms. Broadband Internet accesswas developing rapidly. Traditionaladvertisers were demanding accountabil-ity. And management whiffed, leavingAOL woefully unprepared for thechanges taking place.

VII, 5.22.05

It’s fascinating how differently the samebusiness can perform with two differentleaders. We look first for intellectualhonesty. It drives me crazy when youmeet with management and there are realissues and they act like they aren’t there.Also important is a contrarian bent, aconfidence to go against the prevailingtrend. You generally don’t want peoplewho are saying this is what we should dobecause this is what others are doing.You want people who are spending whenothers are not, and taking chips off thetable when everybody else is puttingthem on.


We look for certain behavior patterns inmanagement that are consistent with anefficient and prudent guardianship of our

assets. If we visit a fan manu-facturer in Texas and theCEO meets us at the airportin his Lexus, spends fivehours with us and then takesus out to an expensive restau-rant and buys $300 bottles ofwine, that is suggestive ofsomebody who isn’t as pru-dent as we would like.


The most important questionwe ask management is whatthey believe is the best andhighest use of the cash theircompany generates. We wantto make sure the answer is top




of mind and, of course, that we ultimate-ly agree with it.


You can usually pick out the empirebuilders simply by asking how they allo-cate capital – they tend to have a hardtime zeroing in on a concrete answer.


If I was stuck on a desert island and hadto make a decision on management tal-ent, I’d chose a summary of past returnson capital over a cell phone to call people.


The historical record on how they allo-cate capital – acquisitions, divestitures,buybacks, etc. – is ultimately most impor-tant to shareholder value, but we also payattention to the level of management anddirector share ownership and whetherthey’re buying or selling. We mean realshare ownership, not just options. It’srare to see excellent capital allocationwithout significant share ownership.


One red flag is when management sitsdown with us and right off asks, “Whatdo you think is wrong with our shareprice?” Any implicit or explicit focus onthe share price rather than the business isa bad sign.


How management communicates aboutmistakes is very important. No one is mis-take-free – as investment managers, about40% of the stocks we buy end up under-performing the market – and I’d be con-cerned about any company where share-holder communication doesn’t include acandid assessment of mistakes.


In keeping with the dictum that toughtimes expose true character, now is a

great time to pay attention to manage-ment pronouncements. If we read onemore statement like this one from RoyalBank of Scotland CEO Tom McKillop, inannouncing giant writedowns and theneed to raise $24 billion in new capital,we're going to be ill: “This is a difficulttime for the financial services industry,and it has presented us with specific chal-lenges.” When times were good, we musthave missed the memo saying, “This is awonderful time in the financial servicesindustry, presenting opportunities tomake money hand over fist without pay-ing much attention to credit standards orwhat we really own.”

VII, 4.30.08

Character today is best judged in theproxy statement – what do they paythemselves and how? Is their financialself-interest truly aligned with mine as ashareholder? I have absolutely no prob-lem with the people running huge, com-plicated, global businesses making a lotof money. The big problem we have nowis that you’re seeing a lot of superstarcompensation for only minor-league per-formance.


We have nothing against successful exec-utives making a lot of money – some trulydeserve every penny they get, and thensome. The problem is when pay is utterlydisconnected from performance – as is thecase with out-of-control severance pack-ages – or when disclosure is lacking. Insuch cases, shareholders should be bothvocal and aggressive in pushing forchange – it is their money, after all, that'sbeing doled out.

VII, 12.30.05

While they won’t always admit it, mostinvestors hold a special place in theirhearts for successful and honest corporatemanagers. That’s primarily driven by thesignificant role strong management playsin their investments’ increasing in value –the surest way into an investor’s heart –

but it also reflects respect for the difficultjob top managers have. As FairholmeFund’s Bruce Berkowitz says of the bestCEOs: “These are people who are greatoperators and managers, with excellentpeople skills – not qualities valueinvestors are generally known for.”

VII, 4.30.08

DEFINING VALUE

Here’s how we think about valuation:The S&P 500 companies sell at 15x nextyear’s earnings, 3x book value, 11x cashflow, 1.5x revenues, have an ROE of 17-18% and have anticipated trend earningsgrowth of 8%. We’re looking for compa-nies with equal or superior growth char-acteristics that sell at discounts to themarket valuation.

Leon Cooperman, 11.30.06

We’re looking for a free-cash-flow“coupon” of 10% – EBITDA minus realcapital spending minus incrementalworking capital, divided by enterprisevalue – combined with a growth profileof 10%. We look three years out at whatwe think the balance sheet looks like,what the cash flows look like and whattype of multiple we should expect – outof that we want to see an annual 20%unlevered return.


If we're getting a 9-10% free-cash-flowyield in an industry that we don't seegoing away any time soon, and then canfind other interesting lottery tickets pro-viding us with upside, that generallystarts to get our attention.


We’re looking to pay 10x free cash flowor less, period. If you find those and youcan’t figure out how to kill the business,you should be buying all day long. We’vealways done very well when we can usesixth-grade math on the back of a post-card to show how inexpensive somethingis relative to its free cash. Once we start




getting more sophisticated – trying toprove something rather than see if we candisprove it by killing the business – we getinto trouble.


I’d consider our style more as GULP,growth at unreasonably low prices. Whypay a reasonable price for anything? Ifyou’re ever in Pennsylvania and see alicense plate that says “10XFCF”, that’sme. That comes from Bill Miller speakingabout how things trading at ten timesfree cash flow, if you understand thebusiness, don’t go down much. Ourclients over the years have made a lot ofmoney off that advice.

James Clarke, 10.31.06

We value companies based on our esti-mate of earnings per share, usually twoor three years out. I don’t look sixmonths to a year out because too manyother people are doing that, and I don’tlook four or five years out because thereare too many uncertainties in looking outthat far. Then it’s a question of putting amultiple on those projected earnings.Over the past forty years the stock mar-ket has sold, on average, at about 15xearnings, so I conclude that an averagecompany is worth 15x earnings. Above-average companies, of course, should beworth more than 15x.


In probably 90% of the cases weuse 15x as our target multiple ofnormalized free cash flow. Thathas been the average for Americanstocks over the past 200 years andit results in a roughly 6.5% free-cash-flow yield, which is quitereasonable if risk-free interestrates are 4-5%.

Francisco García Paramés,11.26.08

I look at it this way: The aver-age annual total return from

equities over long periods of time hasbeen around 10%. When you clean upthe accounting, the real return on equity[ROE] of American business averages inthe low teens. So our conclusion is that astock’s return will approximate the com-pany’s ROE over time, given a constantvaluation and absent distributions. So wechoose to swim in the pool of companieswhere the returns are a whole lot betterthan average, in the 20% range.


We’re looking for businesses whoseshares are trading at a 40% or more dis-count from our assessment of their pri-vate market value. To avoid value traps,we focus on companies that have forwardexpected movement in that intrinsic valueper share from positive growth dynamics.Finally, we’re looking to invest in man-agement teams that treat shareholders aspartners. As long as each of those ele-ments remains in place, our preferredholding period is forever.


The metrics we use to determine value arepretty much what you’d expect. We doprivate-market-value analysis using dis-counted future cash flows and by lookingat breakup values. At the same time welike stocks that are statistically cheap on atraditional price/earnings basis. We focus

on companies trading at a 40% or greaterdiscount to our private market value orno more than 13x our estimate of nextyear’s earnings. We have to have one orthe other to buy.


Once we understand the business andwhere we think it’s going, we’ll estimatethe sustainable free cash flow the compa-ny can generate – net income, plus depre-ciation and amortization, minus mainte-nance capital spending. Depending onthe growth potential, defensibility andprofitability of the business, we’ll put a10- 14x multiple on that free cash flowto arrive at a target price. At a minimum,we want to expect to make at least 50%over the next two years.


We define intrinsic value as what aknowledgeable investor or corporatecompetitor would pay, in cash, for100% of the company. From the groundup we build that by making all the rele-vant adjustments to the income state-ment and balance sheet, then applying amultiple that reflects the quality of thebusiness to the resulting normalizedearnings.


Essentially, we forecast threeyears out what we believe a com-pany is going to earn and then,based on its expected return oncapital, its capital growth andprevailing interest rate levels, wearrive at the multiple at whichwe believe the shares shouldtrade. Including any dividends,we want to see a minimum 25%annualized return potential overthree years.


We don’t have a problem withcyclicality. Wall Street stilllooks for certainty in areas

“I do my own thing.”




that are uncertain. We feel good aboutlumpiness. We just try to be cash coun-ters – if you can buy something at 5xfree cash flow with a limited chance ofpermanent impairment, even if it earnsonly half of what we originally thought,that’s okay.


We’ll estimate what we think earningscan be four to five years out, apply thecurrent multiple to those earnings, andthen see what the price would be if dis-counted back to today using a 20% annu-al rate. If the price today implies a dis-count rate of more than 20% per year,we’re interested.


We’re looking for a total annual return ofat least 25%, with position sizes adjustedfor the degree of difficulty. For a givenexpected internal rate of return, thelower the outcome’s expected volatility,the higher the position size. We create anestimated risk-adjusted IRR for every-thing and then allocate the portfoliobased on that.


In absolute terms, we generally want tosee 50% upside potential over the nextcouple of years. And unless we see atleast 3x more potential upside thandownside from the current price, wewon’t buy it.


We look back as far as possible to informwhat would be the worst-case levels ofrevenues and margins, and then applywhat we think are trough multiples to theresulting worst-case earnings. If theworst case is more than 20% below theexisting share price we won't buy it, nomatter how much the discount is to ourintrinsic value.


We firmly believe no investment is sowonderful that it can’t be ruined by a too-high entry price, so on our discount-to-cash-flow stocks we will not pay morethan the market multiple on forwardearnings. We want to avoid the tempta-tion of making relative valuation bets –say, finding a software company attrac-tive because it’s only 30x earnings whenthe group sells at 40x.


Our primary metric is to look at how ourestimate of annual growth in free cashearnings compares to the current multi-ple. Our portfolio today is indicative ofwhat we look for: on average, we expectour companies to grow cash earnings byat least 15% per year, while the averagemultiple of the companies in the portfoliois around 15x.

