We’ve just been reading through the latest issue of the Graham & Doddsville newsletter featuring a great interview with Mark Cooper and Bruce Greenwald. Mark Cooper is a co-portfolio manager of the International Small Cap Value strategy at First Eagle Investment Management. He’s also one of Greenwald’s former students and current collaborators.
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During the interview Greenwald discusses the difficulty of identifying real compounding businesses today, how his investing philosophy has changed over the past 20 years and, his thoughts on whether it’s possible to teach someone to be a good investor.
Here is an excerpt from that interview:
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Klarman On:
- Bitcoin
- The danger of Chinese leverage
- Discipline while value investing in bubby times
- Value investing is not dead
- Radicalization of politics
- Dangerous FAANG valuations
Mark Cooper: I have another question for Bruce. There’s been a lot of talk in the last 10 years of platform companies and compounders. Earlier, you mentioned that we are seeing more and more of a companies value tied up in future growth. Does it worry you that many investors see themselves as the next Buffett and think they can identify these compounders?
Bruce Greenwald: I think the real test of people who understand compounders is whether they understand that you can’t put a value that’s reliable on a compounder. That the discount rate (r) and the growth rate (g) are too close together when analysts try to estimate terminal value in a DCF. So when you try to select a multiple for that compounder, you really can’t do it.
So, you’ve got to do a calculation of returns. All the return calculations people use are basically dividend discount models, just rearranged. Return (r) = Dividend (d) / Price (p), or the cash return, + Growth (g).
There’s an implicit but missing term here. g is not simply the nominal growth in cash flows, it is the growth in value. To anchor that g, we must multiply it by intrinsic value v and then divide it by market price p. So r = d/p + g(v/p). That is to say, our returns from growth will be greater if we buy the business at half intrinsic value (v/p = 2).
The problem is that at crazy valuations, p is going to be much greater than v. So g may be 20%, but if p is three times v, then we’ve effectively cut our return from growth down to 20/3 = 6.66%.
You have to be very careful about this calculation. I don’t think most of these people who talk about compounders are careful in that way. You have to look at where growth really creates value. That means verifying the franchise, looking at the quality of the capital allocation and so on. Just because a business is growing quickly nominally doesn’t make it a real compounder.
Mark Cooper: Disruption is a common narrative in many industries these days. What industry challenges make identifying great investments more difficult for value investors?
Bruce Greenwald: The hardest challenges are not industry challenges, because where industries are a challenge, it’s almost always where somebody like Amazon has come in and grabbed share.
Well, if somebody can come in and grab share, it’s not a stable market yet. In disruptive industries, before the disruption settles down, there are not going to be barriers to entry because the customers are not going to be captive since the product is changing so much. And the market is going to be changing so much that it’s very hard to secure scale.
If you’re disciplined enough to stay away from the difficult industries in the world, I don’t think industry challenges are the problem. The real problem is management challenges.
You can find what looks like a good company—with lots of assets, earnings, and potential earnings—at a cheap price, and the management can still kill you. An example of that was Dell. Dell was trading at a 20% earnings return. Yes, it was maybe shrinking at 7-9% a year, but the decline wasn’t going to accelerate, so it was still a good return. But CEO Michael Dell was taking 80% of the earnings and trying to buy his way into businesses he was never going to get into. He was destroying 80% of the 20% earnings return, on top of which you have a business that’s shrinking by 7%. It was just not a happy outcome. So, I think the hardest thing for people to get their heads around is management and what they can do to you.
Especially if they don’t understand where their competitive advantage in business is. When that plays out, a guy who used to be a good manager, like Michael Dell, is not a good manager while the industry changes. Now, even as I talk about that I think I’m learning something from it. It’s the interaction of the management with hanging circumstances that’s hard to chart.
Mark Cooper: It’s impossible to successfully and consistently predict.
Bruce Greenwald: Right, and most start reacting badly and trying to buy their way into [other businesses]. A lot of the PC companies did it. They said, “Oh we’ve got a lot of business customers. We can become SAP or Oracle.” They wasted an unbelievable amount of money.
Mark Cooper: What about your investing philosophy has changed the most over the last 20 years?
Bruce Greenwald: Oh, nothing at all. My favorite book to recommend is Jane Austen’s Pride and Prejudice, because it’s about self -awareness. I have learned what it takes to be a good investor. And I have learned that I do not have that kind of character.
I know what my mistakes are. I’m always trying to be the smartest guy in the room, and it’s really dumb. The last time I made that mistake was when I invested in Deere stock. I wanted to absolutely bottomtick it. I wanted a $70 average cost.
I initially bought a big position at $75, but then the stock went up to around $80. I knew I should buy the last 80,000 shares of Deere at this price, but I stopped buying because I said, “Oh, I’ll get it at $70 or $75.” So, I didn’t fill the rest of the position despite the fact that I thought it was worth $150 to $200.
Mark Cooper: If you’re correct about the fair value, then buying at $75-80 doesn’t matter.
Bruce Greenwald: Yeah, we weren’t going to lose any money with that one, but still I couldn’t bring myself to do it. You are who you are. That’s why I’m not really a professional investor.
Mark Cooper: How teachable is being a good investor?
Bruce Greenwald: I don’t think it’s teachable. That’s my lesson. When you’re a kid, the way you think you’re going to make money is that you’re going to guess the cycle. You’re going to guess oil prices better than other people guess oil prices. You’re going to speculate on the future, and good investors don’t speculate on the future.
They look at, for example, which oil companies have good capital allocation, because the amount they spend on exploration and development dwarfs what their profits are.
I would say that for 80% of my students, it’s all about: “What’s the price of oil going to be,” or, “The cycle is going to turn and I’m going to catch it just right,” or, “This new manager, who has no track record, is going to turn this company around and we’re going to get in there first and make money.” Despite what we teach them, it’s very hard to be disciplined enough to stay focused and say no.
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