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The Manual of Ideas: Top Ten Interviews of All Time
Dear Reader,
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Shai Dardashti
Managing Director
Exclusive Interview with
61
Exclusive Interview with
3
Charles de Vaulx
Exclusive Interview with
26
Pat Dorsey
Exclusive Interview with
37
Tom Gayner
Exclusive Interview with
43
Joel Greenblatt
Exclusive Interview with
45
Howard Marks
Exclusive Interview with
55
Michael Maubossin
Allan Mecham
Exclusive Interview with
67
James Montier
Exclusive Interview with
71
Guy Spier
Exclusive Interview with
83
Amit Wadhwaney
4 ofPage 87
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 Morningstar’s “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
Master’s degree in finance.
The Manual of Ideas: It’s 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.
Prior to that, from age five to twelve-
and-a-half, I was living with my
parents in Johannesburg, South
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.
5 ofPage 87
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.
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 investing-
the 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.
MOI: How did working with Jean-
Marie 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, it’s 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. You’re
supposed to have conviction, go
for it.
6 ofPage 87
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.
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
it’s Japan in the late ‘80s, or TMT
stocks in the late ‘90s, or financial
stocks in ’06-’07. It’s important to
note that diversification is okay as
long as it has nothing to do with the
benchmark, as long as you’re 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 it’s 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 don’t feel you need to
know everything. I think we showed
over time that our estimates of the
intrinsic values of the companies
we’ve owned have been quite
accurate. The reason is that even
though we’re not catalyst-driven,
it just so happens that on average
maybe 15% of the stocks we’ve held
for many years have been taken
over. Through all of these takeovers
we’ve 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 there’s no
need to know every detail, rather
there’s a need to understand the key
three, four or five factors affecting
the company.
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.
It’s okay to consider bonds - high-
yield corporates and Treasuries
(when they yield 15% and when
they are labeled Certificates of
Confiscation – that was the term
in 1982). It’s okay also to consider
bonds to try and get equity-type
returns. It’s okay also to have cash
– cash as a residual, not as a way
to time the market. If you cannot
find enough cheap securities, it’s
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 ain’t telling
us”, so why waste time trying to
guess next year’s 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 Grant’s
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 pervasive—debt at the
corporate level, at the household
level, at the government level. I
think being mindful of those credit
cycles made him understand that
7 ofPage 87
We own a billboard
advertising company in
Switzerland called Affichage
[Swiss: AFFN], and it’s quite
small.
…our portfolio today is truly
eclectic and multi-cap. Of
course, if you look at the top
ten holdings you’ll 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
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, I’ve appreciated that
Jean-Marie understood that it
was wrong to forecast. You’re
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, Jean-
Marie 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 I’ll 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 you’ll 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 don’t 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 it’s quite small.
the next year or two or three or four.
So it’s short-duration, high-yield
corporates. The yield is not huge.
Today, we’re talking about 4%, but
these are what we deem extremely
safe instruments and because the
duration is short, there’s no interest
rate risk there.
You also will notice the eclectic
nature by the fact that we have
some sovereign debt, and it’s
approximately 5.1% of the portfolio.
It’s 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 doesn’t
have much of a fiscal deficit,
there’s not much of a long-dated
government bond market to begin
with.
You’ll 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 gold-
mining 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. It’s been a great move! We
own a few gold mining shares, but
it’s really de minimis and only in our
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 ’08-
’09. So, as a result, many of these
bonds will be maturing shortly in
8 ofPage 87
Another negative bet you’ll
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
what’s going on in China.
U.S. registered mutual funds. Our
preference remains, by far, towards
holding gold bullion.
You’ll 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 we’re 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, you’ll 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 it’s 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 you’ll 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 what’s 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. We’ve 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
what’s good for Brazil Inc. as
opposed to doing what’s right for
the company’s shareholders.
Also, we worry about what’s going
on in Europe. We’re not sure what
the outcome will be. It’s a big
unknown and the way we express
our skepticism towards what’s
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.
Conversely, let’s 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
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
it’s 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 what’s going
on has already been priced in.