Edward McAree, 8.31.08

I’m probably more willing to pay up forquality than other value investors mightbe. Some of my investor friends often tellme my ideas are “too high-quality” forthem. I would distinguish somewhat herefrom paying up for growth – I’ll pay morefor a high-quality, slow-growing business.I look for companies that will grow value,not necessarily revenue, at above-averagerates. On average, our typical investmentis 30-35% cheaper than we think it oughtto be and we think it’s increasing value at15-20% per year on top of that.


One of the big mistakes value investorscan make is to be too enamored withabsolute cheapness. If you focus on statis-tical cheapness, you’re often driven tobusinesses serving shrinking markets orthat have developed structural disadvan-tages that make it more likely they’regoing to lose market share.


Many value investors are primarilyfocused on price and valuation, which we

obviously think are important, but wealso believe that when constructing aportfolio you should have companieswith promise beyond just going fromundervalued to fairly valued.

William Fries, 10.31.08

[A] good analyst is more adept at mak-ing judgments on growth. That’s theirjob – based on the business and the com-pany’s position in it, how fast is the com-pany going to grow? It’s pretty hard tolose if you’re right on the growth rateswhen the growth rates are high. In a30x-earnings company growing 25%per year, you’ll be bailed out prettyquickly because in three years the earn-ings will double and the multiple on thatwill then only be 15x.

Julian Robertson, 11.30.06

Borrowing from Warren Buffett, as we sooften do, we see growth and value as allpart of the same equation – to separatethem strikes us as kind of dumb. Thereshould be fairly broad agreement thatwhat constitutes value is a company’sdiscounted future cash flows, so thegrowth in those cash flows is obviouslycentral to figuring that out.

Ric Dillon, 6.29.07

We generally want to invest at a pricewhere if our growth thesis is totallywrong, we can still expect to earn at leastan 8% nominal cash-on-cash return.That’s roughly in line with what the over-all market is likely to return, so we shouldmatch that even if none of the freeoptions pay off.

On average over the past 19 years we'vepaid less than the market multiple forthe stocks we’ve bought, but the subse-quent earnings-per-share growth onthose stocks has been nearly double thatof the S&P 500. We're trying to ownthings that look like value stocks whenwe buy them, but which turn out to begrowth stocks.



Portfolio ManagementW O R D S O F I N V E S T I N G W I S D O M


ACTIVE MANAGEMENT

The only way to add value as an activemanager is to be persistently differentthan the index. We tell prospective clientsthat if their main goal is to minimize stan-dard deviation around the index, savemoney and buy an index fund.


Classical buy-and-hold is really a dyingconcept. The notion that there are safecompanies – like AT&T or IBM oncewere – is a real miscalculation on the partof people who can least afford it. You’remore apt nowadays to come across theblue-chip that has cracked . . . now those,we love.


We buy based on a multi-year horizon,but have found that it typicallytakes about 12 to 18 months –if we’re right – for the marketto recognize the value. If some-thing you considered trulycheap hasn’t shown any signsof working after 18 months, it’sgenerally a good idea to makesure you have a new reason tokeep it, because there’s a goodchance your original thesis waswrong.


Our turnover is typically in thesingle digits. It’s great whensomething goes up 50% in ayear, but if you sell it you’vegot transaction costs and taxesand then need to find an incre-mentally better use for themoney. We’ve never been verygood at trimming andadding but, if we’re right

about buying the long-term compound-ing machines we want to buy, it doesn’tmake much difference.

Christopher Davis, 5.31.07

It’s just very hard to trade in and out ofpositions successfully over the long-term. It’s only possible when you canhave unusually high confidence in theprecision of your intrinsic-value esti-mate. The most common reason we sellis when we find a better opportunity –that naturally takes us out of some high-er-valued stocks that might be mostprone to a correction.


We don’t have many rules, but when astock is down materially relative to itspeer group we assign another analyst toformally review it and then force our-

selves to buy more or get out. Not sur-prisingly, the analyst who originally rec-ommended the stock is the last person towant to sell it. We do something similaron the upside: when a stock gets within10% of our estimate of fair value, a newanalyst will review it and we’ll make aformal decision what to do with theposition.


We have periodic devil’s-advocate reviewsof all our large holdings and a separateanalyst is charged with presenting thenegative case. It’s more than a debatesociety, the devil’s advocate should gen-uinely believe the negative argument isthe right one. We obviously make plentyof mistakes, but that discipline helps usreduce the frequency and severity ofthem. In investing, that’s half the battle.


I remember calling on PhilCarret, the legendary founderof the Pioneer funds, and Iasked him how he possiblycould keep tabs on over 200stocks in his portfolio. Hepaused and then said, “Bill, Ibuy ‘em right.” Things likethat you don’t forget – buyingright with a long-term perspec-tive is much more than half thebattle.


BUYING AND SELLING

We try to fight against state-ments like “this would be agreat investment if it were10% cheaper.” That’s a wussyconclusion because you can’t

be wrong: If it goes down,you can say you knew it was

Portfolio Management

“But I CAN be spontaneous . . . just give me a couple of days.”




too expensive. If it goes up, you can sayyou knew it was a great investment. But ifyou know it’s a great investment youshould buy it.


I expect to hold investments for three tofive years, so the buy decision to me isclearly more important than the sell deci-sion. More poor investment returns aremade by paying too much for a stockthan by selling at the wrong time.


Sir John Templeton had one of the bestmethods for keeping emotion out of theprocess. He used to do his calculations ofintrinsic value when there wasn't a lotgoing on in the market. He'd then place amargin of safety on those intrinsic valuesand place buy orders with his broker at,say, 40% below the current market price.I'm sure a fair amount of those ordersnever got filled, but if there was an enor-mous dislocation in the market or in anindividual stock, the order would fill.Psychologically, that kind of pre-commit-ment is a very powerful tool to help us inperiods of emotional turmoil. If you lookat something when it's just gone down40%, you're probably not going to wantto touch it because it just warned on earn-ings or something similar.


I’m a value guy at heart, so would ratherbuy early than late. The problem withbeing late is that you’re already payingfor the turnaround itself, so you have tocount much more on the turnaroundresulting in sustained revenue and profitgrowth.


I have no idea where the bottom is. If Idid I wouldn't be invested at all todayand would then be fully invested whenthe bottom came. The alternative for meis to say that each time the market dropsand throws up some of these bargain-

basement ideas, I'll deploy some capitalas long as I have some capital left. It's nota fool-proof or painless strategy – BenGraham used a variant on it and nearlygot wiped out during the GreatDepression – but it's one that acknowl-edges that we cannot know the futurewith any degree of certainty.


Many value investors will buy the cheapcompany when there’s just a turnaroundstory attached to it, but we patientlywait for the fundamentals to improvefirst. The philosophy works becauseinvestors underreact to both positive andnegative changes in fundamentals. If wesee all the ingredients of a sustainableturnaround, we’ll buy after one quarterof good earnings, allowing our clients tobenefit from the slow rebuilding of con-fidence that will be reflected in the stockprice over time.

Kevin McCreesh, 10.31.07

Given the way we invest, we will fall intovalue traps from time to time. In general,we try to constantly remind ourselves thatwhen an industry goes south, things oftenget worse than you expect and stay badlonger – there's usually plenty of time tofind the bottom.


We like to live with smaller investments ina company for three to six months beforemaking a full commitment. It gives us an

opportunity to even better understand thecompany and its business while getting toknow management and whether we’re allon the same page.


We’ll probably take “R&D” positions instocks [before completely finishing ourresearch]. Action adds a sense of urgencyto the work – there are so many things tolook at in this business that things can fallthrough the cracks unless you force your-self to focus. Having capital on the booksdoes that.


We don’t generally buy full positions onday one – we’ll buy a half position,watch it trade, live through a quarter ortwo of earnings announcements and con-ference calls, and then decide whether tobuy more.

Vance Brown, 10.31.07

I believe the biggest way you add valueas a value investor is how you behave inthose down-25% situations. Sometimesyou should buy more, sometimes youshould get out, and sometimes youshould stay put. I’ve never actuallylooked, but we probably hold tight 40%of the time, and split 50/50 between buy-ing more and getting out. Making theright decisions at these moments addsmore value, in my opinion, than the ini-tial buy decision.


My threshold for pain is high as long as Ibelieve I’m still right. Historically, we’vemade a lot more money on the long sidewhen what we thought we were buyingcheap went down another 30% beforefinally going up – we always buy more ifour thesis hasn’t changed.


I don’t believe everything is either a buyor a sell – some things are worth holding




to stay connected to the company andlearn more about it. We’ll also makesmall investments for the same reason.

Spencer Davidson, 6.30.08

There are no “holds.” Every day you'reeither willing to buy more at the currentprice or, if you aren't, you should rede-ploy the capital to something you believedoes deserve incremental capital.


I more often than not sell too soon. Toavoid that, I’m trying to better distinguishbetween cases in which the rise in theshare price is still primarily a function ofimproving business fundamentals andthose where multiple expansion hasbecome most important. A rapidlyincreasing multiple often means too manypeople are starting to agree with me,which makes me nervous.


I’ve concluded that leaving money on thetable is a built-in problem for valueinvestors. Our assumptions are generallyso conservative that companies will blowthrough our target prices when they’rereally firing on all cylinders. At least that’show I rationalize it – it stills hurts whensomething I’ve sold takes off.

Alan Schram, 1.31.07

To avoid selling too soon, we’veforced ourselves to look overlong periods at where marginand sentiment peaks have beenin individual stocks, to reallyvet how high something mightreasonably go.


We used to have a fairly rigidrule that as soon as somethingwent above the market multiplewe'd sell, but we thought wetoo often were leaving moneyon the table so we now use trail-

ing stops. That means if something hitsthe market multiple on the day it's trad-ing at $61, we'll set a stop to sell, say, at$59. If the stock goes up to $63, we'll setthe trailing stop at $61, and so on.Hopefully this allows us to better takeadvantage of people's willingness to over-pay for our shares.


We may be willing to hold until 110% ofappraised value if management, throughits strategic decisions or capital alloca-tion, has a proven history of increasingintrinsic value beyond a natural rate. Weactually talk more about managementwhen we're looking to sell than whenwe're looking to buy.


If we’re right on the long-term trends,our bias is to stay with a trade for manyyears to allow that to happen. We try toavoid getting itchy every time somethinghits a new high – a stock that goes up alot over time, by definition, is frequentlyhitting new highs.


