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3
Exclusive Interview with

Charles de Vaulx

37
Exclusive Interview with

Tom Gayner

45
Exclusive Interview with

Howard Marks

61
Exclusive Interview with

Allan Mecham

71
Exclusive Interview with

Guy Spier

26
Exclusive Interview with

Pat Dorsey

43
Exclusive Interview with

Joel Greenblatt

55
Exclusive Interview with

Michael Maubossin

67
Exclusive Interview with

James Montier

83
Exclusive Interview with

Amit Wadhwaney

Charles de Vaulx joined International Value Advisers, LLC (IVA) in May 2008 as a partner and portfolio manager, and
serves as chief investment officer, partner, and portfolio manager.
Until March 2007, Charles was portfolio manager of the First Eagle Global, Overseas, U.S. Value, Gold and Variable Funds,
together with a number of separately managed institutional accounts. He was solely responsible for management of the
Sofire Fund when it won an Absolute Return Award for Fund of the Year in the global equity category in 2005 and 2006.
In addition to sharing Morningstars International Stock Manager of the Year Award in 2001 with his co-manager, Charles
was runner-up for the same award in 2006. From 2000 to 2004, Charles was co-portfolio manager of the First Eagle
Funds. He was named associate portfolio manager in 1996. In 1987, he joined the SoGen Funds, the predecessor to the
First Eagle Funds, as a securities analyst. He began his career at Societe Generale Bank as a credit analyst in 1985.
Charles graduated from the Ecole Superieure de Commerce de Rouen in France and holds the French equivalent of a
Masters degree in finance.

The Manual of Ideas: Its a pleasure

to have with us Charles de Vaulx,
Chief Investment Officer at
International Value Advisers. Charles,
welcome.
Charles de Vaulx: Thank you.

MOI: Charles, how did you become

interested in investing?
de Vaulx: I became interested at an
early age. My first investment was
a gold coin in late 1975 at the age
of fourteen years old. My first stock
was in 1976, after what had been
two very difficult years following the
1973-74 oil crisis and recession. At
that time I was in Paris, but I had just
been there for a few years.

Africa, and before that I was born

and spent five years in Morocco.
My father worked in the oil industry
with Total. I think that my time in
South Africa and my exposure to
business through my father helped
me get interested as a child in
understanding businesses. Even
before the oil crisis of 73-74, there
were major ideological challenges.
Communism was still a major threat
worldwide. We tend to forget.

Prior to that, from age five to twelveand-a-half, I was living with my

parents in Johannesburg, South

Page 4 of 87

Exclusive Interview with Charles de Vaulx

Both of my grandfathers had been
in the military. It occurred to me at
an early age, perhaps at the age of
9, that going forward the real wars
may no longer be military, but more
economic wars, ideological wars
and, hence, I felt that I needed to
understand money, industry and
finance as opposed to doing what
my grandfathers had done and go
into the military.
As a young child in Morocco and
later traveling with my family
through Southern Africa, I was
exposed to poverty growing up,
which scared me. It impressed
upon me the importance of saving
so that you can at least have the
essentials shelter, clothing, food.
These experiences made me realize
that nothing is a given.
After I bought my gold coin and my
first stock my interest only grew. I
read the financial newspapers each
day and during my lunch breaks
at school I would sometimes take
a quick subway ride to the Paris
Bourse. Much later, in 1983, as a
part of my studies in France, I was
able to get a six-month internship
in New York City in 1983. I was
twenty-one years old at the time,
and three out of the six months I
spent with Jean-Marie Eveillard,

with whom I worked subsequently

for a long time. Jean Marie taught
me what I knew nothing of at the
time, which is value investingthe concept that investing is not
necessarily about finding growth
stocks, and that markets can be
inefficient enough sometimes that
some stocks can trade at times at
a 30% or 40% or 50% discount to
what the companies are actually
worth.

Both of my grandfathers
had been in the military. It
occurred to me at an early
age, perhaps at the age of
9, that going forward the
real wars may no longer be
military, but more economic
wars, ideological wars and,
hence, I felt that I needed to
understand money, industry
and finance as opposed to
doing what my grandfathers
had done and go into the
military.

MOI: How did working with JeanMarie Eveillard influence you? Can
you share with us perhaps the
single biggest lesson from working
with Jean-Marie?
de Vaulx: There are several things
I want to mention, but if there
was one overriding theme, its the
clarity with which he conveyed
to me the obvious if one is
mathematically inclined: if you
can minimize drawdowns, and
if you can minimize losses one
stock at a time in your portfolio,
that is mathematically one of the
surest and best ways to compound
wealth. This is opposed to shooting
for the moon, betting the farm and
trying to find stocks that may go up
ten times the ten baggers.
Other related themes would be
that conventional wisdom among
money managers, back then and
still today, was that the only form
of active money management was
a concentrated approach having
only ten, fifteen, twenty stocks and
trying to do as much homework as
possible on those stocks. Youre
supposed to have conviction, go
for it.

Page 5 of 87

Jean-Marie understood that there

was another way his way which
was to have a highly diversified
portfolio, oftentimes a hundred,
hundred and fifty, two hundred
names, be benchmark agnostic, and
be willing to make large negative
bets by owning little or nothing of
what would sometimes become
the biggest part of the benchmark.
Oftentimes, what becomes the
biggest part of the index is the stuff
that has gone up the most, which
can be the least desirable whether
its Japan in the late 80s, or TMT
stocks in the late 90s, or financial
stocks in 06-07. Its important to
note that diversification is okay as
long as it has nothing to do with the
benchmark, as long as youre willing
to make big negative bets and as
long as you know your companies
well enough to have accurate
intrinsic value estimates. We
define intrinsic value as the price a
knowledgeable investor would pay
in cash to own the entire business.
I think its Warren Buffett who many
times said that diversification can
be an excuse for ignorance. If
you only have a forty basis point
position in a stock you can get
lazy and you dont feel you need to
know everything. I think we showed
over time that our estimates of the
intrinsic values of the companies
weve owned have been quite
accurate. The reason is that even
though were not catalyst-driven,
it just so happens that on average
maybe 15% of the stocks weve held
for many years have been taken
over. Through all of these takeovers
weve been able to compare our
own internal estimates of intrinsic

value worth versus the price that

was paid and history shows that
our estimates have been fairly
accurate. I believe that theres no
need to know every detail, rather
theres a need to understand the key
three, four or five factors affecting
the company.

Jean-Marie [Eveillard]
understood that there
was another way his
way which was to
have a highly diversified
portfolio, oftentimes a
hundred, hundred and fifty,
two hundred names, be
benchmark agnostic, and
be willing to make large
negative bets by owning
little or nothing of what
would sometimes become
the biggest part of the
benchmark.
Another insight that Jean-Marie
had, which I guess I implicitly
shared having told you my little
story about my gold coin and my
stock is the idea that one could
be eclectic. One did not have to be
confined to only large cap stocks.
Its okay to consider bonds - highyield corporates and Treasuries
(when they yield 15% and when
they are labeled Certificates of
Confiscation that was the term
in 1982). Its okay also to consider
bonds to try and get equity-type
returns. Its okay also to have cash
cash as a residual, not as a way
to time the market. If you cannot
find enough cheap securities, its
okay to hold cash and just wait

for those opportunities to present

themselves. The main objective is
not losing money and compounding
wealth over the long-term.
Obviously, like the fathers of value
investing Warren Buffett, Walter
Schloss, Ben Graham Jean
Marie was very much a disciple
of the notion that leverage had
to be avoided at the portfolio
level. He also believed that one
had to avoid as much as possible
investing in companies that have
too much leverage or banks or
insurance companies that are
undercapitalized.
Also, I think what was unique with
him, especially as a value investor
back then this was pre-2008 is
that he was willing to pay some
attention to the macroeconomic
environment. Value investors are
typically very proud to say that they
are only stock pickers. Only God
knows the future and He aint telling
us, so why waste time trying to
guess next years inflation, interest
rate, GDP growth rate and so forth.
I think that Jean-Marie, having
been a student of the Austrian
economists as I had been myself in
school, was keenly aware of credit
cycles.
Being a reader of Jim Grants
Interest Rate Observer and other
publications, he was aware,
especially after 1982, that there
were many countries in the world
where the use of debt became more
and more pervasivedebt at the
corporate level, at the household
level, at the government level. I
think being mindful of those credit
cycles made him understand that
Page 6 of 87

sometimes stocks look cheap as

they did in Mexico in 1994 but
then again it was an optical illusion
because those stocks were cheap
based on earnings that were
artificially inflated because of a
big lending boom that had been
happening in Latin America from
92 to 94 or in Asia from 95 to
98 and, more recently, a big credit
boom in Europe and the U.S. from
03-07.
Then finally, Ive appreciated that
Jean-Marie understood that it
was wrong to forecast. Youre
deluding yourself if you think you
can forecast. On the contrary, you
have to be aware of how many
unknowns there are as well as fat
tails and black swans. Also, from
a marketing standpoint, JeanMarie taught me to never promise
anything to clients and certainly
never to overpromise.
MOI: You describe your investing
approach as cautious and
opportunistic. How is that reflected
in security selection and overall
portfolio construction?
de Vaulx: Well, I think Ill try to
answer your question in a sense of
how that cautious and optimistic
approach is reflected today, as
we speak, in the overall portfolio
construction of our funds and the
way we pick stocks.
I think that our portfolio today is
truly eclectic and multi-cap. Of
course, if you look at the top ten
holdings youll find mid-cap or
larger cap stocks. But if you look
at our holdings in Asia, where
statistically today the small cap

stocks are much cheaper than the

large cap stocks, you will find a
wide array of stocks. We also hold
some mega-cap stocks: Total [TOT],
I dont know if Berkshire Hathaway
[BRK] qualifies as one (probably) as
well as tiny, little stocks in Japan,
Korea or Switzerland. We own a
billboard advertising company in
Switzerland called Affichage [Swiss:
AFFN], and its quite small.

our portfolio today is truly

eclectic and multi-cap. Of
course, if you look at the top
ten holdings youll find midcap or larger cap stocks. But
if you look at our holdings
in Asia, where statistically
today the small-cap stocks
are much cheaper than the
large-cap stocks, you will find
a wide array of stocks

We own a billboard
advertising company in
Switzerland called Affichage
[Swiss: AFFN], and its quite
small.

You also see our cautious and

opportunistic approach reflected in
the fact that we own some bonds.
In the IVA Worldwide Fund here in
the U.S., we have a little less than
9% in high-yield corporate bonds,
mostly a residual from a lot of
bonds we were buying late 0809. So, as a result, many of these
bonds will be maturing shortly in

the next year or two or three or four.

So its short-duration, high-yield
corporates. The yield is not huge.
Today, were talking about 4%, but
these are what we deem extremely
safe instruments and because the
duration is short, theres no interest
rate risk there.
You also will notice the eclectic
nature by the fact that we have
some sovereign debt, and its
approximately 5.1% of the portfolio.
Its mostly short-dated government
debt from Singapore. The coupons,
the yields, are de minimis. Here the
attempt on our part is to hopefully
get an equity-type return out of
the underlying currency. The hope
is that the Singapore dollar will
keep appreciating over time and,
of course, in two years from now
when those bonds mature the idea
is to just roll them over and buy new
similar short-dated bonds and to
remain exposed to the Singapore
dollar. Because that country doesnt
have much of a fiscal deficit,
theres not much of a long-dated
government bond market to begin
with.
Youll see the eclectic nature by
the fact that we hold some gold
in the portfolio, both bullion and
gold-mining shares. I am happy
to have convinced Jean-Marie
Eveillard in late 2001 that goldmining shares were so obscenely
expensive, overpriced, that if we
wanted exposure to gold we had
to modify our prospectus to give
ourselves the right to hold gold
bullion. Its been a great move! We
own a few gold mining shares, but
its really de minimis and only in our

Page 7 of 87

U.S. registered mutual funds. Our

preference remains, by far, towards
holding gold bullion.
Youll notice that at the end of June
[2012] we had 12.4% in cash. In
some ways you may want to view
those short-dated, Singapore dollar
bonds as quasi cash in Singapore
dollars. The fact that were not
fully invested tells you that we are
worried that we think that, by and
large, stocks are not dirt cheap
enough to be fully invested.
If you look at the kinds of names we
own in stocks or at least if you look
at the top-ten holdings, youll notice
that the balance sheets of the
companies we own are very strong.
We are very fond of the expression
Marty Whitman coined a while back,
which is that its not enough for a
stock to be cheap, it also has to
be safe safe and cheap. Safety
starts with the balance sheet.
The cautiousness of the portfolio
is expressed by the fact that we are
making some negative bets. We
have virtually no financials except
for a few insurance brokers, except
for and we may talk about it later
some tiny positions in Goldman
Sachs [GS], UBS [UBS]. Financials
in the U.S. are slightly too
expensive and in Europe we think
that most banks remain grossly
undercapitalized
Another negative bet youll notice
is that, other than a few stocks in
South Korea, we have virtually no
exposure to emerging markets.
We have no direct exposure to the
BRICs Brazil, Russia, India and
China because even though these

stocks have come down a lot last

year and some of them this year,
we believe that these stocks are
dead. We are cautious and worried
about whats going on in China. We
believe that a soft landing is in the
cards, and hopefully that will not
become a hard landing. Any sharp
slowdown in China will have major
consequences for commodity
prices, which in turn will hurt many
emerging countries.
Some specific countries like India
have obvious issues with inflation
and current account deficits, not
to mention problems with their
electricity. Weve seen in Brazil
over the past year-and-a-half how
government intervention has
had the ability to hurt investors.
Investors in Petrobras [Sao
Paolo: PETR] have seen President
Rousseff, basically ask the
company to think more about
whats good for Brazil Inc. as
opposed to doing whats right for
the companys shareholders.
Also, we worry about whats going
on in Europe. Were not sure what
the outcome will be. Its a big
unknown and the way we express
our skepticism towards whats
happening in Europe is by being
65% hedged on the euro. We are
willing to hold quite a few European
stocks because we believe that
many of them are multinational and
not necessarily that Euro-centric.

are quite Euro-centric in terms of

where their business is conducted,
we think that some of these
businesses may not be as cyclical
as others, or if they are, the price of
the stock may already reflect that
its going to be a difficult economic
environment for a long time in
Europe. So, in other words, there are
many stocks in Europe where we
think the bleakness of whats going
on has already been priced in.

Another negative bet youll

notice is that, other than a
few stocks in South Korea,
we have virtually no exposure
to emerging markets. We
have no direct exposure to
the BRICs Brazil, Russia,
India and China because
even though these stocks
have come down a lot last
year and some of them this
year, we believe that these
stocks are dead. We are
cautious and worried about
whats going on in China.

Conversely, lets not forget that

quite a few American companies
have a lot of their revenues in
Europe. Also, even in the instances
when some of our European stocks

Page 8 of 87

MOI: In your Owners Manual,

you state that in the short term
you try to preserve capital while
in the longer term you attempt to
perform better than equity indices.
How much of a role does portfolio
management play in achieving this
versus a buy-and-hold strategy in
essentially the same equities for
the long run?

technological changes, the odds

are high that a business today
will be very different fifteen years
from now. For instance, retailers
that were popular fifty or sixty
years agoMontgomery Ward, J.C.
Penney [JCP], Sears [SHLD]none
of these names are truly relevant
today. Nothings permanent.

de Vaulx: Let me start with the

second part of the question. Im
obviously very familiar with the
expression buy-and-hold and
that expression, frankly, makes me
cringe. I dont think it belongs to
the lingo that value investors use.
Value investors know about price
and value. Price is what you pay,
value is what you get. Sometimes
the price is way below that value,
sometimes the price is at or close
to that value and other times the
price is much above that value.

Im obviously very familiar

with the expression buy-andhold and that expression,
frankly, makes me cringe. I
dont think it belongs to the
lingo that value investors use.
Value investors know about
price and value.

The underlying premise for most

value investors is that it may take
two, three, four or five years for the
price to meet that value. Maybe
some of the companys problems
have to be sorted out. Maybe
some of the good attributes of
the company have to be better
recognized over time by investors.
So, yes, value investors are
prepared to wait for awhile for the
value to be recognized or realized.
If for some reason that value gets
recognized sooner then so be it and
its a bonus!
Another reason why buy-and-hold
does not make sense is because
the strength, the moat of many
businesses, is often not permanent.
Because of globalization or

Now, there are a few exceptions,

obviously. Warren Buffett has
tried to look for those the Coca
Colas of the world, the American
Expresses of the world. I think as
an investor its important, especially
from a qualitative standpoint,
to look at the past ten years
earnings, but its always important
to be mindful that businesses may
change and sometimes for the
worse. Technology, the internet,
has revolutionized whats been
going on in the media industry. It
has destroyed, to a large extent,
the economics of the newspaper
industry. So I think from that
standpoint, buy-and-hold is and
I mean by that buy and hold for
fifteen or more years a very
bizarre concept.
Now, the first part of your questionIm intrigued that very few value
investors ever comment on
portfolio construction, in particular

understanding correlations. For

instance, if you are managing a
global portfolio, you should be
mindful that if you own stocks in
China along with stocks in Brazil,
you need to understand that maybe
they are a lot more correlated and
joined at the hip than you would
normally think. If you are concerned
about the outlook for natural gas,
it can be useful to know what
companies in your portfolio would
benefit should prices of natural
gas go up in North America and
conversely which companies would
be hurt.
I think understanding correlations
is very important, especially in a
global world where theres a lot
more debt in the system than in
the past. Weve seen the global
nature of banks. A good example
of this is the paradox of whats
going on in Europe. In countries
like Italy, France and Germany there
has been no residential lending
bubble to speak of, yet the banks
in these countries still managed
to misbehave, not by lending to
their own people, but by lending to
Greece, Spain and Eastern Europe
and buying subprime here in
America.

understanding correlations
is very important, especially
in a global world where
theres a lot more debt in
the system than in the past.
Weve seen the global nature
of banks.

Page 9 of 87

Another thing thats not discussed

enough is position sizing. I think
Ive made my point about us not
being big fans at all of running
concentrated portfolios. I dont
think I could sleep well at night if
I had positions of 8%, 9%, 10% in
individual names. There is an art to
position sizing, whether this should
be a fifty basis point position or 1%
or 3% position. It may be tempting
as a shortcut to believe that you
should always overweight stocks
that offer the highest discount to
intrinsic value and vice versa.
In reality, you have to size your
positions to take into account four
variables plus a fifth one. The first
variable is: Does the company
have a good enough business that
theres scope for some intrinsic
value growth, between the retention
of some of the free cash flow and
maybe some organic growth?
Can that company see its intrinsic
value grow by 7%, 8% or 9% per
annum, which in itself would be an
equity type return. Conversely, is
it a mediocre business, a static or
declining business, where intrinsic
value at best will be static and at
worse maybe declining over time.
Obviously, the more scope for
intrinsic value growth, the more you
can justify allowing for less of a
discount, both when you own it and
then when its time to sell it.
The second variable is leverage.
The more leverage there is, because
leverage magnifies everything, you
should ask for a bigger discount.
You may also, depending on the
leverage, want to size your position
accordingly.

Something that should have a

bearing on the position size is
corporate governance and capital
allocation; for example, if a
company operates in a country like
Brazil where shareholders may be
mistreated by the government or
the regulators. Also, regulators may
ask SK Telecom [SKM] or China
Mobile [CHL] to be good corporate
citizens and help the population by
not raising their fees or keeping the
price of fuel low, but thats at the
expense of the company.
Its important to consider
corporate governance from a
government standpoint and
policymakers standpoint, but also
from a controlling shareholder
standpoint and/or management.
Most companies in Japan and
South Korea do an extraordinarily
lousy job at paying dividends, and
you have to factor that into both
the discount you should require
when you get in and the sizing
of the position. And, of course,
if the company has a history of
diworsification, you should either
not buy it altogether or, if you
do, make sure the position size
remains modest to take that risk
into account.
The fourth variable is liquidity. If a
security is only somewhat liquid,
it is often wiser to ask for a bigger
discount when you buy it.
The fifth variable is comfort level.
For us to be willing to have 3%,
4% or 5% of the portfolio in one
security, our comfort level has to be
very high. It has to be high in terms
of the discount to intrinsic value,
our respect for management in

terms of running the business from

a capital allocation standpoint and,
most importantly, our comfort level
that we understand the business
well enough. For instance, I can
sleep like a little baby having 1.8%
in Microsoft [MSFT], but the fact
is that I dont know where the
company will be ten years out and I
would be unable to sleep at night if
it were an 8% position.

I can sleep like a little baby

having 1.8% in Microsoft
[MSFT], but the fact is
that I dont know where the
company will be ten years
out and I would be unable to
sleep at night if it were an 8%
position.
Obviously, part of portfolio
management in our case is the
idea that theres no requirement to
be fully invested, which should be
obvious if youre a value investor.
If many stocks in your portfolio go
up and get closer to their intrinsic
value estimate, your self-discipline
kicks in. You have to trim your
positions, raise cash, and you
should hold onto that cash unless
you find new securities that offer
discounts to intrinsic value that are
wide enough, and just wait.
Theres another concept that I
enjoy, which Ive read in one of Ben
Grahams books, where I think he
argued that if at any given time
you can put together a portfolio of
genuinely cheap securities- while
at the same time Mr. Market as

Page 10 of 87

a whole is quite expensive, you

should keep some cash and/or
bonds on the side, maybe 20%-25%
of the portfolio. Youre deluding
yourself in believing that the stocks
you have however factually
cheap they are will not suffer a
temporary unrealized loss as Mr.
Market may go down.
MOI: You state that you are trying
to deliver returns that are as
absolute as possible. Describe the
challenges of doing so in a lowreturn environment. How do you
best preserve purchasing power
over time?
de Vaulx: Thats a great question.
We wrote a piece, Volatility as a
Friend in a Low-Return World, in
which one of the points we make
is that an additional difficulty of
being in a low-return environment
is that theres volatility. And,
historically, times of high volatility
and low returns typically have been
associated with difficult economic
times. I obviously have in mind
the 30s after the crash and the
following depression, and the
period from the 73-74 crisis and
then the stagflation that took place
in the late 70s until stocks and
bonds troughed in early August of
82.
Todays low-return environment is
unique from these other low-return
periods in history in that stocks
today are not cheap. For example, if
you think about 1974 or 1982, when
the S&P was trading at eight times
depressed earnings, the average
dividend yield was 6.8%. Today the
average yield is 1.9%. One of the
obvious reasons why stocks were

able to get so cheap in the past

is because we had high inflation
and very high interest rates. When
you have very low interest rates
as we have now, it becomes a lot
harder for stocks to become dirt
cheap. And even though stocks are
in many cases, especially outside
the U.S., as cheap now as in March
2009, and much cheaper than
2006-07, the reality is that after the
crisis, stocks did not go down at all
as much as they did throughout the
70s.
Because the economic outlook is
difficult, because stocks are not
dirt cheap, because I believe that
corporate profit margins will go
down in many instances, I believe
that stocks may only deliver returns
of 4-6% for the next 4-6 years,
which is less than the 7-9% equitytype return that one typically would
expect out of equities.

Because the economic

outlook is difficult, because
stocks are not dirt cheap,
because I believe that
corporate profit margins will
go down in many instances,
I believe that stocks may
only deliver returns of 4-6%
for the next 4-6 years, which
is less than the 7-9% equitytype return that one typically
would expect
That in itself would argue for some
caution, but then again, the trouble
is, if youre not fully invested in
equities, what do you do with the
rest of the portfolio? If its cash and

bonds, these things yield close to

zero and after inflation they yield
less than zero. If you look at the tenyear Treasuries today, in America
they yield 1.84%. If you look at the
ten-year TIPS and subtract one
from the other, the implied inflation
expected for the next ten years is
2.6%. So anyone who buys a tenyear treasury implicitly is willing to
lose, after inflation, 75 basis points
per annum. If you compare that to
a stock offering 7-10% or more FCF
yield and if a portion of that FCF is
paid out in dividends that represent
4-7% or more of the stock price,
that stock starts to look compelling.
On the one hand, because stocks
are not cheap enough to offer an
equity-type return, you may not
want to be fully invested and, yet,
if you decide to only be 60% or
65% invested in stocks, which we
are now, then youre diluting your
returns even more.
This environment clearly makes
it harder to always be up every
calendar year (last year the IVA
Worldwide Fund I share class was
down 1.96% while the MSCI AC
Worldwide index was down 7.35%)
and makes stock picking even more
essential, as mistakes that you
make carry with them much steeper
penalties. However, the underlying
volatility makes it possible for a
good stock picker to do better than
the equity market over time. For
example, if equity markets return an
average of 5% over the next 5 years,
it becomes a lot easier to do better
than that if those returns come with
volatility (helping you buy low and
sell high) than if markets achieve
those low returns in a straight line.

Page 11 of 87

As I mentioned earlier, times of

high volatility and low returns
typically have been associated
with difficult economic times. And
in difficult economic times, you
have the additional complication
of government intervention in
markets. Policymakers tend to try
to make things better or be tempted
to kick the can down the road
and postpone the problems. We
have seen policymakers intervene
through financial repression, putting
a cap at very low levels on what
savings accounts can pay whether
its here in the U.S. or in India or
China or if its through manipulating
foreign exchange rates. Right now,
for example, we see the Swiss
trying to make sure that the Swiss
Franc does not appreciate against
the euro. In a low-return world, all of
these interventions further increase
volatility and also increase the
binary nature of possible economic
outcomes. Whatever policies are
put into place by governments may
lead to deflation, as we saw in the
30s, or it may lead to inflation and
maybe stagflation.
When youre in the business, as we
try to be, of preserving purchasing
power over the short and long
term, I think that you have to be
all the more careful not to bet the
farm if you dont know whether the
final outcome will be inflation or
deflation. For example, you should
resist the temptation to go all
out and only own twenty-year or
thirty-year treasury bonds, or in our
case you should not necessarily
be 100% in gold or stocks with the
premise that if theres inflation or
hyperinflation thats the best way

to be protected. At this time, we

have not made a call either waydeflation versus inflation- and have
positioned the portfolio as such.
If you look at our portfolio today
youll notice that some of what
we have would be good if the
deflationary forces were to gain
strength, for instance, which could
happen if theres a major slowdown
in China or if things get worse
in Europe. What would help our
portfolio is the cash, especially
since we are invested in topnotch quality commercial paper.
In addition, the majority of stocks
that we own have strong balance
sheets, which should perform
better than lower quality stocks in a
deflationary environment.
Conversely, many of the stocks that
we own share attributes that should
help them do well in an inflationary
environment. These are the kinds
of stocks that Buffett owned in the
late 70s when he worried about
inflation non-capital intensive
businesses, businesses where
the companies should be able to
raise prices by at least as much as
inflation. Importantly, with noncapital intensive businesses, all
of the earnings are free cash flow
that can be paid to shareholders
as opposed to being reinvested at
higher prices in the business.

the U.S. devalued the dollar, which

led gold to go from $20.67 in 1932,
33 to $35 in 34, but because gold
becomes very desirable when you
have deflation because theres
no counterparty risk associated
with gold. Gold is not an IOU. So
when banks go bankrupt 40% of
banks went bankrupt in the U.S.
in the 30s any IOU is at risk due
to counterparty risk, even cash
deposited at the bank. Gold does
not have that problem. So, inflation
can be good for gold. We saw it in
the70s. Deflation can be good for
gold. Conversely, what is typically
bad for gold is disinflation.

gold becomes very

desirable when you have
deflation because theres no
counterparty risk associated
with gold. Gold is not an
IOU. So when banks go
bankrupt 40% of banks
went bankrupt in the U.S. in
the 30s any IOU is at risk
due to counterparty risk, even
cash deposited at the bank.
Gold does not have that
problem.

Gold, you could argue, is only a

hedge against inflation. Weve
always believed that gold
historically has been an equally
good hedge against deflation.
Gold did very well in the 30s, not
only because there was a gold
exchange status, not only because
Page 12 of 87

MOI: You state that you seek

investments in companies of any
size that typically have one or more
of the following characteristics
financial strength, temporarily
depressed earnings, or entrenched
franchises. What are some
examples of these temporary
challenges, temporary depressed
earnings for otherwise financially
strong and entrenched businesses?
de Vaulx: Ill give you an example
from the past and a more recent
example. I remember in the late
90s we bought McDonalds [MCD],
the fast food company. Why?
Because we were impressed
by how global they were, much
more global than some of their
competitors. We also, early on,
understood what Bill Ackman saw
a few years later, which is the real
estate angle, the fact that they own
so much real estate, a lot of it they
rent out to franchisees. Addressing
your question of temporary
challenges, the reason why that
stock became so cheap back then
is that the company was suffering
because the food had become
very bad much worse than the
competitors. And the service
there were many complaints about
the quality of the service.
We felt that those two issues were
fixable. Once those issues were
recognized by top management,
they were eventually able to fix
them and the stock over time has
gone up extensively.
A more recent example would
be was last summer, News Corp.
[NWSA], Murdochs media company.
They had the scandal associated

with their tabloids in the UK. The

stock came down and, yet, we were
comfortable building a decentsized position. The company had
a very strong balance sheet, so
we thought that they could suffer
having to pay some fines. With
hindsight, the balance sheet was
so strong that, in fact, the company
has been very aggressive buying
back their own shares since then.
On a sum of the parts basis, a year
ago, the stock fell as low as $15 or
$16. We had, on a sum of the parts
basis, a value of around $30.
News Corp. is a very different
company than it was 20 years
ago. News Corp. almost went
bankrupt in the early 90s and at
the time it was mostly newspapers,
magazines, but todays businesses,
BSkyB, Fox, theres very little print,
in the sense of being threatened
by the Internet. These are very
powerful businesses one of the
businesses is 20th Century Fox,
which is a decent business, so
pretty un-cyclical businesses with
no major immediate sort of threat
to their businesses high margin
businesses, a very strong balance
sheet.
The way we interpreted the
scandal is, we thought it had a
silver lining because via some
super-voting structure, Murdoch
controls the company. We thought
that the scandal because its
such a public business he would
be forced to improve corporate
governance, which I think he has.
We felt the Chief Executive Officer,
Mr. Carey, was very competent as
was the predecessor, Mr. Chernin.

