AR: Barron's editorial I mentioned earlier... (Will post MB's letter shortly.
February 15, 1999
Why Value Investors Are Different
Today's mutual-fund manager is no Warren Buffett
By Seth A. Klarman
The most dramatic and valuable lesson from the fabulous (and still counting)
50-plus-year investment career of Warren Buffett is the legendary account of
his steadfast conviction amidst the 1973-75 bear market. He had correctly
identified by 1973 that the shares of companies such as the Washington Post
were selling for but a fraction of the underlying business value represented by
those shares. He observed that numerous buyers would readily pay several
times the prevailing market price of Washington Post stock to acquire the entire
company, but it was controlled by the founding family and not for sale. Buffett
could acquire a minority interest in the business at a bargain price, but he could
not force the valuation gap to close. For that, he was dependent on the passage
of time to result in improved market conditions and/or on the behavior of
management to successfully run the business and to act in the best interest of
shareholders.
Fortunately for Buffett, the shares of Washington Post and other attractively
priced companies failed to rise from 1973 bargain levels and in fact proceeded
to relentlessly decline over the next two years, enhancing the opportunity by
orders of magnitude. Roger Lowenstein, in his biography Buffett, describes the
"impression of Buffett sweeping down the aisles of a giant store [buying
stock]... . As the market fell, he raced down the aisles all the faster."
Bear Market Memory
Recalling this episode is important because it powerfully evokes the memory of
what happens in bear markets: Good bargains become even better bargains. It
is also inspirational testimony to the wisdom and necessity of staying power:
Had Buffett worried about the interim losses in 1974 or 1975 from his earlier
and more expensive purchases of Washington Post shares, he might have not
only failed to add to his holdings but, conceivably, might also have panicked or
been forced out of his steadily dropping position. That he didn't reflects the
well-founded conviction a value investor is able to have, confident in the margin
of safety that a bargain purchase is able to confer.
Back in 1974 and 1975, when the shares of
Washington Post were declining so sweetly for
Buffett, what might his daily experience have
been like? As confident as Buffett was back
then, projecting out his future wealth from
currently depressed point A to future point B,
there were almost certainly times that a bit of
fear rose in his throat, too. He wouldn't be human
or risk-averse if the near-daily markdowns of his
bargain purchase didn't create room for
reflection.
And profiting from his bargain purchases was not
an immediate occurrence. Buffett was making no
off-market purchase, odd lot or private sale he
could immediately flip for sizable gain. He in fact
bought very much on the market; he had simply
decided that the market was wrong. His view was that the sellers were not
thinking clearly, perhaps were not in a position to think clearly. In all probability,
they were selling not because they believed the shares were fully priced or
overpriced compared with the value of Washington Post as a business. On this
they and Buffett may, perhaps surprisingly, have agreed. Their disagreement, if
there was one, concerned the level of appropriate discount between share price
and business value, a gap that Buffett saw as widening.
It is helpful to note that Buffett did not consider whether Washington Post was
a component of a stock-market index, or about to be added to one (ironically, in
a sense, since the possible inclusion of Buffett's Berkshire Hathaway in the
S&P 500 Index is one of the speculative forces lifting that stock today). He did
not weigh the market capitalization of the company or its daily trading volume in
his purchase decision. He didn't worry about whether the stock was about to
split or pay or omit a dividend. He most certainly did not evaluate the stock's
beta or use the capital-asset pricing model or consider whether its purchase
would move his portfolio to the efficient frontier. He simply valued the business
and bought a piece of it at a sizable discount.
Was Buffett not concerned about risk? Of course he was, but not those risks
that were most pertinent to the shorter-term-oriented, more rigidly constrained
investors who were unwittingly making him wealthier every time they sold him
another share. Those investors, quite like today's big mutual-fund complexes,
were disproportionately worried about their short-term investment results and
their clients' perception of same. In such a world, relative underperformance is
a disaster and the longer term is measured by the frequency with which
investment results are evaluated. Risk for them is not being stupid but looking
stupid. Risk is not overpaying, but failing to overpay for something everyone
else holds. Risk is more about standing apart from the crowd than about getting
clobbered, as long as you have a lot of company.
History Doesn't Quite Repeat
History never repeats itself exactly. So in 1998 investors urgently seeking
liquidity are selling not Washington Post but small-cap and emerging-market
equities. Investors tired of underperforming don't sell Dell Computer (no one, it
seems, sells Dell), which they love for what it has done for them no matter how
expensive it has become. It is so much easier for them to sell whatever has
recently disappointed investor expectations, no matter how inexpensive it has
become. Mutual-fund managers, desperate to put cash to work, don't buy what
is cheap but what is working, since what is cheap by definition hasn't been
working.