When management really makes us angry,we put the file in a drawer for a while and

just don’t do anything. We try not to selljust because we’re angry. If you sell whenyou’re angry, you can imagine everybodyelse who sells that way reaches the pointof exasperation at exactly the same time.That’s the kind of thing that creates atleast a trading bottom. Better to sit on itfor some time, and even if you still hatewhat the company’s doing, you’re proba-bly going to get a better chance to get out.

David Einhorn, 3.23.05

One lesson learned after enduring a fewtoo many round trips is to take more ofan IRR [internal rate of return] focus onwhen to sell – what is the return potentialfrom today, not “I’m holding this until itreaches my target price of $X.” We’ll stillride things up and down, but it’s beenless frequent since we starting thinkingmore in terms of today’s IRR. When weno longer believe something can make us50% over the next two years, we startpicking our spots to sell.


One thing we’ve had to get better at overthe years is sizing our positions to ourconviction level. That may sound obvi-ous, but the only bad year we’ve had wasin 2003, when a lot of our best-perform-ing stocks went to historically high valua-

tions and we made the mistakeof not taking profits.


If a company is doing well andcontinues to earn an attractivereturn on capital, I’m in nohurry to sell. We will sell whenevents materially threaten thatreturn on capital, the discountrate implicit in the stock getstoo low because the valuationhas gone up, or if I just have amuch better idea.


We’ve been too quick at times tosell high-quality businesses. The“‘Be careful’! All you can tell me is ‘be careful’?”




mediocre ones you buy for 50 cents on thedollar, and when they get to 90 cents you’dbetter start thinking about selling. Butbusinesses that have strong moats that canbe protected for a long time, in industriesthat are growing strongly, we make surewe give those businesses a chance to devel-op. Sometimes you should let your trulygreat businesses run a bit.

Zeke Ashton, 2.22.05

If value keeps building in the business,that provides a cushion against round-tripping over time and we’re happy to bepatient. We also think a slightly over-priced stock in the hands of skilled man-agement can be used as a currency inmaking acquisitions and building a busi-ness, so we’re not entirely averse to hold-ing something slightly overvalued.

Amit Wadhwaney, 5.22.05

The argument that losers in your portfo-lio will outperform in the future doesn’tgenerally hold up to close scrutiny. Afteranalyzing the trading records of 10,000discount-brokerage accounts, TerranceOdean, now of the University ofCalifornia, Berkeley, concluded that“Investors who sell winners and hold los-ers because they expect the losers to out-perform the winners in the future are, onaverage, mistaken.”

VII, 4.27.05

We do make a clear distinction when sell-ing between “compounders” and cigar-butt stocks. Once the cigar butts comeback, you know to get out because they’rejust going to go down again. With some-thing like Johnson & Johnson, though,you make a judgment call when it hitsintrinsic value, based on your confidencein its ability to compound returns andwhat your alternatives are.

Christopher Browne, 9.29.06

[SAC Capital’s] Steve Cohen thought itwas the silliest thing in the world to tryto capture the first and last part of a

stock’s move – those were the most dan-gerous parts of investing. For me, I’d liketo capture more of the early part of themove and leave the latter part for some-body else.

Robert Jaffe, 12.22.06

We replace portfolio holdings later intheir earnings cycle and at the high end oftheir valuation range with those that havethe opposite characteristics. There’s notone absolute number against which allideas are compared. This is the value-added of fundamental research – usingour judgment and experience to gaugewhere companies are in their valuationand earnings cycles.


We are required as analysts to presentfive, six or seven key reasons to own astock, and if any of those start to erode,that’s a warning sign that often leads us tosell. For example, we have tended in thepast couple of years to overestimate theintrinsic-value growth in media compa-nies. As we scale those estimates back –taking away a primary reason for ourowning them – we should be selling.


We have three people in charge of theportfolio and we require unanimity on astock in order to buy. It’s majority ruleson selling. The fact is that it’s very hardto sell one of your ideas, especially whenit’s working beautifully.


Sometimes tracking insider selling isn’t sohelpful, but if you do see an insideraggressively selling when the stock isfalling, run. There’s only one reasonsomebody does that, and it’s not becausethey’re bullish on the stock’s prospects. Icouldn’t care less if you’re paying for anew swimming pool or your kids’ tuition– you’re selling and think your stock isovervalued, so why should I own it?


People would disagree with me on this,but I don’t think you can sell based pure-ly on your valuation analysis. The stockhas to at least be at fair value, but I alsolook for the sentiment to be clearly posi-tive. If it’s still negative, I may hold on toit even beyond my fair value.


We have for selling what we call the “IBDtest.” When our companies start showingup on Investor’s Business Daily’s hot top-10 lists, that’s generally the time for us toget out. When the momentum investor’sbible brands one of our companies as ahot growth company, we’re usually readyto sell. Sometimes it’s early, but we’ve got-ten in early as well.


It’s when we’re truly negatively surprisedthat we typically exit a position. If we’resurprised, that usually means manage-ment is also and that there’s somethingmore fundamentally wrong with the busi-ness than we thought.

Steve Galbraith, 12.22.06

When a stock reaches the midpoint of the[valuation] ranking, from cheapest tomost expensive, we sell automatically. Asa stock price goes up and becomes lesscheap, we’ll want to hold less and trim itback as it’s going up, and we’re out whenit reaches the midpoint.

I arrived at that discipline because other-wise I would have no idea how to sell. Itstruck me that if you let your emotionsdictate when to sell, you risk falling inlove with companies that have been doingwell and you ride them too long, and thensomething goes wrong. For me, havingsomething systematic that says “this ischeap” or “this is fairly valued” is really,really important.





It’s a lot easier to know when to buysomething than when to sell it. In gener-al, when the upside/downside ratio fromthe current price gets to parity and we seeno reason to change our targets, we’llstart selling.


I’ve never understood why value investorswho are very disciplined on the buy sidebecome momentum investors when theysell, saying they’ll wait for the market totell them when it’s the right time to sell. Itseems to me that if you think your portfo-lio is being hurt by that last move from fairvalue to overvalued – that that move isgreater than what you’d get by going from60% of fair value to 90% of fair value insomething else – then shouldn’t your strat-egy be to identify names that you’vemissed that have run up to fair value andbuy them for the run to overvalued?


In general, we’re not in the business ofholding securities that are fully priced. Ifin our judgment the company’s valuationis appropriate for its growth prospects,we should be selling and buying thingsthat are bargains.


Value investors should completely exit asecurity by the time it reaches full value;owning overvalued securities is the realmof speculators.


CONCENTRATE OR DIVERSIFY?

If I didn’t have partners, the concentra-tion [65% of the portfolio in the topseven stocks] would be even higher. Acompany compounding capital at wayabove average rates, when I have greatconfidence that will continue and the val-uation is modest, I want to own a lot ofthat. The rationale is that simple.


We believe in constructing the portfolioso that we put our biggest amount ofmoney in our highest-conviction idea,and then we view the other ideas relativeto that. We find things that we think areexceptional only occasionally. So if wefind something that is really set up, wherewe think it’s mispriced, where we have agood understanding of why it’s mispriced,where we think the mispricing is verylarge and the overall risk is very small, wetake an outsized position to make sure wegive ourselves the chance to be well com-pensated for getting it right.

David Einhorn, 3.23.05

What works for us is between 10 and 20positions. Owning more than 20 stocks,it’s too hard to follow the companies veryclosely, and a big winner won’t move theneedle enough. I’m uncomfortable withthe risk of owning fewer than 10, becausewe live in a dynamic world and you domake mistakes. I don’t want to make amistake in a 15% position.


Because my style is so research-dominat-ed, I should run a very concentrated port-folio and force myself to wait – which cango against human nature – for only thefattest pitches.


We want each decision we make to havea meaningful impact on our results and tobe rewarded when we’re right, so ourportfolio is concentrated in only 10-15stocks. We believe that the more compa-nies you own, the more mediocre yourresults will be and the more exposed youare to market risk.

Atticus Lowe, 4.30.07

Our ideal is 25 roughly 4% positions,though the reality varies around that. Webelieve concentration is tied to outperfor-mance, but many institutional investorsdon’t have the stomach for our beingmuch more concentrated than that. The

way we look at it, if we can find five newideas to replace previous winners or mis-takes, that’s an honest year’s work.


We just don’t see the sense in puttingmoney in our 30th-best idea. We do payattention to end-market diversification,within our companies and across theportfolio. Our goal is to own businesseswith uncorrelated enough end marketsthat we can continue growing the intrin-sic value of the portfolio in any kind ofmarket.


One reason focused investing works isthat you box yourself into what I thinkis a very positive corner. You force your-self into the position where you can’tafford to be wrong, so you’d better doall your homework. My goal is to buy astock at such an attractive price thateven if we’re wrong, we get more thanour bait back. Sometimes that comfortcomes from hard assets. Sometimes it’sthe private-market value of the business.We also manage risk by going in whenthe company is already starting to do theright things. If you’re in a concentrated,illiquid situation, the last thing you needis to have to convince somebody to dosomething.

Matthew Feshbach, 5.22.05

We think concentration is the key to bigperformance, but we also have no desireto have our year depend on one or twothings working out, so we have generallykept our largest positions at 5-8% of totalcapital and make sure those big positionsare not particularly speculative or highlylevered.

Gary Claar, 3.30.07

You can understand why many succumbto the pressure to “hug” the index, so tospeak. But we believe if you go down theroad of trying to make sure you’ll neverdo much worse than the index, you’re




almost insuring that you’ll never do wellenough to justify your compensation asan active manager.


Early in my career I had 20% of my port-folio in Johnson & Johnson just beforeTylenol was laced with poison. My objec-tive is to produce an above-average long-term return, and I think I can do thatwithout taking that kind of concentrationrisk. Things happen.

If I really knew the best stock in my port-folio I’d put 100% of the portfolio in it,but I don’t. [Financial columnist] DanDorfman once asked me in an interviewwhat the best and worst stocks were inmy portfolio. I told him the worst stockwas Converse, the shoe company, whichhe dutifully reported in his column. It gottaken over two days later, up 50%.