We realized that the super-voting

control allowed him to make some
mistakes in the past, but small
mistakes.
He lost a lot of money when he
overpaid for Dow Jones, the
publisher of The Wall Street
Journal. He overpaid for MySpace,
but in the grand scheme of things
these were small deals and,
conversely, to his credit as a media
guy, he saw the changes that
were happening in the newspaper
industry and moved away from that
over the years. Today, the stock is
at over $24. I think that was a good
example of what we thought was a
temporary challenge and one that
was limited to just one part of their
empire.

News Corp. is a very

different company than it
was 20 years ago. News
Corp. almost went bankrupt
in the early 90s and at
the time it was mostly
newspapers, magazines,
but todays businesses,
BSkyB, Fox, theres very little
print, in the sense of being
threatened by the Internet.

Page 13 of 87

One stock weve bought over the

past six, nine months is a French
company called Teleperformance
[Paris: RCF]. They run corporate call
centers, and thats a case where all
of the earnings pretty much come
from the United States. Theyre very
powerful in the U.S. In fact, for all
practical purposes, the company
should be headquartered and listed
here. Its sort of an accident that
it is listed in France. The French
founder happens to live in Miami,
and its an interesting case where
the French operations are losing a
lot of money.
Its much harder in France than in
the U.S. to fire people and so they
are not able to stop the bleeding
right away in France, and I think
we feel that we can quantify what
those losses will be. Worst case,
the company can hopefully shut
down the business over time, and I
think those losses in France mask
the quality of their earnings in the
U.S. Historically, there have been
many instances where we have
dabbled a lot in what we call high
quality, yet, cyclical businesses.
If you think about temporary
staffing companies Randstad,
Manpower; if you think about the
freight forwarding companies
Kuehne + Nagel, Panalpina,
Expeditors International If
you think about the advertising
companies, billboard advertising,
they are good businesses in the
Warren Buffett sense of return
on invested capital service
businesses, high returns on
capital, high free cash flow. They
are cyclical because, oftentimes,

other investors have a shorter-term

horizon than we do. Whenever the
economy goes south, in the world
or in the country, these stocks go
down, sometimes excessively so,
so that the stocks implicitly forget
that theres a prospect that its just
a cyclical downturn, not a secular
change in the business. So weve
often been doing some of this in
the past.

One stock weve bought

over the past six, nine
months is a French company
called Teleperformance
[Paris: RCF].

MOI: How does your approach to

international investing differ from
that to investing in U.S. equities, if
at all?
de Vaulx: For a long time, until
almost in 2008 you typically had,
especially in the institutional world,
the distinction between domestic
investors that invest in domestic
U.S. stocks and international
investors that invest outside the
U.S. Weve always felt that being
a global investor made more
sense because many industries
are global. If you look at the
automobile industry, it would be
absurd to look at GM [GM] and Ford
[F] without being aware of Tata
Motors [TTM] and Volkswagen
[Germany: VOW] and Hyundai and
Toyota [TM] and so forth. Or that
billboard advertising company I
mentioned earlier, Affichage in
Switzerland, that company itself is

not global. It has operations mostly

in Switzerland and in a few other
European countries, but to a large
extent, the business model is the
same as similar companies in the
U.S. or elsewhere.
The way we are organized internally
at IVA is that the work has been
divided among analysts along
sector lines.
Value investing is an American
invention. American value investors
were adamant against international
investing for a long time. Even in
the late 90s Warren Buffett was
not willing to invest internationally
because there was this belief that
foreign accounting is difficult
to understand, disclosure is not
as good. The notion was that
managers outside the U.S. dont
care about shareholders and so
forth. The other theme at the time
was that if all you want to do is play
in economic growth in the rest of
the world, you dont need to invest
internationally. Instead, you can
do it through Coca-Cola [KO] or
McDonalds or Microsoft [MSFT] or
Colgate [CL].
In terms of understanding the
companies, we think its a huge
competitive advantage to look at
things on a global scale and by
sector. At the same time, we remain
mindful that there are still some
risks associated with international
investing we have to factor in. For
example, disclosure is not as good
as it is in the U.S. In the U.S., you
have 10-Ks where companies have
to give some description of some
of the business segments theyre
in. They typically will tell you if they
Page 14 of 87

own some of the real estate of the

plants, the plant and the equipment.
In general, international companies
give less granular information
regarding the business segments.
Also, although there have been
improvements in corporate
governance and laws to protect
minority shareholders, I think its
fair to say that there are still risks in
international stocks.
Ive talked about the risk of
government interference. We own
a stock in France called GDF Suez
[Paris: GSZ]. One of the businesses
is the distribution of gas to both
retail clients and corporate clients;
and even though there have been
contracts going back a long time
stipulating that if certain costs
escalate contracts with the
government the company has
the right to pass along those
increased costs. More recently,
the government over a year ago
told the company, no, they cannot.
Even though a recent court some
sort of Supreme Court has
argued in favor of the company,
our understanding is that the
government is not bound to honor
what that court has decided.
With international investing, if you
look at companies in Europe and
Asia compared to the U.S., more
of those companies, especially
the small ones, are controlled by a
family or group. The risk associated
with being a minority shareholder
is all the more prevalent, relevant,
and I think you have to be mindful
of it. Not necessarily in the sense
of not buying any of the stocks,
but maybe sometimes asking for

bigger discounts to intrinsic value

when you get in and also making
sure that the position size, which
we were discussing earlier, doesnt
get too big.

We own a stock in France

called GDF Suez [Paris: GSZ].
One of the businesses is the
distribution of gas to both
retail clients and corporate
clients; and even though
there have been contracts
going back a long time
stipulating that if certain
costs escalate contracts
with the government the
company has the right to
pass along those increased
costs.
However cheap a stock such as
SK Telecom [SKM] would become
it would be hard for me to have an
8% position in SK Telecom knowing
that its a Korean company. Korea
is not known for the greatest
corporate governance, and its a
regulated business where you are
at the mercy of the regulator who
may want to favor the number two
player, the number three player in
the industry as opposed to let SK
Telecom grow market share.
Another obvious challenge which
also impacts U.S. companies
has to do with foreign exchange.
Of course, U.S. companies and
were seeing it now with the dollar
going up against many currencies,
including the Indian rupee, the
Brazil real from a translation
standpoint, we see the earnings of

the Procter & Gambles, the CocaColas go down.. Conversely, we

have to be mindful, when we invest
in yen or in Malaysia, or if we were
to invest in Spain, we have to be
mindful of the foreign exchange
risk. Either way, understand that
we might want to control it through
hedging the currency assuming
that the risk of hedging is not
prohibitive.
MOI: How do you generate
investments?
de Vaulx: Compared to many of
our peers, it would be fair to say
that we may rely a lot less on
screens. It would be easy every
week to run screens globally about
stocks that trade at low price to
book, high dividend yield, low
enterprise value to sales, enterprise
value to operating income, and
so forth. Generally speaking, a lot
of our value competitors begin
the investment process by that
I mean the search for ideasby
trying to identify cheap-looking
stocks.

However cheap a stock such

as SK Telecom [SKM] would
become it would be hard for
me to have an 8% position in
SK Telecom knowing that its
a Korean company. Korea is
not known for the greatest
corporate governance, and its
a regulated business where
you are at the mercy of the
regulator

Page 15 of 87

Sometimes using screen devices

they look for cheap-looking stocks
and once they have identified a list
of cheap-looking stocks, then they
decide to, one at a time, do the
work and investigate each of these
companies. The pitfall with that
approach is typically those cheap
looking stocks that youve identified
will typically fall in two categories.
Either stocks that are of companies
that operate in overly competitive
industries or overly regulated
industries where the regulator may
not always be a friendly regulator.
So you may find steel companies,
or some retail companies, or the
insurance industry in many parts
of the world is notorious for its
overcapacity and lack of barriers to
entry.
So, either youll find companies
in overly competitive businesses
where its hard, or even worse, youll
find typically some of the lousiest
competitors in their respective
industry. If you had run a screen
a day before a company went
bankrupt, the stock probably looked
cheap on maybe a practical basis or
probably enterprise value to sales
basis.
The problem with these cheaplooking stocks of both categories is
that its going to be hard for these
stocks to see their intrinsic value go
up over time. If anything, especially
in the second category, the worst
competitor type category, some of
these companies may actually see
intrinsic value go down over time.
Conversely, what piques our
curiosity, what makes us want to
investigate an investment idea is

not that it looks cheap at first sight.

Its rather that the business looks
neat or that the company seems
uniquely good and well positioned
in what they do, and then we hope
and pray that, for one reason or
another, the stock happens to be
cheap. Ill give you an example
which goes back many years.
Maybe 15 years ago, I was reading
briefly about a company I had never
heard of Thomas Nelson, a U.S.based company.
They were the leading publisher
of bibles in America, maybe in the
world. They were also a leading
publisher of inspirational books and
I said, well, book publishing used
to be a great business. It changed
from being a great business to a
good business. Margins went from
being obscenely high to just high
because authors asked to be paid
more over time. I said, gee, a bible
publisher Theres not much in the
way of author rights. Thats pretty
neat. Next to that brief description
of the business was a P/E ratio that
did not look low- it was15 times
earnings, a P/B that did not seem
low and a dividend yield that did not
look enticing. So the stock did not
look cheap, but I said maybe theres
something hidden. Maybe the
earnings are temporarily depressed,
and so maybe the stock is cheap
even though it does not look so at
first blush.
I was intrigued by the business,
and I took a look at it and realized
that the company had, for the five
years just prior, started to come
up with five new bibles bibles
for children, bibles for the elderly

and so forth and they had

capitalized the costs of creating
these new products. Now that
those bibles were available for sale
in bookstores, the company was
amortizing over five years, or maybe
three years, that cost. So now the
companys earnings per share were
after a pretty big amortization of
capitalized costs, which was not
a cash charge. What looked like a
high price to earnings ratio of 15
times was only a 10 times price
to earnings before amortization
of capitalized costs. So the price
to cash earnings was much more
reasonable.
I was intrigued by the fact that
the company, two years prior, had
misbehaved. Since they had a
good business, they had decided
to diversify and buy into a difficult
business. They had bought a
printing business in the UK. They
had borrowed money for that, but
to their credit, a year later they
realized their mistake and had sold
that business at a loss, but they
had sold it and the proceeds were
high enough to pay down debt.
The bottom line is that for the few
people who knew that company
in the past, who owned it, they
were disappointed in management
because of that one time mistake.
I felt that, hopefully, management
would have learned from their
mistake.
Oftentimes, we will study over the
years great businesses, whether
its a Google, an Expeditors
International [EXPD], 3M [MMM],
and we keep them in mind and
we have a tentative intrinsic

Page 16 of 87

value estimate, and sometimes

there could be a crash. There can
be a crisis like 08, something
happens and sometimes these
stocks fall enough that we revisit
them. I talked about these great
businesses that are cyclical, the
temporary staffing companies,
most of the time theyre too
expensive for us to catch, but once
in a while, especially during an
economic downturn, were able to
buy them.
Even LOreal [Paris: OR], the
French-based yet global cosmetics
company, a few times in the past
during an economic downturn,
sales slowed down and the growth
guys that typically own the stock
dont want to own it, because the
growth rate is not there. So they
dump it. It still optically looks too
expensive for the deep value guys.
In other words, instead of staying at
six, seven, eight times EBIT, it may
still trade at nine, ten, eleven times
EBIT. So the growth guys dont want
it, the deep value guys dont want
it. It sits in limbo, and thats when
were able to get those things.

Even LOreal [Paris: OR],

the French-based yet global
cosmetics company, a few
times in the past during an
economic downturn, sales
slowed down and the growth
guys that typically own the
stock dont want to own it,
because the growth rate
is not there. So they dump
it. It still optically looks too
expensive for the deep value
guys.

So its not much in the way of

screening. Its just the analysts,
based on the sector they follow,
and because some of us have been
in this business for a long time
myself, over 25 years and Chuck [de
Lardemelle] and Simon [Fenwick]
and Thibault [Pizenberg] for many
years and because weve looked
at tiny companies and huge ones,
we have a pretty good idea of what
the best businesses and companies
are out there in the world, and we
keep them in mind and try to revisit
them when theres a crisis or a big
economic downturn.
MOI: Where do you see the biggest
inefficiencies currently?
de Vaulx: Many bonds, especially
U.S. Treasury bonds, German
bunds, possibly Japanese JGBs
strike me as very expensive.
Because of the fear of the unknown,
because investors have not done
well for many years, the flight to
safety is so extreme that investors
are willing to buy those bonds that
have yields that, in all likelihood,
will be less than what inflation will
be during the time period. In other
words, owning a ten-year Treasury
note yielding 1.8% strikes me as a
good way to grow poor, but I think
your question, really, is more on
the long side, what do we think is
cheap?
One of the biggest inefficiencies
would be Japan, where the market
trades at a level thats lower than
in 1983 29 years ago. In Japan,
the smaller the stock, the less
liquid a stock, the cheaper it is
relative to other stocks, so small
stocks in Japan are, by far, the

cheapest. I think some people

have run screens, trying to identify
Ben Grahams net-nets around the
world and an overwhelming number
of names that pop up through
that screen are many small-cap
Japanese names. I think these
stocks are cheap for a reason.
So maybe inefficiency is not a
proper word. Investors have been
very disappointed over the years
in Japan by the fact that many
Japanese companies are well
managed. They run the business
properly, many businesses have a
decent and sometimes very high
return on capital employed, but the
flaw is the capital allocation.
Dividend payout ratios are low in
Japan and, oftentimes, companies
will pay out no more than 20%,
25%, 30% of the earnings. At least
companies do not diworsify the
way they used to in the 80s leading
up to the bursting of the Japanese
bubble, but weve seen many
Japanese companies year after
year keep most of the free cash
flow thats been generated by the
business and let the cash pile up
on the balance sheets. So there are
many small-cap Japanese stocks
that are quite cheap. Theres one
called Shingakukai [Tokyo: 9760].
It trades below net cash and the
business is profitable.

there are many smallcap Japanese stocks that

are quite cheap. Theres one
called Shingakukai [Tokyo:
9760]. It trades below net
cash and the business is
profitable.
Page 17 of 87

The reason why there arent as

many inefficiencies today as we
would expect, especially in such
a difficult economic environment,
is that equity markets around
the world over the past eighteen
months have been quite efficient
in discriminating and establishing
a differentiation between stocks
of companies that are average
or mediocre from stocks of
companies that have great
businesses, especially those
businesses that are not very
volatile. If you look at certain
stocks such as Nestle [Swiss:
NESN], Diageo [DEO], Colgate [CL],
Bureau Veritas [Paris: BVI], many
of these stocks are close to their
all-time highs. They are perceived
as extremely high quality, very
defensive, generate a lot of free
cash flow, and especially if they pay
some sort of dividend, they have
been bid up accordingly.
Im not suggesting that these
stocks are overpriced. Im saying
that they dont offer much in a way
of a discount to intrinsic value.
Even though emerging market
stocks have come down quite a
bit last year and in some countries
even this year, we believe that
many stocks look cheap based
on earnings and cash flows, but
these earnings and cash flows are
at risk of being sharply reduced if
theres too much of a soft landing
in China. So even though emerging
market stocks have come down, we
dont deem them to be inefficiently
priced.

MOI: When it comes to Japan,

where do you see the biggest
values?
de Vaulx: Not so much today
among some of the leading
exporters, global-type companies.
If you look at the share price of
Shimano [Osaka: 7309], which
makes the bicycle parts, if you look
at Keyence [Tokyo: 6861], Fanuc
[Tokyo: 6954], these stocks are not
outrageously expensive, but they
are not cheap. I think its smaller
businesses, oftentimes, although
the example Ill give you is not so
small.
Our largest holding in Japan is
Astellas Pharma [Tokyo: 4503],
which is Japans second-largest
drug maker. The market cap is in
the billions of dollars and whats
interesting with Astellas is that
over the past seven years they
bought back 19% of their shares
outstanding, which is unusual, its
very un-Japanese. Companies
typically dont do buybacks, or
not that extreme, so even though
the company has bought back a
lot of their own shares over the
years, even though the dividend
payout ratio is close to 50%, which
is high by Japanese standards,
the companys net cash today still
accounts for 18% of the market
cap. So the company still has some
net cash, and also the company
has made a few acquisitions in the
past. The last one was a year and
a half ago, a U.S. based company
called OSI Pharma. Because of
those acquisitions, theres a pretty
large expense called amortization
of goodwill and, basically, our sense

is that the local investors forget to

take into account the amortization
of goodwill. They may look at
enterprise value to EBIT.
Most Japanese investors will only
look at the price to earnings ratio.
Some of the more daring investors
will look at enterprise value to EBIT
and that will help them factor in the
fact that theres all that cash, but
EBIT, unfortunately, is 20% lower
than EBITA, the amortization of
goodwill of intangibles is quite high.
Today, with the stock at 33,845
yen, the stock trades at 6.2x EBITA,
earnings before interest, tax and
amortization, 6.2x EBITA of [the
year ending] March 2014. Yet, if
you look at reported EBIT based on
the estimate for [the year ending]
March 2014, the EV to reported
EBIT is 7.5x and thats, at best, what
the locals see.

Our largest holding in Japan

is Astellas Pharma [Tokyo:
4503], which is Japans
second-largest drug maker.
The market cap is in the
billions of dollars and whats
interesting with Astellas is
that over the past seven
years they bought back 19%
of their shares outstanding,
which is unusual, its very unJapanese.

Page 18 of 87

The company has been very good

at their core business. They have
a pipeline thats among the best
compared to other pharmaceutical
companies in the world. Because
of the pretty high dividend payout
ratio and the low stock price, the
dividend yield is 3.4%. As you know,
ten-year Japanese government
bonds only yield seventy-six basis
points. For a local investor, to get
3.4% dividend yield in yen is quite
remarkable. On an EV to EBITA
basis, the stock is very cheap at
6.2x. It has net cash and some
great growth prospects because
of many drugs that are about to be
launched. Thats a good example of
a cheap stock in Japan.
MOI: When it comes to Europe,
most of your investments there
are in companies headquartered
in France and Switzerland. Why
not more in Germany or peripheral
European countries?
de Vaulx: Again, great question.
Let me start with Germany. In
the past, we have had quite a
few investments in Germany. We
used to own in the early 2000s,
late 1990s-2000s, Buderus
[formerly Frankfurt: BUD]. It was
our largest holding. Buderus is a
boiler manufacturer. Weve owned
shares such as Vossloh [XETRA:
VOS], Axel Springer [XETRA: SPR],
Hornbach [XETRA: HBH3], the DIY
retailer and so forth, but the reality
is that most companies in Germany
are not listed. If you think about
industry, industrial companies
in Germany, they are not listed
because they belong to what the
Germans call the mittelstand. The

mittelstand are those thousands

and thousands of basically small
and mid-size companies, many of
which are family-owned, and these
companies are not listed. All those
great German industrial companies
basically are not available in the
stock market.
Now, among the companies in the
stock market, many have been
recognized as good companies
and so the stocks are no longer
cheap if you think about some
of the auto manufacturers like
Volkswagen. So for the time being,
we dont have much in Germany,
although we did buy, a month ago, a
large industrial German company.
Switzerland is an interesting
country where there are many
quality companies. Even though
were value-oriented, we start our
process with trying to identify not
so much cheap-looking stocks, but
quality businesses. We like quality
and then we hope and pray that
somehow, one way or the other, we
can get it for cheap.

staffing company, has much higher

margins than Manpower [MAN],
has higher margins than Randstad
[Amsterdam: RAND]. They just
have top-notch companies in
Switzerland, and sometimes we are
lucky to get them cheaply.
France is an interesting country
because even though France has
had and today has those socialist
tendencies, France has an amazing
number of great businesses, which
oftentimes are global leaders.
Think of Pernod-Ricard [Paris: RI].
Pernod-Ricard started as a little
family-controlled business in the
south of France and through astute
management and acquisitions they
have become a leader in the sale of
liquor competing very well against
Diageo, which is best-in-class in
that industry. Think about LOreal
what a wonderful, global consumer
company. And of course everyone
knows that France is the home of
stocks such as LVMH and Hermes,
the luxury good companies.

Switzerland has so many great

businesses, whether its Kuehne
& Nagel [Swiss: KNIN], which is
an even better freight forwarding
company than Expeditors
International here in America.
Nestle is a wonderful food
company, better in my mind than
Kraft [KFT]. Geberit [Swiss: GEBN]
makes great plumbing products.
Lindt & Sprngli [Swiss: LISN], as
Im sure you know, makes delicious
chocolates, and so its our bias to
its quality that oftentimes has led
us to Switzerland. Adecco [Swiss:
ADEN] is a leading temporary
Page 19 of 87

In France, we own Sodexo [Paris:

SW] a food catering company.
They compete against Compass
[London: CPG] in the UK. Sodexo
is a very well-run, global company.
They have a huge subsidiary here in
America, Marriott Services, which
they acquired a long time ago.
Theres a stock we dont own now
but weve owned in the past. Its
become somewhat of a darling,
Essilor [Paris: EI]. They are, by far,
the leading company worldwide
that manufacturers lenses for
glasses.

In France, we own Sodexo

[Paris: SW] a food catering
company. They compete
against Compass [London:
CPG] in the UK. Sodexo
is a very well-run, global
company. They have a huge
subsidiary here in America,
Marriott Services, which they
acquired a long time ago.
Weve owned in the past Bureau
Veritas. Its a little bit like ISS
[Group] in Switzerland. Its an
inspection service company and
they have big market shares in
many specific niches. Its a service
business, non-capital intensive.
France has companies such as
Legrand [Paris: LR]. Legrand is
the leader worldwide in electrical
switches.
France does have those global
companies that are very good at
what they do and, at the same
time, many of these companies

are family-controlled. We at IVA

believe that more often than not
family-controlled businesses do
better than other types of business
and could not agree more with
Tom Russo from Gardner Russo
& Gardner on that topic. One of
his big themes is that he loves, for
the same reason we do, familycontrolled companies because they
have a long term vision and often
times do great things.
The final point I want to make about
France, and its important from a
protection of minority shareholders
standpoint, is that France is a
pretty good place to be a minority
shareholder. When there are
takeovers in places like Germany
or Switzerland, not to mention Italy,
you often, as a minority shareholder,
can be abused.
In France, especially now,
compared to 20 years ago, minority
shareholders are well treated
when there are squeeze-outs
and takeovers. The protection of
minority shareholders is pretty
high in France. Thats important
because it just so happens that
quite a few of our companies, not
by design, get taken over, and when
that happens we want to be well
protected.
If you look at places like Italy, there
arent that many listed companies,
sort of the same reason as
Germany. All these companies,
like industrial companies based
in northern Italy, most of them are
family-owned and not listed. So
theres not that much available in
the stock market, and some of the
other countries in Europe Spain,

Portugal, Austria oftentimes

the biggest stocks are just the big
banks and insurance companies.
Most of them are, especially
on the banking side, grossly
undercapitalized. They may look
cheap, but they are certainly not
safe. Again, not a lot of quality
stocks are available in the Greek
stock market, or the Portuguese or
Spanish one.

France is a pretty good

place to be a minority
shareholder. When there
are takeovers in places like
Germany or Switzerland, not
to mention Italy, you often, as
a minority shareholder, can
be abused.
MOI: You recently initiated a few
small positions among large global
bank stocks. What is the rationale
for this, and why now?
de Vaulx: Lets keep things in
perspective. Were just dipping our
toes here. We have small positions
in UBS [UBS] and Goldman Sachs
[GS] and had a small position in
Credit Suisse [CS] that we are
now out of, as our confidence
level was not high enough. In the
case of UBS, their private wealth
management business does strike
us as having a lot of value. If you
assign some value to the private
wealth management business,
and if you add that value to the
shareholders equity of the firm, then
youll reach the conclusion that
the bank is more than adequately
capitalized.
Page 20 of 87

The rating agencies, as a rule, dont

factor in the value of the private
wealth management business,
but we are willing to do that. On
that basis UBS strikes us as well
capitalized and somewhat cheap.
Goldman Sachs we think has a
unique culture. We think that being
a global leader, as they are, will give
them a competitive advantage. We
think that Goldman Sachs will be
willing to cut costs further to make
sure their return on equity, two or
three years from now, covers the
cost of capital.
Goldman Sachs will see many of its
competitors exit certain businesses
like trading, market making, and
investment banking. As capacity
shrinks in the industry, with many
of Goldman Sachs competitors
abandoning certain businesses,
Goldman Sachs will end up with a
larger market share. Theyll be more
dominant, and if they can reign in
those compensation costs, they
will end up with a decent return on
capital. We have a two- to fiveyear horizon with Goldman Sachs,
hopefully for them to do some good
things.
MOI: In the case of UBS, I guess
you own both equity as well as
debt; one of your largest positions
is debt in Wendel [Paris: MF]. Im
curious if you could explain just
why you hold certain of these debt
securities, perhaps also explaining
the risk/reward versus holding the
equity.
de Vaulx: In the case of UBS, we
do own the equity and the debt. In
fact, the UBS debt we own is a very
unusual bond, which in a few years,

the fixed coupon will be replaced by

a floating-rate coupon. So, basically,
even though these are long-dated
bonds, we do not take interest
rate risk because they will have a
variable rate. In essence, we view
those UBS bonds as quasi-cash
in terms of the interest rate. The
yield is not huge, but it is still a very
competitive yield that will be some
200 points higher than what we
currently get on our cash.
In the case of Wendel, we have
known the company for over a
decade. We started buying the
stock at my previous firm in the
early 2000s. We did very well with
the stock in the 2000s, but the
company made a big mistake in
2006, I think, they overpaid and
over-borrowed to buy a stake in
Saint-Gobain, a French company,
and so they levered themselves
up just as the financial crisis was
about to hit. When the financial
crisis hit, we started buying some
bonds at IVA. We own several
bonds some mature in 2016,
others in 2017 and others in 2018.
So its not too short and not too
long. It is a perfect duration and
those bonds, in late 2008, were so
depressed that we were getting
yields to maturity of 16%, 17%, 18%.
Since then, the holding company,
which is a family-controlled holding
company, has been able to shed
assets. Theyve reduced their stake
in Legrand. Theyve reduced their
stake in Bureau Veritas. Theyve
shed other assets, so the balance
sheet has improved greatly and
these bonds are, in our mind, very
safe. I wouldnt say extremely safe,

but very safe and now the yields

have come down tremendously, but
these bonds still yield in excess of
5%. So its still a pretty reasonable
yield in a zero return world, and
so were very comfortable with
Wendel. Now, you may argue that
5% is not exactly an equity-type
return of the 7-9%, but its a pretty
safe piece of paper, so were happy
to hold onto it.
MOI: How has your view on owning
gold, cash and fixed income
changed recently, if at all, and the
rationale for each in terms of overall
portfolio and risk management?
de Vaulx: Our view on gold which
is not only today, but in general
we think that gold is a nice tool to
have. Of course, its a tool where we
give ourselves the latitude to buy
either gold bullion or gold mining
shares. Sometimes which of the
two you buy makes a difference.
Sometimes gold may do well, but
gold mining shares not so well, or
vice versa. Gold is misunderstood.
Gold tends to be viewed, too often,
strictly as a hedge against inflation
because people remember what
gold did in the 1970s. I would argue

we think that gold is a nice

tool to have. Of course, its a
tool where we give ourselves
the latitude to buy either gold
bullion or gold mining shares.
Sometimes which of the two
you buy makes a difference.
Sometimes gold may do well,
but gold mining shares not
so well, or vice versa.
Page 21 of 87

that gold also should be viewed as

a hedge against deflation. Lets not
forget that in the 1930s when we
had the depression and deflation,
gold did well. Under the gold
exchange standard, we saw gold
go from $20.67 in 1930 to $35 an
ounce in early 1935.
Why can gold do well when theres
deflation? Because when theres
deflation, theres counterparty
risk. Companies default, banks
default. In America, almost 40% of
banks defaulted. Gold, not being
an IOU, is a very precious tool in a
deflationary environment.
What typically can hurt gold is an
environment where real interest
rates are high. The incentive to
be in gold when you could earn a
nice, fat, juicy, positive real return
is a high burden to want to own
gold. Conversely, when real interest
rates are negative, when the cash
at the bank or on treasury bills
yields less than inflation, when you
have a negative real interest rate,
its infinitely more palatable and
tempting to own gold, so negative
real rates are a tailwind while real
interest rates being positive would
be a headwind.
Gold is not as cheap now as it
was in 2001 when gold crossed
$255 an ounce. Gold today is
around $1750. At the same time,
if you adjust all the inflation that
has taken place since the late
1970s, inflation defined as what
the Consumer Price Index (CPI)
has done or money supply growth
around the world, if you look at how
much central bank balance sheets
have grown over the years, so if you

adjust for that, youll notice that

the price of gold today, in fact, is
not that high compared to the late
1970s.
Within the context of portfolio
management, the way we use
gold is simple. The concept is as
follows: when stocks and bonds
are dirt cheap as in hindsight
they were in 1982, for instance
theres no need for gold. What does
being cheap mean? Cheap means
that something, a stock or bond,
trades way below intrinsic value, so
the bigger the gap between price
and value, the bigger the so-called
margin of safety. So you dont
need gold. Conversely, when stocks
and/or bonds are expensive, like
many stocks were in the late 1990s
and early 2000s at the height of
the tech bubble, this is when it can
be very handy in a portfolio to own
gold. Of course, the beauty is that
the market, in its all too unusual
kindness, gave gold away for
almost nothing. Gold was around
$260 an ounce in 1999, and it hit a
low of $255 an ounce in 2001. It is
now over $1750 an ounce.

gold as a hedge. We also realize

that it does not always work as a
hedge.
If you think of 2008 or 2011, gold
performed as a hedge. When stocks
were down in 2008, gold was up
6% or 7% for the whole year. Last
summer, July and August 2011,
when stocks were falling worldwide,
gold went from $1,200 an ounce
in July to over $1,900 an ounce in
early September. Conversely, there
are other times when gold, instead
of being inversely correlated to
stocks or bonds becomes positively
correlated, and in those times gold
does not act as a hedge. In 200910, we saw gold go up insipidly with
stocks and bonds and did not act
as a hedge during those two years.

