Reblog: Bruce Greenwald Conference Notes: Lessons Learned Over 25 Years

Unusual challenges going forward in being a value investor, beyond active vs. passive or quant-based.

How the view of value investing has evolved over time.

One fact you should never forget: Investing is if you are judged relative to the market a zero-sum game. Asset by class by asset class, the average return to all investors in that asset class has to be the average return to all assets in that asset class. All the assets are owned by somebody, and the derivatives net out. If the asset class if up by 12%, the average investor is going to be up by 12%. What that means: If you’re going to be above average, somebody else has to be below average. That’s important because it seems good that more people are doing passive, leaving less competition. But it’s not true because you need someone to be stupid.

First reality: To the extent that the people who are doing index funds are people who populated the lower half of the investment distribution, it’s going to make your life harder not easier.

Second reality: Late cycle underperformance of value. Not something that should upset you. Today, we are in the middle of a fundamental change in the nature of profitability and in the nature of value generation that is related to a fundamental underlying change in society ad I think in various ways it has made value investing substantially harder.

History: Depression was considered caused by the Depression. Thirty-five percent of the population was dependent on agriculture, and it was difficult to move out of it. They had no money to move to the cities and retrain themselves for manufacturing jobs.

In 1929-1932, as agricultural sector dies, migration from agriculture ceases.

Transition today: manufacturing is dying for exactly the same reason that agriculture died. Productivity is much higher than global demand growth, and it’s been going on for a long time.

Service economies look very different from manufacturing economies, in ways that are important for investors.

Of the 160 million workers in the U.S., the number of non-professional (non-degreed) is 130,000. The number of professional athletes and coaches, a classic service job, is about 260,000. When you think about the nature of those jobs, the extractive workers work together, they work out a platform together. It’s hard to identify who the good and bad ones are. IN a service economy, the coaches and pro athletes work on their own and the distribution of income is uneven because you get paid for what you do. Those trends in the distribution of income are not going to change, and they’re going to create big problems for sustaining consumption.

Second big problem from manufacturing to local services economy: Profitability comes from two sources. In competitive markets it comes from a fair return on investment, but it also comes from barriers to entry (moats). Moats are a function of market size. One of the things that WB will not talk about – when you talk about a moat there are actually two elements to the width. First: minimum sustainable share that you have to get in that market to survive economically and earn your cost of capital. That depends on market size. If you look at a global auto market, companies can be viable at 2.5% of that market. In smaller local geographic service markets, you need a much bigger market share to be viable. If you look at cell phone companies, companies with 10% make nothing. 15% break even.

Second element of a moat: how hard is it to get to that sustainable level of market share, and that has to do with market share sustainability. If purchase frequency is infrequent, share stability is about 1% share per year. To get to viable position of 2.5%, that moat is 2.5 years wide. Cell phones: something you use continuously, tech changes a little rapidly, but more day-to-day stability, typically .5% market share changes hands every year. Coca cola, to get to 25% share, their market share is remarkably stable. To get to 25% share, at fifth of a percent a year, is 125 year moat. That’s why coca cola is one of the most sustainable, profitable monopolies in the world.

When you move to service products where you consume it, customer activity increases dramatically. In transition, the width of moat in local service markets, has increased dramatically. See that in the data nobody talks about.

History of corporate profits in the U.S. Pre 1990, profits as a share of U.S. nat income was 8.5%. Everyone worried about global profit pressure. Today is over 14-14.5% of national income. Is that a return to increased capital investment? It’s actually going down. Investment has gone down and profits have been going up. Up about 70% as a share of national income over that period.

What it has meant: Because general upward slope in profitability, 10-year PE ratios which assume stable profitability and regression to the mean look very expensive, but if this trend continues, that is a mis measure of what this actually looks like. Corporate profits have been going up – this is not a new trend. Going on for 25-plus years, not just in U.S. Will continue to go up.