Diversification is a big part of our riskmanagement. An important percentage ofOmega’s total capital is our own moneyand we’re just trying to do what we thinkis intelligent in a highly uncertain world.Our level of diversification reflects ourunwillingness to make giant bets or togive up liquidity. We could liquidate ourportfolio in 48 hours.


We want to have enough good ideas atwork that if we’re wrong or unlucky onone or two, we haven’t lost a significantamount of capital. It’s not unusual for usto make a good decision that has a badoutcome – this is a probabilistic business.If you’re really concentrated and havetwo bad outcomes out of ten perfectlygood decisions, 10% of your portfoliocan blow up. I’ve heard the argumentthat if you have your top ten best invest-ments, why would you want to dilute itwith your 11th best investment? But if Ihad to order my top ten ideas by howmuch I thought they’d go up, I guaranteeyou that wouldn’t end up being the top

ten in actual performance. So we’re justmore comfortable being somewhat morediversified.

Zeke Ashton, 2.22.05

People tend to assume that the only formof active portfolio management isthrough relatively concentrated portfo-lios. We think there's an equally legiti-mate form of active money managementin running a diversified portfolio that hasnothing to do with the benchmark. Ourmandate is first and foremost the returnof capital, which has also so far resultedin above-market returns. With that man-date, we don't want a concentrated port-folio that bets the farm on a few stocks.This year has been an excellent reminderof how valuable diversification can be asa risk-management tool.


We have fairly strict diversification rulesso that we don’t get overexposed to anyone sector or industry. We state those lim-its in absolute terms, not relative to abenchmark. Being slightly underweightfinancials when financials had grown tosuch a large portion of the market a yearago wouldn’t have served you very well.

Ric Dillon, 6.30.08

We typically have 50 to 60 positions. It’snot more concentrated out of prudenceand humility. There’s always a chancewe’ll be wrong on any given idea.


I’ve never had the confidence to makeprecise distinctions about which of thestocks we own will go up more than theothers. It’s hard enough at any one timejust to find 40 stocks that won’t kill youand another ten that will make youmoney.

Susan Byrne, 1.31.08

The knock on diversified funds is thatthey’re index-huggers, which given the

geographic breadth of where we invest, isnot at all the case for us. I know the argu-ment that you should only own your best30 or 40 ideas, but I’ve never proven overtime that I actually know in advance whatthose are.


While we’ve generally avoided being hurtby underhanded executives, that risk isalways there and it’s far more pro-nounced if you’re running a concentratedglobal portfolio. A second reason we’remore diversified is because I believe a lotof our alpha comes from being in theright sets of companies rather than theright specific companies. If we get thethemes right, we’ll do as well, with lowervolatility, owning more names ratherthan fewer.


Having a broadly diversified portfolio isjust a more prudent way to invest insmall companies. The myriad of unex-pected things that can happen, whichmight be short-term glitches for a biggercompany, can take a small companydown. We don’t want to be overexposedto that.


Our flagship mutual fund today has 300stocks. Buying things when they meet thevaluation characteristics that haveworked for us in the past is our selectionmethodology, period. It’s not about pick-ing the “best” 5%, 10% or 20% of those– I don’t know which ones those are.

John Buckingham, 8.31.07

MANAGING RISK

It's not during up years that great invest-ment track records are made.


Long periods of prosperity tend to breedoverconfidence on the part of investors,which leads to a misassessment of risk.




During times of excesses, we concentrateon reducing risk by holding particularlystrong companies.


One of the key ways we manage risk isby buying securities for which there areminimal expectations. If expectationsare minimal or no one is paying atten-tion, short-term volatility can be muted.This is really just another way of sayingit’s prudent to buy securities with valuecharacteristics.


We think our way of investing lowers riskdramatically. If you invest only in qualitybusinesses that generally aren’t exposedto external shocks – like union actions ora lot of cyclicality – that are growing 8-10% per year and earning 10% currentreturns, you don’t ever really dig yourselfany big holes.


We’ve found that the best way to dealwith the fact that market sentiment canchange so quickly is to try to own absurd-ly cheap things.

Stephen Roseman, 9.28.07

In periods of rapid change in liquidity andeconomic conditions, the odds that we’resimply wrong about our estimates ofcompanies’ near-term fundamentals arehigher than average. As a result, we’remore focused today than ever on main-taining flexibility – through cash levelsand buying power – and in sizing our betsaccording to the medium- to lower-confi-dence environment we’re in. We’re notnecessarily making fewer bets, but they’resmaller in size.

Larry Robbins, 12.21.07

Not to be flip, but all we count on in anumber of our investments is just forthings to return to normal. There’s a lotless risk in wanting that to happen than

looking for some huge transformation ina company’s business.


By focusing on stocks we know very well,with a high level of tangible downsideprotection, we’ve so far captured morethan the market return in up markets andonly 15% of the market’s loss in downmarkets. For value investors, that’s kindof what it’s all about.

Atticus Lowe, 4.30.07

We like it when expectations are verylow and we have a contrarian view on abroader issue impacting the company.Low expectations help limit the down-side and can result in prices that leaveyou paying nothing for the upside ifgood things happen. As Joel Greenblatt,who is one of my oldest friends, alwayssays, “If you don't lose money, most ofthe remaining alternatives are goodones!”


To some extent, balance sheet risk is acharacter issue for us. The CEO whosecompany has a great balance sheet prob-ably isn’t going to make the big, dumbacquisition that will kill the company.He’s probably not the guy throwing $2

million birthday parties for his third wifeat company expense. Other investors likethe leverage that having debt gives you onthe upside, but we generally try to lookdown before we look up – leverage does-n’t look so great from that perspective.


We do cap a given industry’s exposure at25% of the portfolio, which is a check onthe innate lack of humility we often haveas investment managers. Owning five orsix positions in an industry is a good,strong bet, but also isn’t betting thehouse on how smart we are relative toeveryone else.


We’ll have no more than 30% in any onesector, which is meant to insure that wewon’t follow a very strong sector as itgrows in importance in an index.


Investing is often about knowing yourstrengths and we've learned that we'rebetter at spotting profitable, unglam-ourous, under-valued companies than weare at identifying traditional turnarounds– by which I mean money-losing compa-nies we expect to get back into the black.As a result, we set a guideline for our-selves that no more than 10% of the port-folio will be in companies with negativetrailing 12-month earnings.


We don’t benchmark at all. I don’t careif we own almost no financials and Idon’t care if we own an excess amountof energy. We’ll go where we think thevalue is and let the weightings fall wherethey may.


We spend 12 months building a position,are actively engaged with managementover the next 12 months and if it allworks out, we’re exiting after another 12




months. The activist approach to roll upour sleeves and work to improve share-holder value is the best risk managementtool we have.

Christopher Kiper, 7.31.07

I’ll sacrifice some upside in bull marketsto protect the downside in bear markets.That provides a valuable service to theaverage investor who can’t handle thelevel of volatility inherent in equityinvesting. It also allows me to spend lesstime talking to upset investors.


One of our strategies for maintainingrational thinking at all times is to attemptto avoid the extreme stresses that lead topoor decision-making. We have oftendescribed our techniques for accomplish-ing this: willingness to hold cash in theabsence of compelling investment oppor-tunity, a strong sell discipline, significanthedging activity, and avoidance ofrecourse leverage, among others.


GOING TO CASH

One big reason we like to hold cash isthat my inherent nature is to feel some-thing better to buy is always going tocome along and I want to have the cashavailable to buy it. People assume theycan always sell something to buy some-thing better, but I don’t like potentiallyselling into a lousy market when the liq-uidity isn’t there.


Every couple of years there’s a crisis, inone industry or across markets. We thinkit’s very important to have buying powergoing into something like that, which wealways have either through holding cashor having significant borrowing power.Without the ability to buy in the middleof a crisis, you’ll suffer the volatility of itbut won’t be able to buy the cheap assetsthat result from it.


Ben Graham always made the point thateven if you thought you had a portfolio ofvery cheap stocks, if the market at thetime was fully priced, you should have atleast 25% of your portfolio in somethingother than equities, such as cash orbonds. To do otherwise would be todelude yourself that your stocks, no mat-ter how cheap they appeared to you,would be magically immune if the wholemarket was to correct.


Many value investors have a very partic-ular view of when things are cheap andwhen they’re expensive and they shouldhold cash. They portray holding cash as arisk-reduction method. My view is that’sjust taking on a different risk. You’re bet-ting there is going to be regular cyclicali-ty and things are going to get cheap againand you’re going to be able to buy them.But if they don’t, you’re screwed. You’llend up like the guys that have been bear-ish for 20 years and don’t have any assetsany more.


By having a high cash balance, one is sug-gesting that he has some wisdom orknowledge about timing the market forwhich he or she should be compensated. Ihave none of that.


Our cash balance is purely a residual ofwhether or not we’re finding enough toinvest in.


THE SHORT SIDE

Well-functioning markets depend on thetransparent flow of information, whichcan be greatly hindered when critics areattacked not for the quality of their analy-sis, but simply for being skeptics. “Thevilification of critics, be they short-sellers,journalists or regulators, chills the free

flow of ideas and analysis – indeed, chillsfree speech – by making it so darn expen-sive,” writes David Einhorn. “If postingan analysis on a Web site or making aspeech gets you an SEC investigation,why bother?”

VII, 5.30.08

Short sellers play a valuable market role.There are obviously cases in which peo-ple may try to start rumors more thananything else, but that’s as true on thelong side as on the short side. Marketswork better when both sides of the tradeare heard.


Without having a commitment to theshort side, it’s difficult to be offensivewhen you should be. The highest-returnopportunities are available when marketsare in free fall, but if you’re gettingshelled, you may not have the emotionalconviction to be aggressively opportunis-tic and you may not even be able to do it,because of redemptions. Being able to beoffensive when everybody else is defen-sive, in and of itself, can yield excessreturns.


We have consistently prepared for theworst, incurring significant hedging costson an ongoing basis. While many of ourholdings did not truly require hedges inorder to be attractive, and while many ofour hedges ultimately proved unnecessarybecause the anticipated risks failed tomaterialize, our hedges were quite valu-able as enablers, in that they gave us thecomfort and the confidence to, at times,incur fairly concentrated positions thathave produced such excellent long-term,risk-adjusted results.