9 ofPage 87
I’m obviously very familiar
with the expression “buy-and-
hold” and that expression,
frankly, makes me cringe. I
don’t think it belongs to the
lingo that value investors use.
Value investors know about
price and value.
MOI: In your Owner’s 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?
de Vaulx: Let me start with the
second part of the question. I’m
obviously very familiar with the
expression “buy-and-hold” and
that expression, frankly, makes me
cringe. I don’t 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.
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 company’s 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
it’s 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
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 ago—Montgomery Ward, J.C.
Penney [JCP], Sears [SHLD]—none
of these names are truly relevant
today. Nothing’s permanent.
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 there’s a lot
more debt in the system than in
the past. We’ve seen the global
nature of banks. A good example
of this is the paradox of what’s
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.
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 it’s important, especially
from a qualitative standpoint,
to look at the past ten years’
earnings, but it’s always important
to be mindful that businesses may
change and sometimes for the
worse. Technology, the internet,
has revolutionized what’s 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 question-
I’m intrigued that very few value
investors ever comment on
portfolio construction, in particular
…understanding correlations
is very important, especially
in a global world where
there’s a lot more debt in
the system than in the past.
We’ve seen the global nature
of banks.
10 ofPage 87
Another thing that’s not discussed
enough is position sizing. I think
I’ve made my point about us not
being big fans at all of running
concentrated portfolios. I don’t
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
there’s 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 it’s 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 that’s at the
expense of the company.
It’s 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
di”wors”ification, 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 don’t 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 don’t 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 there’s no requirement to
be fully invested, which should be
obvious if you’re 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.
There’s another concept that I
enjoy, which I’ve read in one of Ben
Graham’s 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
11 ofPage 87
a whole is quite expensive, you
should keep some cash and/or
bonds on the side, maybe 20%-25%
of the portfolio. You’re 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 low-
return environment. How do you
best preserve purchasing power
over time?
de Vaulx: That’s 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 there’s 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.
Today’s 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% equity-
type return that one typically would
expect out of equities.
bonds, these things yield close to
zero and after inflation they yield
less than zero. If you look at the ten-
year 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 ten-
year 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 you’re 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.
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% equity-
type return that one typically
would expect…
That in itself would argue for some
caution, but then again, the trouble
is, if you’re not fully invested in
equities, what do you do with the
rest of the portfolio? If it’s cash and
12 ofPage 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
it’s here in the U.S. or in India or
China or if it’s 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 you’re 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 don’t 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 there’s inflation or
hyperinflation that’s the best way
to be protected. At this time, we
have not made a call either way-
deflation versus inflation- and have
positioned the portfolio as such.
If you look at our portfolio today
you’ll notice that some of what
we have would be good if the
deflationary forces were to gain
strength, for instance, which could
happen if there’s 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 top-
notch 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 non-
capital 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.
Gold, you could argue, is only a
hedge against inflation. We’ve
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
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 there’s
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
the’70s. Deflation can be good for
gold. Conversely, what is typically
bad for gold is disinflation.
…gold becomes very
desirable when you have
deflation because there’s 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.
13 ofPage 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: I’ll give you an example
from the past and a more recent
example. I remember in the late
‘90s we bought McDonald’s [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], Murdoch’s media company.
They had the scandal associated
with their tabloids in the UK. The
stock came down and, yet, we were
comfortable building a decent-
sized 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 today’s businesses,
BSkyB, Fox, there’s 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 it’s
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 today’s businesses,
BSkyB, Fox, there’s very little
print, in the sense of being
threatened by the Internet.
14 ofPage 87
One stock we’ve bought
over the past six, nine
months is a French company
called Teleperformance
[Paris: RCF].
One stock we’ve bought over the
past six, nine months is a French
company called Teleperformance
[Paris: RCF]. They run corporate call
centers, and that’s a case where all
of the earnings pretty much come
from the United States. They’re very
powerful in the U.S. In fact, for all
practical purposes, the company
should be headquartered and listed
here. It’s sort of an accident that
it is listed in France. The French
founder happens to live in Miami,
and it’s an interesting case where
the French operations are losing a
lot of money.