Going forward, if stocks and

bonds became dirt cheap
we dont view them as dirt
cheap today say, if stocks
fell 20%, we would not need
to own as much gold as we
do.

Going forward, if stocks and bonds

became dirt cheap we dont view
them as dirt cheap today say, if
stocks fell 20%, we would not need
to own as much gold as we do. We
roughly have 5.5% of the portfolio in
gold right now. Conversely, if stocks
move back up, and if some of the
worlds economic imbalances have
not been addressed yet, if all the
policymakers do is kick the can
down the road further, we probably
will decide to add a little bit to our
gold exposure. So we really view

Page 22 of 87

MOI: When it comes to fixed

income, you talked about some
positions there essentially as a
cash substitute. You also talked
about gold, I believe, as essentially
money. So is that really then, when
we look at those three categories
gold, cash and fixed income in
a way would it be fair to say that is
really all some form of cash
de Vaulx: No. In fact, typically
whenever we buy fixed income,
its an attempt to get equitytype returns, and so when we
buy high-yield corporate bonds,
sovereign debt, and distressed
debt, its trying to get an equitytype return. Now, the exception
would be, for instance, we have
6% of the portfolio in short-dated,
Singapore dollar bonds issued
by the Singapore government.
Those bonds yield very little, but
the attempt is for us to get an
almost equity-type return out of
the underlying currency. It is our
belief that the Singapore dollar will
appreciate over time and give us
an almost equity-type return. One
can also look at those short-dated
bonds like quasi-cash in a currency
other than U.S. dollars.
Now, when it comes to cash, I want
to make a very important point.
Whenever we hold cash today we
have 15% of the portfolio in cash
some investors believe that us
holding cash is us attempting to
do tactical asset allocation. Its us
trying to time the market. It could
not be further from the truth. When
a real value investor holds cash,
cash is a residual. Cash reflects the
portfolio managers inability to find
enough cheap stocks.

As a value investor, if youre lucky

to find some cheap stocks, once
you buy them, if you get even
luckier, the price of the stock goes
up and gets closer to the intrinsic
value estimate that you have. This
is when the self-discipline kicks
in and you have to start trimming
that position and when you do that,
you raise cash again. As a value
manager, you have to hold onto
that cash until you find new stocks
that are cheap enough to offer the
margin of safety that Ben Graham
defined, which oftentimes will be
a 20%, 25%, 30% or 35% discount
between the price and the intrinsic
value. Cash is truly a residual and
Im sure youve read or heard of
Seth Klarman from Baupost talk
about how he uses cash as a value
investor, and we use it in exactly the
same spirit as he articulated.

Whenever we hold cash

today we have 15% of
the portfolio in cash
some investors believe
that us holding cash is us
attempting to do tactical
asset allocation. Its us trying
to time the market. It could
not be further from the truth.
When a real value investor
holds cash, cash is a residual.
Cash reflects the portfolio
managers inability to find
enough cheap stocks.

MOI: What is the single biggest

mistake that keeps investors from
reaching their goals?
de Vaulx: If I have to mention one
mistake, one overwhelming mistake
is the inability of investors, be it
individual or professional investors,
to pay enough attention to the
price. I think investors pay way
too much attention to the outlook
and not enough to the price. When
they wait for the sky to be blue or
at least for the gray sky to become
bluer and when the outlook looks
better, they will want to buy, but
typically its too late. It has already
been priced in.
Conversely, when the outlook is
bleak, investors are too scared to
realize that maybe the bleakness
of the outlook may have been
more than priced in. As you know,
markets tend to overshoot on the
way up and on the way down. So
when the outlook is bleak, when
everybody worries about whats
going to happen to Europe, for
example, they forget that a lot of
that negativity typically will already
be priced in, and sometimes more
than priced in. So I think that is, by
far, the biggest mistake.
If there was a second mistake
I could comment on, its these
two types of investors those
that trade too much, which is not
healthy, and those that have too
much of a buy-and-hold mentality.
As a value investor, I dont like the
expression buy and hold. All I
know is price and value. I know it
may take two, three, four years for
the price of the cheap stock to go
up and get closer to the companys
Page 23 of 87

intrinsic value, but that has nothing

to do with buy and hold. If, for some
reason, markets are so volatile that
the price of the stock, within six
months, gets closer to the intrinsic
value estimate, the value investor
has to sell. Self-discipline kicks in.
Theres a mistake both from people
that overtrade on the one hand and
those who have too much of a buyand-hold mentality.

value investors, being insistent that

not only must a stock be cheap,
but that it also needs to be safe.
The balance sheet has to be strong,
and that also kept us out of trouble.
So from 2008-09, I do not think
there was a lesson to be learned.
Marginally speaking, over time, in
terms of how do we improve the
process and the judgment, I would
mention two improvements.

MOI: How have you improved your

investment process or investment
judgment over time? Have you
tweaked anything as a result of the
crisis in 2008-09?

One, for many years, we typically

only calculated one core intrinsic
value estimate for a company, and
typically we did not do discounted
cash flow (DCF). We did not try to
guess what the future earnings
of a company would be. We
would typically rely on merger
and acquisition multiples, private
market value, that sort of thing,
but the one thing we started doing
a few years ago is we computed
a worst-case intrinsic value. We
make much harsher assumptions
regarding revenues. We make much
harsher assumptions regarding
operating margins. We try to better
understand what costs are fixed,
what costs are variable, and when
we run these worst-case scenarios,
it gives us, of course, worst-case
intrinsic values that can help us
identify some good entry points
into stocks.

de Vaulx: Well, specifically 20082009, the answer and I dont want

to sound arrogant is no. We have
been mindful, starting in 2003-04,
that there was a big credit bubble
taking place in Western Europe,
in the United States, in Eastern
Europe, and we also noticed that
more and more companies around
the world were becoming more and
more levered financially, including
banks that were becoming more
and more undercapitalized, and so
the crisis that took place did not
take us by surprise at all. Frankly,
we were surprised that it took so
long for the crisis to hit. I would
have imagined that the crisis would
have happened in 2006, frankly.
The fact that we, going back 20 to
25 years or so, had paid enough
attention to the big picture credit
cycles, reading carefully Grants
Interest Rate Observer or Gary
Shillings deflation pieces and
having paid attention to the macro
helped us identify that there was a
big credit bubble happening and, as

Say a company has a core intrinsic

value of 50, the stocks trading at
35, the worst-case intrinsic value
is 32 the stock price is almost at
that worst-case intrinsic value, and
that typically creates a pretty solid
floor below which the stock will not
go. Thats the big improvement
to have worst-case intrinsic value

estimates because it forces our

analysts, even more so than we
had ever done in the past, to worry
about what can go wrong. We
always have done it, but this takes
that worry to another level and also
you quantify it.

We would typically rely

on merger and acquisition
multiples, private market
value, that sort of thing, but
the one thing we started
doing a few years ago is
we computed a worst-case
intrinsic value. We make
much harsher assumptions
regarding revenues. We make
much harsher assumptions
regarding operating margins.
The second improvement, if I may
say, is that a long time ago 10,
15, 20 years ago we had a strong
bias towards quality within the
value camp, away from the guys
who like to dabble in cigar butts
and mediocre businesses. We were
willing to pay up for quality, the
way Warren Buffett learned to do at
one point. Today, in a very difficult
economic environment worldwide
with, at best, very modest economic
growth and low returns going
forward, I think we are trying to
pay even more attention to the
qualitative aspects of the business
and not relying on the rearview
mirror. More than ever, we try to ask
ourselves more and more questions
such as: are these high margins
sustainable? What will Microsoft
look like 10 years from now? In a
Page 24 of 87

low-return, low economic growth

world, quality deserves to be at a
premium to lower quality stocks,
and we need to focus even more
than ever on the qualitative aspects
of the businesses.
MOI: I think you mentioned some
books, but what resources in
general have you found helpful
to become a better investor? You
mentioned the bias toward quality
and quality businesses, quality
management teams who have
perhaps some of the businessmen
that one should study to learn
about how to operate a business,
how to allocate capital effectively
anything you can share with us
in terms of books or resources or
people that we should study?
de Vaulx: Besides the classics,
Ben Graham, of course, Berkshire
Hathaway annual reports. One has
to not only read them, but re-read
them. Im fond of Vladimir Nabokov,
the writer of Lolita. He said, a good
reader is a re-reader.
I think some of the books that are
a must would be Peter Bernsteins
book about risk, Against the Gods:
The Remarkable Story of Risk.
I believe that awareness of history,
in particular, economic history,
financial history, history of how
technological improvements and
technological breakthroughs have
impacted the world, and history
of geography are important, so
I think some history books are a
must. Financial history, theres a
wonderful historian who passed
away a year or two ago, Charles
Kindleberger, who many people

know. One of his most famous

books is Manias, Panics and
Crashes, but he also wrote more
in-depth books. One is called, The
Financial History of Western Europe,
and there are other books that are a
compilation of many of his essays,
and I think these are very valuable.
There is a great book by David
Kynaston called City of London.
It goes back 300 or 400 hundred
years and basically walks through
the financial history of the world
through what happened in the city
of London.
Some reading that delves into
behavioral finance and psychology
can be very interesting. Daniel
Kahnemans books should be read
along with Poor Charlies Almanack,
which has transcripts of many of
the speeches that Charlie Munger
has made over the years.
Otherwise, for anyone who begins
as an investor, I would recommend
books by John Train. Some 20 or
30 years ago he wrote, The Money
Masters, where you have a chapter
on Ben Graham, one on Philip
Fisher, one on Warren Buffett and
so forth ,and then ten years later
John Train wrote,

There is a great book by

David Kynaston called City
of London. It goes back 300
or 400 hundred years and
basically walks through the
financial history of the world
through what happened in
the city of London.

The New Money Masters, with Peter

Lynch, Mario Gabelli, and so forth.
The advantage of those books is
that you have one chapter on one
money manager, and that book
helps the reader understand that
there are many ways, many recipes
to invest money, and each of these
ways has its own internal logic
and own set of rules. If someone
who starts as an investor reads
the book, he or she will appreciate
that there are many ways to do it,
many ways to cook, and he or she
will probably be able to, based on
his or her temperament, identify
and find some affinity with one of
those investment styles, whether
its George Soros or Paul Tudor
Jones or Ben Graham with the cigar
butts, or Philip Fisher. I think The
Money Masters and The New Money
Masters are great books to read to
begin in our business.
MOI: On that note, Charles, thank
you for your time and all the
insights.
de Vaulx: I really enjoyed it.

The Manual of Ideas is indebted to

Christopher Swasbrook, Managing
Director of Elevation Capital
Management, for making this
conversation possible.

Page 25 of 87

Exclusive
Interview
with Pat Dorsey
Pat is President of Sanibel Captiva Investment Advisers, where he leads the investment team and helps guide capital
allocation. Pat was previously Director of Equity Research at Morningstar for over ten years, where he was responsible for
the direction of Morningstars equity research effort. He led the development of Morningstars economic moat ratings as
well as the methodology behind Morningstars framework for competitive analysis. Pat is the author of The Five Rules for
Successful Stock Investing and The Little Book that Builds Wealth.
The Manual of Ideas: Please tell us
about your background and how you
became interested in the topic of
moats.
Pat Dorsey: I was director of equity
research at Morningstar for about
10 years. I basically built the equity
research team and process there,
starting with about 10 analysts and
building it to about 100 analysts
when I left. I formed the intellectual
framework that we use to evaluate
companies. A big part of that is a
focus on a competitive advantage,
or an economic moat. I became
interested in the topic because
some companies essentially defy
economic gravity and manage to
maintain high returns on capital
despite competition.
Its a fascinating topic because
economic theory suggests that all
companies should just revert to

mean over time. Competition shows

up, capital seeks excess profits, and
you drive returns down. But, both
empirically and intuitively, we all
know thats not the case. We can all
name a dozen companies off the
tops of our heads who have basically
defied the odds and maintained high
returns on capital for decades at a
stretch. What frustrated me when I
got into the topic is that most of the
literature on competitive advantage
is written from a strategy standpoint.
Most of your readers are familiar
with Michael Porters Five Forces
model, which is very useful and a
great starting point, but its always
from the perspective of a manager of
a business. In other words, I manage
a company or a unit of a company,
and what can I do to make that piece
of that company better? So, its all
about maximizing the assets that
you have.

Its a fascinating topic

because economic theory
suggests that all companies
should just revert to mean
over time. Competition
shows up, capital seeks
excess profits, and you drive
returns down. But, both
empirically and intuitively, we
all know thats not the case.
As investors, we have a different
challenge. Were not stuck with a
set of assets of which we need to
maximize the value; we can choose
from thousands of different sets
of assets called companies. So we
need more objective characteristics
by which we can assess the quality
of competitive advantage and
then make some judgments about
whether a company is likely to have
high returns on capital in the future
or not.

Page 26 of 87

Exclusive Interview with Pat Dorsey

MOI: Lets start from the beginning.
Can you define what you mean by
moat?
Dorsey: When you think of an
economic moatand lets be
clear I stole the term from Warren
Buffett; hes the one who coined it.
If youre going to steal, steal from
the smartest guy arounda moat
is structural and sustainable. I
think those are the two key things
for investors to think about. Its
structural in that its inherent to
the business. The Tiffany brand is
inherent to Tiffany [TIF]; you cant
imagine Tiffany without it. The
switching costs of an Oracle [ORCL]
database are inherent to the way
databases are used in business.
Contrast that with a hot product
or a piece of a hot technology that
may come or go.
Moats are also sustainable. They
are likely to be there in the future.
As investors, we are buying the
future. Look at the investments
we make today. How they turn
out will depend largely on what
happens three years from now, five
years from now, or ten years from
now. So, we need to think about
sustainability of a competitive
advantage. A company with a very
hot product and a cool brand right

now may have very high returns on

capital, but the sustainability is in
question. Whereas you can look at
a railroad or a pipeline that would
not have as high returns on capital
as an Abercrombie & Fitch [ANF],
but its very sustainable because
you can predict the likelihood of
that competitive advantage sticking
around for many years, and that
makes the investment process
easier.
MOI: So it sounds like, almost by
definition, good management would
not qualify as a moat. Is that right?
Dorsey: Not by itself. Theres a
wonderful quote from Buffett on
this: When management with the
reputation for brilliance meets a
company with a reputation for bad
economics, its the reputation of
the company that remains intact.
But theres another one that I think
people are less familiar with that
Good jockeys will do well on good
horses, but not on broken down
nags. Thats how investors should
think about competitive advantage.
The smartest manager in the world
will not make an airline have the
economics of a software company
or an asset manager; its physically
impossible.

Smart management is a wonderful

thing to have; Id rather have smart
people running my companies than
dumb people. Smart managers
can build moats; they can enhance
moats; they can destroy moats,
but they are not moats themselves
because management comes and
goes. Corporate CEO turnover is
higher today that it has been in the
past. Getting back to this idea of
buying the future, the economics of
businesses change slowly. Airlines
dont suddenly overnight become
wonderful businesses. Software
companies dont overnight become
bad businesses, whereas managers
can come and go. Its hard to make
a confident bet, in most cases,
absent high managerial ownership
or a family position, that the guy
whos in charge today will be there
five years from now.

The smartest manager in

the world will not make an
airline have the economics
of a software company or an
asset manager; its physically
impossible.

Page 27 of 87

MOI: What about people in

general in an organization? A lot
of companies say, Our biggest
advantage is our people, and there
are, in fact, a lot of businesses
where thats the case, where the
assets essentially walk out the door
at night and walk in in the morning.
Can that be described as a moat, or
do you feel that those people will
find ways to extract the economics
for themselves if they are, in fact,
the asset of the company?
Dorsey: Thats a fascinating
question. You see the people
extracting the rents when they are
unique. So this is why, for example,
in the entertainment industry,
usually it is the producer, the
director, or the actor who extracts
the economic rents, not the minority
shareholder of a movie studio.
Thats typically the case because
theres only one Tom Cruise; theres
only one Ridley Scott. So they will
extract all the economic rents they
can.
But then if you look at Southwest
[LUV], for example, which arguably
did create a corporate culture that,
for a time, gave it something of an
edge over the competition. Those
individuals did not extract excess
economic rents from Southwest,
and I think its reasonable to say
that was a factor in Southwests
success. Was it a more important
factor than Southwest being one of
the first airlines to do point-to-point,
fast-turn, single-model aircraft, and
all the other issues and attributes
people are familiar with? I think its
hard to say; the two go together. I
would say that corporate culture

as an economic moat is very fuzzy,

and unless youre prepared to get
to know a company incredibly
deeply, it can be hard to qualify as a
competitive advantage.
MOI: You mentioned that moats are
structural, and it almost seems like
theyve been there forever. How do
moats actually come into being?
How are they born at a company?
Dorsey: You can build moats over
time. Were not talking only about
businesses that have been around
for 50 years, like a Coca-Cola
[KO] or Procter & Gamble [PG]. Its
important for the management
of the company to be thinking
about how it builds competitive
advantage. One example might
be, in addition to selling a product,
you sell a service relationship
along with the product. Look at the
way jet aircraft engines are sold
today. Rolls-Royce will often price
engines by hours used, so youre
really buying a service more than
you are buying a big chunk of metal
you stick underneath an airplane.
That increases the switching costs
tremendously.
Youre seeing a lot of
manufacturers of mission-critical
equipment, start to realize that
if they sell a service relationship
along with the product, they can
really increase customer loyalty and
thus increase customer switching
costs down the road. If a company
moves from just selling a thing
and things can be swapped out
to selling a relationship or service,
its a stickier proposition. Thats
what you would do if your goal is to
create a network effect.

CoStar Group, which is

basically the FactSet or
Bloomberg of commercial
real estate. If youre C.B.
Richard Ellis, you cant live
without CoStars data. What
they did is they scaled
very quickly because they
realized that if they could
stitch together a lot of very
fragmented databases of
commercial real estate
information from different
parts of the U.S. and different
parts of the world, that would
give them an advantage over
the competition
A good example here might be
CoStar Group [CSGP], which is
basically the FactSet [FDS] or
Bloomberg of commercial real
estate. If youre C.B. Richard
Ellis [CBG], you cant live without
CoStars data. What they did is they
scaled very quickly because they
realized that if they could stitch
together a lot of very fragmented
databases of commercial real
estate information from different
parts of the U.S. and different parts
of the world, that would give them
an advantage over the competition
because they would benefit from
a network effect, where the more
users they have, the more data they
have and so forth. For them, the key
was scale. You wanted them to get
big fast. Thats not always what you
want from a company, but given the
moat they were trying to build, it
made sense for them.

Page 28 of 87

MOI: In your book The Five Rules

for Successful Stock Investing
you also talk about moats. You
state that companies generally
build sustainable competitive
advantage through either product
differentiation, real or perceived,
driving costs down, locking in
customers with high switching
costs, or locking out competitors
through high barriers to entry. Can
you tell us what type of moat you
prefer, and which are generally
more sustainable?
Dorsey: Im not sure one is better
than another. I get this question a
lot, and I thought about it quite a
bit. I would say that there are weak
and strong brands. There are weak
and strong switching costs. There
are cost advantages that are very
durable and some that are a little bit
more ephemeral. Im not sure that
I would regard one type of moat
as stronger than another, with the
possible exception of a network
effect, which you see in financial
exchanges, credit card processors
like Visa [V] and MasterCard [MA],
and businesses that tend to get
more powerful the more users they
have because the way a potential
competitorers they have, the more
would need to try to articulate their
economic profits is essentially by
creating a similarly sized network,
and that can be a very difficult thing
to do. Generally speaking, if you can
identify a true network effect and
its a business that is reasonably
priced and has a lot of room for
reinvestment of capital at high
marginal returns on capital, youve
probably found a business thats
going to have high returns for some

time to come. But that would be the

exception more so than anything
else.
MOI: Would you consider
businesses that are, in a sense,
natural monopolies or essentially
have this virtuous cycle of volume
and price like a Wal-Mart [WMT],
related to the network concept
because the more customers they
have the cheaper they can sell
things. Is that a good moat? Is that
sustainable?
Dorsey: Its interesting to
characterize Wal-Mart as benefiting
from a network effect, and I would
say that for Wal-Mart simply buying
more stuff isnt what gives them
the lower costs so much as it is
efficiently moving that stuff around.
If I had to think about Wal-Mart
and think of it just as pure volume
versus efficient use of capital, in
other words, the hyper-efficient
distribution system driving down
working capital as much as
possible, I would say the latter is
more important than sheer size.
If you think about it, we use Visa
or MasterCard because lots of
other people do, and thats why
its accepted at lots of merchants.
We trade securities on a particular
exchange because we get a tight
spread and a deep level of volume,
and we get that benefit because
of the people who are there, too.
We dont care that lots of people
shop at Wal-Mart; we just want the
lowest price. Wal-Mart happens
to get that low price by being very,
very efficient, but the simple fact
that you can frequently see is that
there are people who can undercut

Wal-Mart. We just wind up going

to Wal-Mart because they have
everything in one spot. Its an
interesting question, but I would
say that, generally speaking, I dont
think that the network effect is
always driving down costs because
usually its what you do with that
buying power that tends to matter
more than simply having to share
buying power.

for Wal-Mart, simply

buying more stuff isnt what
gives them the lower costs
so much as it is efficiently
moving that stuff around.

MOI: We also posed this question

of moats to some of our members,
and Josh Tarasoff of Greenlea Lane
Capital wrote that his least favorite
moat is customer captivity because
it tends to be kind of static and it
doesnt really imply progress for a
business and may actually make
it harder to win new customers if
they know theyre going to become
captive for a long time. It also
seems to me that if thats your
moat, you may not have a very
happy customer base; you just may
kind of have them by the guts and
they cant get away, but the minute
they see an alternative they might
jump at it because theyre not very
happy. Theyre just there because
theyre captive.
Dorsey: I dont know about that.
Its true that you see very strong
switching costs. You often see that
in more mature areas. So, you think

Page 29 of 87

of a Jack Henry [JKHY], which does

back office processing for banks,
usually smaller ones. The customer
retention rate is in the high 90s.
Of course, the number of banks
isnt growing a lot year to year, so
theyre not losing anybody but not
gaining anybody either. Oracle is
a pretty similar business. Oracle
doesnt lose much market share,
but databases are a very mature
business; it doesnt grow a lot from
year to year. Oracle mainly grows
the core database business by
raising the price a little bit from year
to year.
There is probably a decent
correlation between the strength of
a switching cost and the maturity of
a market; I think thats a reasonable
thing to say. But just because a
market isnt mature doesnt mean
that the business isnt a quality
business and cant be mispriced.
If its being valued as a declining
business, for example, look at the
elevator companies, whether its
Otis [owned by United Technologies,
UTX], Schindler [Frankfurt: SHR]
or Kone [Helsinki: KNEBV], despite
the very high switching costs of
an elevator or escalator once
its in the building you typically
dont rip it out and put another one
in theyve experienced pretty
reasonable levels of growth as
youve seen the urbanization of
China and other areas of the world.
I guess I wouldnt say that its my
least favorite kind of moat. You do
tend to see it more often in mature
businesses, so you have to be a
little more careful of what you pay
for those, obviously. I think being
able to raise prices every year on

your customers is a pretty good

thing. The key there is to not abuse
it.

Look at the elevator

companies, whether its
Otis, Schindler or Kone
once its in the building
you typically dont rip it
out and put another one
in theyve experienced
pretty reasonable levels of
growth as youve seen the
urbanization of China and
other areas of the world.
If you want to think about a
business that really does have
some of its customers by the
short hairs, CoStar would be a
good example. CB Richard Ellis,
Jones Lang [JLL] and other big
commercial real estate brokers
literally cant live without this data.
Morningstar hosted the CEO of
CoStar at their conference, and I
remember asking how he thinks
about pricing because he has a lot
of pricing leverage over customers.
He obviously thought about it very
carefully. He said, Were interested
in long-run profit maximization, not
in angering our customer base.
I think thats how you have to
think about it if youre a business
with a product that is critical to a
customers business where you
have enormous pricing power. If
you really do that in a very strong
and aggressive fashion, you will
invite competition, as Josh was
implyingthat the customers are
going to want to go somewhere
else. But if you balance the value

youre delivering versus the cost to

the client, you can keep that going
for quite a while without really
making the customer want to go
somewhere else.
MOI: When you talk about a
business that has a moat through
network effects, those network
effects directly make the customer
experience better. Theres just
more value to each customer from
the network. With something like
customer captivity, it seems to have
the connotation that if the customer
could decide every day to make a
blank-slate decision where it would
want to take its business and there
would be no switching cost, it might
actually go to a competitor because
they might have a better product or
a better price. Even if a competing
offering is better, the customer
captivity makes a customer stay
there and theres that gap
Dorsey: Exactly. You could call up
a bunch of the smartest engineers
you know and create The Manual
of Ideas Database. Maybe its
15% faster and 20% cheaper than
anything Oracle has on the market,
and you walk over to Procter &
Gamble or Amazon.com and say,
I think you should buy my new
MOI database; its really cool.
Theyre going to have to invest
tens of millions of dollars and how
many hundreds of thousands of
man-hours to rip out their current
one and install yours. If you had
something that was 80% faster
and 80% cheaper, they might do it.
There is some point at which you
do switch, but its scientifically a
pretty high one.

Page 30 of 87

MOI: Ideally, you have a moat and

its sustainable for a very long time.
Buffett has been great at finding
businesses like that and investing
for the long term. Do you think that
consumer-facing businesses that
essentially build up mindshare
in the consumer, like a CocaCola, have the most sustainable
moats, or do you think businessto-business companies can have
similarly sustainable moats?
Dorsey: What matters less is who
your end customer is, a business
or consumer. Its more about the
speed of evolution of the product
set. Soda doesnt evolve; soda
doesnt change a lot from year to
year. Software does. If I had to
make a bet today as to who is more
likely to have high returns on capital
ten years from now, Im going to
bet on a soda company before a
software company simply because
theres less stuff thats likely to
change over the next decade, so
thats whats important. Its more
about, what is the product and not
about who is the end customer.
The thing with brands is they
take constant care and feeding.
Brands dont just run themselves.
Management teams can try to
destroy brands. Do you remember
Schlitz? Schlitz was number one
or number two in market share
in the U.S. beer market from the
mid-50s to the early 70s. It was
number one or two for each year.
What did they do? They changed
their recipe. Well, thats not smart.
You have the number one beer and
you change the recipe. You cant tell
what stupid management teams

are going to do. Remember New

Coke? My point is that these things
dont run on autopilot; they require
constant care and feeding. You can
look at some consumer product
categories. Would you imagine
ten years ago that there would be
private-label beer? Kirkland. Costco
[COST] sells private-label beer,
and its not bad. Its not great, but
its not bad. Thats an area where
I think its hard to say its not all
about whether its consumer or
business. If you had asked me ten
years ago what product categories
would be least susceptible to
private-label competition, I probably
would have put alcoholic beverages
and confections as number one
and number two. I would have
been wrong on one of them. Now
Im waiting for Kirkland-brand
chocolate. Thats probably not
going to happen.
Thats kind of a long answer to
a very interesting question. Its
more about the speed with which
a product category changes than
really anything else.

What matters less is who

your end customer is, a
business or consumer. Its
more about the speed of
evolution of the product set.
Soda doesnt evolve; soda
doesnt change a lot from
year to year. Software does.

MOI: It seems that in the businessto business market the customer

is pretty rational; theyre going
to weigh the costs and so forth.
Does it matter how rationally
the customer makes his or her
decision?
Dorsey: Youre right, theres less
of an emotional standpoint. But
there are, sometimes, emotional
reputational factors. Remember
the old quote: You dont get fired
for buying IBM. Reputation in
brands can matter in a businessto-business market as well. But
the key thing to look at is and
this gets back to your initial point
about mindshare does the brand
change customer behavior? Does it
make the customer act differently?
It can do that in one or two ways. It
can either increase the customers
willingness to pay. You pay more
for Coke than you do for Presidents
Choice Cola. You pay more for
Hersheys [HSY] than you do for
lower-end chocolate. Or does it
reduce search costs? You become
familiar with a product. You dont
want to compare prices all the time
on a stick of gum; so you just buy
Wrigley [owned by privately held
Mars]. You buy Wrigley because
its what you want, and its a $0.50
pack of gum. Im not going to sit
here comparing 50 cents. Youve
reduced my search costs.
But if the brand doesnt change my
behavior one of those two ways, I
would argue its not worth a dime.
Think of the Sony [SNE] brand. The
Sony brand is incredibly well known.
Its one of the top 20 most valuable
brands in the world, according to

Page 31 of 87

the big annual Interbrand survey.

But would anyone reading this
interview now pay 20% more for
a Sony DVD player relative to one
from Philips [PHG] or Panasonic
[PC]? I doubt it. So, there you have
a company with mindshare. Sony
has mindshare. Weve all heard of
it; we know Sony well, but it doesnt
change our behavior. So what good
is the brand?