We think shorting makes us better ana-lysts. Charlie Munger says you reallyunderstand a company when you canarticulate the negative scenario better




than the person on the other side of thetrade. We also think that from a businessstandpoint, if you’ve done all the workand conclude the negative scenario ismost likely to play out, it makes a lot ofsense to be able to short.

Ric Dillon, 6.29.07

We short because I think it is the mostprudent way to manage a portfolio, froma risk perspective, and because I believethe key to successful long-term investingis to never have losses.


An important way we try to minimizerisk is by actively deploying short sales.We don’t do it primarily for that reason– we do it to generate incremental prof-its – but the outcome of shorting is thatin periods of declining market prices itdoes tend to preserve the gains or trumpthe losses we have on the long side of thebook.


When you short, it’s important to havethe right benchmark. People look backand say, “I spent all this time and efforton shorting and only broke even – what awaste of time.” We compare how ourshorts have done against the market. Ifwe’ve broken even on our shorts over aperiod where the market is up 7-8% peryear, we’ve generated huge alpha that hasallowed us to be levered to our longs. Iwould call that a zero-cost hedge and avery valuable tool.


When there is a cyclone of wealth trans-fer into an area, some of the participantsin the fledgling industry will be real com-panies whose products and services willchange the world. But there will also bedozens of other companies that are bogusand run by unscrupulous promoters.That’s the subset of the market we’reattracted to on the short side.


One thing we like to do on the short sideis to see things start to break down beforewe get involved. Once something starts tocrack, there will still likely be plenty ofdisagreement – reflected in the stock price– on whether or not the business is reallybroken. So we’ll typically miss the top,but the risk/reward can look even betterto us long after the break.

Alan Fournier, 2.28.07

We won’t short on valuation – say,because Google is trading at 20x nextyear’s cash flow when we think it shouldonly trade at 15x.


One challenge we’ve had in shorting iswith growing but grossly overvaluedcompanies, in which the market candelude itself for a long time. We gave upon our short of solar energy companyFirst Solar [FSLR], for example, afteranalysts started doing things like setting aprice target and then backing into themultiple at which they thought it shouldtrade today.


We made a few more general mistakeswhen we started our own firm. One wasthat we told ourselves that we should behedging against macro concerns whenthat wasn’t really our expertise. Shortpositions were never going to be a bigpart of our portfolio, but they took up aninordinate amount of time and added aninordinate amount of stress.


How would you judge an investing strat-egy that had the following fundamentaleconomic characteristics: 1) Limitedpotential returns, but unlimited potentiallosses; 2) Skyrocketing competition; 3)Tax inefficiency; 4) Aggregate net lossesover its history; 5) The elimination of asignificant source of income in recent

years; 6) Risk of asset repossession atcreditors’ whim.

Having spent 15 years of my careerdoing nothing but short selling – includ-ing periods of great prosperity and otherperiods of fast, painful losses – I canargue with some authority that, as aninvestment strategy, shorting suffersfrom each one of these characteristics ofa bad business.

Joe Feshbach, 2.28.06

ACTIVISM

Poor management persists because share-holders aren’t willing to do anythingabout it, which we think is an abdicationof responsible ownership and fiduciaryduty. The private-equity business is builtaround taking over companies and doingwhat shareholders should have gottendone, while they keep most of the moneyfor themselves. The amazing thing is thatthe same shareholders who do nothing toeffect change at a poorly managed com-pany before a private-equity firm comesin to take over line up to pay a stupidmultiple for the company when it comespublic again.


If you think about where the corporatesystem has fallen down in the UnitedStates, it’s when the actual capital hasgotten too far removed from the enter-prise, and the agency relationshipbetween owners and management hasgotten so broad and wide. That’s whenyou have disconnects or conflicts ofinterest. Everything we do tries to shrinkthe distance between the capital and theenterprise.


Michael Price [CEO of Mutual Seriesfrom 1988 to 1998] was at the forefrontof shareholder activism. His and our atti-tude became that just selling if youweren’t happy wasn’t the right conclu-sion. As the owners of the company,shareholders really deserve full credit for




what companies are worth. So it’s not justour right, it’s our obligation to do all wecan to see that we get that credit.


A corporate board has three main respon-sibilities: set overall strategy, hire the rightCEO, and put in place compensation sys-tems that create alignment in the agencyrelationship with owners. If we do ourjob right, we can bring courage to thefirst, hopefully some insight to the secondand accountability to the third.


Much of the activism you see today is“buy shares today and tomorrow throw ahissy fit.” The focus is on shortening timehorizons by being your own catalyst.That’s a problem for me, because thatstyle is transparent and could discredit allactivists. Activists are going to need thecapital base, experience and credibility to

follow through – by buying the companyor going on the board to help fix it – ifsteps aren’t being taken to address theirconcerns. You’ll need to be more than ayeller and screamer whose biggest asset isthat you don’t care what anybody thinksabout you.


There’s a certain trendiness to activism,driven by the fact that the opportunitiesfor activism aren’t always there. In the1980s you heard a lot about it, but thenas valuations changed in the 1990s youdidn’t hear much about it at all. Now it’spopular again, but we’ve always consid-ered a willingness to be active as justanother weapon in our arsenal.


We like to invest with management thatgets it and is doing what we think theyshould. Some investors want to buy

cheap stocks where the businesses arerun by morons and then force them to dosomething different. That’s not a badstrategy, but that’s not how we tend to dothings.

Wayne Cooperman, 3.30.07

The fact is, when I feel I have to write aletter and make noise, that almost alwaysmeans I’ve made a mistake and the moreproductive use of my time is to sell andmove on.


I will say that I have in the past falleninto what I call “time traps,” where I’vespent too much time trying to resolveproblem investments. We will pick ourbattles, but usually we’re better off help-ing our best investments maximizeopportunities than trying to performbrain surgery on dogs.


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Learning CurveW O R D S O F I N V E S T I N G W I S D O M


Becoming a better investor has alwaysstruck me as a process of self-education –you read everything you can and learnthrough trial and error. My financedegree, except for having to take someaccounting courses, was worthless.


I’ve had the good fortune of beingaround smart investors my whole life,including my father. But I’d have to saylearning from what works and whatdoesn’t is how you really become a betterinvestor. In the end, the market is the bestteacher.

Wayne Cooperman, 3.30.07

I generally find the best investors are veryopen and have almost a child-like curios-ity about how everything works. Theydon’t come to the table with preconceivednotions. Americans, in fact, are more like-ly to have this kind of attitude thanEuropeans or Asians. It’s much harder tolearn new things when you think youalready know everything.


If you stop learning, the world rushesright by you. It's very hard to do this bymerely hearing someone else talk. That'swhy most teaching is vivid. For example,when they trained soldiers for WorldWar II, they shot real bullets abovethem, which really taught them to hugthe ground.

Charlie Munger, 7.31.07

Around 1982 it hit me that there were alot of lousy stocks in my portfolio and Istarted wondering why. While it soundslike an obvious conclusion now, the com-mon denominator of the losers was thatthey were in lousy businesses. I realized I

should be more of a business analyst thana stock analyst, meaning that I had to bet-ter understand how companies them-selves created value. I moved more awayfrom classical stock metrics of P/E andbook value to business metrics of returnon capital and cash flows.


If one is wrong in judging a company tohave a sustainable competitive advantage,the investment results can be disastrous.


People suffer from an illusion of control,that even if things do go wrong, they'llbe able to sort them out. A lot of themodern risk-management techniquescreated a totally false illusion of safety.The idea that by quantifying risk using atool like VaR [Value at Risk] that youcould therefore control it is one of theslightly more ridiculous things to havecome along in years.


Back in the late 1990s we invested in afew too many “concept” stocks – earlier-stage companies with developing tech-

Learning Curve

“I didn’t actually catch anything, but I do feel I gained some valuable experience.”




nologies where the stories were com-pelling and indicated that there would beconsiderable future value. The problemis that without a real underpinning ofasset value or earnings, these types ofcompanies can run into big trouble whenthe thesis doesn’t pan out as quickly asexpected or new competition disruptsthe story.


One mistake we’ve too often made isbuying lagging companies that stay thatway much longer than we expect, oftenbecause we misread a macro trend.Another thing we’ve learned from experi-ence is to get out when a restructuringcompany’s balance sheet worsens ratherthan improves.


I’ve learned from experience to avoidacquisition-driven stories during theactual acquisition-growth phase – bigproblems always come of that. I’ve alsorecently concluded that if you find your-self going back to the well with the sameidea a third time, you’re not generatingenough ideas and are likely to get killed.You’re not as vigilant as you should bebecause you think you know it already.When I find myself doing that, I tellmyself I’m just not working hardenough.


The biggest mistakes we ever madeinvolved a few investments in highlyacquisitive companies that had balancesheet leverage. The big lesson is thatwhen you mix financial risk, in the formof leverage, with operating risk, fromhaving to integrate acquisitions, youcompound the overall risk dramatically.


One mistake we’ve made more than we’dlike is sticking with great niche companiesthat get bored and start to make acquisi-tions around the periphery. Each one of

them individually doesn’t really botheryou, but then you wake up over two orthree years and find that the core businessis now 40-50% of revenues instead of 80-90% of revenues, the new businesses arenot doing so well and now the companyhas too much leverage. It can catch up toyou slowly, but the cumulative effects canbe devastating.


[Lessons from a money-losing investmentin Sprint?] I’d put this in the category ofwhat David Packard once said, that morecompanies die of indigestion than starva-tion. This was a company that had notdone a big acquisition, so our mistakewas in taking the company’s plan afterthe merger at face value. There were a lotof reasons, in retrospect, to imaginethey’d have a much more difficult timethan they expected.


You have to be willing to double downwhen you invest in the types of companieswe invest in, where things often get worsebefore they get better. But I don’t want toleave you with the impression that alwaysworks. In the late 1990s I had about a12% portfolio position in SuperiorNational, a big player in California work-ers’ compensation insurance. I increasedmy position in a rights offering and it gotas high as 20% of my portfolio. When theworkers’ comp business in California fellapart, the company turned out to be tooleveraged and the shares went from $22to zero. The lesson wasn’t not to beaggressive, but not to be overweighted inanything that’s so leveraged that it reallyhas the risk of going to zero.

