Reblog: Lessons From 40 Years of Value Investing – Charles Brandes

Here’s an excerpt from the Brandes interview on the CFA Institute website:

Kim Shannon, CFA: I would like to begin by noting that you did not start your career on the buy side. Is there a story about your career transitions?

Charles H. Brandes, CFA: Well, it was somewhat serendipitous. The overall stock market was down 45% from top to bottom in 1970, which was understandably debilitating to investors, and there was very little activity in our office. An older gentleman walked in to open an account. When he told me his name, I knew who he was—Benjamin Graham, the father of value investing and a teacher of Warren Buffett, who had already done pretty well in investing.

He purchased a thousand shares of National Presto Industries, a company that had been an example in his most recent edition of The Intelligent Investor. The example had been of a net–net current asset value issue, which had been one of Graham’s famous criteria from the 1930s for investing. The goal was to buy companies at a price no higher than two-thirds of their net–net current assets. Thus, the investor gets the whole company at a cost below that of its net liquid assets.

After making the purchase, I asked Graham if we could get together to talk about investing. Graham had been an instigator of the CFA designation as well as an adjunct professor at Columbia University in New York, and he taught a little at the University of California, Los Angeles, after moving to California. When I told him I would like to learn about investing, he was very enthusiastic about the opportunity to teach someone.

The things I learned from Graham were fundamental and made so much sense to me. I learned about the need to focus on long-term thinking and to think like I was the owner of the whole company—regardless of how much of the stock I owned. I also learned that it is not possible to outperform other investors if I am thinking like them. It is imperative to find a different perspective from others to obtain different results.

The end of this story is that I accepted Graham’s philosophy completely at that time. I had checked the investing track records back to the 1930s of all of those following the Graham and Dodd philosophy, and they all exhibited superior long-term performance. But accepting the value investing philosophy was easier than implementing it at the time.

The early 1970s was the era of the “Nifty Fifty,” in which the prevalent investing philosophy was that the only stocks that should ever be purchased—and purchased regardless of their current prices—were the 50 biggest growth stocks in the world. These stocks were trading at an average of 46 times earnings, which made no sense to me after listening to Graham.

Then along came 1974, and the market was down 47.5%; it was the perfect time to move to the buy side as a newly converted value investor. I started my own firm in 1974, and it has worked out very well ever since.

Shannon: I noticed in your book that you have a copy of the letter you received from Graham on the opening of your firm, with his comment that this was an excellent time to start an enterprise of this nature.

Brandes: Yes, that was his quote in the letter. He was flattered that I was going to use the Graham and Dodd philosophy. This was in 1974, and his health was starting to deteriorate; he passed away in 1976.

Shannon: Not many firms have a 40-year track record in global investing itself. Not only were very few firms investing globally 40 years ago, but also, few have survived of those that were. How did a guy in San Diego come to do global and emerging market investing so early in the game?

Brandes: That was another circumstance that was somewhat beyond my control, similar to the visit from Graham. My very first client was a non-American who had moved to California for the weather. He said that he appreciated our fundamentalism and adherence to the Graham and Dodd philosophy, but could we not find good companies at big discounts outside of the United States?

Because he was my very first client, I replied, “Of course we could do that. Value investing works anywhere in the world.” We found this to be a true statement, even though we did not know it to be true at the time!

Shannon: I imagine that you must consider yourself to be a contrarian, as all good value investors seem to be. But are there not some difficult moments in being a value investor? How quickly were you tested? I know that you have been deeply invested in Japan when no one wanted to be there, as well as being out of Japan when everyone thought it was the place to be. Talk about being a contrarian investor and hanging in during the tough times.

Brandes: I do not know if I would use the term “contrarian” for deep value investors. We do not look at companies or build a portfolio just to be different from other investors. The fundamentals have to be there. As Graham taught me, it is necessary to think differently from everyone else to outperform everyone else.

Two of the important advantages of value investors over “normal” investors are patience and long-term thinking. Those traits go against our human nature. But human beings are herd animals, too. We like to be part of a group and to think that we are accepted because we are doing what everyone else thinks is right.

So, value investors have to have a non-herd personality. Clients often criticize us for this characteristic because they become uncomfortable with what is happening. The clients may be worried with the concerns of the world and busy with short-term thinking in general. And the value investor may be thinking about how he can take advantage of the same geopolitical concerns that make clients uncomfortable.

You mentioned Japan as an example. In 1988 and 1989, Japan was considered to be one of the strongest economies; it was going to “take over the world,” at least partially because of its superior management techniques. Japan was buying a lot of major real estate properties in the United States at this time, and Japan’s market was trading in the range of 30–50 times earnings.