The Sony brand is incredibly

well known. Its one of the
top 20 most valuable brands
in the world, according
to Interbrand. But would
anyone reading this pay 20%
more for a Sony DVD player
relative to one from Philips or
Panasonic?
MOI: If we flip that around and lets
take Apple [AAPL], which is doing
phenomenally well right now
Dorsey: Its not the brand; its the
network effect. Pure and simple.
I get this question all the time.
People think that Apple buyers
are all just about the brand and
looking cool and having the little
white threads dangling out their
ears. Its the network effect. The
iPhone does have a wonderful user
interface and lots of good features,
but it also has tens of thousands
of apps. Why does it have tens
of thousands of apps? Because
developers want to write for the
platform with the most users, and
the users want to buy the phone
with the most apps. Its a beautiful

network effect, and we can validate

this by looking at initial iPod sales.
When the iPod first came on the
market, remember the Zune [sold
by Microsoft, MSFT] was on the
market at the same time. In the first
year or two of the iPods existence,
that was before iTunes, and the
iPod sold reasonably well, but it
wasnt a huge hit. Then iTunes
came along and suddenly you could
buy songs by the drink, but only
if you had an iPod. Hockey stick
growth. If youre a music publisher,
why do you want to be on iTunes?
Because you have all those people
with iPods out there. Why, as a
user, do you want to buy an iPod?
Because its the only thing I can
use to buy songs one by one legally
this is before they shut down
Napster its a network effect for
Apple.

Its not the [Apple] brand; its

the network effect. Pure and
simple. I get this question
all the time. People think
that Apple buyers are all just
about the brand and looking
cool and having the little
white threads dangling out
their ears. Its the network
effect.
When I look at Apple and when I
think about Apple as a business
and its in the portfolio Im
far less concerned about nice
advertising or cool design than I
am about anything that increases
the switching costs, anything that

increases the difficulty I would

have of switching from my iPhone
to an Android, anything they can
do to make that path dependence
stronger that once I have an
iPhone, I want the next generation
and next generation. Thats what
strengthens their moat more than
anything else.
MOI: Could you tell us a few
examples of companies that you
consider have strong durable
moats? Perhaps some names that
are not as well-known as maybe
some of the Berkshire Hathaway
[BRK] holdings.
Dorsey: I always want to try to go
off the beaten path when I can.
Its not the easiest thing. Whats
cheap now and whats been cheap
for a while has been the big stuff,
so thats what Ive been focusing
on. Do these need to be well-priced
right now or just have good moats?
MOI: Lets just have good moats for
now.
Dorsey: Good, because the smaller
stuff tends to get more expensive.
CoStar, which I mentioned before,
has data on property and tenants
for commercial real estate users.
Commercial real estate is much
more differentiated than residential
real estate because each office
building is unique. Having a rich set
of data gives them an enormous
advantage. They have about
90% client retention and usually
inflationary price increases. To
replicate this database you would
basically need to spend everything
that CoStar has been acquiring over
the past eight years, and even then

Page 32 of 87

you would have a hard time doing

it because typically what theyve
done is bought the best regional
commercial property databases,
and so there isnt another one
out there. So you would need to
replicate this from scratch, which
would be very difficult. So thats a
very interesting little business that I
dont think people know as well.
What would be another really
interesting one? Express Scripts
[ESRX] or MSCI [MSCI]. The latter is
in the financial business. It spun off
from Morgan Stanley a while back.
They own the MSCI indexes, which
is a pure index licensing business
model thats just gorgeous because
every time a Brazil ETF launches,
they need to license MSCIs. That
generates them a fairly small but
essentially no-cost revenue stream,
and thats just an unbelievably
beautiful business. They also have
a business called Barra that is
basically the gold standard for risk
management software for asset
managers. An asset manager will
often get asked Whats your Barra
risk? or Show me your Barra
printout. And even if they dont
believe in Barra and even if they
dont think Barras philosophy of
assessing risk based on volatility
is worth a hoot, it doesnt matter
because the consultant is going
to want to see it, so youre going
to have to have it. So, they have
about an 85% renewal rate, which is
pretty good. Thats a wonderful little
business.

MSCI indexes is a pure

index licensing business
model thats just gorgeous
because every time a
Brazil ETF launches, they
need to license MSCIs.
They also have a business
called Barra that is basically
the gold standard for risk
management software for
asset managers.
MOI: Do Moodys [MCO] and S&P
Ratings [owned by McGraw-Hill,
MHP] have a moat?
Dorsey: Their returns on capital and
margins certainly suggest that they
do. You dont have to love them.
Last quarter, Moodys operating
margins are still running in the high
30s. Thats down from the mid50s, but its not chopped liver by
any stretch. I wouldnt mind having
those kinds of margins. I would say
they do. At the end of the day, the
nature of the bond rating market
lends itself to a natural oligopoly.
Sean Egan at Egan-Jones has
had some wonderful calls. Hes a
controversial guy, but theyve done
good work. They really havent
gained much market share at all.
Its a business that is not
particularly cheap right now, and
I think its pretty hard to figure out
what the growth rate looks like
going forward. I think the hard
thing with Moodys is not figuring
out whether they still have good
margins five years from now,
but figuring out, how big is the
business. Thats the hard thing. In
terms of is it a natural oligopoly

and will it retain its high returns on

capital, I dont think theres much
question of that. I think a much
harder thing is figuring out what
the size of that business is and
then how you price that cash flow
stream. I cant do that, which is why
I dont own it.
MOI: Do you think American
Express [AXP] or Visa/MasterCard
have a wider moat? What Im
alluding to is the closed-loop model
of American Express versus the
more open model of Visa and
MasterCard.
Dorsey: Its close, but theyre
also different businesses. AmEx
is lending money, whereas Visa
and MasterCard are not. I think
its an important distinction to
make because you saw that in the
run-up to the credit crunch, AmEx
had some serious underwriting
mistakes. Some of their
underwriting metrics were based on
home prices, and that came back
to bite them. The nice thing about
credit cards, unlike mortgages,
is that the problem loans run off
pretty quickly; they reprice pretty
fast. So, it didnt kill it because it
was a well-capitalized business,
but you saw that sub-optimal
underwriting really did damage to
them. Visa and MasterCard are
not lending money to anybody, so
its a much less risky business in
that sense. I think that the scope
for management to mismanage
those businesses is a lot lower than
AmEx. AmEx has learned from its
mistakes; certainly its gotten better
at the underwriting.

Page 33 of 87

The hard thing with MasterCard and

Visa right now is that you are seeing
some chance of technological
disruption with the emergence of
PayPal [owned by eBay, EBAY] and
other mobile platforms. How likely
are they to really hurt things is hard
to say, but you have more risk of
disruption than you would with a
Coca-Cola or Budweiser [owned by
Anheuser-Busch InBev, BUD].
The other difficulty theyre facing
is that youre seeing a bit of a
price war emerging where they
are engaging in these rewards
programs, and its almost like, who
can give the most rewards out, and
thats how consumers are starting
to choose what card they use.
Thats probably, in the long run, not
a great thing for the business. I
dont think theyre losing sleep over
it, but I dont think its a great thing
in the long run.
MOI: What do you think of major
pharma? Those businesses have
high returns and have always had
high returns, but it seems that
if you have a blockbuster drug,
its all about when the patent
expires. Do you feel that those
really big pharma companies have
sustainable competitive advantage?
Dorsey: Yes. Again, its a little bit
like Moodys. The margins are
there; its the growth thats hard. I
think big pharma was very slow to
realize that the business model had
changed. Two decades ago, even
one decade ago, it was all about
bringing out big blockbuster drugs
that treated chronic conditions:
high blood pressure, depression
with Lexapro, and drugs like

that. These are drugs where its

a chronic condition and so you
need to get it out to lots and lots
of potential patients at a relatively
low marketing cost. So, what
do you need? You need an army
of salespeople. So that was a
business model 15-20 years ago.
Then, as we got what you would call
good enough products for treating
high blood pressure, cholesterol,
depression, and those went generic,
the opportunity to improve upon
the prior drug is very small, so you
would see the business model shift
to higher-priced drugs, especially
in oncology. Theyre higher priced
drugs, but you need to market to
a much more specialized set of
doctors. So you dont need tons
and tons of salespeople; you need
a smaller number of very highlytrained salespeople. That business
model shift took some time, and it
was only really a couple of years
ago after one of the two big pharma
mergers that you started to see
sales forces really come down.
There were big cuts in sales forces,
and I think that was an important
moment because it meant that big
pharma was sort of realizing that
the world had changed a bit.
I think of big pharma almost as a
distribution platform more than
anything else. Part of their value
is, to some extent, those giant
R&D labs, but so much of the
innovation is happening in large
molecule drugs and in biologics
right now. You hear the big pharma
companies buying the more
innovative smaller businesses
and that the value a big pharma

company generates is in having

this massive distribution platform,
trusted relationships with tens of
thousands of practitioners around
the globe, and thats going to be
very hard to replicate, much more
so than having a new innovative
molecule.

the value a big pharma

company generates is
in having this massive
distribution platform, trusted
relationships with tens of
thousands of practitioners
around the globe, and thats
going to be very hard to
replicate, much more so
than having a new innovative
molecule.
MOI: Buffett talks about how he
wants Berkshire subsidiaries to
essentially just think about how
they can widen the moat every
day. What would be your advice to
companies and CEOs on what they
can do to widen the moat of their
companies?
Dorsey: I think it really depends
on what kind of moat youre trying
to build. If I had to think about a
few themes, one would be that
you tend to see commoditization
is correlated with management
impact. If youre the manager of
a retailer, an insurance company,
a commodity company, a miner,
or a bank, you can have a huge
impact on whether your business
is great or good. If youre managing
a business that already has a wide

Page 34 of 87

moat, youre more of a caretaker.

Your job is to not screw up. Your
job is not to roll out New Coke. Your
job is to keep the business going
the way it is. But waking up every
morning this goes back to what
have you done to widen the moat
whatever your moat is should
constantly inform every business
decision that you make.
We began this conversation with
Wal-Mart. Think about five to seven
years ago when Wal-Mart started to
try and compete with Target [TGT]
in fashion. Did it work? Not really
because you dont go to Wal-Mart
for hot clothes; you go there for
cheap club prices. They got offstrategy; they forgot the reason why
their customers shopped there, and
then they kind of retooled and that
laser focus on low prices is what
matters to them.
Think about LVMH [Paris: MC] and
their focus on exclusivity. Theyll
actually destroy unsold bags.
Theyll take a $2,000 bag and just
shred it to keep that scarcity out
there.
Or my favorite example because
its one that I got wrong think
about Amazon.coms [AMZN] laser
focus on the customer experience.
That drives everything they do; its
how can they make the customer
experience better. That really
is what created their moat and
wasnt anything else, because Jeff
Bezos realized early on that online
shopping is different than offline
shopping. With offline theres no
trust involved. If I walk into a store, I
hand somebody cash and they had
me a product. Our relationship is
finished; theres no trust.

But online I have to trust youll

send me the right product; I have
to trust you wont steal my credit
card; I have to trust you send it to
me in the time you say youre going
to send it to me. Theres a lot of
trust there, so brand matters more
online. I think Bezos figured it out
very early on. Everything Amazon
does is about making the customer
experience better, and thats why
people use it. Ive probably given 50
talks on moats around the world,
and I always ask the audience
how many people have bought
something off Amazon without
checking the price anywhere else.
Usually over three-quarters of
hands go up, which is an amazing
statement when you think about
the ease of checking the price
somewhere else. So focus matters,
not diversifying.

think about Amazon.coms

laser focus on the customer
experience. That drives
everything they do; its how
can they make the customer
experience better. That really
is what created their moat

You frequently see CEOs have a

good but slower-growing business
that has a great moat and high
returns on capital, and then they
say, My gosh, we still have to
grow. Then they take the capital
and they basically set it on fire,
investing in a business where they
have no competitive advantage, like
when Cintas [CTAS] moved from

uniform rental to fire safety and

document management. Stupid.
Cisco [CSCO] moving into set-top
boxes and buying the Flip. Stupid.
Garmin [GRMN], the GPS company,
trying to expand into handsets and
competing with Nokia [NOK] and
Samsung [Korea: 005930]. Stupid.
In all three of those cases, the
company would have been far
better off just sticking with what it
did best and then taking whatever
capital it couldnt reinvest in the
core business and returning it
to shareholders. But, of course,
because CEOs of bigger companies
get paid more than CEOs of smaller
companies, the institutional
imperative for growth is always
there and always a risk to a minority
shareholder.
MOI: Is there anything that we
havent touched on that you like to
mention in your talks and maybe
highlight here?
Dorsey: When people are thinking
about how to value a moat, and
when a moat is really valuable and
when it is less valuable, the key
to think about is the length of the
runway. What are the reinvestment
opportunities that a company
has? So Visa or MasterCard or
a Chicago Mercantile Exchange
[CME] or a C.H. Robinson [CHRW]
or Expeditors [EXPD], these are
all companies that are in growing
markets or in mature markets with
very small market shares. Theres
a lot of opportunity to reinvest
capital at a high incremental rate
of return, and that moat and that
ability to reinvest for ten years
before someone really wanted to
Page 35 of 87

steal your competitive lunch are

incredibly valuable.
Contrast that with a Microsoft
[MSFT] or a McCormick [MKC], both
of which have very strong moats,
but the volume of Windows isnt
going up much year to year; the
volume of spice consumption in the
U.S. is not increasing much year
to year. McCormicks moat doesnt
really add a lot of economic value;
it adds stability and predictability,
but its not worth paying a ton of
money for because it doesnt allow
the company to grow all that much.
Whereas the moat for a business
that has reinvestment opportunities
is very, very valuable. Thats often
how I think about the when
do I want to pay up for a moat
question, is whether that moat is
actually going to allow the company
to reinvest a lot of capital at a high
rate of return, or does it just add
stability and predictability.

Fastenal still has singledigit market share and

maybe even double-digit,
but they certainly have
plenty of runway ahead of
them. Both Expeditors and
C.H. Robinson, which are in
different parts of the freight
forwarding market, have
plenty of runway ahead of
them right now. I think Visa
and MasterCard have that
attribute.

MOI: Do a few companies come

to mind that fit the bill of having a
wide moat and ability to reinvest a
lot of capital.
Dorsey: I think Fastenal [FAST] still
has that characteristic. They still
have a single-digit market share
and maybe even a double-digit, but
they certainly have plenty of runway
ahead of them. Both Expeditors
and C.H. Robinson, which are
in different parts of the freight
forwarding market, have plenty of
runway ahead of them right now.
I think Visa and MasterCard have
that attribute.
Although their market shares are
unlikely to grow, the evolution of
payment from paper or check to
plastic is not as far advanced as
you might think. So they have a nice
secular tailwind behind them, even
if they dont wind up gaining much
market share from one another. So
those would be a few examples.
There are plenty of other ones, but
those would be the ones that come
immediately to mind.
MOI: Pat, thank you very much
for sharing your insights with our
members.

Page 36 of 87

In this timeless interview from March 2009, Thomas S. Gayner, Chief Investment Officer of Markel Corporation, provides
some much-needed perspective and investment wisdom.
The Manual of Ideas: You have
stated that the businesses you seek
should have (1) a demonstrated
record of profitability and good
returns on total capital, (2) high
measures of talent and integrity
in management, (3) favorable
reinvestment dynamics over time,
and (4) a purchase price that is fair
or better. Perfection, however, is
rarely attainable in the stock market.
Have you had to compromise on
these criteria, and if so, could you
illuminate for us how you decide
on acceptable versus unacceptable
trade-offs?
Tom Gayner: While you say that
perfection is rarely obtainable in
the stock market, I would go so far
as to say that it is never obtainable
in the stock market. Perfection
doesnt exist in this world. All of my
choices involve various degrees of
compromise and tradeoffs. As an
accountant, I can tell you that my
wife and children are sick of hearing

me use the phrase opportunity

cost. Every decision is also another
decision (at least) and every nondecision is also a series of other
decisions.
The challenge is to get the balance
roughly right between the choices
that actually exist. All of the four
points I lay out are north stars that
guide me. I admit though, that I have
never personally been to the North
Pole.
The one area where I will not
compromise is in the area of
integrity. I may not make every
judgment correctly when Im trying
to make sure Im dealing with people
of integrity but I will never knowingly
entrust money to people when I am
concerned about their integrity. Even
if you get everything else right, the
integrity factor can kill you. My father
used to tell me that, you cant do a
good deal with a bad person. And he
was right.

My father used to tell me

that, you cant do a good
deal with a bad person. And
he was right.
The other factors can be thought of
as shades of gray and nuances. We
look for as much of the good as we
can find and weigh that against what
we have to pay for it, our expectation
of how durable the business will be,
and what our other alternatives are. I
dont have a formula or algorithm to
get that precisely right, I just spend
all my time thinking, reading, and
adapting as best as I can.

Page 37 of 87

Exclusive Interview with Tom Gayner

MOI: How does your approach to
international investing differ from
that to investing in U.S. equities?
Gayner: I dont think international
investing is as different as it used
to be. I believe that the world in
general is becoming a smaller
place. Given the advances in
technology and communication,
everything is starting to correlate
with everything else. I think
that growth rates, economic
development, and rates of return on
investment are all tending to head
in the same direction. Capital has a
universal passport and it heads to
wherever it needs to go to earn the
best returns possible.
Companies, especially the larger
global companies where we tend
to make most of our investments
are doing business all around the
world. All of these things tend
to make nationality and borders
slightly less relevant than what was
previously the case.
One question I usually ask people
when they ask me about our global
investment approach is to mention
two companies to them. I say that
both companies make engines
and move things from one place to
another. One of them is Caterpillar
and one of them is Honda. Which

one is the international company

and which one is the domestic
firm? Depending on my mood, I
give the person either an A or F
on that exam. While Caterpillar is
headquartered in Peoria Illinois, it
does more of its business outside
the U.S. than inside. While Honda
is headquartered in Japan, I believe
the U.S. is still its largest market.
Your brokerage statements or pie
chart presentations will probably
show CAT as a U.S. company
and Honda as an International
company. I think that is a superficial
difference and not a good guide
to know if you are investing
internationally or not.
Both of those are global companies
and doing business all around the
world. In my mind it is a distinction
without a difference to describe one
as a U.S. company and the other as
an international firm.
That same sort of look through to
where the company does business
applies to a lot of the companies
we invest in. Even though Markel
is a relatively small company in
the grand scheme of things, over a
third of our business comes from
outside the U.S. these days. That
is just business written outside the
borders of the U.S. Digging deeper,

I think you would find that a lot of

our U.S. written business relates
to companies doing meaningful
foreign sales and a lot of our
internationally written business
relates to activities that circle back
to the U.S. The world is increasingly
interconnected and I just try to
make sure we are investing in
the best business possible at the
appropriate price.
MOI: You emphasize the impact
of the passage of time on your
investments. With the trend toward
compression of time horizons and
a focus on short-term performance
in the investment industry, we are
seeing many investorseven those
who consider themselves value
investorsemphasizing near-term
stock price catalysts. Do you see a
growing inefficiency in the pricing
of boring investments that will
deliver returns over time versus
investments that are expected to
pay off at a foreseeable point in
time?
Gayner: Yes. To expand on that
one word answer, I think there is a
real time arbitrage opening up right
now. An old saying is that in a bull
market, your time horizons grow
longer and longer. In a bear market,
they grow shorter and shorter.

Page 38 of 87

The bear market experience of the

last few years compresses time
horizons for a lot of people. Even
if they want to remain focused on
the long term, there are inevitable
career risks in not putting results on
the books today when people are
so anxious about every aspect of
their lives.
I think that means the playing
field for longer term investing is
getting less crowded. Fewer people
are able to think about the long
term and I believe that creates an
opportunity to buy wonderful, long
duration investments, at better
prices than has been the case in the
last decade or so.

the playing field for longer

term investing is getting
less crowded. Fewer people
are able to think about the
long term and I believe that
creates an opportunity

MOI: What is the one mistake that

keeps investors from reaching their
goals?
Gayner: Ive made so many
mistakes over the years that I
struggle to isolate just one as the
biggest single mistake. Among the
choices though I think excessive
leverage has been the most
personally painful. I did not fully
appreciate the degree of leverage
that existed in so many aspects
of so many businesses and how
painful the unwinding of that
leverage would prove to be.

Leverage also can be a good

guide on the integrity factor that I
mentioned earlier. One of the great
investors Ive tried to learn from is
Shelby Davis. Shelby said that you
almost never come across frauds
at companies with little or no debt.
If you think about it, that statement
makes perfect sense. If a bad
person is going to try and steal
some money, they will logically
want to steal as much as possible.
Typically, that means they will
have as much debt on the books
as possible in addition to equity
in order to increase the size of the
haul. Staying away from excessive
leverage cures a lot of ills.
Another huge mistake that I
think people in general make is
to mislabel risks. Specifically,
people seem to think about risks in
nominal rather than real terms. To
have a lot of cash or government
bonds has been a comforting
thing in the past few years, but I
think it is a mistake to think that
means you are not taking risks.
You are, its just that you are taking
real risks as opposed to nominal
ones. The purchasing power of the
currency continues to decline. It is
a huge mistake not to take that into
account.

To circle back to your original

question about what is the
single biggest risk, I would try to
summarize all of these things as
examples of not thinking. You can
never put things on autopilot in this
world. You must be constantly and
continuously engaged with what is
happening in business, technology,
marketplaces, governments, social
trends, demographics, science
and absolutely everything you can
possibly process in order to be as
good a thinker as possible. When
you go to sleep each night, be
prepared to get up in the morning
and do it all again for as long as
you are responsible for taking care
of peoples money. There are no
days off.

If a bad person is going to

try and steal some money,
they will logically want to
steal as much as possible.
Typically, that means they will
have as much debt on the
books as possible in addition
to equity in order to increase
the size of the haul.

The other types of mistakes are

well known and probably not
too valuable to rehash. Chasing
performance, thinking you can
really effectively trade in and out
of the market, using volatility as a
precise quantitative measurement
of risks etc are all potential
mistakes that investors tend to
make.

Page 39 of 87

MOI: The rationale for institutions

acting as conduits of capital has
been that the average investor
cannot possibly know as much as a
professional devoted to researching
companies on a full-time basis.
However, as David Swensen and
Warren Buffett have observed,
investment funds of all stripes have
failed investors on an after-fee,
after-tax basis. Has our system of
investment by agents rather than
by principals destroyed value for
the ultimate owners of American
equity capital, and if so, is there any
remedy?

way of describing how agents tend

to push aside the interests of the
principals over time.
Over the years, I guess that
problem has mostly been solved by
institutions growing so big that they
gradually or suddenly decline or
fail. The agents lose their positions
and new principals emerge to build
up new institutions. It seems like
we are going through one of those
cycles in a big macro way right now.

Agents in general became

too powerful recently and
abused their stewardship
responsibilities to their
principals.

Gayner: One risk I worry about in

this interview is oversimplifying
things. I run that risk again in trying
to answer this question. I think that
principal/agency conflicts describe
a lot of what we are struggling
with these days. Agents in general
became too powerful recently
and abused their stewardship
responsibilities to their principals.
First off, that is an incredibly broad
statement and there are countless
examples of agents who are doing
a great and honest job. That being
said though, in general, the agents
have the upper hand and theyve
abused it.

MOI: You have observed a strong

connection between managing
companies and investing in them.
Unlike most investors, you have
had an opportunity at Markel to
be intimately involved in both
managing and investing. How
should investors go about building
this critical skill set if they dont
have an opportunity to manage a
business?

I make that statement in a broad

sense and beyond just the realms
of investing and business. Buffett
talks about the institutional
imperative and the behaviors that
stem from that notion. One of the
central management challenges for
any large institution or organization
is how to keep the principal/agency
conflict in balance. The familiar
saying of, The inmates are running
the asylum is really just another

Gayner: Well, my wife did her

undergraduate degree in chemistry
and her masters degree in
chemical engineering. When asked
about the difference between the
two she talks about thinking about
things theoretically, doing them on
a bench scale, and then scaling
them up to industrial quantities.
Wherever you are and whatever
you are doing you are probably at
least thinking about some things

theoretically, and practicing them

at a bench scale level. Do that as
much as possible and scale up
where it makes sense to do so. If
you are thinking along the way it
would seem almost impossible not
to learn at the same time.
In my case, the academic training
of accounting and the gradual
increase in responsibilities in
business and investing have all
constantly worked together to help
me understand, manage, and act.
Over the last two years Ive told
people, Every day seems like a dog
year. I cant help but think that a
lot of us are learning tremendous
lessons from this period in our
lives. Fortunately, with longevity
increasing, being only 47 should
give me a lot of years to continue
to learn and apply better wisdom to
my tasks.
MOI: You define a fair price
as one that allows you to earn
long-term returns in line with the
returns on equity of the business
in which you invest. When paying
a fair price, the expected return
therefore comes entirely from the
business rather than from multiple
expansion. Based on this definition,
the recent market carnage has
created an opportunity to pay less
than a fair price for many great
businesses. In Wall Street parlance,
does this make you a bull?
Gayner: Yes. This too is a
complicated question and I run the
profound risk of oversimplifying
again. Investing to me is the
ownership of an interest in a
business. Business to me is the
form and organization by which

Page 40 of 87

people creatively apply their skills

and talents to solving problems
or serving other people. The more
a business serves others, and the
more problems they solve, the more
profitable they will be and the more
an investor in those enterprises
should make.
I believe that the path of human
progress will continue forward.
We are not going into a new dark
age and I think comparisons
with the great depression are
over done. Frankly, I am bullish
not just because of the valuation
opportunity you describe but
because of my fundamental
belief that as a world we continue
to make secular progress amid
cyclicality.
The good news to come will
surprise me just as much as the
bad news did in the last few years
but I believe good news will happen.
The most energizing activity for
me is spend time with my high
school and college age children and
their friends. They are not scarred
by looking at their lower 401k
balances. They dont have 401ks.
They dont talk about the market
and a lot fewer of them are talking
about going to Wall Street. They talk
about alternative energy, biofuels,
technology and other things that
will propel human progress in real
ways.
I would rather own a piece of their
dreams and future economic
prospects than a bar of gold or a
government bond. Those pieces of
dreams are called equities. Equities
are congealed intellectual capital
and that is what I want.

MOI: As equities declined

precipitously in 2008, seemingly
with little regard for valuation, some
value-oriented investors adopted
the view that it was no longer
possible to invest from the bottom
up but that survival depended
on having a solid grasp of the
big picture as well. Seth Klarman
appeared to disagree with this view
when he said that he worried from
the top down but invested from the
bottom up. Has your scrutiny of the
macro picture changed as a result
of the economic crisis of 2008 and
2009?
Gayner: Seth Klarman is smarter
than me and I think he phrased
it exactly right. The experiences
of 2008 and 2009 exposed some
things that I should have been more
worried about than I was. I read a
lot of financial history and studied
about human nature. Ive found
it is a far different experience to
live through this type of period as
opposed to just reading about it
and I think I will be a better investor
as a consequence of having lived
through this time.
My main worry right now is the
possibility of inflation due to the
actions of the government. Inflation
is part of how the world is trying
to get out from under the excess
level of leverage that exists. Not

to contradict another gentleman

who is smarter than I am, Milton
Friedman, but inflation is not just
a monetary phenomenon in my
opinion. There are psychological
aspects to it as well. If inflationary
psychology takes hold I dont see
how you could keep long term
interest rates anywhere near where
they are today. If long rates go up
then the price of every asset goes
down. While I think intellectual
capital with repricing ability is the
best way to mitigate that risk it
will not be fun to go through that
process if inflation heats up too
much. There is a tipping point as
Malcolm Gladwell would say where
a little inflation is helpful, but too
much is absolutely destructive. And
I mean destructive way beyond just
the stock market but in terms of
social fabric issues. I am constantly
thinking about this dimension and
trying to be a good steward of the
finances at Markel in the context of
this risk.

My main worry right now is

the possibility of inflation

I am bullish not just

because of the valuation
opportunity you describe but
because of my fundamental
belief that as a world we
continue to make secular
progress amid cyclicality.
Page 41 of 87

MOI: In his 2008 letter to Berkshire

Hathaway shareholders, Warren
Buffett commented on the
once-unthinkable dosages of
government aid to banks and other
companies. He warned that one
likely consequence is an onslaught
of inflation. How can investors
protect themselves from the risk
of accelerating inflation? Is buying
good businesses with pricing power
sufficient, or should investors try to
expand their circle of competence
to include companies engaged
in the production of natural
resources?
Gayner: I think I answered this
question partially when I answered
the previous question. If inflation
really gets going, I dont think
anything I can do would really be
enough to fully protect against that
risk. I would rather own a dynamic
business with pricing power than
physical assets. Natural resource
stocks would probably go up as
that environment manifested itself
but Im not sure that those are
really good businesses in the long
run. Every time an oil company
pumps out a barrel of oil, it needs
to replace that to keep going next
year. The costs of finding new
supplies tend to go up just as
much if not more than the sales
prices. The accounting lags reality
since the costs of goods sold
reflect historical rather than future
costs, which creates an illusory
accounting profit that isnt real in
an economic sense. In fact, the
misunderstanding of accounting,
and agency risks often lead to
uneconomic behavior on the part
of many managements. As a result

of all these factors, Im not sure

that investing in natural resources
accomplishes as much as you
might want.
The most important real protection
is to own businesses which can
reprice their products faster than
their costs rise. That is a lot easier
to say and describe than it is to
actually find.
MOI: In a 2007 interview with
Morningstar you described Warren
Buffett as the leading teacher of
all of us. What is the single most
important thing you have learned
from Warren Buffett?
Gayner: It would be impossible
to answer this question and do
it justice in the context of this
interview.
To list a few thoughts though,
I think that remembering that
investing is based on underlying
businesses, constantly working to
learn as much as you can about
as many things as you can, telling
the truth, remembering that you
are a steward and that people are
depending on you to do your best,
and working as many hours of the
day as you can stay awake covers a
lot of what I think we can learn from
his example.
MOI: What books have you read
in recent years that have stood
out as valuable additions to your
latticework of mental models?
Gayner: There are a number of
books that help you to think and
teach you things you didnt know.
We all know Security Analysis and
The Intelligent Investor and they
have stood the test of time.