It’s 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 there’s a prospect that it’s just
a cyclical downturn, not a secular
change in the business. So we’ve
often been doing some of this in
the past.
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. don’t
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 don’t need to invest
internationally. Instead, you can
do it through Coca-Cola [KO] or
McDonald’s or Microsoft [MSFT] or
Colgate [CL].
In terms of understanding the
companies, we think it’s 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 they’re
in. They typically will tell you if they
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. We’ve 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
15 ofPage 87
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.
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 it’s
fair to say that there are still risks in
international stocks.
I’ve 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, doesn’t
get too big.
the Procter & Gambles, the Coca-
Colas 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 ideas—by
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 it’s a Korean company. Korea
is not known for the greatest
corporate governance, and it’s 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
we’re 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
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 it’s
a Korean company. Korea is
not known for the greatest
corporate governance, and it’s
a regulated business where
you are at the mercy of the
regulator…
16 ofPage 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 you’ve 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 you’ll find companies
in overly competitive businesses
where it’s hard, or even worse, you’ll
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 cheap-
looking stocks of both categories is
that it’s 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.
It’s 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. I’ll 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… There’s not much in the
way of author rights. That’s 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 there’s
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
company’s 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
it’s a Google, an Expeditors
International [EXPD], 3M [MMM],
and we keep them in mind and
we have a tentative intrinsic
17 ofPage 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 they’re too
expensive for us to catch, but once
in a while, especially during an
economic downturn, we’re able to
buy them.
Even L’Oreal [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
don’t 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 don’t want
it, the deep value guys don’t want
it. It sits in limbo, and that’s when
we’re able to get those things.
So it’s not much in the way of
screening. It’s 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 we’ve 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 there’s 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 that’s 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 Graham’s 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 di”wors”ify the
way they used to in the ‘80s leading
up to the bursting of the Japanese
bubble, but we’ve seen many
Japanese companies year after
year keep most of the free cash
flow that’s 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. There’s one
called Shingakukai [Tokyo: 9760].
It trades below net cash and the
business is profitable.
Even L’Oreal [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 don’t 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.
…there are many small-
cap Japanese stocks that
are quite cheap. There’s one
called Shingakukai [Tokyo:
9760]. It trades below net
cash and the business is
profitable.
18 ofPage 87
The reason why there aren’t 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.
I’m not suggesting that these
stocks are overpriced. I’m saying
that they don’t 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
there’s too much of a soft landing
in China. So even though emerging
market stocks have come down, we
don’t 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 it’s smaller
businesses, oftentimes, although
the example I’ll give you is not so
small.
Our largest holding in Japan is
Astellas Pharma [Tokyo: 4503],
which is Japan’s second-largest
drug maker. The market cap is in
the billions of dollars and what’s
interesting with Astellas is that
over the past seven years they
bought back 19% of their shares
outstanding, which is unusual, it’s
very un-Japanese. Companies
typically don’t 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 company’s 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, there’s 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 there’s 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 that’s, at best, what
the locals see.
Our largest holding in Japan
is Astellas Pharma [Tokyo:
4503], which is Japan’s
second-largest drug maker.
The market cap is in the
billions of dollars and what’s
interesting with Astellas is
that over the past seven
years they bought back 19%
of their shares outstanding,
which is unusual, it’s very un-
Japanese.
19 ofPage 87
The company has been very good
at their core business. They have
a pipeline that’s 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. That’s 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. We’ve 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 don’t 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
we’re 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.
Switzerland has so many great
businesses, whether it’s 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 & Sprüngli [Swiss: LISN], as
I’m sure you know, makes delicious
chocolates, and so it’s our bias to
its quality that oftentimes has led
us to Switzerland. Adecco [Swiss:
ADEN] is a leading temporary
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 L’Oreal —
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.
20 ofPage 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.
There’s a stock we don’t own now
but we’ve owned in the past. It’s
become somewhat of a darling,
Essilor [Paris: EI]. They are, by far,
the leading company worldwide
that manufacturers lenses for
glasses.