Robert Robotti, 8.25.06

One of our biggest mistakes was ten yearsago going too heavily into emerging-mar-ket closed-end funds, which were sellingat 25-30% discounts to net asset value.When the Russian debt crisis hit, theNAVs got hammered. It’s one of the firstlessons you learn: be diversified enough

that if that 1-in-100 event happens, youdon’t blow up.


We have become very leery, based onexperience, of companies that need toraise capital in order to survive and pros-per. It’s not a good thing to be vulnerableto the whims of capital markets, whichcan close rapidly and surprisingly.


At the peak of the Internet bubble I wentto an investor presentation by [checkmanufacturer] Deluxe Corp., in whichthey described how the Internet wasgoing to flatter, not tarnish the checkbusiness. Then the CEO launched into abig discussion about how he was going toconvert his core franchise to a new plat-form he called Internet gift sales, and thatthey were going to lose $50 million a yearon it. I went away and didn’t buy thestock, disgusted with that idea. What Ilearned from this, however, was that real-ly dumb ideas like this one actually havea habit of meeting an early death. In fact,it turned out to be such a dumb idea thatit died quite quickly, leaving the businessto flourish under its core dynamics,unburdened by ill-considered strategicmoves. That was a big lesson.


A bubble is a logical impossibility, whenpeople are investing on a premise that notonly won’t happen, it can’t happen. Thetech bubble in 2000 wasn’t because stockprices were high, it was because stockprices incorporated the belief that manycompanies in the same industry were allgoing to have 20% market shares andhigh margins. That can’t happen.


One final Internet-bubble lesson is obvi-ous, but bears repeating: Make your owndecisions. Crowds can be ugly when theychange directions.

VII, 9.28.05




It’s hard to get away from truisms andclichés, but things that appear too goodto be true – investments or otherwise –usually are. The market exposes thatfrom time to time and we’re in the processof that with respect to credit right now.


Top executives from a Japanese propertyand casualty insurer we’ve owned foryears were just in our office last monthexplaining the extent of the CDO expo-sure in their investment portfolio, whichwas upsetting to us. We said, “Didn’t thefact that you were buying a triple-Arated product with a yield much inexcess of what you could get fromProcter & Gamble sound too good to betrue?” But that kind of thing happenedaround the world.


We were interested inFannie Mae a year ago butfirst wanted to understandtheir credit risk better. Wespoke with the ratingsagencies and asked themwhat would happen ifhouse prices fell. “Youmean a six- sigma event?”they asked. “No,” I said,“just if prices fell 5 or10%.” They said, “That'ssix-sigma!” Well, if houseprices going back to wherethey had been just 12months earlier was consid-ered six-sigma by the rat-ings agencies, I thought wewere in trouble.


What’s most embarrassingand annoying to me is thatwe foresaw credit prob-lems for the owners ofmortgage-backed securitiesand CDOs backed by

poor-quality mortgages, but we failed torecognize the vulnerability of some of ourcompanies to the liquidity crisis thatwould occur as the market had its emper-or's-new-clothes moment.

Wally Weitz, 12.21.07

We’ve looked carefully at why we sooften sell investments too early. Peopletend to give you a pass on that, sayingyou invested in the safest part of the prof-it cycle. But I have to say, people havemade a lot of money buying stocks fromme. Over an investment career, that’s nota good thing. What I discovered is thatthe investments that have done much bet-ter than I expected – after I sold – are con-sistently those in superior businesses orwith superior managements. That’s whywe now spend so much time analyzingmanagement’s prior actions and theirresults in creating shareholder value.


I’ve been fooled many times by being tooimpressed by executives who are articu-late and have done well in the past. I’velearned to be humble about my ownopinions and rely more on the opinionsof people who aren’t biased and haveknown the management personally orprofessionally for a long time.


The lesson for investors is clear. Payattention to the signs of managementhubris: the overly grand pronounce-ments, the unwillingness to communi-cate, the lavish perks and pay packages,the building of “monuments.” Ignorethem at your peril.

VII, 5.22.05

Some of my biggest investment drub-bings have come from not respondingquickly to inconsistencies in what man-agement is saying over time or in differ-ent forums. Changing stories are a huge

red flag.Robert Lietzow, 2.29.08

We have at times underes-timated how quickly anddeeply ineffective manage-ment can impact a compa-ny’s operations. We typi-cally haven’t put a highpriority on site visits andmeeting with management,but we are starting to putmore emphasis on thattoday.


I’ve seen far too manybusinesses – investmentfirms and others – runinto the ground byimpressive people whostart to think they’resmarter than everyoneelse. That’s when big mis-takes get made. There areenough ways to screw up

“C’mon, we won’t get burned this time.”




in this business without bringing it onyourself because of ego.


We shorted crude oil at $40 per barreland thankfully Karen [Finerman] got usto cover around $44. When prices detachon the upside from fundamentals, the bestthing to do is to run screaming from thebuilding. There’s no reason a ridiculousprice can’t go to 3x ridiculous.


This is not at all to say valuation doesn’tmatter, but there have been times I’ve beenright about the trend but didn’t buy aleader because it was 20% too expensiveand that turned out to be a mistake.


When something spooks me, I shouldmore often take advantage of the liquidi-ty of the market to get out and finish thework on whatever the new issues are. Ifyou determine the problem is a big one,you can avoid a lot of pain. If you con-clude the problem is only temporary, youcan typically get back in at a lower price.

David Eigen, 1.31.06

If you believe the market can at times beinefficient, as I do, the logical conclusionis to be wary of what it's telling you whenit says you’re wrong. That can sometimesmean I don't cut my losses when I should.


The single biggest thing people do wrongis to believe there is a single right way toinvest, like it’s handed down from God.Things trade at different values from theirtrue worth because human beings look atthem in certain ways in certain circum-stances. Those ways and circumstancescan change, so the tools you use and yourthought processes have to evolve. Thesame thing doesn’t work over and overagain – the market’s too smart for that.


Mistakes of judgment are the toughest tolearn from, because each one is different.There were a lot of ways to look at themistake of buying AT&T when MichaelArmstrong took over, for example, thatwould have prevented you from buyingIBM when Lou Gerstner came in.


When I worked for New York City, I metan old-time surveyor in my departmentwho had gone broke betting on horses.The first time he had gone to the race-track he decided to bet on a horse namedSurveyor, and the worst possible thinghappened – the horse won. This guy fig-ured it was easy money and over the next20 years he proceeded to lose just abouteverything he had.


One lesson borne of experience is that thebest course in investing is often to donothing. That’s a hard lesson to apply inpractice, given the propensity most of ushave for tinkering.


Is investing a creative process? Hard-charging money managers resist definingwhat they do in terms usually reserved forartists. But if one defines a creative person– as does the American Heritage diction-ary – as “one who displays productiveoriginality,” there’s little doubt that suc-cessful investors fit the mold.

To be sure, creativity isn’t possible withoutperseverance, effort and, of course, theright attitude. Edison went through morethan 9,000 experiments in his quest to cre-ate the incandescent light bulb. Whenderided by colleagues for what they per-ceived to be the foolish quest, he respond-ed: “I haven’t even failed once; 9,000 timesI’ve learned what doesn’t work.”

VII, 10.28.05

If you never make a mistake, you’re beingtoo conservative and missing profitopportunities you shouldn’t.


Don’t be paralyzed by the fear of makinga mistake. Understand that the bestopportunities usually carry more per-ceived risks, and distinguish carefullybetween the risks that matter most andthose you can live with. As long as I knowthe risks I’m taking and the stock pricesare compensating me to take those risks,I can live with that.

Brian Gaines, 5.26.06

I’ve been doing this for more than 25years and have learned never to takemistakes lightly. What’s most importantfor us, though, is to stay focused on thediscipline of only investing in companieswith the characteristics of leaders, lag-gards and innovators that we’ve seenwork as investments over a long periodof time. That discipline keeps us ground-ed, and helps us keep mistakes in per-spective. Otherwise, you can drive your-self crazy.


We're quite open and honest about ourmistakes, but we have to be very carefulnot to take the experiences of the lastyear as justification for fundamentallychanging how we analyze and selectstocks. Our common belief is that this isa very unique environment that we prob-ably won't see again for some time oncewe get through it. It's important to keepthat in mind, or you may find yourselfchanging how you do things at exactlythe wrong time.

Connor Browne, 10.31.08

The best advice is to learn from mistakesand move on. “If every shot you hit ingolf was a hole-in-one, you’d lose inter-est,” Warren Buffett has said. “You gottahit a few in the woods.”

VII, 4.27.05


Of Sound MindW O R D S O F I N V E S T I N G W I S D O M


For perfectly logical evolutionary rea-sons, the human brain constantly triggersimmediate physical and emotionalresponses to external events. While thesemay work beautifully for choosing a mateor avoiding danger, they can also form thebasis for behavioral biases that getinvestors into trouble.

VII, 10.31.07

The risk among any group of investors isthat they only pay attention to what theyalready agree with. That’s limiting in ouropinion, and dangerous.

Michael Mauboussin, 8.31.07

How can investors counteract the nega-tive ramifications of being wired to chasethe big score? Never make snap invest-ment decisions, instead putting all poten-tial investment ideas through a similarprocess checklist. Be wary of “story”stocks and of situations that are reminis-cent of previous big investment successes,both of which can lead to costly analyti-cal shortcuts. Focus on being an “empiri-cal skeptic” – rather than accepting thatearnings can grow 30% annually for tenyears or a given level of return on capitalcan persist, look at the distribution ofoutcomes from a large historical sampleto see how reasonable such estimates are.Finally, spend as much time defining whatthe downside can be as the upside, andlook to make highly asymmetrical bets.

VII, 7.31.08

Our brains automatically anticipate thatrising stock prices will continue to rise and,if they do, the natural chemical dopamineis released, resulting in a feeling of eupho-ria. To counter this and other tests toinvestor willpower, Benjamin Graham sug-gests the use of more mechanical methodsfor portfolio rebalancing, which today

could take the form of formulaic adjust-ments based on asset-class exposure,industry exposure or position size.

VII, 9.28.07

Mozart was an example of a life ruinedby nuttiness. He was consumed with envyand jealousy of other people who weretreated better than he felt they deservedand he was filled with self-pity. Nothingcould be stupider. Envy, huge self-pity,extreme ideology, intense loyalty to a par-ticular identity – you've just taken yourbrain and started to pound on it with ahammer.