Second thing that happens: cyclical disturbances are mitigated. Ina big competitive market when demand falls, all entrants compete against each other and get price reduction and margin erosion. In service markets, excess capacity doesn’t rise to the same degree and dominant competitors have pricing power. John Deere (NYSE:DE) transitioned to software, local second-hand markets because machines last a longer time and value added is higher because nobody does deep plowing anymore, seeds are individually planted. Because that is so valuable, the price you can charge goes up a lot and financing becomes increasingly important which is based on local knowledge of creditability. Locally dependent fixed-cost service package. Has dominated one geographic location at a time. If you’re in one of those locations, competitors can’t get into that market.

In 2000-2001, revenues went down around 2%. From 2008-2009, sales fell from 26.2 billion to 21.1, profit margins fell, then rose.

What it means: where a lot of value investors have made a lot of money which is sticking with companies in bad times, those are attenuated because the bad times won’t be so bad because there’s a fundamental structural change. Fluctuations in the value of bad times has been minimised.

What else has happened: characteristics of franchise businesses compared to competitive markets. Think about organic growth in a market without barriers to entry. What does that do to long run? Nothing. Firms see the opportunity, no barriers, they spread the increase in organic demand over a greater amount of capacity and you go back to the same equilibrium. Growth in profits associated with these franchise businesses that is not there in non-franchise businesses.

In a market protected by barriers to entry, companies get to take come some of the investments in technology. When you move from non-franchise manufacturing (competitive, no barriers) to local service markets, not only do profit margins go up steadily, profits decline but growth suddenly adds value. It’s now worth paying for growth. Sensible value investments are going to look very different from non-franchise businesses. One of WB’s great lessons for industry: Buffett companies bc of fundamental shift are becoming more pervasive. Will need a better understanding of franchise businesses and pay more for them to be successful value investor.

Have to understand fundamental change in economy. Nowhere near through with.

Fourth: Obviously, sophistication of investors relative to value has increased. Many more people not naturally going to fit into the below-average investors. Will make your job harder because of zero-sum characteristic of investing.

Put it together: this is a uniquely difficult and challenging environment for value investors. Some late cycle and some will moderate, but other changes will not go away because due to fundamental changes.

How should going forward a value investor cop with these challenges?

Important to understand, there’s a search part – what do you want to look for opportunities? Where more often than not you’re going to be the person who will have an advantage in that investment. Be good at valuing these increasingly growth related companies and do active research and think about managing risk.

Search strategy from a value perspective: simple answer was look for bargains. Cheap. Idea is: dollars for fifty cents. Bad news is: Nobody is in the business of paying $1.50 for $1.00. Everyone thinks they’re looking for bargains. Was a well-defined set of characteristics for bargains based on dysfunctional. People will overpay for the change to get rich quick. Second: nobody likes to embrace ugliness. You will be in a minority for that and gain advantage. Third: People tend to think they know much more than they know. When they think it’s a good stock it’s a good stock, and crappy is crappy. Mean? Glamour stocks going to be overvalued and ugly systematically undervalued? Classic value search strategy. Seems that in this environment where more businesses have local service-based barriers to entry, that is not as reliable guide as it has been in the past. Have to find another way to consistently be on the right side of the trade and it’s obvious but nobody talks about it.

It is: If I spend my life investing in Omaha-based food companies, you will beat someone who doesn’t. Specialisation is something they have not embraced and will have to. Similar to circle of competence. Look at WB: has done systematically better in banking, old media, insurance – even for him, specialisation, with starting with location. Most important strategy change: Have to become specialist. Don’t have to be one industry specialist, you can manage several, don’t have to do as many as Buffett. There is substantial evidence that specialised investors do much better than general investors.

Third: Exemplified by Buffett and Graham but hasn’t penetrated the market: plagiarism. Got to expand the menu of just the traditional things. It’s not just going to be the value premium. It’s really going to be about specialised because services businesses are local and SEC filings or active networking.

Question: Coke has still been in $40s?