I think Mark Twain is a great writer

and his insights and observations
about human nature and money
are invaluable. He was broke and
rich several times in his life and his
writing carries an undertone of his
struggles with money. You get a
twofer from Twain. You can laugh
and learn at the same time.
I read endlessly. John Wooden,
the basketball coach at UCLA
during their dynasty is a hero to
me. General Grant is a hero. Warren
Buffett is a hero. Pick some good
heroes and read everything you can
about them.
I also like reading about history,
psychology, and human nature,
technological progress and
scientific thought. The world is a
fascinating place and you will never
run out of rich material if you want
to keep understanding more and
more.
I think I saw a recent interview
with Seth Klarman where he said
something like, value investing
is the marriage of a contrarian
and a calculator. Some books,
like Twains, the histories and
biographies help you with the
human nature and contrarian side
of that equation. Some books,
like the ones about science and
technological developments, along
with the accounting homework I did
a long time ago, help you with the
calculator side. Both elements are
essential. Each is severely limited
without appropriate balance and
understanding from the other side.

Page 42 of 87

Joel Greenblatt founded Gotham Capital in 1985 and has amassed one of the best long-term track records in the
investment business. He is co-CIO of Gotham Asset Management, a professor on the adjunct faculty of Columbia
Business School, the former chairman of a Fortune 500 company, and a member of the investment boards of the
University of Pennsylvania and UJA. Along with Blake Darcy, Joel is a major force behind Formula Investing, an investment
firm that seeks to make the magic formula approach more widely accessible to institutional and retail investors. He
holds BS and MBA degrees from the Wharton School.
The Manual of Ideas:
Congratulations on the recent launch
of the Formula Investing mutual
funds and the publication of your
third book, The Big Secret for the
Small Investor. What is your vision
for value-weighted indexing?
Joel Greenblatt: I think valueweighted indexing makes so much
sense that is, placing more weight
in those stocks that appear to be
at bargain prices, rather than larger
market caps or other weighting
measures that eventually logic
will take over and many of the large
investment firms will design their
own value weighted indexes over
time. I cant imagine that this wont
be a very accepted way of creating
indexes within a few years.
MOI: One of the reasons magic
formula investing should continue to
outperform is the fact that investors
have a hard time sticking with

the approach during long periods

of underperformance. Have you
considered value-weighted indexing
in a closed-end vehicle to avoid
capital flight at times of greatest
investment opportunity?
Greenblatt: In short, I think a closed
end vehicle would be wonderful
for value weighted indexes. Equity
closed end funds, however, have
not been particularly popular in
recent years but I do believe they are
very well suited to value investing
strategies, especially value weighted
indexes.
MOI: You shared the simple yet
powerful magic formula in The
Little Book That Beats the Market in
2005. To what extent do the Formula
Investing funds make tweaks to
the magic formula as described in
the book? For example, have you
considered using forward consensus
earnings estimates instead of trailing

earnings, or eliminating any sectors

beyond financials, such as miners or
oil companies?
Greenblatt: There are a number of
tweaks in the Formula Investing
funds that we have created. First,
we created our own database, we
do not use a commercially available
database. Instead, we have a
team of analysts who analyze the
balance sheet, income statement
and cash flow statements of each
of the companies in our investment
universe. Second, we have developed
a model for financials and those
are included in our diversified value
weighted funds.

In our experience,
eliminating the [magic
formula] stocks you would
obviously not want to own
eliminates many big winners.

Page 43 of 87

Exclusive Interview with Joel Greenblatt

Third, we have made some tweaks
to the metrics we use to take
advantage of the added information
that we get from doing the
fundamental work ourselves. One
more difference is that we make
small trades daily to continually
reweight the portfolio towards
those stocks that appear to be
priced at the greatest value.
MOI: Ideally, good companies
not only maintain high returns
on existing capital but also have
opportunities to invest incremental
capital at high returns. Would it
make sense to avoid companies
that rank highly based on the magic
formula (using trailing EBIT) but
operate in industries with limited
reinvestment? Newspapers, paper
check processors, and legacy
technology companies come to
mind
Greenblatt: No. In our experience,
eliminating the stocks you
would obviously not want to own
eliminates many big winners.
MOI: Tell us a bit about your foray
into non-U.S. stocks. How difficult
has it been to implement a magic
formula approach in overseas
markets, what countries have you
targeted to date, and what are your
future plans for applying the magic
formula globally?

Greenblatt: We have created

our own international database
covering 26 different countries
outside of the U.S. In our
experience, it is not possible to
use commercially available data
due to the fact that we need to
homogenize the data between
countries, and also the available
commercial data does not appear
to be high enough quality to use for
our purposes.
MOI: Aside from magic formula
stocks, what other types of
situations do you consider to be
particularly worthwhile hunting
grounds for sophisticated
investors?

institutionalized and therefore more

short-term focused in the last few
decades than ever before. This
opens up huge opportunities for
individual investors with longerterm investing horizons.

the biggest impediment to

long-term success is having
too short of an investing time
horizon. I think the world
has actually become more
institutionalized and therefore
more short-term focused in
the last few decades than
ever before.

Greenblatt: I wrote three books. I

still believe in the methodology in
You Can Be a Stock Market Genius;
in fact, there are many more
investable opportunities worldwide
in this area than in decades past.
MOI: What is the single biggest
mistake that keeps investors from
reaching their goals?
Greenblatt: In the Big Secret for
the Small Investor, I suggested the
biggest impediment to long-term
success is having too short of an
investing time horizon. I think the
world has actually become more

Page 44 of 87

Since the formation of Oaktree in 1995, Mr. Marks has been responsible for ensuring the firms adherence to its core
investment philosophy, communicating closely with clients concerning products and strategies, and managing the
firm. From 1985 until 1995, Mr. Marks led the groups at The TCW Group, Inc. that were responsible for investments in
distressed debt, high yield bonds, and convertible securities. He was also Chief Investment Officer for Domestic Fixed
Income at TCW. Previously, Mr. Marks was with Citicorp Investment Management for 16 years, where from 1978 to 1985
he was Vice President and senior portfolio manager in charge of convertible and high yield securities. Between 1969 and
1978, he was an equity research analyst and, subsequently, Citicorps Director of Research. Mr. Marks holds a B.S.Ec.
degree cum laude from the Wharton School of the University of Pennsylvania with a major in Finance and an M.B.A. in
Accounting and Marketing from the Graduate School of Business of the University of Chicago, where he received the
George Hay Brown Prize. He is a CFA charterholder and a Chartered Investment Counselor.

The Manual of Ideas: You have

published a book with the title
The Most Important Thing, which
has received praise from Warren
Buffett and, and according to Joel
Greenblatt, is destined to become
an investment classic. Before we
get into discussing some of the
concepts in the book, tell us, what
was your motivation for writing the
book in the first place?
Howard Marks: I have been writing
memos to my clients for 22 years.
I started in 1990, and I frankly cant
remember what the initial motivation
was; it was too long ago. I also cant
remember what kept me going for
the first ten years, because the first

ten years I wrote these memos and

I never had a response. I never had
one response in ten years. So, as I
say, I cant remember what kept me
going, but something did.
Then, on the first day of 2000, I wrote
one called bubble.com, which
talked about tech being a bubble and
turned out to be right soon thereafter.
So, as I say, after ten years, I became
an overnight success. I have been
publishing the memos continuously
ever since. I always thought that
when I retired I would pull it together
into a book. My retirement is some
years off, but then I got a letter from
Warren Buffett a couple of years ago,
and he said If you will write a book,

I will give you a blurb for the jacket.

That was the deciding factor, so I
wrote it. I was also approached by
Columbia about doing it, and those
two factors convinced me to write it
in 2010, and then it was published in
2011.

Page 45 of 87

Exclusive Interview with Howard Marks

MOI: You start the first chapter with
a rather inauspicious but profoundly
true statement that few people have
what it takes to be great investors.
You go on to introduce the concept
of second-level thinking. Help us
understand, what is that and how
can it help us as investors.
Marks: The interesting thing
about investing is what I call the
perversity. The point is that it is so
not intuitive. It is so not obvious
investing. A great example lies
in the fact that, people think that
to be a good investor, you have to
understand companies. But the
market has an understanding of
companies, and if you understand
the company the same as the
market does, even if the market and
you are right, you are not going to
make any special profits.
The success, which is doing better
than the market in a risk-return
sense, comes from understanding
things better than the market. Most
people dont understand things
better than the market, and most
people dont understand the need
for understanding things better
than the market. As I say in that
chapter, not only do I not want to try
to simplify the process of investing,
I want to show how not simple it is.
Too many people try to simplify it.

I mentioned in that chapter the guy

on the radio who says, Well, you go
into a store and you buy a product
and if you like it, buy the stock.
That is so wrong, because liking the
product has either nothing to do
with making a good investment or
it is just very, very first step of many
steps. So you really do have to
think, as I say in that chapter, either
I mean or probably both better than
the average better and at a higher
level.

The interesting thing about

investing is what I call the
perversity. The point is that
it is so not intuitive. It is so
not obvious investing. A
great example lies in the fact
that, people think that to be
a good investor, you have to
understand companies.

You have to understand

that, first of all, the
consensus has an opinion,
and you have to understand
that the consensus is not a
moron.

MOI: So how can we actually

improve our chances of thinking
different from the consensus while
also being right? What is the impact
of nature versus nurture, if you will?
Marks: You have to understand
that, first of all, the consensus
has an opinion, and you have to
understand that the consensus is
not a moron. So, much of the time
the consensus is about right.
If to do better than the consensus
you have to think differently than
the consensus, it means you
have to find the times when the
consensus is wrong. It doesnt
mean that the consensus is always
wrong and just thinking differently
is the key to success. You have to
find the time when the consensus
is wrong, and then you have to think
differently, but not just differently,
differently and better, because you
could think differently and worse. It
is not just holding a non-consensus
opinion. That is not the secret. It
is having a correct non-consensus
opinion when the consensus is
wrong, which is not all the time.
I mentioned in the book when my
son comes to me, who is a budding
hedge fund investor, he gives me
an idea, a stock, macro trend,
or something like that, the first

Page 46 of 87

question I always ask is the same:

Who doesnt know that? That is
really the question. When you think
you know something, the question
is whether the market knows it too.
And if it does, then your idea has no
relative superiority.

MOI: You have applied secondlevel thinking to great success in

inefficient markets, which have
been a focus for Oaktree. What
types of mispricings are your
favorite hunting grounds, and have
they changed over time?

MOI: With a trend toward

compression of time horizons in
the investment industry, do you see
a growing inefficiency in the pricing
of longer-duration securities or
securities that may lack a so-called
catalyst?

MOI: In the investment industry,

where lucrative careers can be
build just based upon consensus
thinking, what types of work
environments are conducive to
develop ones second-level thinking
abilities? How do you ensure that
you have such an environment at
Oaktree?

Marks: Thirty-four years ago when

I started Citibanks high-yield bond
fund, it was easier because the
investing world was much more
narrow-minded at the time. Many,
for example pension funds or
endowments, had a rule: We wont
invest in any bonds that are rated
below investment grade, below
BBB.

Marks: It makes sense. When

everybody thinks one way, then
there should be a reward for
thinking the other way. When I
started off as an investor fortythree years ago, we used to think
about holding things for five years
or ten years, and now five months
would be a long time, and maybe it
is five days or five weeks.

Almost on the surface, if everybody

says We wont do that, then that
is probably going to be cheap. The
world has changed in this time
since, and now most people will do
anything to make money. Of course,
the world has filled up with hedge
funds whose job is to do everything.
So it hasnt gotten easier and
arguably it has gotten harder, but,
on the other hand, not necessarily
because I think our margin of
superiority versus the higher-yield
bond averages has remained about
the same.

On the one hand, there should be

a return for thinking longer. On the
other hand, a lot of people say that
the long term is just a series of
short terms. I would say that is one
of the things working on the side
of the patient investor, is the fact
that he has a longer time frame. On
the other hand, we dont explicitly
there is a new phrase time
arbitrage. We dont explicitly pursue
time arbitrage, but we have patient
capital, and we are patient people.
In our distressed debt funds, for
example, the money is locked up
for ten or eleven years. So we can
be patient. Again, if you are the only
person in the world who is open to
making Investment X, then maybe
it will be available to you cheaply.
Having patient capital is a great
advantage.

Marks: I think that the people there

have to be deep and stimulated
and stimulating and interested
in discussing. I try very hard to
create an environment where one
persons success doesnt have to
come at the expense of another. In
fact, everybody collectively can be
more successful than they would
have been separately. I think these
things are important. You have to
start with smart people who are
also wise or introspective. For
example, I dont get the concept of
trading to make money. So I like to
surround myself with other people
who dont get the idea of trading
to make money. By the way, there
are probably some people out there
who trade to make money. I dont
say my way is the only way, but it is
the way for us.

We think the ability to make money

in the distressed debt business still
exists. I think there is this process
that I call efficientization that in
theory should happen and hasnt
really happened as fast as I thought
it would, and I think it is all down to
the foibles of people. Many are
people individually and markets
are ruled by emotion, and as long as
emotion takes over, then efficiency
will not be realized.

Page 47 of 87

MOI: You state that an accurate

estimate of intrinsic value is the
indispensable starting point for
investing to be reliably successful,
but for you that is not enough. One
needs to hold the view strongly
enough to be able to hang in
and buy even as a price decline
suggests that you were wrong.
How do you build such confidence
in an uncertain world, and how
do you walk this fine line between
confidence and the overconfidence?
Do you have any mental models or
any check lists that are helping you
and Oaktree in navigating this?
Marks: I really think the things in
the book have been our models for
the last seventeen years since we
started the company and longer
when we were working together
before starting the company. It is
not an algorithm. It is a mindset. I
think that we always try to stress
the danger of overconfidence. I
forget if I put it in the book, but it
is better if you invest scared, if you
worry about losing money, if you
worry about being wrong, if you
worry about being overconfident
because these are the things you
want to avoid. They should be
foremost in your mind.
The most dangerous thing is to
think you got it figured out, or that
you cant make a mistake, or that
your estimates are right because
they are yours. You have to always
recheck your information, bounce
your ideas off of yourself and
others.
On the other hand, it is really not
a good business for people who
dont have some ego because you

have to do the things that Dave

Swensen describes as lonely
and uncomfortable. I think it was
[Jean-Marie] Eveillard who said it
was warmer in the crowd, in the
herd. But if you only hold popular
positions, you cant do better
than average, by definition. And I
think you will be very wrong at the
extremes.

The most dangerous thing

is to think you got it figured
out, or that you cant make
a mistake, or that your
estimates are right because
they are yours. You have
to always recheck your
information, bounce your
ideas off of yourself and
others.
You have to be strong enough
in ego to hold difficult unusual
positions and stay with them.
As I say in the book, you have to
have a view that is different from
the consensus, and you have to
be willing to stay with it, and you
have to be right. If you have a nonconsensus position and you stay
with it and you are wrong, that is
how you lose the most money.
I keep going back to what Charlie
Munger said to me, which is none
of this is easy, and anybody who
thinks it is easy is stupid. It is just
not easy. There are many layers to
this, and you just have to think well.
I cant tell you how to think well.
Some people get it, some people
dont.

MOI: You devote three chapters

of the book to the concept of
risk how to understand it,
recognize it, and how to manage
risk. You take particular issue with
the traditional risk-return graph,
which you say communicates the
positive connection between risk
and return but fails to suggest
the uncertainty involved. Tell us
how your interpretation of the
risk-return relationship helps you
avoid the losers to achieve better
performance?
Marks: First of all, as you know
from reading the book, we define
risk primarily as losing money, the
potential for losing money. We dont
want to lose money. Our clients
dont want us to lose their money.
They dont mind if we experience
volatility we have patient capital
which permits us to live through
volatility. In the end, they dont want
to lose money.

we dont empathize
with the view that risk is
variability and that variability
is the thing to be avoided
per se. Every once in a while,
especially in good times,
I hear people say the way
to make more money is to
take more risk and that
is ridiculous, in my opinion.
Taking more risk should not
be ones goal. Ones goal
should be to make smart
investments even if they
involve risk, but not because
they involve risk.

Page 48 of 87

Number one, we dont empathize

with the view that risk is variability
and that variability is the thing to
be avoided per se. Every once in a
while, especially in good times, I
hear people say the way to make
more money is to take more risk
and that is ridiculous, in my opinion.
Taking more risk should not be
ones goal. Ones goal should be to
make smart investments even if
they involve risk, but not because
they involve risk. That is a very
important distinction.
The figure I draw in the book
called 5.2 shows that what
risk means is a greater range of
outcomes, some of which are
negative. You have to bear in mind,
when you make investments,
the presence of the potential of
negative outcomes. You have to
only make investments where you
are rewarded for taking that risk
and where you can withstand the
risk. That requires diversification,
patient capital, and eventually being
right in your ideas.
MOI: There is another profoundly
insightful chart on page two of
the book, which shows how the
risk-return graph is affected by
historically low interest rates in
the U.S. With thirty-year Treasuries
priced to yield 3%, what investment
implications do you draw from this?
Marks: It is very difficult. When
thirty-year treasuries yield 3%, that
kind of sets the bar for everything
else. Everything else trades off
of that, which means not at very
high returns. That means we are
in a low-return environment. One
of the things I believe is we must

understand the environment we are

in, understand the ramifications
and accept it in the sense of accept
the reality.
One of the hardest things is to
make high returns in a low-return
world. If you insist on doing so,
you can get into trouble. If you
say, Well, Treasuries used to be
6% and high yield bonds traded at
500 [basis points] over, so I made
11% with ease on the average
high-yield bond. So even though
Treasuries are now 3%, or 2% on
the ten-year, I still want 11%, and I
am going to get my 11%. Then you
end up making investments that
may appear poised to pay 11%, but
because you now need 900 [basis
points] over [Treasuries], you may
take greater risks than you used to
take to get the same return. So just
insisting on making the same return
that you used to make can be very
dangerous.
Peter Bernstein once wrote
brilliantly, or maybe he passed on
a quote from Elroy Dimson, who
said that the market is not an
accommodating machine. It will not
give you high returns just because
you need them. You have to realize
that. If you say, I used to get 11%
and I still need 11%, so I am going
to take more risk, you can do that.
But the key is to recognize that
you have to take more risk to do it,
and to make a conscious decision
that you are going to do it. Blindly
accepting more risk to get the
return you used to get in a highreturn world can be a big mistake.

MOI: In this context, how worried

are you about the potential risk of
inflation as a result of this lowinterest rate environment in the
U.S. and the actions of the Federal
Reserve? How do you ensure
that you still keep up with the
purchasing power ability for your
capital?
Marks: It is very difficult. A lot of
our investing is in fixed income.
Fixed income, by definition, doesnt
adjust to inflation. If we buy 8%
bonds today with inflation at 3%,
and inflation goes to 6%, we still
have that 8% bond, [but] our real
rate return has gone down. Period.
There is no adjustability in fixed
income
I am personally not worried
about a return to hyperinflation.
Inflation is modest and could go
higher. Everybody would like to
see it go higher because usually
higher inflation is associated with
prosperity. I would like to see that.
Governments around the world
would like to see it so they can pay
their debts with low-value currency.
I dont think we are going to have
hyperinflation.

I am personally not
worried about a return to
hyperinflation. Inflation is
modest and could go higher.
Everybody would like to see
it go higher because usually
higher inflation is associated
with prosperity. I would like
to see that. Governments
around the world would like
to see it so they can pay
their debts with low-value
currency.
Page 49 of 87

I always get in trouble with I stray

into the macro, and I am far from
an economist. But, where does
inflation come from? Demand
pull comes from too much money
chasing too few goods. I dont
think we have that or will anytime
soon. The cost push comes from
an escalation of the cost of the
factors of production. For the most
part, I dont see that unless the
Chinese crowd us all out in terms
of buying currencies. Most of the
possible sources of inflation I think
would come from international
considerations like that like the
guy that works in China for $0.60 a
day demanding $1.20 a day. It could
happen, but I dont think it is going
to be pervasive enough to pitch us
into hyperinflation.
MOI: Risk control is Oaktrees first
tenet in its investment philosophy.
I hear you make an important
distinction between risk control and
risk avoidance. Help us understand
this distinction, perhaps, by way of
an example.
Marks: The greatest example
is this: If you went to the horse
races, would you always bet on the
favorite? The favorite, assuming the
crowd is intelligent, which usually
it is, is the horse with the highest
probability of winning. That doesnt
mean that the favorite is always the
best bet. You might have another
horse that has a lower probability
of winning but the odds are so
much higher, thats the smart bet
leaving alone anything specific that
you know about the horses.
The point is, this is second level
[thinking] again. First level says,

Native Dancer is going to win

the race. It has always won. So
we should bet on Native Dancer,
even if the payoff is 6 to 5. You
put up $5, and if it wins you get
$6. Maybe the better bet is Beetle
Bound, which nobody expects to
win and, consequently, it has a
lower probability of winning but if
it wins it will pay four to one. So its
the same thing. You have to make
investments where the risk can be
assessed, diversified, and where
youre highly paid to do so.
The book is full of explanation
of why so-called safe, so-called
high-quality investments are not
always and, in fact, maybe are
rarely the best bet. That is what
this distinction is all about. We
want to make intelligent bets. We
dont want to invest in high quality
or safe things because a so-called
safe thing at bad odds is a bad
investment. Sometimes I think the
word quality should be banished
from the investment business if you
want to make money.
MOI: In todays environment, there
is a lot of talk about U.S. Treasuries
being a safe haven and it is proving
true. Do you see that as an example
of what we just talked about?

the certainty of 1.9% return for ten

years. Is that really a good thing to
lock up? Under what circumstances
will that turn out to have been
an attractive investment? The
answer is, in my opinion, deflation
or depression. I dont think we are
going to have those things, or we
cant plan on having them. So the
range of outcomes under which
that safe asset turns out to have
been a smart investment is rather
narrow. I was on a panel two days
ago in Los Angeles with Jeremy
Grantham, and he said, people
talk about the risk-free return.
Treasuries are the return-free risk. I
think he has got something there.

Today you can buy the

ten-year [Treasury] and with
no risk, lock up the certainty
of 1.9% return for ten years.
Is that really a good thing
to lock up? Under what
circumstances will that turn
out to have been an attractive
investment? The answer
is, in my opinion, deflation
or depression. I dont think
we are going to have those
things

Marks: U.S. Treasuries Jim

Grant called them certificates
of confiscation are a great
example. They are a safe
investment in the sense that the
outcome is known and not really
subject to variation. I think they are
not a good investment because the
known outcome is an unattractive
one. Today you can buy the ten-year
[Treasury] and with no risk, lock up
Page 50 of 87

MOI: You talk about the importance

of being attentive to cycles and
the pendulum-like oscillation of
investor attitudes and behavior.
However, most value investors tend
to ignore macroeconomic events
and investors sentiment, often
relying on a measure of normalized
through-the-cycle earnings and
relying on their own convictions.
How do you define being attentive,
and how do we ensure we do not
become too attentive?
Marks: First of all, all your
questions start with the word how.
It is very hard to answer that. There
is no secret method for any of this
stuff. You just have to be aware of
concepts, smart in their application,
and it helps to be an old man so
that you have the experience that
helps, or an old woman
If you are a value investor and you
invest whenever you find a stock
which is selling for one-third less
than your estimate of intrinsic
value, and you say, I dont care
about the macro, nor what I call the
temperature of the market, then you
are acting as if the world is always
the same and the desirability of
making investments is always
the same. But the world changes
radically, and sometimes the
investing world is highly hospitable
(when the prices are depressed)
and sometimes it is very hostile
(when prices are elevated).
I guess what you are saying is
we just look at the micro; we
look at them one stock at a time;
we buy them whenever they are
cheap. I cant argue with that. On
the other hand, it is much easier

to make money when the world

is depressed, because when it
stops being depressed, its like a
compressed spring that comes
back.
If you buy a cheap stock when the
market is high, it is a challenge
because, if the market being high
is followed by a general decline in
prices, then for you to make money
in your cheap stock, you have to
swim against the tide. If you buy
when the market is low, and that
lowness is going to be corrected
by a general inflation, and you buy
your cheap stock, then you have the
tailwind in your favor.
I think it is unrealistic and maybe
hubristic to say, I dont care about
what is going on in the world.
I know a cheap stock when I
see one. If you dont follow the
pendulum and understand the
cycle, then that implies that you
always invest as much money as
aggressively. That doesnt make
any sense to me. I have been
around too long to think that a
good investment is always equally
good all the time regardless of the
climate.
MOI: You say that the necessary
condition for the existence of
bargains is that perception has to
be considerably worse than reality.
Where do you think perception has
potentially reached such a level? Is
the eurozone a potentially fruitful
hunting ground for Oaktree?
Marks: You keep using the word
potential, which gives me a
good out because anything which
has gone down in price a lot is

potentially a source of opportunity.

But the question is, has it declined
sufficiently relative to reality? If a
stock was efficiently, fairly priced
five years ago at X. Today the stock
is down half, but in some sense
reality is also down half then the
stock is only fairly priced, lower in
price but not cheaper.
What the investor has to do is
weigh out on the one hand price
and on the other hand reality.
Everybody thinks very dire thoughts
about Europe and the Euro, and
I would be the last person in
the world to argue against that
position. Then the next question is,
European assets are lower in price
because of the macro conditions,
but are the macro conditions being
viewed too pessimistically? The
answer is, how do you know? Go
back to second-level thinking. Are
you capable of thinking different
and better about the fate of Europe?
I dont think so. I dont think I can.
I dont think anybody really has a
good handle on what is going to
happen in Europe.

What the investor has to do

is weigh out on the one hand
price and on the other hand
reality. Everybody thinks very
dire thoughts about Europe
and the Euro, and I would be
the last person in the world to
argue against that position.
Then the next question is,
European assets are lower in
price because of the macro
conditions, but are the macro
conditions being viewed too
pessimistically?
Page 51 of 87

So then, how can gaming the

Europe situation give you an edge?
If you dont have control over
something, superior insight I
dont see control in the sense of
being able to make it work if
you dont have superior insight,
then how can something be to
your advantage? One of the tenets
of our philosophy you named
number one, which is risk control
number five is, we dont bet on
macro forecasts. It is very hard
to consistently be above average
in correctness with regard to the
macro.
MOI: You say knowing what you
dont know can provide a great
advantage as an investor. Warren
Buffett calls this the circle of
competence. What is Oaktrees
circle of competence? More
importantly, can you give us an
example of what lies just outside
that circle?
Marks: We have been making
credit-based investments since I
started Citibanks high-yield bond
fund. We went from high yield
and converts to international
converts and European high yield
to distressed debt, to distressed for
control, to distressed mortgages,
to mezzanine finance. So a lot
of what we have done, although
not all, has been credit based. We
consider that, to use your term
certainly, one of our greatest circles
of competence.
We emphasize the things that have
a high probability of paying off for
us, albeit there are other people
out there who are better than us at
investing in things that have a low

probability of paying off but with

are very high payoff. Our emphasis
is on risk-controlled situations we
are probably more competent in
that than other things.
I think maybe another example of
something that may be outside our
competence is, we never made an
investment in sovereign credit. I use
sovereign debt investing as largely
a political analysis rather than
economic analysis. I dont know
how to do it. I hope it can be done,
and maybe one of these days we
will go out and find somebody who
can do it and maybe well add that
competence to what we do.
We would be silly to bet on the
bonds of peripheral Europe just
because they have gone down if we
are not capable of superior secondlevel thinking. How would we know
enough to out-think the person who
is selling them to us and to have
a high probability of a successful
outcome?
MOI: In addition to corporate and
distressed debt, a considerable
amount of Oaktrees portfolio is in
a category you define as control
investing. Help us understand
better how you approach distressfor-control situations and what
you think makes Oaktree more
successful here versus other funds.
Marks: When I was talking about
circles of competence, I think one
of the elements on our side is that
we have been doing it for a long
time. We have a lot of experience in
the things I have been discussing,
and I think experience is very
important. You have to learn the

hard lessons. One thing I mentioned

in one of my memos is that the
human mind is very good at blotting
out bad memories. Unfortunately,
most important learning is from
bad memories. We have enough
institutional memory to retain the
lessons of the past.
We organized our first distressed
fund in 1988 and then branched
out into our first distressed-forcontrol fund in 1994. We figured
that we could identify cases we
spun that fund out because we had
done it in the past we invested in
big chunks of the debt of smaller
companies so that when the debt
was exchanged for equity we ended
up as the controlling shareholder.
The question is, number one, is this
a company that you would like to
control? And number two, is this a
company where the creditors will
get control? And then number three,
which creditors? Because usually
there is something called the
fulcrum security, which is the first
impaired class. The unimpaired will
get their money. The first impaired
class may get the company, and
the lower impaired classes may get
nothing.