It seems obvious that so long as there are inflows into the hands of institutional
investors, there will be a telescoping of investment into the several dozen names
that have reliably reported quarter-by-quarter earnings growth and almost
constant share-price appreciation. It seems obvious, but is actually a slippery
and very dangerous slope. When stocks are rising for no better reason than that
they have risen, the greater fool is at work. Consider the Internet-stock mania,
where the mere rumor of a stock split, as irrelevant to value as a rumor could
be, sends not only that stock flying but a whole group of stocks rising in
sympathy. This is no different from the purchase of any investment based on
how the market might possibly regard it in the future rather than on investment
fundamentals. An investor who initially purchases based on value knows to buy
more when an already undervalued stock falls and to sell when it becomes fully
valued. An investor in an Internet stock or in the extraordinarily expensive
shares of a very good company has no idea what to do when the price moves
up or down. This creates a serious dilemma for the great majority of investors
and a real opportunity for a few.
Necessary Arrogance
At the root of value investing is the belief, first espoused by Benjamin Graham,
that the market is a voting machine and not a weighing machine. Thus an
investor must have more confidence in his or her own opinion than in the
combined weight of all other opinions. This borders on arrogance, the necessary
arrogance that is required to make investment decisions. This arrogance must
be tempered with extreme caution, giving due respect to the opinions of others,
many of whom are very intelligent and hard working. Their sale of shares to
you at a seeming bargain price may be the result of ignorance, emotion or
various institutional constraints, or it may be that the apparent bargain is in fact
flawed, that it is actually fairly priced or even overvalued and that the sellers
know more than you do. This is a serious risk, but one that can be mitigated first
by extensive fundamental analysis and second by knowing not only that
something is bargain-priced but, as best you can, also why it is so. (You never
know for certain why sellers are getting out but you may be able to reasonably
surmise a rationale.) This is the position in which investors should, over and
over, want to put themselves (and an astonishingly different type of
consideration than the great majority of today's investors are bothering to
make).
Now consider mega-growth-fund manager Buff T. Warren, who has been
racking up year after year of great performance buying and holding the shares
of expensive but steadily rising growth companies. Buff has consistently been
and remains bullish, since that is what got him where he is today. High stock
prices have long since ceased to worry Buff, who is nothing if not flexible. And
what choice does he really have, anyway? The fundamentals are excellent as
far as the eye can see, so share prices should be high. His portfolio companies
are among America's greatest, they are in sync with the times and they beat
analysts' earnings expectations every quarter. There is apparently nothing in the
great demographic roller coaster to interrupt the steady cash inflows into the
stock market. Almost no one, in fact, can even imagine a reason why these
large, well-liked companies won't continue to command the greatest share of
investor demand.
At the end of the Hall of Greater Fools is a mirror. Buff, unaware of entering
the building, actually thinks of himself as a prudent investor. After all, he owns
no junk, only the shares of great businesses. And the market's constant
vindication of his judgment only reinforces his conviction and self-image.
Obviously, selling his best performers to dabble in anything else would be wildly
speculative and he has convinced himself that he is a risk-averse investor, even
a "value" investor. Buying and holding, using inflows to add to positions, is his
watchword.
Occasionally, one of Buff's shooting stars falls to earth; fortunately, his
compatriots at other mutual funds probably owned it in about the same
proportion. Then he does what you should always do when a stock disappoints
and plunges in price: He blows it out. You can't, after all, trust a company that
is incapable of massaging earnings into a steady growth pattern; why, the same
thing might happen again. And he knows all his compadres are thinking the
same thing and blowing it out, too.
Buff has a lot of company. His stocks are going up, not necessarily because
they should but because they do. That no one can think of why they wouldn't is
taken as evidence that they will rise further.
Lost Art of Contrary Thinking
Lost in Buff's world is the art of contrary thinking. Ignored, out-of-print titles
about the madness of crowds (not to mention the importance of a margin of
safety) suggest that the majority cannot be right in the long run. Being very
early and being wrong look exactly the same 99% of the time, and early in
Buff's line of work means unemployed. Anyway, it is Buff's job to be fully
invested. It's hard to deviate from what has been working; and buying smaller,
less liquid names really wouldn't make a dent in the mountain of cash that
comes in every week. Maybe Buff even halfheartedly believes it is he who is
the real contrarian, and that the rally has a lot farther to go.
The investment world today is turned upside down; what is seen as risky is
almost certainly much safer than what is viewed as rock solid. Not only that,
but in the ultimate irony, Warren Buffett's and Buff T. Warren's portfolios look
a fair bit alike. Some of Berkshire Hathaway's largest holdings, including
international consumer stocks like Gillette and Coca-Cola, now trade at over 40
times earnings and are among the favorite stocks of growth managers like Buff.
The preface to Benjamin Graham's Security Analysis contains the quote from
Horace's Ars Poetica: "Many shall be restored that now are fallen and many
shall fall that are now in honor." It does not say when.
SETH A. KLARMAN is president of the Baupost Group, an investment adviser in Cambridge,
Massachusetts.
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