WB talks all the time about persistence in drinking Coke. Doesn’t talk about Coke makes 108% of operating profit in 10 countries. Economies of scale in local distribution. Think about future of Coke, better understand the extent to which those two interact and take advantage of them, which the company hasn’t done with success. Hasn’t been as big success as it has been historically. Not going to understand those factors without understanding local distribution of consumer nondurables.

Search strategy three: Be traditional value investor. In terms fo valuation. DCF is taught for MBA. Reality of valuation is good valuation is specific to the nature and precision of the information you have. If you have precise over near-term horizon on payouts, go ahead and do DCF. On other hands, if imprecise depend on growth rates over long horizon, what does DCF do? Takes a sum of future value cash flows. That means you take very good info and really crappy info and adding it together. Is adding bad info to good produce bad or good info? Bad. IN competitive markets, the value of growth is zero. IF you are going to invest in growth have to know when it adds and doesn’t add value. Absolutely clear why growth doesn’t add value in competitive markets. Good thing about growth is a growing income stream is better than constant. Bad thing about growth is you have to invest to support the growth which means in any amount of time the amount available is less for growing than non-growing. Concentrate not on growth rate but on the investment. Invest $100 million in growth. I have to pay the people who provided that capital, 10%. Annual cost of that investment is $10 million a year. Invest at a competitive disadvantage. What is value created? Negative $5 million a year because make $5, pay $10, net value is -5 million. Growth in a competitive market where you just earn in the long-run, make 10% which is 10 million, pay 10% to people who provided investment, net value of growth is zero. In competitive markets growth adds no value. Only int eh case where you earn 20% and to earn sustainably you have to have barriers to entry. Only in franchise businesses does growth matter.

Start with DCF if you have short horizon and precise cash flows, asset value earnings per versus price in competitive asset based businesses and in franchises you have a big problem. In those, can’t calculate a value. Reason: most of the value is out in the distant future. Even though, can calculate returns.

John Deere example

Cash payout/price = sustainable earns/price x pay-out ratio

= 6% x 0.8% = 4.8%

Organic growth = AG Automation growth + margin growth

= 4.5% + 1.5% = 6%

Investment growth = value creation x investment

=1 x 1.2% = 1.2%

Total return = 4.8% = 7.2% = 12%

Market return = 6% Margin of safety = 6%

How looks as an investment? Reasonable margin of safety. DFC on Deere’s value? Wont’ get that kind of clarity. Will be all over the lot. When dealing with growth stocks, look at returns. Adjustment: as a specialised investor, will have to look at valuation approaches that are tailored to the nature and horizon of the information that you’re using. Not one-sized fits all whether DCF or asset value earnings power value. Specialised and plagiarised in search strategy and value oriented and agnostic and tailored in your valuation strategies.

What about research?

Again to do active investing well you want to collect info that is legally obtained and not widely known by other people. Want to do focused analysis. Not diffused, broad analysis. Good to know trend of services but need to know what it looks like on company by company, locality by locality and industry by industry. Look at what insiders are doing, what industry experts are doing – not slavishly but networks and official sources are crucial. Endorse previous speaker – natural human behaviours dysfunctional in most investing environments. Be self-aware. If you think it’s a great investment and market doesn’t, don’t have to agree with the market but have to know what the market thinks. If you can’t avoid being contaminated by the consensus, you should be in another business. When you differ from the word, you’re going to be wrong a lot of the time. Have to track your own behaviour. Will make mistakes once but better know what your characteristic mistakes are so you don’t make them a lot.

Research is cumulative. One big advantage of specialisation. Economies of scale there.

Look at management, should not be just send us the money. Should concentrate on continuous performance and improvement.

Want to know management understands competitive advantages and won’t go to China just for the growth where it’s operating at a disadvantage. Ought to be able to explain why they’re doing that at an advantage. Better be succession plan in place that they articulate to replace important leader. Don’t want them to hire a lot in good times and dump them in bad times where they can’t get jobs.