The question is, number

one, is this a company that
you would like to control?
And number two, is this
a company where the
creditors will get control? And
then number three, which
creditors? Because usually
there is something called the
fulcrum security, which is the
first impaired class.
Page 52 of 87

So it is the fulcrum, the one in the

middle there, we try to identify that.
We try to figure out if it will get
control and how much it will have to
pay for control. If it gets control at
that price, will that be a successful
investment? It is a very interesting
area of course, more moving
parts to go wrong. The investments
are by definition less liquid. I would
say its the difference between
dating and getting married. When
you are a distressed debt investor,
you are dating; but when you try
for distressed-for-control, you get
married. You have to live with the
consequences, for better or for
worse, richer or poorer. But, it can
produce some good outcomes.
MOI: Listed equities are a rather
small portion of Oaktrees overall
portfolio. Are those investments a
residual of distressed-for-control
strategy, or do you also target
equities particularly. How you end
up with equities in your portfolio?
Marks: We established a couple of
strategies to invest in listed equities
because we thought markets were
inefficient or less efficient. The
first case was in the middle of
1998 when we decided to go into
emerging markets. So we formed
an emerging markets long/short
hedge fund that we have ever since.
Tenet number three of our
investment philosophy says we
are active in less efficient markets
only. We probably wouldnt do a
hedge fund for large-cap New York
Stock Exchange firms because the
tendencies are that those would
be more efficient than others. But
emerging markets, yes. Japan,

yes. It didnt work out so well

the worlds cheapest market has
continued to get cheaper.
So it is not a residual of some other
activity. We never pass securities
from one strategy or portfolio
to another Just a few markets
where weve concluded that it was
worth investing in equities, despite
the fact that our main circle of
competence is credit.
MOI: You make a distinction
between playing defense and
offense when investing; in other
words, limiting risk and striving for
return. Does Oaktrees ability to
invest across the capital structure
enable it to get the balance more
right in terms of defense and
offense versus other investors that
may be more constrained?
Marks: If you have flexibility in
where you invest, it stands to
reason that you should be able to
make adjustments that enable you
to reach your goals. This goes back
to what we said before. You said
some value investors are willing
to ignore the macro. They say if
stocks are selling for one-third less
than intrinsic value, I am going to
buy it. But the question is, do you
want to be equally aggressive all
of the time, or do you want to play
offense some times and defense at
others?
I would argue that you should
adjust your activities based on
the climate of the market. So, that
is what we do. Sometimes in a
distressed debt portfolio, we want
to be at the very top of the capital
structure. That may be because

that is where the best bargains

are, it may be because the macro
environment is threatened and
we dont want to live with macro
uncertainty. At other times when
these things are cheaper and
when the environment seems less
treacherous, maybe well drop
down into the second level on the
balance sheet or maybe the third.
Historically, we dont go to the
bottom of the stack very often, but
I think these adjustments are worth
making.
It is a great dilemma because, on
the one hand you want to stick to
your circle of competence. On the
other hand, it is probably a mistake
to say, I do this. I dont do that.
Because, at the same time that you
want to capitalize on your expertise,
you want to be flexible enough to
pursue the bargains where they
are, and you dont want to be so
dogmatic that you say, I only do
this, which implies, I do it whether
its cheap or not. So this is one of
the great dilemmas.

You asked earlier where

inefficiencies come from.
Largely they come from
people who say, I do this, and
I dont do that. What they are
basically saying is, I dont do
that regardless of how cheap
it is. Well, that is silly because
then you just leave bargains
for others.

Page 53 of 87

You asked earlier where

inefficiencies come from. Largely
they come from people who say, I
do this, and I dont do that. What
they are basically saying is, I dont
do that regardless of how cheap it
is. Well, that is silly because then
you just leave bargains for others.
If you say, I do this, but I dont do
that regardless of how cheap it
is, you are basically saying, I do
this regardless of how expensive
it is. That doesnt make much
sense either. This is why I think you
have to be realistic. You have to
be sensitive to conditions in your
world, and you should adjust your
tactics offense and defense
based on conditions in your
environment.
MOI: The title of the book is The
Most Important Thing, but, as
your readers will know, all of the
concepts in the book are important
and leaving out even one of them
will likely lead to not optimal
performance. So if all of these
concepts and we have touched
on a few, risk, the relationship
between value and price if
they are all important to achieve
superior performance, what is the
single biggest mistake that you
think keeps investors from reaching
their goals?
Marks: First of all, let me mention
that I think the twenty things
listed in the book are all the most
important thing, and then I thought
of the twenty-first. So later on this
spring, I think we will be coming out
with the new electronic edition of
the book called The Most Important
Thing Illuminated, which will include

comments on the content of the

book from Seth Klarman and Joel
Greenblatt and Paul Johnson and
Chris Davis, in addition to myself,
and a new twenty-first chapter,
which says that the most important
thing is realistic expectations.
Because I think that people tend
to get in trouble in investing when
they have unrealistic expectations,
especially when they have the
expectation that higher returns
can be earned without an increase
of risk. That is a very dangerous
expectation.
Which is the thing which is most
dangerous to omit? I think it is risk
consciousness. I think that the
great accomplishment in investing
is not making a lot of money, but is
making a lot of money with lessthan-commensurate risk. So you
have to understand risk and be very
conscious of it and control it and
know it when you see it.

Which is the thing which

is most dangerous to
omit? I think it is risk
consciousness. I think that
the great accomplishment
in investing is not making a
lot of money, but is making a
lot of money with less-thancommensurate risk.

The people that I think are great

investors are really characterized
by exceptionally low levels of loss
and infrequency of bad years.
That is one of the reasons why we
have to think of great investing in
terms of a long time span. Shortterm performance is an imposter.
The investment business is full of
people who got famous for being
right once in a row. If you read
Fooled by Randomness by [Nassim]
Taleb, you understand that being
right once proves nothing. You can
be right once through nothing but
luck.
The law of large numbers says
that if you have more results, you
tend to drive out random error. The
sample mean tends to converge
with the universe mean. In other
words, the apparent reality tends to
converge with the real underlying
reality. The great investors are the
people who have made a lot of
investments over a long period of
time and made a lot of money, and
their results show that it wasnt a
fluke that they did it consistently.
The way you do it consistently, in
my opinion, is by being mindful of
risk and limiting it.
MOI: Thank you very much for your
time and the insights you have
shared.
Marks: It was a great pleasure for
me, and I appreciate your interest in
the concepts.

Page 54 of 87

Michael J. Mauboussin is a Managing Director and Head of Global Financial Strategies at Credit Suisse. Prior to rejoining
Credit Suisse in 2013, he was Chief Investment Strategist at Legg Mason Capital Management.

The Manual of Ideas: Tell us how you

got started in finance.
Michael Mauboussin: I joined Drexel
Burnham Lambert straight out of
college in 1986. It was an 18-month
program that had a great mix of
training and hands-on experience
we rotated through all aspects of the
firm including trading, investment
banking, research and operations. I
figured even if it didnt work out Id
have a good exposure to Wall Street
and some sense of what Id like to
do.
The area that seemed the best fit
with my personality was equity
research. My breakthrough was
getting hired as the food industry
analyst at First Boston (now
Credit Suisse) in 1992. A great
deal of my focus in the early days
of my research career was on
valuation. I was deeply inspired
by Al Rappaports book, Creating

Shareholder Value. The principles

Al laid out were very consistent
with what I had learned at Drexel
and remain the cornerstone of my
thinking today. One of my career
highlights was writing the book,
Expectations Investing, with Al. That
book basically took the principles
of creating shareholder value
and applied them to the world of
investing.
Around the mid-1990s, I started
to expand my reading, including
a fair bit on evolutionary theory.
That led naturally into more reading
on psychology including Daniel
Kahneman and Amos Tverskys
seminal work on heuristics and
biases. I also learned about complex
adaptive systems, a focal point of
the research at the Santa Fe Institute
in New Mexico. I felt strongly that
each of these areas had a lot to
contribute to an investment process.

MOI: Explain the challenges

youre trying to address through
your research. What is the multidisciplinary approach to investing
and why is it necessary?
Mauboussin: At the end of the day,
successful investing is about buying
something for less than its worth.
Saying it somewhat differently,
the idea is to always look for gaps
between fundamentalsfor example,
the financial performance of a
companyand expectations, which
is the stock price. While that may be
stating the obvious, the devil is in the

always look for gaps

between fundamentals
for example, the financial
performance of a company
and expectations, which is
the stock price. While that
may be stating the obvious,
the devil is in the details.

Page 55 of 87

Exclusive Interview with Michael Mauboussin

details. How do you know that price
and value are misaligned? Why are
markets inefficient? What makes it
so difficult to go against the crowd?
I have come to believe in the mental
models approach to investing.
This approach has most famously
been articulated and advocated by
Charlie Munger. The basic idea is
that it is really helpful to understand
the big ideas from multiple
disciplines. You might think of
these ideas, or models, as tools in
your mental toolkit. So when you
face a vexing problem, you have
access to lots of tools to solve it
and one of them is likely to work.
The alternative is to go through
the world with a narrow range of
knowledge. When a problem arises
that you understand, youll nail it.
But therell be a lot of problems you
wont be equipped to solve. The
challenge with a multi-disciplinary
approach is that it requires
constant learning. Most people
arent willing or able to put in the
time. Thats fine. But to me there
appears to be a high correlation
between intellectual curiosity
and success in the investment
business. Many great investors
spend their days reading and
thinking.

MOI: In your book Think Twice you

argue that the right process for
making decisions conflicts with
how our minds work. When faced
with complexity, our brains revert
to simplified patterns that obscure
better approaches. What are some
of the default patterns to which
investors are prone to succumb?
Mauboussin: Investors succumb
to a number of mistakes, but Ill
highlight a couple in particular.
The first comes from a paper by
Kahneman and Tversky called On
the Psychology of Prediction. The
core idea is that when you make
a prediction, you can consider
the individual circumstances of
the case and/or the base rate.
In the first case, youre taking
the information you have and
combining it with your own view
of things. Psychologists call this
the inside view. Consideration of
the base rate basically means you
ask the question: when others
have been in this situation before,
what happened? This is known
as the outside view. Kahneman
and Tversky showed that for most
decisions, people rely too much on
the inside view and not enough on
the outside view.

Let me give you an example. A

couple of years ago, an analyst did
a bottom-up analysis of Amazon.
com and suggested the company
could grow 25% compounded
annually, off a $20 billion starting
revenue number, for ten years. This
is the inside view. The outside view
would ask how many companies
have grown at that rate for that
long off that base in history. As
you might guess, the number is
tiny. So the inside view often gives
a projection thats too optimistic,
although its certainly possible that
its too pessimistic as well.
The second mistake, which is
somewhat related, is a failure to
understand reversion to the mean.
Whats funny is that most investors
think they understand the concept,
but when you look at the aggregate
behavior, mistakes around reversion
to the mean consistently show up.
For instance, investors consistently
buy a fund, or even an asset class,
after its done well or sell after a
spell of poor performance. In the
aggregate, these actions lead to
dollar-weighted returns that are
lower than the stated returns.
While its not too surprising that
this would be true for individual
investors, its also true for
institutions.

Page 56 of 87

MOI: Institutionalization has

compounded principal/agent
problems. Buffett talks about the
institutional imperative. Are your
prescriptions for better decisionmaking destined to fall on deaf
ears in the context of financial
intermediation and escalating
principal/agent problems?
Mauboussin: You need three types
of edge to do well as a long-term
investor: analytical, behavioral, and
organizational. And youre right, at
the core of the organizational edge
is being able to manage principal/
agent problems.
The core issue is that there can
be a tension between delivering
long-term excess returns to your
fund holders (Charlie Ellis calls
this the profession) and creating
revenues and profits for the moneymanagement firm (Ellis calls this
the business). The profession
tends to be contrarian, long-term
oriented, and valuation-based. The
business tends to focus on whats
hot, is short-term oriented, and
momentum-based.
Over the last four or five decades
the pendulum has swung from the
profession to the business. We see
evidence of this with the greater
incidence of closet indexing.
Active sharea measure of how
different a portfolio is from its
benchmarkhas been drifting lower
since the 1980s, indicating that
portfolios today look more like their
benchmarks than they did back
then.
But let me say that money
management clients have some

culpability in this, too. Investors

appear to be less patient than they
used to be and that has an impact
on an investment firms ability to
make long term-oriented decisions.
The goal is to have the time
horizons of the investors and the
investment firm align. Easy to say
but hard to achieve in practice.

You need three types

of edge to do well as
a long-term investor:
analytical, behavioral, and
organizational.
MOI: Understanding behavioral
finance concepts such as
overconfidence and loss
aversion may equip investors to
deal with the emotional challenges
of investing. However, even if one
can master emotional biases, the
application of corrective tools in
any given situation is likely too
much to ask of the average human.
What emotional biases are typically
the hardest to shake off?
Mauboussin: Your point is
extremely well taken. Its one thing
to know about the biases and
another thing altogether to manage
them effectively. That said, I do
think there are some practices that
you can weave into your process
that can be helpful. For example,
be aware of the outside view
and make sure you implement
it into your thinking. Or maintain
the discipline to consider every
situation probabilistically and keep
an investment journal so as to track
your thinking and give yourself
honest feedback.

The biases that are hardest

to shake off, I believe, are the
confirmation bias and anchoring.
The confirmation bias says that
once weve made a decision we
seek confirming information and
disregard or discount disconfirming
information. Most of us have
a strong need to feel like were
right, and hence naturally seek
information that proves our point.
Anchoring is also pernicious. The
idea is that we tend to anchor
on figures that may be arbitrary.
For instance, if you ask people to
write down the last four digits of
their phone number and then ask
them to estimate the number of
doctors in Manhattan, youll find
a strong correlation between low
phone numbers and low estimates
and high phone numbers and high
estimates. You can then explain
whats going on to the group. And
then you can rerun a variation of the
experiment and get a similar result.

The biases that are hardest

to shake off, I believe, are
the confirmation bias and
anchoring Most of us
have a strong need to feel
like were right, and hence
naturally seek information
that proves our point.

Page 57 of 87

The good news is that you dont

need to weed out every one of your
biases to do fine over time. But the
more ways you can find to be aware
of and manage your biases, the
better off youre likely to be.

are fearful, and vice versa few

act on it. How do you explain this
phenomenon in the context of
investors choices and the nature of
a complex adaptive system such
as the stock market?

MOI: To what extent do quantitative

investment methods offer a remedy
to investors who cannot master
their emotions? For example, what
is your view of Joel Greenblatts
Magic Formula approach to
investing?

Mauboussin: This is a great

question. The stock market is a
canonical example of a complex
adaptive system. These systems
have three features: heterogeneous
agents, interaction that leads to
emergence, and a global system
that has properties and features
that are distinct from the underlying
agents. In other words, crowds
are wise under certain conditions
and you cant understand markets
by talking to investors within the
market.

Mauboussin: There have been

certain empirical regularities that
weve seen in markets over the long
termfor example, value beats
growth and small cap beats large
cap. But these patterns are very
sensitive to starting and stopping
points. Had you invested in small
caps in 1982 believing they would
deliver superior returns to large
caps, you would have had a couple
of tough decades. And value
struggled mightily in the late 1990s.
To me, the value of Greenblatts
formula is that it identifies highquality companies at cheap prices.
If you can do that over time, you
should be fine. So anything that can
steer you toward stocks that have
low expectations relative to the
companys fundamental prospects
is useful.
MOI: It seems that many emotional
biases can be classified under
the headings of greed and fear.
Buffetts advice is to be fearful
when others are greedy and greedy
when others are fearful. While many
investors will agree with Buffetts
advicebe greedy when others

But heres the key: the market

needs to meet certain conditions in
order to be efficient. The investors
have to have diversity (think
fundamental and technical, shortterm and long-term, etc.), there
must an aggregation mechanism
to bring together the information
of investors, and there must be
well-functioning incentives. When
all three are in place, markets are
efficientand I mean that in a
textbook sense.
The essential challenge for
investors is figuring out when
markets are inefficient, and the
answer is when one or more of
the conditions for efficiency are
violated. By far the most likely to go
is diversity. Rather than operating
independently, our views tend to
correlate. We become uniformly
bullish (spring 2000) or uniformly
bearish (spring 2009). In fact,

you can say that the moment of

maximum bullishness defines
the market top while maximum
bearishness defines the market
bottom.
So this is why Buffetts advice is
so good but so hard. The point
when theres a valuation extreme
is precisely the point when the
emotional pullin the wrong
directionis strongest.

The stock market is a

canonical example of a
complex adaptive system.
These systems have three
features: heterogeneous
agents, interaction that leads
to emergence, and a global
system that has properties
and features that are distinct
from the underlying agents.

MOI: In More Than You Know:

Finding Financial Wisdom in
Unconventional Places you draw on
a range of fields such as gambling
and biology to pinpoint parallels
to investment challenges and the
workings of the market. What can
investors learn from poker players
or the average member of an ant
colony?
Mauboussin: Investing is a
probabilistic field, similar to
fields such poker or sports team
management. You can also
observe that some people in
these fields do better than others.
So the question is: what are the
best in each of these fields doing
that distinguishes them from the

Page 58 of 87

average person in those fields?

I think it boils down to three things.
First, they focus on process and
not outcomes. In other words, they
make the best decisions they can
with the information they have, and
then let the outcomes take care of
themselves. Second, they always
seek to have the odds in their favor.
Finally, they understand the role
of time. You can do the right thing
for some time and it wont show
up in results. You have to be able
to manage money to see another
daythat is, preserve options for
future playand take a long-term
view.
From the ants you realize the colony
has behaviors that are distinct
for the underlying ants. You cant
understand the colony by talking to
the ants. Hopefully, the similarity to
the market is apparent. If you want
to understand the market, look at
asset prices. Dont bother listening
to the pundits. Market prices
whether you think they are right or
wrongconvey useful information.
MOI: You have long advocated the
importance of investment process
over outcome. What are the
essential building blocks of a good
investment process?
Mauboussin: There are three
components. The first is analytical.
This means that you should always
seek gaps between fundamentals
and expectations. Like most things,
its easy to say but hard to do. Id
also include position sizing under
the analytical heading. Lots of
firms spend time finding what they
believe are mispriced securities

but allocate less time to figuring

out how big those positions should
be within the portfolio. Both
overbetting and underbetting are
suboptimal, and lots of portfolios
do one or the other.
The second component is
behavioral. This covers much of
what weve discussed. The idea
is that we all operate with certain
heuristicsrules of thumband
that predictable biases emanate
from those heuristics. Learning
about those biases is really
important but whats even more
important is weaving methods into
your process to manage or mitigate
the biases. Another piece of the
behavioral component is what I
call the Mr. Market mindset. This
refers to the metaphor that Ben
Graham used, and Warren Buffett
popularized, to define a proper
attitude toward markets. In short,
Mr. Market is an accommodating
fellow in the sense that he always
provides bids and offers but also
suffers wild emotional swings,
from ebullience to depression. The
important point to remember is that
Mr. Market is there to serve you,
not to inform you. You can take
advantage of him when hes foolish
but its important to avoid getting
swayed by his moods.
The final component is
organizational. The goal is
to minimize conflict between
principals and agents. For an
investment firm, this means
always putting the interests of
investors first. Naturally, a healthy
business is essential to nurturing
the profession of investing. But

markets must precede marketing in

the minds of the individuals running
the firm.
MOI: What is the key mistake that
keeps investors from reaching their
goals?
Mauboussin: The biggest mistake
is a failure to distinguish between
fundamentals and expectations.
Using a metaphor from the
racetrack, the idea is that you
make money only when you find
a discrepancy between a horses
chances and the betting odds.
Whats important is that almost
everyone thinks that they are doing
this, but very few actually do.
So when things are going well,
people tend to buy and when they
are going poorly, they tend to sell.
They dont separate fundamentals
and expectations. These are
really two distinct aspects of an
investment, and they must be
kept separate. Unfortunately, our
emotions cause us to allow them to
bleed together.

The biggest mistake is

a failure to distinguish
between fundamentals
and expectations. Using a
metaphor from the racetrack,
the idea is that you make
money only when you find
a discrepancy between
a horses chances and
the betting odds. Whats
important is that almost
everyone thinks that they
are doing this, but very few
actually do.

Page 59 of 87

MOI: What investment-related

resources have you found
particularly useful?
Mauboussin: You mean besides
The Manual of Ideas? My
investment-related reading probably
isnt very different than most. I find
the Economist useful and certainly
try to listen to what great investors
have to say. But most of the ideas
I get are from reading outside
the world of investingeven in
tangential fields like gambling.
There are lots of great ideas out
there and the fact is, most of them
relate back to investing in one way
or another.

Page 60 of 87

Allan Mecham heads Arlington Value Management based in Salt Lake City, Utah.

The Manual of Ideas: Over the

ten years ended December 31st,
2009, the S&P 500 delivered an
underwhelming return of negative
9.1%, equaling a 1.0% annual loss.
Bruce Berkowitzs Fairholme Fund
achieved a net annualized return of
13.2% during the same period, while
your fund returned 15.5% annually
net of fees. Berkowitzs record has
made him somewhat of a rock star
in the investment business. How
come you are still flying below the
radar?
Allan Mecham: Ha! Good question
Im eagerly awaiting The Little Book
on Becoming a Hedge Fund RockStar. In all seriousness, its likely a
combination of factors (Salt Lake
City-based LLC, only $10+ million
under management for the first five
years with no serious marketing), but
certainly my limitations marketing
Arlington are partly to blame.
Additionally, and probably the biggest
reason for our obscurity, stems from

our fanaticism about accepting

the right capital. Maintaining a
culture thats conducive to rational
thinking and investment success
has been the top priority since
inception. We have turned down
significant sums of money on
many occasions because of this
stubborn commitment. As I said in
my most recent letter, we get far
more satisfaction from producing
top returns than from the size of our
paycheck though were hopeful
this distinction wont need to be
highlighted for much longer!

has done a fantastic job. We believe

patience and discipline are critically
important to investment success.
Taking emotion out of the equation,
or at least minimizing it as much
as possible, is vitally important and
difficult to do if you have investors
peering over your shoulder in real
time, questioning ideas. Thats
like telling someone whats wrong
with their golf game in the middle
of their backswing its the last
thing you need when youre trying to
concentrate and execute a shot.

Many potential investors require

monthly transparency into the
portfolio and are overly focused on
short-term results. Accepting hot
money would endanger the culture
and my ability to perform. My partner
Ben [Raybould] considers it his most
critical job to cultivate and maintain
a culture that minimizes emotional
noise and short-term performance
pressures, to which I must say he

Taking emotion out of

the equation, or at least
minimizing it as much as
possible, is vitally important
and difficult to do if you
have investors peering over
your shoulder in real time,
questioning ideas.

Page 61 of 87

Exclusive Interview with Allan Mecham

MOI: We could conduct this entire
interview simply by revisiting
quotes from your past letters,
which are a tour de force. You
recently didnt hold back on your
view of certain types of institutional
investors: Many times these gatekeepers of capital have expressed
admiration for our results. Yet
for them to invest we would
need to not only continue to find
undervalued stocks, wed need to
find more of them; additionally, we
would need to identify overvalued
stocks and short them as well
as find ideas across the globe in
both large and obscure markets.
Such comments are flattering, yet
we see nothing but wild-eyed hubris
attempting to outsmart people,
more often, in more ways, and
in more markets, as opposed to
sticking with what produced top-tier
results in the first place. Clearly, the
proliferation of investment vehicles
whose partners interests are at
odds with those of the ultimate
owners of capital has resulted in
misallocation of capital. Do you see
owners waking up to this inherent
conflict and demanding a more
sensible approach to investment?
Is it feasible for a fund like yours to
bypass the agents and go directly
to the owners of capital?

The financial middlemen

satisfy the clients emotional
needs more than the
financial needs. The comfort
of crowds is strongly at play
throughout the system. At
the end of the day I think
managers are giving clients
what they want peace of
mind and smoother returns,
albeit at the expense of longterm results.
Mecham: I think its possible to gain
traction but Im not optimistic about
change on a large scale as there are
multiple factors at play. Bypassing
the agents is a laborious process
thats difficult for a two-man shop
like ours. The fees throughout the
financial system are crazy and
make no sense when thinking
about the industry as a whole. A
lot of financial intermediaries and
hedge funds operate using a form
of the Veblen principle where
status is attached to the high cost
and exclusivity of the product.
The financial middlemen satisfy
the clients emotional needs more
than the financial needs. The
comfort of crowds is strongly at
play throughout the system. At the
end of the day I think managers

are giving clients what they want

peace of mind and smoother
returns, albeit at the expense of
long-term results.
MOI: Short-term thinking seems to
be alive and well in the investment
industry despite overwhelming
evidence that a longer-term
perspective yields better results.
You have alluded to the fact that
good ol career risk may be the
culprit: Non-activity in the face of
short-term underperformance is
simply not tolerated, even though
realistic assumptions (you cant
outsmart other smart people all
the time) and basic math (lower
frictional costs) confirm its worth.
Most fund managers capital would
not stick around long enough so
they simply comply with more
standard methods of operation
in the spirit of keeping their jobs.
Incentives are one of the most
powerful forces driving behavior,
so its little surprise investment
managers have adjusted to the
prevailing industry incentives. What
could be done to better align career
risk with investment risk?
Mecham: I am a strong believer
in the power of incentives. That
being said, Im not sure I have a
silver bullet on how to solve the

Page 62 of 87

problem. You need investors to

think and act like owners, rather
than short-term renters, and to
judge performance over longer time
frames. I remember reading a talk
that Mark Sellers gave at Harvard
a few years back. He basically
said good investors have the right
temperament by age 15, and theres
not much one can do to improve
later in life. So I dont think arguing
the merits of ones philosophy is
going to gain a lot of traction
it seems people either get it or
they dont. If you could somehow
get investors to accept annual
reporting (which is arguably too
often), or some type of soft or hard
lock-up, that may help, but again, its
a hard problem to solve as youre
dealing with human nature to a
large degree.
We are fanatical about partnering
with compatible investors those
who get it and we still have
soft lock-ups at Arlington Value
Capital. The sophisticated family
offices (and others) often ask,
Whats your edge? I firmly believe
it is our investor base they act
and think like owners rather than
traders, which enables us to wait
for exceptional opportunities. Such
an investor base really adds value
when you go through periods of
distress and underperformance;
precisely the time when you need
confidence and stability is apt to be
the time when investors are rushing
for the exits and questioning the
approach. Our investor base is
unique: despite above-average
volatility weve had minuscule
withdrawals over the years. Part
of the genius in the structure of

the Buffett partnerships (which

has largely been maintained at
Berkshire), is the culture and
environment Buffett created and
insisted upon; Buffett wouldnt
disclose positions and reported
just once a year he created an
environment where nobody was
questioning how or when he swung
the investment bat.
MOI: Lets switch gears and
discuss the investment philosophy
behind your track record. Help us
understand the kind of investor
you are, perhaps by highlighting a
couple of examples of companies
you have invested in or decided to
pass up. What are the key criteria
you employ when making an
investment decision?
Mecham: Its really quite simple. I
need to understand the business
like an owner. The firm needs to
have staying power; I want to be
confident about the general nature
of the business and industry
landscape on a longer term basis.
Im big on track records, and
generally stay away from unproven
companies with short operating
histories. I also believe a heavy
dose of humility and intellectual
honesty is important when looking
at potential ideas.
Theres a strong undercurrent
constantly percolating to buy
something its fun, exciting
and feels like thats what youre
getting paid for. This makes it
easy to trick yourself into thinking
you understand something well
enough when you dont, especially
if you are in the investment derby
of producing quarterly and yearly

returns! When looking at ideas,

I have a Richard Feynman quote
tattooed in the back of my brain:
Dont fool yourself, and remember
you are the easiest person to fool.
Ultimately, what tends to cover
all the bases is the mentality of
buying the business outright and
retaining management. Critical
to implementing this approach is,
again, having a compatible investor
base. Whose bread I eat his song
I sing An owners mentality
forces you to think hard about the
important variables and makes you
think long term, as opposed to in
quarterly increments. In fact, I think
very little about quarterly earnings
and more about the barriers to
entry, competitive landscape/
threats, the ongoing capital needs
and overall economics, and most
importantly, the durability of the
business. Over the years Ive
come to realize the importance of
management, so we look hard at
the people running the business as
well. And, obviously, the price needs
to make sense.

When looking at ideas, I

have a Richard Feynman
quote tattooed in the back of
my brain: Dont fool yourself,
and remember you are the
easiest person to fool.

Page 63 of 87

The criteria bar is set high; we really

try to avoid mediocre situations
where restlessness causes you to
relax investment standards in one
area or another. We also stress
test the business under various
economic scenarios and look to
a normalized earnings power.
We passed up many seemingly
attractive ideas over the years
as we would ask, What happens
under 7-10% unemployment (when
unemployment was in the 4-5%
range) and 6-8% interest rates?
And we would ask, Is the business
overly reliant on loose credit
extension and frivolous spending?
Many names didnt hold up under
these stress test scenarios, so
we passed. We bought AutoZone
[AZO] a few years back as it held
up under various adverse macro
scenarios, and in fact performed
exceptionally well throughout
the Great Recession. I constantly
try and guard against investing
in situations where the intrinsic
value of the business is seriously
impaired under adverse macro
conditions. We prefer cockroachlike businesses very hardy and
almost impossible to kill!

Oftentimes a key cog of

value is in a form thats
difficult to measure
Sometimes its the location
of assets that can be hugely
valuable. Waste Management
and USG both have assets
that are uniquely located
and almost impossible to
duplicate, which provides a
low-cost advantage in certain
geographies.

MOI: You have said that analysts

tend to overweight what can be
measured in numerical form, even
when the key variable(s) cannot
easily be expressed in neat, crisp
numbers. Can you give us an
example of how this tendency
occasionally creates an attractive
investment opportunity for the rest
of us?
Mecham: Sure. In a generic form,
I think there are many instances
where a company hits a speed
bump and reports ugly numbers,
yet the long-term earnings power
and franchise value remain intact.
Oftentimes a key cog of value
is in a form thats difficult to
measure brands, mindshare/loyal
customers, exclusive distribution
rights, locations, management,
etc. Sometimes its the location of
assets that can be hugely valuable.
Waste Management [WM] and
USG [USG] both have assets that
are uniquely located and almost
impossible to duplicate, which
provides a low-cost advantage in
certain geographies.
Reputation is valuable in business,
though hard to measure in
numerical form. Reputation
throughout the value chain can
be a strong source of value and
competitive advantage. I think
Berkshire Hathaways reputation is
very valuable in a variety of areas,
most obviously in acquiring other
companies.
The various cogs of value differ
between companies, but many
times the key variable(s) are
difficult to capture in a spreadsheet
model and/or are not given the
weight they deserve.