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, family-
controlled companies because they
have a long term vision and often
times do great things.
The final point I want to make about
France, and it’s 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. That’s 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
aren’t 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
there’s not that much available in
the stock market, and some of the
other countries in Europe — Spain,
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.
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.
We’ve owned in the past Bureau
Veritas. It’s a little bit like ISS
[Group] in Switzerland. It’s an
inspection service company and
they have big market shares in
many specific niches. It’s 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
MOI: You recently initiated a few
small positions among large global
bank stocks. What is the rationale
for this, and why now?
de Vaulx: Let’s keep things in
perspective. We’re 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
you’ll reach the conclusion that
the bank is more than adequately
capitalized.
21 ofPage 87
The rating agencies, as a rule, don’t
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. They’ll 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 five-
year 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]. I’m
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 it’s 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. They’ve reduced their stake
in Legrand. They’ve reduced their
stake in Bureau Veritas. They’ve
shed other assets, so the balance
sheet has improved greatly and
these bonds are, in our mind, very
safe. I wouldn’t say extremely safe,
but very safe and now the yields
have come down tremendously, but
these bonds still yield in excess of
5%. So it’s still a pretty reasonable
yield in a zero return world, and
so we’re very comfortable with
Wendel. Now, you may argue that
5% is not exactly an equity-type
return of the 7-9%, but it’s a pretty
safe piece of paper, so we’re 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, it’s 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, it’s 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.
22 ofPage 87
that gold also should be viewed as
a hedge against deflation. Let’s 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 there’s
deflation? Because when there’s
deflation, there’s 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,
it’s 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, you’ll 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 —
there’s 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 don’t
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.
Going forward, if stocks and bonds
became dirt cheap — we don’t 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
world’s 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
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 2009-
10, 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 don’t view them as dirt
cheap today — say, if stocks
fell 20%, we would not need
to own as much gold as we
do.
23 ofPage 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,
it’s an attempt to get equity-
type returns, and so when we
buy high-yield corporate bonds,
sovereign debt, and distressed
debt, it’s trying to get an equity-
type 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. It’s 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 manager’s inability to find
enough cheap stocks.
As a value investor, if you’re 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
I’m sure you’ve 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.
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 it’s 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 what’s
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, it’s 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 don’t 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 company’s
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. It’s 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
manager’s inability to find
enough cheap stocks.
24 ofPage 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.
There’s a mistake both from people
that overtrade on the one hand and
those who have too much of a buy-
and-hold mentality.
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?
de Vaulx: Well, specifically 2008-
2009, the answer — and I don’t 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 Grant’s
Interest Rate Observer or Gary
Shilling’s deflation pieces – and
having paid attention to the macro
helped us identify that there was a
big credit bubble happening and, as
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.
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.
Say a company has a core intrinsic
value of 50, the stock’s 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. That’s the big improvement —
to have worst-case intrinsic value
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.
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.
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
25 ofPage 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. I’m 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 Bernstein’s
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, there’s a
wonderful historian who passed
away a year or two ago, Charles
Kindleberger, who many people
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.
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
Kahneman’s books should be read
along with Poor Charlie’s 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,
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
it’s 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.
26 ofPage 87
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 Morningstar’s equity research effort. He led the development of Morningstar’s economic moat ratings as
well as the methodology behind Morningstar’s 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.
It’s a fascinating topic because
economic theory suggests that all
companies should just revert to
Exclusive
Interview
with Pat Dorsey
It’s 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 that’s not the case.
mean over time. Competition shows
up, capital seeks excess profits, and
you drive returns down. But, both
empirically and intuitively, we all
know that’s 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 Porter’s Five Forces
model, which is very useful and a
great starting point, but it’s 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, it’s all
about maximizing the assets that
you have.
As investors, we have a different
challenge. We’re 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.
27 ofPage 87
Exclusive Interview with Pat Dorsey
The smartest manager in
the world will not make an
airline have the economics
of a software company or an
asset manager; it’s physically
impossible.