Sadly, there's no twelve-step process foreradicating envy from your life. The bestadvice for investors is probably Sir JohnTempleton's admonition: “It is impossibleto produce superior performance unlessyou do something different from themajority.” On a more personal level, we'llleave the last word to Charlie Munger:“Learn how to ignore the examples fromothers when they are wrong, because fewskills are more worth having.”

VII, 11.26.08

When I started in research, I had one ofthe worst character traits an investor canhave – I was a “believer.” I was too oftenseduced by charismatic CEOs and byconcept stocks, where the product orservice made a lot of sense but thereturned out to be cost, competitive orother reasons it would never succeed. Ilearned the hard way to be a skepticabout management’s – and my own –ability to forecast with precision wellinto the future.


Skepticism is the chastity of the intellect,and it is shameful to surrender it too soonor to the first comer,” wrote philosopherGeorge Santayana. Sound investmentadvice, indeed.

VII, 9.29.06

You’re a product of your experience, sothe fact that I came of age as an investorin the 1970s has basically made me scaredof everything. I’ve found that abject fearand sound analysis can be a very healthycombination for an investor.


We are big fans of fear, and in investing itis clearly better to be scared than sorry.


An early mentor of mine started out dur-ing the Depression and used to always saywe were in the rejection business – thatwe’re paid to be cynical and that a bigpart of success in investing is knowinghow to say no. He never dwelled onmissed opportunities because somethingelse – even the same thing later on –would always come along. I’m a bigbeliever in that approach.


Of Sound Mind




The biggest payoffs go to those holdingthe best cards. Getting into that positionrequires patience, discipline and anunnatural willingness to hoard your chipsuntil the time is right. That’s not some-thing investors can turn on and off as thesituation warrants. Warren Buffett hasspent an investing lifetime putting himselfin positions in which the deck is stackedin his favor. We should all strive for thatluxury.

VII, 9.30.08

In 1939, right after Hitler marched intoPoland, John Templeton bought 100shares of every stock on the Big Boardselling for less than $1. Within a fewyears he had quadrupled his money. Healways said the time to buy was at thepoint of maximum pessimism and pain –obviously something to keep in mindtoday.


In a world in which most investors appearinterested in figuring out how to makemoney every second and chase the idea dujour, there’s also something validatingabout the message that it’s okay to donothing and wait for opportunities topresent themselves or to pay off. That’slonely and contrary a lot of the time, butreminding yourself that that’s what ittakes is quite helpful.


You obviously have to get your analysisright to be a great investor, but successalso comes down to patience. We think ofourselves as like a lion lying in wait.There are plenty of gazelle runningaround, but we can’t run after them all,so we wait for one to get within 125 feetbefore we go. Not 150 feet or 200 feet,but no more than 125. Sometimes themarket offers up those great kills and wetry our best to be ready and to takeadvantage when they come along.


As Graham, Dodd and Buffett have allsaid, you should always remember thatyou don’t have to swing at every pitch.You can wait for opportunities that fityour criteria and if you don’t find them,patiently wait. Deciding not to panic isstill a decision.


I always respected that [mentor] Jean-Marie Eveillard never showed emotionslike anger, fear or panic – and maybemost importantly, greed.


It is stressful to have pockets of underper-formance, but one truly remarkable thingabout our firm is how calm it is. Peopledon’t get too worked up whether out-comes are particularly good or particular-ly challenging. We try to keep pluggingaway on the process and how the expect-ed returns on the portfolios are improvingas market prices correct.

Michael Mauboussin, 6.30.06

Investors shouldn’t underestimate theimportance of keeping balance in theirlives. Sometimes going for a walk or meet-ing a friend for lunch when the market isdown 200 points is a lot better then star-ing at the screen trying to figure out whatto do. You don’t have to do anything andmost of time you shouldn’t. I’m absolute-ly convinced that regularly clearing yourmind helps you make better decisions.


People who are in a good mood are moreinclined to try learning new skills, to seethings in a broader context, to think ofcreative solutions to problems, to workwell with other people, and to persistinstead of giving up. If you were writing arecipe for how to make more money,those are among the first ingredients youwould include.

Jason Zweig, 10.31.07

I think my background has helped melearn to think well conceptually.Investing is not just about numbers. It'salso about imagination and structure andnarrative and characters – the types ofthings we liberal-arts majors shouldknow something about.


The biggest lesson from my father wasthat investing was all about businessesand people. He’d talk about McDonald’svs. Burger King or the rise of Nike orhow Steve Jobs started Apple, all in away that was very interesting for a kid.There was nothing about P/E ratios ormarket caps – things he figured we couldlearn later. He wanted us to understandthe essence of business and what made abusiness successful.


I did a simulation of how often a topmoney manager earning 20% per yearwith a 15% standard deviation wouldlose money over short time periods. A20% return would be about double themarket’s long-term average return and a15% standard deviation would be lowerthan historic market volatility. So this issomeone doing very well.

But on any given day, this hypotheticalmanager would lose money almost halfthe time. He’d lose money in 35% of themonths and, on average, one quarter peryear. Once every ten years he’d have a los-ing year. I think it’s healthy for investorsto remember that even great long-termrecords are full of plenty of down monthsand quarters. Remembering that is hardto do sometimes as time horizons in theindustry have gotten so short.

Bryan Jacoboski, 8.29.05

I’d always said that if a guy was long thebest 50 companies he knew and short the50 worst, if that didn’t work you were inthe wrong business. But that strategy wasliterally a recipe for bankruptcy from1998 to 2000. I said when I closed down




that it was a market I didn’t understand,and I didn’t.

Julian Robertson, 11.30.06

It’s important to play to your strengths.As an investor, I’m not a home-run hitterand can’t think of a lot of securities onwhich I’ve made ten times my money. ButI also can’t think of a lot of securities,post-1970, on which I’ve lost a meaning-ful amount of capital. It’s not really muchmore complicated than that.


One reason our results have been relative-ly strong is because our mistakes havebeen in smaller positions and our success-es in larger ones. I attribute a lot of thatto our partnership: I tend to be a glass-half-full person, while Ed [Co-managerEdward Studzinski] behaves more as ifthe glass is broken and empty. He helpsrestrain my more aggressive instincts andhis natural skepticism has been incrediblyvaluable.


Value managers on their own can tooeasily make big, dumb mistakes. Becauseyou’re stubborn, you’re apt to overlookthe warning bell that should be ringing assomething is going down – if you loved itat $10, isn’t it that much more attractiveat $5 or at $2? Having a partner to ringthat warning bell adds a lot of value.


There’s no question confidence in one’sabilities is a prerequisite to successfulinvesting. To commit your own and oth-ers’ hard-earned capital requires convic-tion, and conviction requires confidence.But as with fine scotch or pepperonipizza, too much of a good thing can causeproblems.

VII, 5.22.05

This is the world’s best business whenyou’re doing well and somewhat less so

when everybody’s yelling at you becauseyou’re trailing the market. It’s importantnot to get carried away with yourselfwhen times are good, and to be able toadmit your mistakes and move on whenthey’re not so good.


Over a long career you learn a certainhumility and are quicker to attribute suc-cess to luck rather than your own bril-liance. I think that makes you a betterinvestor, because you’re less apt to makethe big mistake and you’re probablyquicker to capitalize on good fortunewhen it shines upon you.


The fundamental principles of valueinvesting, if they make sense to you, canallow you to survive and prosper wheneveryone else is rudderless. We have aproven map with which to navigate. Itsounds kind of crazy, but in times of tur-moil in the market, I’ve felt a sort ofserenity in knowing that if I’ve checkedand re-checked my work, one plus onestill equals two regardless of where astock trades right after I buy it.


This is a core message of BenjaminGraham’s: A stock price matters at anygiven time only in relation to the value ofthe company behind it. Staying focusedon value rather price during times ofmarket turmoil is most likely to payfinancial – not to mention psychological– dividends.

VII, 9.28.07

Changing an investment style to the latestfad produces the same result as changinglanes during rush-hour traffic jams: Youincrease the risk of an accident with littlechance of achieving better results. Thepsychological pain of sticking to yourguns, though, is tough. I was up 35% in1999 but had people telling me I didn’thave enough technology in my fund and

they were taking money out. This is notnuclear physics, but it’s hard to stick toyour guns when the crowd’s running overyou. We don’t believe value investing isever out of style – it just doesn’t work allof the time.


By controlling risk and limiting lossthrough extensive fundamental analysis,strict discipline, and endless patience,value investors can expect good resultswith limited downside. You may not getrich quick, but you will keep what youhave, and if the future of value investingresembles its past, you are likely to getrich slowly. As investment strategies go,this is the most that any reasonableinvestor can hope for.


Traditional value investing strategieshave worked for years and everyone’sknown about them. They continue towork because it’s hard for people to do,for two main reasons. First, the compa-nies that show up on the screens can bescary and not doing so well, so peoplefind them difficult to buy. Second, therecan be one-, two- or three-year periodswhen a strategy like this doesn’t work.Most people aren’t capable of sticking itout through that.


If you are a value investor, you’re a long-term investor. If you are a long-terminvestor, you’re not trying to keep upwith a benchmark on a short-term basis.To do that, you accept in advance thatevery now and then you will lag behind,which is another way of saying you willsuffer. That’s very hard to accept inadvance because, the truth is, humannature shrinks from pain. That’s whynot so many people invest this way. Butif you believe as strongly as I do thatvalue investing not only makes sense,but that it works, there’s really no credi-ble alternative.



The Craft of InvestingW O R D S O F I N V E S T I N G W I S D O M


THE BIG PICTURE

Baupost Group's Seth Klarman, in hismost recent investor letter, described therecent tenor of the market perfectly: “Thechaos is so extreme, the panic selling sourgent, that there is almost no possibilitythat sellers are acting on superior infor-mation; indeed, in situation after situa-tion, it seems clear that investment funda-mentals do not factor into their decision-making at all.”

VII, 11.26.08

Anything is possible, of course. BritneySpears may get her act together. TheChicago Cubs' free-agent spending spreemay lead to a World Series triumph thisyear. The next presidential race may be allabout issues, not personal attacks. Butour thinking tends to be more in line withSeth Klarman's, who in his most recentletter to Baupost Group investors statessimply: “Eras of quite low volatility andgeneral prosperity are often followed byperiods of disturbingly high volatility andeconomic woe.” We think we'll positionour portfolios more with that in mind.