MOI: You wrote recently that

your appetite is paltry for risky
investments, almost regardless
of potential reward. Theoretically
this stance is illogical as pot
odds can dictate taking a flyer
where the potential payoff
compensates for the chance of
loss however these situations
are difficult to handicap, and can
entice one to skew probabilities
and payoffs. You put your finger
on an interesting phenomenon:
Many investors systematically
overestimate the probability and
magnitude of favorable outcomes.
We recall the countless times we
have read investment write-ups that
peg the expected return at 50-100%,
yet virtually no investor manages
to achieve even 20+% performance
over any meaningful period of
time. What kinds of situations do
you consider too risky or, more
appropriately, too susceptible to
the skewing of probabilities and
payoffs?
Mecham: Im not sure I can
categorize the situations Any time
you are paying a price today thats
dependent on heroics tomorrow
fantastic growth far into the future,
favorable macro environment, R&D
breakthroughs, patent approval,
synergies/restructurings, dramatic
margin improvements, large payoff
from capex, etc. you run the risk
of inviting pesky over-optimism
(psychologists have shown
overconfidence tends to infect most
of us), which can result in skewed
probabilities and payoffs. We want
to see a return today and not base
our thesis on optimistic projections
about the future. Many early-stage
companies with short track records
Page 64 of 87

fall into the too risky category

for us. Investments based on
projections that are disconnected
from any historical record make
us leery. Investments dependent
upon a continued frothy macro
environment (housing, loose credit)
are prone to over-optimism as
well how many housing-related/
consumer credit companies were
trading at 6x multiples growing
15%+ inviting IV estimates 5x the
current quote?
Many times I think it can be a
situation where you just dont
understand the business well
enough and the bullish thesis is the
nudge that sedates the lingering
risks you dont fully grasp. Its
important to keep the litany of
subconscious biases in mind when
investing. Charlie Munger talks
about using a two-track analysis
when looking at ideas. I think thats
an extremely valuable concept
to implement when looking at
investment opportunities. You
have to understand the nature and
facts governing the business/idea
and, equally important, you need
to understand the subconscious
biases driving your decision
making you need to understand
the business, but you also need to
understand yourself!
MOI: How do you generate
investment ideas?
Mecham: Mainly by reading a lot.
I dont have a scientific model to
generate ideas. Im weary of most
screens. The one screen Ive done
in the past was by market cap, then
I started alphabetically. Companies
and industries that are out of favor

tend to attract my interest. Over the

past 13+ years, Ive built up a base
of companies that I understand well
and would like to own at the right
price. We tend to stay within this
small circle of companies, owning
the same names multiple times.
Its rare for us to buy a company we
havent researched and followed for
a number of years we like to stick
to what we know.
Thats the beauty of the public
markets: If you can be patient,
theres a good chance the volatility
of the marketplace will give you
the chance to own companies on
your watch list. The average stock
price fluctuates by roughly 80%
annually (when comparing 52-week
high to 52-week low). Certainly,
the underlying value of a business
doesnt fluctuate that much on
an annual basis, so the public
markets are a fantastic arena to
buy businesses if you can sit still
without growing tired of sitting still.

The average stock price

fluctuates by roughly 80%
annually (when comparing
52-week high to 52-week
low). Certainly, the underlying
value of a
business doesnt fluctuate
that much on an annual
basis, so the public markets
are a fantastic arena to buy
businesses if you can sit
still without growing tired of
sitting still.

MOI: You have stated that your old

fashioned style embraces humble
skepticism and is wary of most
modern risk management tools and
ideas. Give us a glimpse into how
you construct and manage your
portfolio and how you protect
it from the kind of upheaval the
markets experienced in late 2008
and early 2009.
Mecham: Theres no substitute
for diligence and critical thinking.
Its ingrained in my DNA to think
about the downside before any
potential upside. We try and stick
with companies we understand,
where we have a high degree of
confidence in the staying power of
the firm. We spend considerable
effort thinking critically about
competitive threats (Porters
five forces, etc). We really stress
long-term staying power and
management teams with proven
track records that are focused
on building long-term value.
Then we always stress test the
thesis against difficult economic
environments. As I said earlier, we
try and guard against investing in
businesses reliant on some type of
macro tailwind.
If you have the above, combined
with the freedom to take the long
view, managing the portfolio is
based more on intellectual honesty
and common sense rather than any
sophisticated tools, models, or
formulas. If the financial crisis
taught nothing else, it showed
how elegant financial models
that calculate risk to decimal
point precision act like a sedative
towards critical thinking and even

Page 65 of 87

common sense risk models

were like the bell that told the brain
it was time for recess! I also think
risk management by groups can
have similar effects. Being diligent,
humble and thinking independently
are key ingredients to solid risk
management.
MOI: What is the single biggest
mistake that keeps investors from
reaching their goals?
Mecham: Patience, discipline
and intellectual honesty are the
main factors in my opinion. Most
investors are their own worst
enemies buying and selling too
often, ignoring the boundaries of
their mental horsepower. I think
if investors adopted an ethos
of not fooling themselves, and
focused on reducing unforced
errors as opposed to hitting the
next home run, returns would
improve dramatically. This is where
the individual investor has a huge
advantage over the professional;
most fund managers dont have
the leeway to patiently wait for the
exceptional opportunity.

MOI: What books have you read

in recent years that have stood
out as valuable additions to your
investment library?
Mecham: I enjoy all the behavior
psychology stuff and would
recommend Predictably Irrational
[by Dan Ariely], Nudge [by Richard
Thaler], How We Decide [by Jonah
Lehrer], and Think Twice [by Michael
Mauboussin].
The Big Short [by Michael Lewis] is
a good book and a very entertaining
read. Roger Lowensteins new book,
The End of Wall Street, is very good
as well. Id also recommend The
Relentless Revolution [by Oldham
Appleby]. I like reading history of
all sorts and think its beneficial to
investing.
MOI: Allan, thank you very much for
your time.

Most investors are their own

worst enemies buying and
selling too often, ignoring the
boundaries of their mental
horsepower.

Page 66 of 87

Value investing strategist James Montier serves on GMOs asset allocation team and is the author of Value Investing and
The Little Book of Behavioral Investing.
The Manual of Ideas: How did you
become interested in behavioral
finance and value investing?
James Montier: It all started way
back, well over twenty years ago
when I was at university. One of my
tutors was concerned that I had too
much faith in the classical approach
of economics, and suggested I
read some papers by some of the
earliest advocates of the behavioral
approach, and I was smitten.
When I actually starting working in
markets the first paper I wrote was
on excessive volatility in the bond
markets (i.e., the fact that the long
bond moves more than is justified
by the change in future short rates).
I returned regularly to the themes of
behavioral finance many times over
the years, but in the period of the
TMT bubble I got really interested in
applying the insights of psychology
to investment (what I call behavioral
investing) The more I understood
about the behavior mistakes to

which we are all prone, the more I

found myself naturally drawn to value
investing as a way of mitigating
those mistakes.
MOI: You have been a member
of GMOs asset allocation team
since joining the firm in 2009. What
research topics are you focused on
at GMO?
Montier: Im one of the portfolio
managers in the asset allocation
department. My interest is in
unconstrained global asset
allocation, effectively a value-based
approach to multi-asset allocation.
We are a very research driven
organization; so all the portfolio
managers are highly involved in
the research. My work these days
covers a wide range of topics from
high-level ideas spanning philosophy,
process and construction, to
investigating forecast robustness
and down to individual trade ideas
like European dividend swaps. I also

write white papers occasionally on

investment topics that pique my
interest such as tail risk protection.

the bias blind spot is

simply that we dont see the
biases at work in ourselves,
but clearly see them in
others.
MOI: In The Little Book of Behavioral
Investing, you observe that we all
seem to have a bias blind spot.
Could you explain this concept, and
what can investors do to eliminate or
mitigate this weakness?
Montier: Sure, the bias blind spot is
simply that we dont see the biases
at work in ourselves, but clearly see
them in others. So when Ive taught
behavioral investing I often hear
people talking about Bob the trader,
or Bill the portfolio manager as
examples, but rarely do people have

Page 67 of 87

Exclusive Interview with James Montier

the self insight to know that they
themselves are making exactly the
same mistakes.
As to eliminating or at least
mitigating, being aware of their
existence is a pretty good first step.
Keeping a diary of your investment
ideas is a powerful aid memoir
when it comes to behavioral
biases, as you can see what you
were thinking in real time, and
then evaluate your process in the
cold light of day provided by the
distance of time. The downside of
this approach is obviously that it
takes time to build up a catalogue
of mistakes to learn from.
MOI: Behavioral finance can seem
daunting at times, with numerous
studies, theories and inferences.
How should one approach the
subject? What are the limits and
drawbacks, if any, of behavioral
finance?
Montier: It can appear that
behavioral finance is an unwieldy
beast, with a theory to explain
almost every observed action.
However, I think a number of
authors had done an excellent
job of trying to explain the salient
aspects and insights of the field
to investors. Im thinking of books
like Jason Zweigs Your Money &

Your Brain, or Richard Petersons

Inside the Investors Brain (and Little
Book of Behavioral Investing written
by someone whose name has
escaped me). It is also worth noting
that the late great Amos Tversky
(one of the great founding legends
in the field of decision-making
biases) once said that he wasnt
suggesting anything that secondhand car salesmen hadnt known
for years. Once you invest time
in understanding how we make
decisions, you will see examples in
all walks of life, which makes it all
the more real.
I think the most useful application
of behavioral investing is to
understand the major biases
that are likely to appear in the
investment process, and then
try and work out which ones you
personally are most likely to make.
Then safeguards (or checks and
balances) can be put in place to
try and prevent you stumbling into
these pitfalls.
For instance, lets say you are
particularly prone to empathy gaps
(i.e., not being able to imagine
how you will feel and act under a
different set of circumstances, say
like the market being down 50%),
you can force yourself to do your

research work on normal days

when nothing much is happening,
reach your conclusion on intrinsic
value and an appropriate margin
of safety. To ensure consistency
with this effort, you can place
limit orders with brokers, such
that you buy when the stock or
market reaches the level your work
suggested.

The best rule of thumb is

that if you feel confident you
are probably overconfident.
I have regular debates with
one of my colleagues on
this subject. He is a great
believer in having confidence
behind an idea. I am
much more skeptical. The
evidence is overwhelming;
we are generally massively
overconfident, so erring on
the side of caution makes
sense to me.
MOI: There appears to be a fine
line between confidence and
overconfidence. Can we ever make
the distinction a priori?
Montier: The best rule of thumb
is that if you feel confident you
are probably overconfident. I

Page 68 of 87

have regular debates with one of

my colleagues on this subject.
He is a great believer in having
confidence behind an idea. I am
much more skeptical. The evidence
is overwhelming; we are generally
massively overconfident, so erring
on the side of caution makes sense
to me. That said, investing is a
very fine balance between humility
and arrogance. You need a certain
amount of arrogance to be willing
to take positions that are contrary
to everyone else, but you must also
have the humility to keep looking
for the evidence that shows you are
wrong in your arrogance.
MOI: Never invest in something
you dont understand is one of
your seven immutable laws of
investing. How should investors
go about expanding their circle of
competence over time?
Montier: There is so much jargon in
finance that it is often hard to see
what is actually going on. I place a
lot of faith in simplicity, as Einstein
said if you cant explain it to a five
year old, then you dont understand
it. When making an investment you
should be able to understand the
basic idea behind the investment in
a few lines. One of my colleagues
who invests in distressed debt is
an expert at distilling the complex
into the simple. After all, in his
world everything is about the
detail, but when he talks to those
of us outside the area, what he
actually does is very simple, and the
investments he uncovers can be
explained in very simple terms.

best you can find. But above all

remember the overriding power
of simplicity. Never feel afraid of
asking a question, no matter how
daft it sounds. Confucius said, To
ask a question is but a moments
shame; to live in ignorance, that is
lifelong shame. In investing it can
be disastrous not to ask a question.
MOI: Aristotle has written, It is
the mark of an educated man to
look for precision in each class
of things just so far as the nature
of the subject admits You have
often talked about the dangers of
seductive, but irrelevant details in
modern risk management. While
researching an investment, when
should we say enough is enough?
Montier: It is easy to get suckered
into excessive detail in our industry.
Ive worked with analysts who can
take a computer apart in front of
you, and tell you what every little
bit does, but they dont have a clue
about valuing shares. In essence,
I believe most investors would be
best off thinking about the three
or four things they really need to
know in order to make a good
decision (such as intrinsic value,
margin of safety, an assessment
of fundamental risk) rather than
getting bogged down in the details.
However, to do this you have to be
prepared to say I dont know, and
that is never an easy admission. It
makes for very poor dinner party
conversations. But it allows you
to focus on things that will really
determine the success or failure of
your investment process.

MOI: How do you define good

investment judgment?
Montier: The longer Ive spent in
this industry the more I have come
to realize that common sense just
isnt so common when it comes
to investing. Good judgment really
seems to come hand in hand
with experience. For instance,
there was a great research paper
written by Stefan Nagel and Robin
Greenwood, which showed that it
was the younger fund managers
who really bought into the TMT
bubble, while the old grey beards
where much more skeptical. People
only really seem to learn when they
themselves have made the mistake
and accepted it as such. Ive spent
a lot of time trying to help people
learn vicariously, but nothing can
replace the power of lesson learned
the hard way.

I believe most investors

would be best off thinking
about the three or four things
they really need to know
in order to make a good
decision (such as intrinsic
value, margin of safety, an
assessment of fundamental
risk) rather than getting
bogged down in the details.

In terms of expanding the circle

of competence, learn from the
Page 69 of 87

MOI: Explain the concept of killing

an idea. What if you can conjure
up a scenario that would kill an
idea, but you conclude it is still a
good risk-reward is this ever be a
legitimate conclusion?
Montier: Killing the idea is an
attempt to keep confirmatory
bias in check. We humans have
a bad habit of looking for all the
information that shows we are
correct, rather than looking for the
information that might show we
are wrong. So Kill the idea for us
is when someone presents an idea,
the rest of us must try to spot its
weaknesses. Of course, few ideas
are so good that they cant be killed
in extremis. For instance, very few
ideas can withstand nuclear war!
However, the point of killing an idea
isnt that we wont put a position
on, but rather than we are aware
of potential weaknesses and have
tried to think of them ahead of time,
such that if they come to pass we
can react. It is perfectly legitimate
to kill an idea and then conclude it
is a good risk-reward, it just needs
to be sized appropriately. You dont
want all of your fund in such an
investment.
MOI: Investors often fall for
cyclical stocks exactly when their
valuations start to imply strong
growth far into the future. Why is it
so hard for investors to apply a high
multiple to trough earnings and a
low multiple to peak earnings?
Montier: The short answer is
human nature. The longer version
is that people like to do things that
are comfortable, and dislike doing
things that are uncomfortable. So

it is easy to put a high multiple on

peak earnings because everything
is going right in the world. However,
when the world is going to hell
it is hard to put a high multiple
on trough earnings (thats if you
can convince yourself that these
are trough earnings). People love
extrapolation and forget that cycles
exist. The good news is that you
get paid for doing uncomfortable
things, when stocks are trough
earnings and low multiples their
implied return is high, in contrast
you dont get paid for doing thing
that are comfortable.

it is easy to put a high

multiple on peak earnings
because everything is going
right in the world. However,
when the world is going to hell
it is hard to put a high multiple
on trough earnings (thats if
you can convince yourself that
these are trough earnings).
People love extrapolation and
forget that cycles exist.

MOI: What is the single biggest

mistake that keeps investors from
reaching their goals?
Montier: The most common
mistake I come across is the one
you alluded to in the previous
question, a habit I have described
as overcapitalizing hope. The sex
appeal of growth stories is another
prime example of this problem.
Growth is exciting and seductive,
it short-circuits our abilities to
rationally assess because it
appeals to the brains love of tall

tales. However, when one does the

analysis in the cold light of day,
the implied growth is often all but
impossible to achieve (and that
simply is to justify the current price,
let alone any increase).
MOI: In addition to your
books, investors may find your
commentaries on the GMO website.
What other resources on behavioral
finance or value investing would
you recommend?
Montier: If I had to suggest just
three value investing books I
would encourage people to go
and read Graham and Dodds
Security Analysis. it never ceases
to amaze me how few people have
actually made the effort to read
this foundational work. I love Seth
Klarmans Margin of Safety. It is
all about understanding yourself
and others and keeping it simple.
Howard Marks The Most Important
Thing is best modern book on
investment Ive read the insights
are timeless.
On the behavioral front Im a huge
fan of Dan Arielys books. Daniel
Kahneman has a book coming out
later this year, which Im excited
about.
A Selection of James Montiers
recent writings:
A Value Investors Perspective on
Tail Risk Protection
The Seven Immutable Laws of
Investing
In Defense of the Old Always
Is Austerity the Road to Ruin?
Strategic Asset Allocation Is Not
Static Allocation
Was It All Just A Bad Dream? Or,
Ten Lessons Not Learnt
Page 70 of 87

Guy Spier has been running Aquamarine Capital Management since 1995. Investors include friends and family, high net
worth individuals, and private banks. The fund has market-beating returns, and has received mentions by Lipper and
Nelsons worlds best money managers. The investees can be obscure or they can also be very well known. The fund has
also done well owning the shares of less understood, but very high quality, cash generative businesses.

The Investment Process

MOI: Your fund has outperformed
the market indices by a wide margin
since inception, posting a cumulative
net return of 115% from September
1997 through June 2009, compared
to cumulative returns of 9% for the
Dow Jones Industrial Average, 0%
for the S&P 500 Index and -13% for
the FT 100. Do you use short-selling
or leverage in the portfolio and how
concentrated is your fund typically?
Guy Spier on short selling: I do not
use short selling. The fund has not
shorted a stock since the 2002 to
2003 time frame. At that time I did
short three stocks, on which I broke
even on two and made money on
one of them. The experience taught
me that I was not going to be using
short selling going forward for a
slew of reasons. The first is the
straightforward logic of the matter.
The trend of the market is up, not
down. Shorting stocks puts you
against that trend and thus makes it
more difficult to make money. Other

than a time period like the one weve

gone through, short selling will tend
to be a difficult strategy to make
money with.

The trend of the market

is up, not down. Shorting
stocks puts you against that
trend
Second, the mathematics of shorting
when you short something and
it goes down, it becomes a bigger
and bigger part of your portfolio,
thus creating increasing risk as
things go against you, making it an
unbalanced and unstable thing to
manage. By contrast, when you go
long something and it goes against
you, it becomes a smaller and
smaller proportion of the portfolio,
thus reducing its impact on the
portfolio. So there is a tendency for
long positions to self-stabilize in a
certain way they have a stabilizing
effect on the portfolio, whereas short
positions have a destabilizing effect
on the portfolio.

This results in two things. First,

it means that if you are going to
short, you have to make each short
position a small proportion of the
portfolio. Most of the people I
respect who do short make their
short positions no more than 1% or
2% of the portfolio, which means that
in order to derive advantages from it,
you need to short a lot of stocks. The
other effect is that you have to be
super vigilant. When you have shorts
in your portfolio, you have to be
watching them all the time, looking
for indications of something that
will cause the stock to go up on you
many multiples and thus eat away
much of the value in your portfolio.
That is not the way that I want to
run money. What I found when I was
short the three stocks was that I
was doing things, and having to pay
attention in ways that I dont think my
brain is wired for. As you know, and
many of your readers know, much of
investing is finding a way to invest
successfully to play the odds which
are in tune and in congruence with

Page 71 of 87

Exclusive Interview with Guy Spier

the way your own nervous system
is wired. I think that there are some
people out there who have nervous
systems that are wired to do
shorting very well. I take my hat off
to them, but I am not one of those
people.
I would also add that short selling
falls into a category of trade that
Nassim Taleb has described very
well in Fooled by Randomness. It
has been described as picking up
pennies in front of a steamroller.
There are many trades that appear
to be profitable on a cash basis,
meaning that one can go for years
picking up the pennies, showing
an income, while pretending to
ones self, or ones risk managers,
or investors that the risk of a loss
on that trade is minimal to zero.
The practical reality is that one
can go for long periods of time on
those trades and can do just fine
until a big bath happens that eats
away all of the previous profits
that were gained. I would argue
that short selling is one of those
kinds of trades and the big bath
is exemplified by the experience
that people had in the recent
Volkswagen/Porsche pair trade.
The price of VW went up many,
many, many times and resulted in a
huge loss for the people who were

in that position, potentially wiping

out many years of shorting gains.
I see a lot of these kinds of
opportunities, and the right thing to
do is just to say no. I think one of
the hard things about these types
of trades is that they are extremely
attractive. They are dressed up
to look extremely sexy for the
kinds of people that are thinking
about investing in funds like mine.
I think that often investment
managers consider doing them not
because they believe in the trade
themselves, but because they know
it will be attractive to certain types
of investors who perceive the trade
as being smart. I think that the best
thing to do is walk away from them.

Guy Spier on leverage: I was

actually levered to 110% of the
value of equities, so 10% levered
in 1998, as I purchased more
securities during the Asian crisis. I
was very lucky, because everything
worked out for me and I made a
little bit more return as a result.
Since then, the fund has never been
leveraged for a very good reason.
Most of the people that you and I
know, the readership of your fine
publication, will be in trades that
will make them money provided
they can play out their hands.

short selling falls into a

category of trade that has
been described as picking
up pennies in front of a
steamroller.

We know that leverage can prevent

you from playing out your hand
because exactly the time when
markets go into crisis is when your
credit gets called. I am aware of
funds that had their credit lines
pulled at the most inconvenient
times and suffered catastrophic
losses which would not have been
suffered had their credit not been
pulled.

leverage can prevent you

from playing out your hand
because exactly the time
when markets go into crisis
is when your credit gets
called.

It is worth saying that except in

the case of a very large fund that
can arrange for some kind of
long-term loan from their broker,
the loans tend to be overnight.
You get money overnight and the
trades can usually be liquidated
within a very short period of time.

Page 72 of 87

Good investment ideas usually take

months, if not years, to play out.
I would argue that levering up an
investment portfolio, even if it is
composed of liquid securities, is a
profound mismatch of assets and
liabilities.
I think that the experience of Bear
Stearns and Lehman Brothers
exemplifies this case. They were
borrowing money short-term
and the investments they were
making were liquid, so from the
perspective of the lender they were
not bothered because they knew
they could force the brokerage firm
to liquidate in order to pay their
short-term funding. The reality was
that the bets that they were making
needed time to play out and to the
extent that those firms didnt have
the time to let those bets play out,
they suffered insolvency, and that is
not something that I am about to do
for my investors.
Guy Spier on concentration:
The portfolio was extremely
concentrated in that about six
positions were as much as 85%
of the total value of the fund. I
think that part of the reason for
my substantial decline in 2008
was the fact that risks that I was
not aware of cropped up in the
portfolio and impacted some
positions substantially. If I were
able to go back in time and look at
the information I had, I am not sure
I would not have owned the things
that I owned. However, I think
that one of the ways I could have
protected my investors from such
a substantial decline is to have
less concentrated positions. Going

forward a 5% position will be a full

position. An idea will have to be
something absolutely extraordinary
to become a 10% position and
many positions in the portfolio are
currently 2-4%.
MOI: When it comes to stock
selection, you have talked about the
importance of checklists. Why are
they so crucial, and what are some
of the key items on your checklist?
Guy Spier: Those readers who have
seen my two or three presentations
know that I have talked about
checklists. All of these ideas have
emerged from conversations with
Mohnish Pabrai, who noticed an
article by Atul Gawande in The New
Yorker with profound implications
for investors. Ill share the basic
insight that I have had as a result
of these conversations: I think that
we just have to acknowledge that
there are some individuals out
there I think Warren Buffett in the
investment world is one, Ajit Jain
in the insurance world is another
who have a very particular ability
to rationally analyze a situation in
spite of crazy things going on in the
world.

A checklist pulls us away

from the kinds of actions that
we would take if we were in
either fight-or-flight or greed
modes.

Most of us do not have that specific

wiring. In spite of that, we can still
improve our decision-making an
awful lot by using checklists. The
main way that I see it is that the
investment world, either by design
or by nature and I think it is a
combination of the two throws
up plenty of information that is
designed to trigger one of two
areas in the brain.
One is the threat detection fear
mechanism, which throws up a very
primeval response that has evolved
within us for a very long time. It is
one of the oldest parts of our brain
the fight-or-flight response. When
we see something that makes us
fearful, and we dont have time to
act, analyze and make weighted
judgments, we have to decide either
to run or to stay. We all know days
in the market where that part of an
investors brain is dominating and
in which share prices can move
around rather dramatically when
compared to what appears to be
very small amounts of news. So
that is one sort of mode that the
markets can be in, which is really
the psychological mode of the
majority of the participants in the
market.
Then there is another side, which
is irrational exuberance, as Alan
Greenspan has described it,
where the part of the brain that is
being triggered is, as Ive seen it
described in various articles, the
pleasure center of the brain. It
turns out that the part of the brain
we stimulate by the expectation of
future profits is not that far away
or dissimilar to the part of the brain

Page 73 of 87

that is stimulated, or lights up in

CAT scans, when cocaine addicts
either contemplate or are taking
cocaine. These are very powerful
centers.
Whether it is the fight-or-flight
or the expectation of pleasure
centers, the effect of both is to
short-circuit rationally considered
thoughts. They undermine the
path of the brain that can make
weighted, careful judgments
about probabilities and about
expectations. My perception is that
it is the rational neocortex from
which flow the very best investment
decisions. Unfortunately, the world
in which we operate is a minefield
of opportunities to get caught up
either by the fight-or-flight or by the
pleasure center. So to the extent
that somebody will talk about an
investment being good when one is
trembling with greed I would not
subscribe to that because trembling
with greed implies that your greed
and pleasure mechanisms in the
brain are dominating the rational
side.
I think that somebody like Warren
Buffett is naturally wired not to be
in either of those two extremes
and spends his time in the happy
middle. I think that what the
rest of us human beings can do
to train ourselves to be in that
happy middle is use checklists. A
checklist pulls us away from the
kinds of actions that we would take
if we were in either fight-or-flight or
greed modes. So that is the basis
for checklists.
The example I have given in talks is
an airplane that is crashing. There

is no question that checklists have

been extremely helpful in reducing
airplane accident rates. What it
does is it brings the brain back
to the place where one can make
rational decisions.

in terms of building
checklists, there is no question
that the place to go is past
mistakes.
MOI: What advice would you give
other investors on building an
effective checklist? Is it primarily
a product of past investment
experience, i.e., mistakes and
if so, how does one differentiate
between mistakes that should go
on the checklist versus others that
are simply unavoidable?
Guy Spier: Obviously, in terms of
building checklists, there is no
question that the place to go is past
mistakes. Not only ones own past
mistakes, but also to look at other
investors past mistakes and see
what those mistakes were. It seems
to me, and it is a process that I am
still going through, that the more
specific the checklist item is the
better.
I can give an example of an
investment that I made where
the CEO of the corporation was
going through a divorce a long,
protracted and bitter divorce. In
retrospect, when I look at what
went wrong in that investment, I
can see very clearly that the fact
that he was going through this
divorce meant that the CEO was
much less able to focus both on

the needs of the business and on

capital allocation decisions. His
whole investment, in fact, would
have gone to his former wife if she
had won the lawsuit. The whole
company would not have belonged
to him. So his emotional ties to
the company were predicated on
the outcome of the court case.
His desire to make money for the
companys shareholders would
have been hugely diminished if his
wife had ended up controlling the
company. So one of the items in
my checklist is whether the CEO
is going through major divorce
proceedings, in which case I would
tend to weigh that very heavily.
To give an example of checklist
items that dont come from
individual or personal mistakes is
the example of Coca-Cola and its
ownership by Berkshire Hathaway.
There was a period earlier this
decade when Coca-Cola was
trading at a multiple which was as
high as 40 to 45 times earnings.
We all know that Warren Buffett did
not sell. I think that there is at least
one statement in the public domain
where he said that if given the
chance to revisit that decision, he
would have sold Coca-Cola.

checklists are not wish lists.