MOI: Let’s start from the beginning.
Can you define what you mean by
moat?
Dorsey: When you think of an
economic moat—and let’s be
clear I stole the term from Warren
Buffett; he’s the one who coined it.
If you’re going to steal, steal from
the smartest guy around—a moat
is structural and sustainable. I
think those are the two key things
for investors to think about. It’s
structural in that it’s inherent to
the business. The Tiffany brand is
inherent to Tiffany [TIF]; you can’t
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 it’s 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. There’s a
wonderful quote from Buffett on
this: “When management with the
reputation for brilliance meets a
company with a reputation for bad
economics, it’s the reputation of
the company that remains intact.”
But there’s 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.” That’s 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; it’s physically
impossible.
Smart management is a wonderful
thing to have; I’d 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
don’t suddenly overnight become
wonderful businesses. Software
companies don’t overnight become
bad businesses, whereas managers
can come and go. It’s hard to make
a confident bet, in most cases,
absent high managerial ownership
or a family position, that the guy
who’s in charge today will be there
five years from now.
28 ofPage 87
CoStar Group, which is
basically the FactSet or
Bloomberg of commercial
real estate. If you’re C.B.
Richard Ellis, you can’t live
without CoStar’s 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…
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 that’s 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: That’s 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.
That’s typically the case because
there’s only one Tom Cruise; there’s
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 it’s reasonable to say
that was a factor in Southwest’s
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 it’s
hard to say; the two go together. I
would say that corporate culture
as an economic moat is very fuzzy,
and unless you’re 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
they’ve been there forever. How do
moats actually come into being?
How are they born at a company?
Dorsey: You can build moats over
time. We’re not talking only about
businesses that have been around
for 50 years, like a Coca-Cola
[KO] or Procter & Gamble [PG]. It’s
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 you’re
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.
You’re 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,
it’s a stickier proposition. That’s
what you would do if your goal is to
create a network effect.
A good example here might be
CoStar Group [CSGP], which is
basically the FactSet [FDS] or
Bloomberg of commercial real
estate. If you’re C.B. Richard
Ellis [CBG], you can’t live without
CoStar’s 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. That’s not always what you
want from a company, but given the
moat they were trying to build, it
made sense for them.
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
The Manual of Ideas: Top Ten Interviews of All Time
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The Manual of Ideas: Top Ten Interviews of All Time

  • 2. Dear Reader, Since the inception of BeyondProxy in 2008, our goal has been to bring timeless investment wisdom and timely ideas to our members worldwide. Through The Manual of Ideas and ValueConferences, we have rallied intelligent investors around a shared mission of lifelong learning. Our community has grown to include investment professionals at Abrams, Aquamarine, Arlington, Artisan, Baupost, Berkshire Hathaway, Brave Warrior, Citadel, Citigroup, Diamond Hill, GAM, Gardner Russo, GMO, GoldenTree, Goldman Sachs, IVA, Invesco, J.P. Morgan, Markel, Merrill Lynch, MIT, Pabrai, Raymond James, Rothschild, Royce, Ruane Cunniff, Schroders, Senator, Soros, Southeastern, Third Avenue, Tiger Global, Tweedy Browne, Yacktman, and many smaller funds, advisors, analysts, and individual investors. As we continue on our mission of catalyzing the global community of intelligent investors, we aim to connect you to wisdom, ideas, and like- minded investors. Join us on a journey of enriching relationships and lifelong learning. Warmly, John Mihaljevic Managing Editor Shai Dardashti Managing Director
  • 3. Exclusive Interview with 61 Exclusive Interview with 3 Charles de Vaulx Exclusive Interview with 26 Pat Dorsey Exclusive Interview with 37 Tom Gayner Exclusive Interview with 43 Joel Greenblatt Exclusive Interview with 45 Howard Marks Exclusive Interview with 55 Michael Maubossin Allan Mecham Exclusive Interview with 67 James Montier Exclusive Interview with 71 Guy Spier Exclusive Interview with 83 Amit Wadhwaney
  • 4. 4 ofPage 87 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 Morningstar’s “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 Master’s degree in finance. The Manual of Ideas: It’s 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. Prior to that, from age five to twelve- and-a-half, I was living with my parents in Johannesburg, South 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.