As value investors, we had nothing invested in Japan at the time, and people were wondering, how we could not be invested in Japan? Then, about three or four years ago, we began to invest heavily in Japan. At that time, everyone was concerned with Japan’s aging population, its tremendous sovereign debt, its deflationary environment, and the fact that corporate management had little concern for shareholders.

Some of our institutional clients were saying, “How could you be so dumb?” And we would respond to them, “We realize all of these things, but we are also looking at the prices on very good companies trading at 35-year lows.” Well, it is possible that we invested in Japan a little early, but these situations have happened in the past and will happen again in the future. Actually, we look forward to it happening because when people are really scared about what we are doing, more often than not, it is probably a very good thing to be doing.

Shannon: Moving on to valuation methodology, what are the key valuation criteria that you use to invest? What sort of companies do you avoid? How do you pick stocks at your firm, and do you ever break the rules?

Brandes: I have always expressed one basic principle to the people in our research department: Never buy an airline! But they have ignored this rule, and we have lost a great deal of money on some airlines and done pretty well on others. We try to be totally flexible while relying on basic fundamentals.

We start with basic value screens, such as price to book, price to earnings, price to cash flow, and solid balance sheets. And when we identify something that may have value, it is time for our research analysts—who are industry specialists rather than country specialists—to conduct deep fundamental research from the standpoint of really understanding the company in relationship to the industry it is in and the part of the world it is in.

Our analysts come to understand the markets, the technology, the balance sheets, and the long-term history of earnings. It is not that complicated, but it is intense, fundamental research.

Shannon: Do you think that valuation using value investing principles is more challenging today with the current market structure? Is it more difficult to identify opportunities?

Brandes: No, I do not think so. Whether it is high-net-worth clients or institutional clients, the human behavior of short-term thinking and acting on fear or greed does not change. Obviously, some of the more recent developments, such as the credit crisis, put certain companies at values that, in hindsight, were ridiculously low.

Now we know that if investors had purchased early in 2009, they would have made a lot of money. But markets were inefficient for all of the reasons that we know, including such things as mark-to-market accounting that forced banks and other financial firms to raise capital at very low prices. These sorts of events will continue to happen in the future, and value opportunities will continue to exist.

Shannon: Is a focus on dividend investing important to you? Are dividends or share repurchases more important?

Brandes: Dividends are not something that we look for as a basic fundamental characteristic of a business; they are a secondary characteristic. The basic fundamental characteristics include, of course, earnings, cash flows, and the necessity of reinvestment, as well as changes in technology. None of these items have anything to do with dividends, but I admit that, generally, the portfolios of value investors have a higher dividend yield than their benchmarks do. I was looking at our large-cap international portfolio today, and its dividend yield was 4.1%. So, yes, the dividends are there.

Shannon: Where are you finding investment opportunities globally—Japan, Europe, emerging markets? Where are the so-called dark spaces where other investors are not looking, if there is such a thing in today’s marketplace?

Brandes: Taking your last question, yes, there are such places. What is so great about value investing is that the values do not tend to disappear altogether; something is always available. We like to have the flexibility to follow value opportunities anywhere, and our clients typically provide that flexibility.

Considering simple criteria, such as price to earnings or price to book or dividend yields or decent economics, the best values today are generally in emerging markets. Although emerging markets did experience a recovery after the financial crisis, they have offered no performance at all over the past three years. We are finding some good companies that are very cheap in China and in South America. Brazil, for example, is a scary place now from a geopolitical perspective, but there are some good companies there that are very cheap.

Also, people are afraid of Europe because of the potential for recession or because of the euro, but we are finding good companies there. There are even some good values based in France. If a company has good global dispersion of sales, the euro–US dollar exchange rate will be less important.

In Japan, we were overallocated during its major rally in 2013, although we have reduced our current exposure closer to benchmark. Regarding the yen, Japanese exporters are now in pretty good shape, so we still own Japan.

Shannon: What is your average holding period? Can it be less than a year?

Brandes: It can be less than a year, but only if the stock price has increased a tremendous amount in a short period of time. Our average holding period is closer to four years, so our turnover is somewhere in the range of 20%.

Shannon: How do you define risk from the perspective of concentration in individual securities? Do you take big bets or small bets?

Brandes: We tend to take medium bets. If you look at the rest of the institutional investor world, our portfolios appear to be fairly concentrated with 50–70 different positions. Over the years, there have been several studies on the issue of proper diversification. Some of the studies have stated that adequate diversification is possible with as few as 10 securities when they have no correlation. But we have found that we can handle 50–70 positions well and that it is a good way to build a portfolio.

Shannon: Thank you for sharing your insights from more than 40 years of global investing.

The original post appears on www.valuewalk.com and is available here.

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