I ask myself to what extent he was

unable to make that choice at the
time and execute a sale because
he had already made public
statements in the annual reports
and elsewhere that Coca-Cola

Page 74 of 87

was an inevitable and permanent

holding of Berkshire Hathaway.
Making such a public statement is a
very powerful driver of commitment
consistency bias, which may have
affected his ability to make rational
decisions.
So what would go on the list? You
would ask yourself the question,
Have I made public statements
about this? Obviously, the note
to self is, dont make public
statements about positions you
own that will predispose you
towards owning them or not owning
them or being able to sell them or
not.
There is another example from
Berkshire Hathaway, which is
the acquisition of Cort Furniture,
which did not turn out to be the
phenomenal acquisition that some
commentators suggested it was.
It seems that one of the reasons
is that Cort was in the business of
renting furniture to people who had
a temporary need. Cort benefited
dramatically from the Internet
bubble in which many companies
were setting up offices that needed
to be furnished rather quickly and
had large amounts of money to
spend. In the aftermath of the
Internet bubble, the demand from
that portion of the market was
extremely attenuated and Corts
earnings power was diminished
significantly.
The basic insight that seems
to have not been applied in the
Cort acquisition, which has gone
onto my checklist, would be, Am
I investing in an industry or a
company that is benefiting from

another industry that has just

experienced a dramatic boom?
Another way of saying the same
thing would be, Am I investing
while looking in the rear view mirror
rather than looking at the road
ahead? Whether they are yours
or somebody elses, I think that
mistakes are the most fruitful place
to look for checklist items.
It is important to note that
checklists are not wish lists.
Obviously, we are looking for
certain kinds of businesses and
certain types of investment. That
is what we are navigating for. The
checklists are very specific items
that are designed to bring our
brains away from the influence of
greed and fear. I would argue that
I am not sure a mistake that is
unavoidable is a mistake in terms
of your question. I think that there
are so many ways where one can
go wrong. In retrospect we can see
what we should have known. It is
hard to control for the unknowable,
because it is by definition unknown.
The more one can throw onto an
investment checklist, the better.
It is worth pointing out that no
investment is going to pass every
single investment checklist item.
What the investment checklist
will do is to throw up the issues
that one should be focused on.
Then an investor can try to weigh
them to decide if they negate the
benefits of the investment or not.
One of the things that the checklist
has done for me is to bring up the
basic question: Are we stretching
to make the investment? In this
way investing is very similar to

golf. In golf, one never hits a good

shot if one is stretching or pushing
oneself. The best golf shots come
when we are acting well within our
capacity. To that extent, a term
that I do not think should apply to
investing is, I spent time getting
comfortable. The investment
should leap out to you. If you are
trying to get comfortable with
something or it takes too long
for you to get comfortable with
it, then it is probably not a good
investment. You shouldnt have to
get comfortable. That implies to me
that I would be stretching.

no investment is going to
pass every single investment
checklist item. What the
investment checklist will do is to
throw up issues that one should
focus on
MOI: What is the single biggest
mistake that keeps investors from
reaching their goals?
Guy Spier: The biggest mistake is
when we as investors stop thinking
like principals. I think that when
we think as principals, when we
apply Ben Grahams maxim that we
should treat every equity security
as part ownership in a business
and think like business owners, we
have the right perspective. Most
of the answers flow from having
that perspective. While thinking
like that is not easy, and most of
the time the answers are not to
invest and to do nothing, the kind
of decision-making that flows from
that perspective tends to be good
investment decision-making.
Page 75 of 87

Ill just give you examples from

my own life and from people close
to me of the ways in which that
perspective can be deformed by the
environment and circumstances.
It can be deformed by having the
wrong investors investors who
see you, the investment manager,
as a proxy for their desires.
I had an experience with an investor
who was admonishing me for
holding too high much cash. The
investor claimed that they were not
paying me to hold cash balances.
Well, that created a pressure on me
to get fully invested. The person
making the investment wanted me
to show that cash was being put
to work. I was responding to the
situation rather than to the logical
and rational dictates of having a
prudent amount of cash. I was
responding to the actual demand
of the client. To the extent that I
did respond to that pressure, I was
acting less like a principal and more
like somebody that was putting
together a marketing story.
In another example, to the extent
that I have been associated with
the for-profit education industry,
I have received questions as to
why I dont market my fund as a
global education fund. Again, if I
were to do so, I would no longer
be acting as a principal trying to
maximize the return on investment
for my shareholders, but I would
be seeking to market the fund by
appealing to a particular niche
audience. That could result in
some substantial misallocations of
capital.

I think that this mistake comes

in varied forms and it influences
all of us. When we talk about
creating the best environment
for making investment decisions
a lot of that entails investing
within the right structure, the right
incentive structure. It also comes
from having the right investors as
partners and aggressively moving
away from and not engaging with
people who show themselves
to be the wrong type of partner
because they are focused on the
wrong thing. I think that everything
falls from having a principals
perspective.
MOI: How do you generate
investment ideas?
Guy Spier: My answer is all of
the above. The nature of a good
investment idea is that it puts
together new facts in old ways or
old facts in new ways. You need
to have the mental flexibility and
creative ability to see something
new and see why it fits together in a
certain way. I think that the answer
in my case is to look at everything,
to do everything in a certain way,
and to reserve a lot of time for
thinking.
I read other managers letters. I
look at the positions they own.
The lists of portfolio securities
that other managers own are
very useful because it means the
investment has already passed
a very important filter. I think
that whenever something in Seth
Klarmans portfolio is trading below
the price that he paid for it, it is
worthy of looking at, and at the
same time, it performs another

function. To get better at investing

you want to study the moves of the
masters.
I also read a number of industry
publications. The publications
vary at any time depending on
the particular industries that
I am interested in and what
subscriptions I have decided to
subscribe to. One subscription that
I have right now is to The Nilson
Report on the credit card industry.
Based on my interest in following
the U.S. banking sector I recently
subscribed to The American
Banker. I also recently subscribed
to The Oil and Gas Journal. These
are all interesting journals that dont
necessarily throw up investment
ideas per se, but they throw up
background information. While a lot
of this information is available on
the web, it is very nice to look at it in
the form of a publication.
So, wide reading, including the
daily newspapers, is important. I
like to screen for companies, but
increasingly I have found that your
service and other people present
me with screens that perhaps
provide a shortcut. Having said that,
it is also worth saying that I dont
think there is any shortage of ideas
for anyone who is interested in
investing. It doesnt take a moment
of browsing on the Internet before
you have 30 ideas to look at.

whenever something in Seth

Klarmans portfolio is trading
below the price that he paid for
it, it is worthy looking at.

Page 76 of 87

The real question is, as I look at

the ideas, why am I discarding
them and what personal biases am
I engaging in as I discard them?
I think something I have seen in
a number of portfolios, including
my own, is that the contents of
the portfolio are a reflection of the
particular biases of the person
running the portfolio. To the extent
that those biases or the model of
the world that person has is faulty,
it can lead to either phenomenal
returns if the stars are aligned or it
can lead to very bad returns if the
stars do not align.
As I look at other peoples
portfolios, I look to understand
what their biases are and what
particular chinks in their armor
they may have. They may have a
predilection for small-cap stocks
or they may have a predilection
for niche companies with niche
ideas. Ultimately, what I can say for
myself, I have had a bias towards
low-capital invested, high-ROE
businesses. In general, that is a
bias that has probably been very
productive. However, there are
environments, particularly the one
that we have just been through over
the past 18 months, where that has
probably hurt the portfolio more
than it has helped the portfolio.
So the way in which we go about
generating ideas is obviously both
important and critical and I think
that ultimately it is a journey to
explore our own personal biases.

Global For-Profit Education

MOI: Please share with us
your thesis on global for-profit
education. Which countries are
particularly good places to invest in
this growing trend?
Guy Spier: The thesis on the global
for-profit education business is
a very simple one. We have an
educational infrastructure whose
legacy was the industrial revolution.
This has been valid whether we
talk about China, Brazil, the United
States, or Western Europe. The
basic outlook was that the vast
majority of people being educated
would go to work in factories.
They didnt need more than a
certain level of education. These
educational systems would then
skim off the very best who would
go off to be lawyers, doctors, and
accountants white-collar suited
pen pushers.
The IT and post-industrial revolution
that we have been through and
continue to go through over the last
30 years has been one in which the
need for relatively low skill levels
has attenuated and the need for
people with high skill levels has
grown dramatically. Whether it is
people who can do research into
biochemistry and biotechnology
or whether it is people who are
developing gaming software for
the gaming industry. Obviously the
people who design computer chips
or computer programmers need to
achieve a certain skill level.
In every growing part of the global
economy, you have the need for
highly skilled workers, and the

infrastructure is just not set up to

generate the number of people
we need. For various reasons, the
private and the state sector are very
slow in responding to those needs.
What has jumped in to fill the gaps
are the for-profit institutions, which
are very responsive to the needs
of people who need to improve
their skill sets and to prove their
marketability in the workforce. That
creates the demand for education.
I should add that in emerging
markets the demand is dramatically
heightened by the fact that these
economies are trying to grow at a
rapid rate, and most of the growth
comes from the sectors which
require skilled people. I would argue
that in places such as China and
Brazil there is a dramatic shortage
of skilled people.

the need for relatively low

skill levels has attenuated
and the need for people with
high skill levels has grown
dramatically.

Then we come to the supply side.

It turns out that the supply of
educational services is profoundly
constrained for a number of
reasons. I think that this relates
to the work that I did in the credit
rating business, and there is much
that is similar. First of all, the
education business tends to be
highly regulated. In most countries
around the world, you cannot just
go and set up a post-secondary
college and expect to be allowed

Page 77 of 87

to stay in business. There are

regulatory requirements which
have to be met, and the tendency
in all regulated businesses is
that the leaders and the largest
companies tend to dominate the
regulatory process. There is a good
aspect to the regulatory process
in that it raises standards in the
industry and it ensures that you
do not have charlatans and fly-bynight companies engaging in the
industry. At the same time, it has an
anti-competitive effect. Now, from
the consumer perspective, that is
not good. From the perspective of
an investor in those industries it is
very good.

There are two final elements

to the thesis. First, the return
on investment to the student is
extremely high. This is something
that has been studied across
economies and has been shown to
be the case across many different
economies. The payback of any
degree, even if you spend $20,000
to $30,000 per year on a two-year
degree which is not as effective
as a four-year degree is usually
within two years. Somebody
earning $50,000 will end up, after
they have finished their degree,
earning $60,000 or $70,000. Thus,
they can pay off the cost of the
education very quickly.

The other side of the story, which is

not regulatory, is equally important.
There is a reputational and
branding effect which takes place
when an educational institution
has been around for some time, in
which the very fact that you have
attended and studied at a certain
place gives you credibility in the
marketplace. There are a limited
number of brands that people can
carry in their heads. We all know
that when it comes to the United
States, it is extremely unlikely
that any university would displace
Harvard, Yale, or Princeton. This
branding effect also extends to the
kinds of colleges that are offering
for-profit degrees in that when they
establish a brand, it becomes very
marketable. The students who
are going for higher education
to improve their skill sets are not
going to attend any institution. They
are going to attend an institution
with a good brand.

The ROI on a degree has not been

definitively studied, but I estimate
to be well in excess of 50%, and
the institution is only capturing a
small proportion of that return on
investment. Then when it comes
to the institutions themselves, it
turns out that you can have very
high operating leverage, very high
returns on invested capital, and
very high returns on equity in
these businesses because your
customers benefit and because
there are barriers to entry, both
regulatory and other. That means
that if you are established in the
business, you can make very
high returns. The key is to buy
these companies at reasonable
valuations and to buy companies
that dont run into regulatory
problems that have a long hill to
slide down.

[Regulation] raises standards

in the industry and ensures that
you do not have charlatans
and fly-by-night companies
engaging in the industry. At
the same time, it has an anticompetitive effect. From the
consumer perspective, that is
not good. From the perspective
of an investor in those
industries it is very good.
MOI: Do U.S. giants such as Apollo
Group have a chance of becoming
leaders in overseas markets, or
do you expect locally grown
companies to dominate?
Guy Spier: I should say that I have
not been particularly focused
on the U.S. for-profit education
sector, even though it is the most
developed in the world, because my
perception is that the companies
have had extremely rich valuations.
I also think that since the U.S.
market is so large and so full
of opportunity, the majority of
companies have focused, probably
rightfully, on the domestic market.
The result has been that the
international markets have been
wide open for other companies to
pursue.
I can think of at least one non-U.S.
company that has a substantial
chance of becoming the dominant
player in the for-profit industry over
the next 20 or 30 years. But there
are some very good United Statesbased companies that I believe will
do extremely well. I have visited the
operations of Laureate Education
[taken private in CEO-led buyout
Page 78 of 87

in 2007] in a number of different

countries. They do an outstanding
job of running a campus and they
also have a global vision.
I think that another company that is
developing steadily internationally
is Kaplan of the Washington Post
[WPO], although they have been
slower than Laureate to move
internationally. The Kaplan testing
service exam preparation service is
already very international, so they
have a good basis upon which to
expand their operations.
A third company, DeVry [DV],
has started to gingerly expand
into international markets. They
recently bought a company in
Brazil and they have had their
international medical school,
Ross University, which is based in
Dominica. They also have means
for exploring expansion through
Becker Review. The guy who runs
international development is named
Sergio Abramovich, who is a very
interesting guy to get to know. So
they are developing, but I would
still argue that all those companies,
except for Laureate, are very much
American in their focus and that
creates great opportunity for nonAmerican companies to pursue
international opportunities.

for-profit education providers

have enjoyed significant
pricing power. [] education is
a fantastic example of a Giffen
good.

MOI: For-profit education providers

have enjoyed significant pricing
power despite the fact that many
companies derive a majority
of revenue directly or indirectly
from government-supported loan
programs. Do you expect tuition
price increases to continue to
outpace inflation?
Guy Spier: It is true that the forprofit education providers have
enjoyed significant pricing power.
It is worth saying, as an aside, that
education is a fantastic example
of a Giffen good. Those of us who
are economists will know that a
Giffen good is something where the
higher the price goes, the more we
want of it. Examples usually given
are luxury goods such as a Rolls
Royce or a Rolex watch. Warren
Buffett, in his own inimical way,
has described this as when you go
and buy a diamond ring for your
fiance. You dont want to come
home and say, Honey, I took the
low bid. That is true when it comes
to certain brands of chocolates, it is
true in the case of high-end jewelry,
it is true in the case of certain
luxury goods, and it is also true for
education. It is true in any place
where price becomes an indicator
of value. Where someone is
engaging in a purchasing decision
where there is a huge amount of
uncertainty, they dont know much
about the product they are buying,
and they very much want to get it
right. Price becomes one of the
ways in which you discern that
a purchasing decision is a good
thing. This creates an incredibly
strong business advantage for
companies and enterprises that are
leaders in their field.

I have absolutely no doubt that

the Harvard Business Schools of
the world will continue to lead the
industry in terms of price increases.
As more and more people get rich
around the world, they will all want
elite educations. So as long as
there is an increase in demand for
their services, as there is today, the
Harvard Business Schools of the
world will be able to increase their
prices at a greater rate than the
rate of inflation. Those elite private
universities create the pricing
umbrella for the for-profit industry
to move underneath. So if Harvard
is raising its prices 10% per year, it
is perfectly possible for a for-profit
university to raise its prices 5% or
6% per year, and I absolutely expect
them to do that.
It is true that much of the revenues
in the United States come from
government-supported programs,
but ultimately the decision to
take on the debt and the decision
to attend an institution is taken
on by the student themselves. If
the companies were pricing their
education above the value that
their educational services would
deliver to the student, then one
could expect that the price rises
would not continue, but that is
not the case at all. In fact, studies
would suggest that the value of an
education is going up, not down.
One of the statistics you can look
at to support this is to look at
different economies and look at
their salaries per degree. What
is the salary of the non-college
graduate workers? What is the
salary of a college graduate?

Page 79 of 87

What is the salary of a masters

degree graduate? The gap between
educated and non-educated is
increasing. In a knowledge-based
world, degrees which help you work
with knowledge become more
valuable because you can add more
value in the workplace. Therefore,
the people who are offering these
degrees can charge higher prices.
I dont expect that process to end
any time soon.

International Investing
MOI: You have invested globally for
a long time what are the main
pitfalls to global investing and how
big a role do transaction costs play
when investing locally in emerging
markets?
Guy Spier: I have been investing
internationally for a very long time
since I started investing. The main
insight I would pass along is that I
try to see the world as borderless.
I think this is a better way to see
things. I am not too concerned
as to where a company is based.
I am more concerned to find the
business qualities that I need to
find in order to make an investment.
While it is easier in the United
States, I think that an investor is
crazy to stop the search for great
investments at the borders of the
country that they happen to be
living in.
I think that the most profound
pitfall and thing that one has to
get over when investing beyond
your borders is not to take the
conditions that exist in the home

investing country and assume

that the same conditions exist in
the country where the investment
is being made. I have seen that
going both ways. From the United
States investing out, there are
assumptions that investors have
made about how the managers of
the foreign company will allocate
capital. There are also assumptions
about what kind of standard
managers hold themselves to. Not
all managers of companies want
to be remembered for being the
best capital allocators. In some
countries, being rapacious and
greedy is considered a normal
standard. Russia might be an
example of that. At the same time,
there are some countries such as
Switzerland, where I would argue
the ethics of drawing a modest
salary and really acting for best
interest of the shareholders are
possibly even higher than the very
high standards that already exist in
the United States.
The reverse is also true. For
example, Korean investors think
that the United States is a very
risky place to invest because they
make assumptions about the
way Americans act. I think that
the key danger is that we make
many assumptions that have to
be checked and revised. One of
the ways to do that is to spend
some time in the country where
the investments are being made.
One of the rules that I have is that I
want to be able to read the source
documents in the language in which
they are produced. I think there is a
lot of subtlety that is missed when
one reads a translation.

Transaction costs in international

markets have been going down
over time, so I dont think that they
should be a big concern. I have
been a buy-and-hold investor, and
my average holding period is in
excess of three years. To the extent
that the transaction costs a bit
higher, it has not been a deterrent
for me.
MOI: Is globalization irreversible?
Guy Spier: The global economic
downturn has made protectionism
more popular. We absolutely know
that. We see that in a number of
different ways, and we all know as
free traders that this is unfortunate
but true. The anti-globalization and
the anti-world trade movement is
a strong movement. People who
feel like their jobs have been lost
and their livelihoods have been lost
to workers from other countries
have a specific and very genuine
grievance which is something that
all globalizing economies have to
deal with.
To deal with it doesnt mean to
ignore it. To deal with it means
to find a way to buffer the effects
of the jobs of these people going
overseas. Of course, in theory a
laid-off autoworker can become a
creative web designer. However, the
truth is that a laid-off auto worker
may only be good at making cars.
I have absolutely no doubt in my
mind that this is one of the reasons
why we pay taxes to ensure that
people who are laid off through
globalization have opportunities to
retrain and have opportunities to go
into new professions and new jobs
and be productive human beings.
Page 80 of 87

In terms of whether globalization

is irreversible, I would argue
that it is absolutely irreversible
in the same way that the phone
created irreversible changes, and
the Internet created irreversible
changes. I would argue that much
of what is driving globalization
is actually the implementation
of these new communications
technologies around the world.
One great example that I heard
was of the remote Indian village
in which there are no telephones.
One day you install one telephone
and the effect of that telephone
is profound even though there
is only one. Suddenly farmers
can phone hundreds of miles
away and discover the prices
for their produce at markets.
Suddenly, middlemen have a much
diminished opportunity to engage in
taking middleman profits. Farmers
are able to discover weather
patterns and storm fronts and thus
plan when they plant and how they
manage their fields. It is the subject
of a talk that I have given. Once
you have that convenience, you are
not going to give it up at almost
any price. Once you have lived in
a concrete and steel constructed
house, you are not going want
to go back to living in a mud hut.
Once you have had the benefits of
speaking on the telephone to your
loved ones, you are not going to
want to go without that.
I would argue that globalization
is inevitable and irreversible. It is
similar to thinking that southern
Manhattan once had fields and
crops planted there. Over time there

was an increased concentration of

offices and residential activity in
southern Manhattan, and the fields
moved away from Manhattan such
that you dont have any planted
fields within at least a ten-mile
radius of Manhattan, let alone
southern Manhattan. The process
by which southern Manhattan
developed was inevitable and
irreversible. Much as the probability
that southern Manhattan would be
ploughed over and turned into fields
is extremely low, I would argue that
the probability that globalization is
reversible is equally as low.

globalization is irreversible
in the same way that the phone
created irreversible changes,
and the Internet created
irreversible changes.

And Finally
MOI: What books have you read
in recent years that have stood
out as valuable additions to your
investment library?
Guy Spier: I sent Alice Schroeders
book7 out to a bunch of investors.
I think that it is a very valuable
book to read. I know that it has
been controversial, but setting that
aside, I think that Alice probes into
aspects of Warren Buffets mind
and psyche to reveal more of his
personality with all of the foibles
of the human being behind Warren
Buffet.

For those of us that are big Buffett

fans, that is a huge advantage. It
helped me to understand why I
am different than Warren Buffett.
I think it is a valuable read in that
regard. It helps to place his mind
in the center of the decisions he
has made. The book lets you look
at the kind of emotional life that
Buffett had growing up. I do not
think his phenomenal track record
could have come about without that
emotional makeup.
There are three books that I
have read not so long ago on
complexity theory. I think that they
are extremely valuable. One is by
John Gribbin.8 Even though I studied
economics and I felt I had a good
grasp of the kind of economics
taught academically, I feel that
the study of complexity theory
as applied to the global economy
is actually a much better model
for understanding how the global
economy evolves.
One of the books is by Benoit
Mandelbrot 9 who is famous for
the Mandelbrot set. He also wrote
a book about the fractal nature
of financial markets. Mandelbrot
is obviously a very modest guy
because his fractal approach to
financial markets predicts that
sooner or later something like what
happened over the last 18 months
was going to happen. Unlike other
commentators, who get in front of
the TV cameras and say I told you
so, he has not done that. He is a
true scientist.

Page 81 of 87

by placing an area to
play bridge right outside of
Borsheims, Buffett is saying
that bridge is more than just a
great game it is something
that has really helped him
develop his mind.

that has really helped him, I believe,

develop his mind. I think it can
develop all of our minds in a way
which is helpful to investing.
MOI: Guy, thank you very much for
taking the time to interview with us.
We remain indebted to David M.
Kessler for transcribing the interview

Lastly, an investor of mine gave

me one of the two books by Atul
Gawande who is focused on
the very small things that make
hospitals better. One of the books
is actually called Better. The other
book is called Complications. Atul
Gawande gives a sense of how you
can be extremely knowledgeable
and totally focused on the right
outcomes and still fail by a wide
margin to get close to the ideal that
you would like. Of course, this has
massive lessons for investors.
I recently took up bridge, so I
have been reading a lot of bridge
books. I am looking forward to
going outside Borsheims at the
next Berkshire Hathaway meeting
and playing bridge with whoever
is willing to play me. I dont think
that it is a coincidence that Buffett
chose to put an area to play bridge
outside of Borsheims rather than
chess or table tennis or any one of
a number of other things. It is not
just that Buffett likes bridge. He
likes an awful lot of things. I think
that he is sending a message, in
his inimical way, which is not to
force it down anyones throat. But
by placing an area to play bridge
right outside of Borsheims, Buffett
is saying that bridge is more than
just a great game, it is something

John Gribbin: Deep Simplicity: Chaos

Complexity and the Emergence of Life

(Penguin Press Science).
9

Benoit B. Mandelbrot: Fractals and Scaling In

Finance: Discontinuity, Concentration, Risk.

Page 82 of 87

Amit Wadhwaney is the co-founder of Moerus Capital Management and has managed foreign stock portfolios since 1996.
He has been particularly interested in emerging economies where he has long believed that market inefficiencies favor
bottom-up value investors. Amit formerly was a founding
manager of the Third Avenue International Value Fund as well as the Third Avenue Global Value Fund and the Third Avenue
Emerging Markets Fund. Earlier in his career, Amit was a securities analyst and subsequently Director of Research for
M.J. Whitman. He holds an MBA in Finance from the University of Chicago, a B.A. with honors and an M.A. in Economics
from Concordia University in Montreal (where he also taught economics) and B.S. degrees in Chemical Engineering and
Mathematics from the University of Minnesota.

The Manual of Ideas: How do you

approach Japan? What is different
about your approach and why do you
see value in Japan?
Amit Wadhwaney: Now, a couple of
things. Japan, if you were focused
on safe and cheap and forgot about
everything else your portfolio would
have nothing but Japan in it. It is
very, very cheap. Numerically its very
cheap. And companies are often
flush with cash. It is neglected, it
is disliked, it meets many of these
criteria that draw people some
would say suckers like us. Theres
a whole collection of value investors
there gnashing their teeth and
wondering, what is it that we do and
have done?
First, before last year, before 2011,
disproportionally to my mind value

existed in the domestic companies

disproportionally, by a big margin.
Exporters were battle-hardened.
Locally, Japanese companies have
been constantly coddled, and the
local companies tend to operate
quite differently.

if you were focused on

safe and cheap and forgot
about everything else your
portfolio would have nothing
but Japan in it. It is very, very
cheap.
So our focus was on domestic
companies. They all met the safe
and cheap criteria. Now, the question
of course you ask is after some
years of requisite impatience and
nothing happening, how are we

going to make money here? Thats

the question everybody asks. So
having been worried about that
same question some years ago
earlier, having watched you must
understand, my history with Japan
goes back to the early to mid 1990s.
And Japan has been a place where
you invest and you wait and wait
and wait and suddenly make money,
lots of it and very fast. Its always
been this sort of hockey stick
phenomenon. Its like watching paint
dry.
Now, this time may be different. I
dont know, I cant tell you. But the
way Ive approached this is you buy
things, you put yourself in the path of
some kind of change, change which
may come from the companies
themselves doing the right sort

Page 83 of 87

Exclusive Interview with Third Avenues Amit Wadhwaney

of thing. So we dont buy perfect
companies. Let me be very clear
about this. Are these great capital
allocators? Often not.
Let me give you an example of
one of our holdings which we
have, which has done everything
right except for one of the most
important things. Mitsui Fudosan
[Tokyo: 8801] is a magnificent real
estate company, almost near trophy
real estate. A great balance sheet,
growing the top rapidly. Its building.
Theyre building buildings; theyre
doing all the right sorts of things.
However, whats the rub? The rub
is the following. Youre building
buildings there with cap rates of 5%
when you can repurchase shares
at high single digits like 9-10%. To
my mind its not a very big leap of
imagination that gets you there. Yet,
for the last number of years they
visited us here, for the last number
of years we asked them, Why do
you not do that? They said, No, no,
no, we have to grow the business.
So the business is growing. It is
cheap. And it may stay cheap for
a while. However, value is building.
We are waiting for the lightning bolt
to hit there.

MOI: So what do you say to people

who when you tell them about your
approach to Japan and then they
say, Well, yes, I get what youre
saying but how do you get over this
corporate governance?
Wadhwaney: Please. You have
terrible corporate governance in
other places, too. Japans been, I
think, singled out. Japan has been
pushed into a crisis. They will
change. They will change. Japans
response to the tsunami and
Fukushima was shockingly slow.
Youre actually seeing change, I
think, flowing from that now. Im
a patient investor. Again, we dont
have a huge amount in Japan.
Some people are very Japan
sensitive so they wont buy it if you
have an index rating. Again, we
bought what we could buy which
was interesting to us. We are very
patient. We are seeing industries
reconfigure, restructure themselves.
We are seeing gradually eke out
more and more and more.
The response of Japanese
companies has not been entirely
irrational. For example, for
companies to hang on to cash
in a period of deflation is a very
rational response. Its a logical
safety blanket. Logical, completely
logical. Because it enhances

the probabilities of survival. And

they did that. They have very
conservatively figured balance
sheets to cope with this kind of
deflation, the spiral the country
went through. They also worked
hard on their costs. Theres a lot of
good thats gone on in the process.
The arguments against Japan
revolve around the lack of M&A
market. Because if there was a
very active M&A market you would
seriously start to see a change
happen in terms of valuations being
recognized.

For example, for companies

to hang on to cash in a period
of deflation is a very rational
response. Its a logical safety
blanket. Logical, completely
logical.
MOI: So this argument about
corporate governance then in your
view does not reflect the specific
opportunities that often pose
exceptions to that overall negative
view?
Wadhwaney: Oh yeah, theres lots
of reasons to avoid Japan. Lots of
reasons, heavens. The graphics,
the slow responses to crises, the
civic economics. Maybe civic
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economics. A lot of stuff that they

could do. A lot of the damage is
self inflicted, quite clearly. The lack
of active M&A market. But by the
same token the steps are slow
baby steps, evolutionary steps is a
culture not characterized by a lot of
people wish to be outliers in their
conduct.
Let me tell you yet another worry I
have. Japanese companies being
increasingly seized by the fear that
Japan is so permanently ex-growth
given the fact that there are too
many of these cash balances,
given the fact that there are fewer
and fewer growth opportunities
in Japan, we start making crazy
acquisitions outside Japan at
very high prices. That is, for me, a
much more scary thing than the
other ones you mentioned so far.
That scares me because Japanese
companies historically have not
been the stingiest of acquirers.
They have not been willing to
engage in some knock them out,
drag them out, got to fight to save
the last nickel. They just have not.
They dont have it in them. They
prefer to be viewed as friendly.
Friendly takeovers sometimes are
expensive takeovers, unfortunately.
MOI: Now, some people would also
say that if they can get over the
corporate governance then often
would cite it as but its bad, there
are graphics and the economy. How
do you perhaps realizing that that
doesnt present a hurdle for you,
how does that perhaps filter down
to the selection of the specific
companies? So Im thinking are
there any themes in terms of more

export-oriented companies, more

certain sectors? How does that
enter if at all?
Wadhwaney: Well, the hurdle of
getting into Japan is overcome by
looking at two times earnings for
companies. Id rather be two times
earnings for companies. Insurance
companies, I used to certainly
love the idea of owning insurance
companies at fractions of book
value, fractions of embedded
value, as opposed to buying them
at multiples and multiples of book
value in China because China had
growth, this had none. So thats one
hurdle. I have a much bigger hurdle
to deal with in the case of these
growth markets, or at least once
growth markets. They are repricing,
too, as they should.
I wouldnt say export companies
have particularly been a theme
for us. The most recent purchase
of ours actually two of them
would be Daiwa Securities [Tokyo:
8601] which was largely domestic.
In fact, unlike Nomura, they have so
much smaller global ambitions so
theyre not going to do silly things
like buy Lehman Brothers and then
find out everybody runs away after
they buy them and stuff like that, all
that stuff. Theyre much more local,
theyre much more focused on
things like their asset management
business locally. That gives me a
source of comfort.

multiple of operating earnings,

which it has grown over the years.
This is a company which is a
systems integrator. Its a company
which is kind of like Ingram Micro
in the U.S., for example. Theyre
very big, very big. And Japan has
been itself a slow innovator in
terms of its installed computer
base. Its much, much, much
slower. Theyre very good at what
they do. Its a company which was
set up by a Ricoh copier repair
guy who basically got into these
and saw this huge opportunity to
help automate, modernize small
to medium enterprises in Japan
which were very, very slow. Theyve
actually been growing and growing
very rapidly at the expense of
the mom and pops. And even in
this horrible market theyve been
growing rapidly.
The surprise what probably will
surprise people more is the rate
of earnings growth happening in
Japan. Thats not what we focused
on. We focused on cheapness,
bought our stocks and what
happens, happens. Im incapable of
forecasting the future.

A company we bought,
Otsuka [Tokyo: 4768].
Otsuka trades at a very
modest multiple of operating
earnings, which it has grown
over the years.

So companies that have really

narrowed their focus, where theyre
very good and very big players, is
of some interest to us. A company
we bought, Otsuka [Tokyo: 4768].
Otsuka trades at a very modest
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