VII, 2.28.07

One of the economists who has heavilyinfluenced the way I think is HymanMinsky, who always said, “Stabilitybegets instability.” The very idea is thatthe more stable things appear, the moredangerous the ultimate outcome will bebecause people start to assume everythingwill be all right and end up doing stupidthings.


We're avid followers of the Austrian-school economists, who have done anexcellent job of explaining economiccycles and how the expansion of credit

leads to overinvestment, bubbles and thencrashes. That thinking kept us out offinancial stocks over the past few years,because we believed there was a creditbubble in the U.S., Spain and elsewhere.


Today, we’d argue the disinflationaryforces of the past 25 years are levelingand, if you look at any model of the costof labor, the cost of capital, the cost ofenergy and the cost of food, are probablystarting to go the other way. We’vealready had the best of times in terms offalling interest rates. U.S. tax policies forinvestors are better than they’ve everbeen, and one could imagine thosebecoming less, rather than more, posi-tive. What this all means is that the rock-et fuel of a declining discount rate isprobably behind us. I know this soundsself serving, but that means the activestock picker should have a relativeadvantage over the next five years – pas-sive index investing will no longer havethe wind at his back. It also means thatour return expectations over those nextfive years should be lower.


It seems much more likely that in the nextfive or ten years, the most successfulinvestors will be of the growth variety,not of the value variety. Investors aregoing out of their way today to look forcompanies with certain cash flow charac-teristics, returns on assets that are stableand that have objectively verifiable tangi-ble assets that could be liquidated at somepoint. If that's going to be the focus forliterally thousands of funds ... how couldyou possibly have outstanding results byjust doing the same thing?


Particularly in the U.S., the market hastended to be long on stuff in people’sbasements and attics that they won’t everneed and short on stuff that can have abroader impact on economic efficiency.Consumer spending is two-thirds of theU.S. economy, but I don’t know that thatis a permanent state. Perhaps at the mar-gin we’ll start to see people forgo a fewextra boxes that will sit in their basementin order to get the Van Wyck Expresswaypaved so they can get to JFK airport 20minutes faster – I know I certainly would.

Jesse Stuart, 6.30.08

An indication that the worst is overwould be when the respected wisdomsays we’re in a bear market and it’s notgoing to rally. Today I think people areeither bullish because they believe theworst of the financial crisis is over, orthey’re bearish but nervous about beingbearish.


You could argue that for the past 10 oreven 20 years, equities haven’t beenallowed to get cheap. When it appearedthe market was really going down – in1987, 1998, 2000 – the government tend-ed to intervene to prop it up. In the pastfifteen months we’ve seen a completebreakdown of the private-equity model –since there is no available leverage – andwe’re starting to see stocks trade at what-ever price. There’s a much higher proba-bility that fundamental value investors inthis type of period will be able to addvalue with specific stock selection.


Virtually all studies show that about 60%of the return and volatility of the averagecommon stock is determined by themovement in the aggregate stock market.

The Craft of Investing




So while we’re bottom-up stock pickers,we think it’s important to have a view ofthe economy and the overall market tohelp us determine which industries andsectors to emphasize.

Steven Einhorn, 11.30.06

We just don't see what we're not lookingfor. We're governed by our recent expe-riences and don't actually ponder thebigger picture very often. Just becausesomething hasn't happened in the past12 months, or even five years, doesn'tmean it can't.


Whenever Ben Graham was asked whathe thought would happen to the economyor to company X’s or Y’s profits, healways used to deadpan, “The future isuncertain.” That’s precisely why there’s aneed for a margin of safety in investing,which is more relevant today than ever.


INVESTOR AS MANAGER

It's wonderful to be trusted. Some think ifwe just had more compliance checks andprocess, virtue would be maximized. AtBerkshire, we have subnormal process.We try to operate in a web of seamlesstrust – deserved trust – and try to be care-ful whom we let in.


If one of our portfolio managers has onegreat year, it doesn’t factor at all intohow he or she is paid. That could just bea random event. I think it’s actually astretch to say five years is long enough tobe relevant, but I realize not everyone hasthe same time frames. Clients do havefinite patience, so I consider five years adecent compromise between what clientswill give you and what we think is theminimum necessary to have any statisti-cal significance.

Ric Dillon, 6.29.07

One of my biggest jobs is to keep every-one focused. Don’t stare at the red num-bers on the screen – call companies, callindustry contacts to hear what’s reallygoing on, dig for new ideas and just lookto take advantage of the volatility.Markets like today’s make it ever moreobvious that volatility in stock prices canenormously exceed actual changes infundamentals.


We’ll make mistakes, but it won’t bebecause of lack of discipline or focus orbecause of conflicts of interest. No equityportfolio manager or analyst has anyequity investments other than our fundsand company stock.

Ric Dillon, 6.29.07

If I believed having 10 people rather than52 would allow us to be more successful,we'd quickly make that transition. Butwith the specialization of the people we'recompeting against today, I think it's verydifficult to have a meaningful edge with-out significant depth and expertise. Weshould know more about every one of thecompanies in which we invest than anyother non-insider.


There’s a real premium in this business oninnovation. That doesn’t mean chasingthe latest fad, but it does mean recogniz-ing new opportunities and taking advan-

tage of them even if they don’t fit exactlyinto your historical playbook.


Great advice I once heard was to struc-ture your business so you respect yourcustomers, because they’ll bring out thebest in you and you’ll feel better aboutyourself.


It’s important to hire people with diverseexperiences and viewpoints, which youdon’t necessarily get if you just hirestraight-A Harvard MBA’s. Getting goodgrades and having courage are not thesame thing. Being really smart and hav-ing good judgment are not the samething. People – men or women – should-n’t be winnowed out so early in life.


It’s important to realize that the brainisn’t programmed like a computer, andthat every individual can approach prob-lems and issues in a unique way. Even atmy age, I try to remain flexible and opento new ideas and ways of approachingthings. That keeps me from being a frus-trated pedagogue and also allows me toget more from the individual strengths ofthe people who work for me.


The art of what we do is in the interpre-tation of data produced by our valuationmodel and deciding what to actually buyand sell. Here you need to rely on experi-ence, judgment and continuous learning.Is that repeatable as the people change? Ifyou pick the right people, teach them welland give them the experience necessary toact on their own, we think so.

Ronald Mushock, 10.31.07

I spent my career at one firm before set-ting out on my own and have always beeninterested in being long-term selfish, notshort-term selfish. I’ve hired people for

“Don’t bother me with facts. Tellme what I want to hear.”




$50,000 a year, three years later paidthem a multi-million-dollar bonus andthen had them quit to make more money.It’s ‘Pay me, pay me, pay me if I do well,and if I lose money, I’ll see you later.’ Ican’t bemoan the way things are, the sys-tem has treated me very well. But peopleshould recognize that it’s a vacuum innature, not some God-given right, thathas created the opportunity to make themoney that we do.


FINDING MOTIVATION

There’s a big difference between loving towin and hating to lose, which has a lot todo with one’s approach to risk. Someonewho loves to win is willing to take a lot ofrisks because the euphoria of winningoutweighs the bad outcomes. If you hateto lose, though, any bad outcome is notacceptable. To be a great investor, I thinkyou really have to hate to lose.


You mean besides the incredibly attrac-tive financial characteristics? I love learn-ing about businesses and the intellectualchallenge of investing. I’m also intenselycompetitive about generating greatreturns. That’s not to say I’m particularlyfond of those days when you feel like anidiot and your numbers make you looklike an idiot. But as a competitive person,I wouldn’t have it any other way.


When I started in the business I wasmotivated by being a real competitor. Ilove to win, and the idea of being in anindustry where you keep score and knowwhere you stand every day was highlyappealing to me and, in the end, seemedinherently fair.


Trying to find hidden gems just fits mypersonality. I love the detective aspect ofbeing an investor and uncovering thingsno one else seems to be seeing. What

advantage do I have in being one of thethousands of people analyzing every moveApple or Microsoft or Google makes?


I love the intellectual challenge of invest-ing – there are always new questions totry to answer. But it’s important toremember that you don't actually have toanswer all the questions you ask yourself.It’s like being able to take a test in schoolwhere you can answer any 10 questionsof your choice on a 100-question test.You answer only those you know welland ignore those that are very difficult toanswer. That’s what investing is all about.


I’m a golfer, and one of the things I loveabout it is that you can play the samecourse 20 days in a row and every daywill be different. It just rained, or it’s hot,or the wind is blowing from a differentdirection. You have to adjust all the timefor a lot of changing factors, which is alsotrue of investing. People who really loveto invest wouldn’t have it any other way.


First, I enjoy the process of trying to fig-ure out what’s going on in the world andthink investing is about as good as it gets

in business in terms of intellectual stimu-lation. Second, I’m very competitive, butin the positive sense of trying to improveand always measuring how well I’mdoing that. The third part – makingmoney – is not required, but convenientlyand pleasantly is a result of being good atthe first two.


What I particularly enjoy is when you canhelp change the choices people have intheir lives. I put my sister into shares ofBerkshire Hathaway at $200 per shareand she still has them. That’s the coolestexperience of all.


One reason why investors eschew valueinvesting is that it's a get-rich-slowlyapproach. Poring over numbers and dig-ging for deeper insight into a company orindustry isn't exactly the adrenaline rushsought by the Mad Money crowd. Tothat, we'd suggest an alternative view ofexcitement: Compounding money at agreater rate over time seems pretty darnfun to us.

VII, 11.30.06

One great thing about investing is that,unlike the pitcher who starts to lose hisfastball in his mid-30s, my fastball as aninvestor should keep getting better. I’mone of those guys who says ‘Thank Godit’s Monday,’ because this is as much myhobby as it is how I make a living. If youdon’t feel that way, you should probablybe doing something else.


I’ll be 81 in September. Since I’m notqualified to be a tennis instructor, whatelse am I going to do with my time? Ienjoy being a perpetual student, andworking with good people. I’ll probablybe here until I go non compos mentis. I’lllose my marbles, then they have a right toget rid of me.

Marty Whitman, 5.22.05“I’m trying to achieve total harmony of

body, mind and cashflow.”



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