Thinking of management: activism or suggestivism. Here, want to talk about something misunderstood about value traps. VTs get described classically as buying stock at 20 when worth 40, but what’s going to make it go to 40. Answer is you don’t care. Bc if you buy is at 20, you’re getting a 20% return on that investment whether it goes to 40 or not. Mere fact that price hasn’t recognised it isn’t a bargain will still get a return.

VTs are really: assets are there, buying at a bargain and mgmt. is destroying value.

Betting on future improvement is almost always speculation. Don’t try to forecast cycles, it’s very hard even if you knew the financial crisis was coming, it could have come any time between 2000 and 2008. Don’t get on exceptional events, bet on continuity.

Example: people want to invest in energy based on what’s going to happen to oil prices. Add back depletion and depreciation, you get very stable revenue even as prices drop. Upstream earnings plus DMV fall from 30 billion to 24 billion. Question: want to invest in oil companies based on them that do disciplined effective e&p and don’t do it when things look like they’re overpriced and there’s a threat and do it in a geographically specified way? Very few oil investors who are non value investors do it that way.

Second: Deere

Forecast turned out to be true. 2012 2013 revenue was 36.2, 37.8 and in 2014 was 36.0. When stock was 90 and they all shorted it, it went as low as 75. Today $140. Why? Nature of that business had changed. Look at margins: up in 2012, in 2015 when market collapsed and 2016 margins only fell a bit. Did not go negative or fall to 0. Back up to 10.6 by 2017. Had to do with understanding nature of the market for Deere and what company had become. That was investment as opposed to speculation based on cyclical demand for agriculture.

Finally: risk management

Answer is most interesting: value investors understand that measures of risk are a waste of everybody’s time. Dominated by upside variances and assumption is things are symmetrical and you care about the downside, permanent impairment of capital. Second: when people talk about variances, do it in time independent manner. Assumption is five-year variances is five times, one year is 12 times the one month variances. In short-run they are positively serially. In long-run is substantial regression to the mean. Variances don’t tell the complicated story you need.

Look at scenarios.

Second, fastest way to permanently impair capital is to pay 200 for something that’s worth 100. Want substantial margin of safety. Low leverage bc it will convert temporary into permanent.

Diversification is also important. First three categories of risk are diversifiable. Freebie when it comes to management.

Cannot be decentralised. Story want to tell here doesn’t have to do with risk management, has to do with transaction costs. First job was bell labs, ATT pension funds had 200 indie equity managers. Asked: per week, how much of what one manager was selling was another manager buying. It was about 90%. Look at net buys, 93% of it was the market. Applies to risk: 200 managers, this guy will embrace a risk that guy is avoiding. Can’t allow them to do that on a decentralised basis. Investing in the future: management will be highly specialised, highly focused and decentralised. Wealth management has to be done centrally, has to be done by people who know the full range of their client portfolios. Means: increasingly important will be – being able to communicate between analysts and pms what risks are, how to manage those relationships and convey that risk will be increasingly important.

What about active investing? Sound active investing is going to be value investing. All of these principles are what you’re going to have to do. Discipline is crucial. Last speaker said if you look at really good investment analyst, will outperform market by maybe 4%. Individual investors in period when equities earn 7-9% they earn 1-3%. Inability to stay in the market costs them. Look at valuated returns to funds, they are on average basis points below the average, meaning they are taking it out at the wrong time and putting it in at the wrong time.

Last thought: Quant based passive investing is not easy to do. Talk to the people who do it, average life of successful quant models was years, went to 18 months, now under 12 months probably.

Scariest number: Quant investing is not going to be an easy form. Choice will be between focused, research-focused active value investing and quant investing to try and do better than the market as a whole. Clear that in that competition, your money and my money is going to be on properly conceived, highly specialized value investing.

Thank you.

The original article is written by Holly LaFon, appears on and is available here.

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