  • 5. 5 ofPage 87 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. 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 investing- the 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. MOI: How did working with Jean- Marie 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, it’s 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. You’re supposed to have conviction, go for it.
  • 6. 6 ofPage 87 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. 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 it’s Japan in the late ‘80s, or TMT stocks in the late ‘90s, or financial stocks in ’06-’07. It’s important to note that diversification is okay as long as it has nothing to do with the benchmark, as long as you’re 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 it’s 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 don’t feel you need to know everything. I think we showed over time that our estimates of the intrinsic values of the companies we’ve owned have been quite accurate. The reason is that even though we’re not catalyst-driven, it just so happens that on average maybe 15% of the stocks we’ve held for many years have been taken over. Through all of these takeovers we’ve 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 there’s no need to know every detail, rather there’s a need to understand the key three, four or five factors affecting the company. 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. It’s okay to consider bonds - high- yield corporates and Treasuries (when they yield 15% and when they are labeled Certificates of Confiscation – that was the term in 1982). It’s okay also to consider bonds to try and get equity-type returns. It’s okay also to have cash – cash as a residual, not as a way to time the market. If you cannot find enough cheap securities, it’s 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 ain’t telling us”, so why waste time trying to guess next year’s 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 Grant’s 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 pervasive—debt at the corporate level, at the household level, at the government level. I think being mindful of those credit cycles made him understand that
  • 7. 7 ofPage 87 We own a billboard advertising company in Switzerland called Affichage [Swiss: AFFN], and it’s quite small. …our portfolio today is truly eclectic and multi-cap. Of course, if you look at the top ten holdings you’ll 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 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, I’ve appreciated that Jean-Marie understood that it was wrong to forecast. You’re 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, Jean- Marie 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 I’ll 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 you’ll 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 don’t 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 it’s quite small. the next year or two or three or four. So it’s short-duration, high-yield corporates. The yield is not huge. Today, we’re talking about 4%, but these are what we deem extremely safe instruments and because the duration is short, there’s no interest rate risk there. You also will notice the eclectic nature by the fact that we have some sovereign debt, and it’s approximately 5.1% of the portfolio. It’s 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 doesn’t have much of a fiscal deficit, there’s not much of a long-dated government bond market to begin with. You’ll 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 gold- mining 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. It’s been a great move! We own a few gold mining shares, but it’s really de minimis and only in our 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 ’08- ’09. So, as a result, many of these bonds will be maturing shortly in
  • 8. 8 ofPage 87 Another negative bet you’ll 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 what’s going on in China. U.S. registered mutual funds. Our preference remains, by far, towards holding gold bullion. You’ll 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 we’re 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, you’ll 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 it’s 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 you’ll 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 what’s 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. We’ve 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 what’s good for Brazil Inc. as opposed to doing what’s right for the company’s shareholders. Also, we worry about what’s going on in Europe. We’re not sure what the outcome will be. It’s a big unknown and the way we express our skepticism towards what’s 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. Conversely, let’s 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 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 it’s 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 what’s going on has already been priced in.
  • 9. 9 ofPage 87 I’m obviously very familiar with the expression “buy-and- hold” and that expression, frankly, makes me cringe. I don’t think it belongs to the lingo that value investors use. Value investors know about price and value. MOI: In your Owner’s 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? de Vaulx: Let me start with the second part of the question. I’m obviously very familiar with the expression “buy-and-hold” and that expression, frankly, makes me cringe. I don’t 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. 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 company’s 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 it’s 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 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 ago—Montgomery Ward, J.C. Penney [JCP], Sears [SHLD]—none of these names are truly relevant today. Nothing’s permanent. 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 there’s a lot more debt in the system than in the past. We’ve seen the global nature of banks. A good example of this is the paradox of what’s 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. 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 it’s important, especially from a qualitative standpoint, to look at the past ten years’ earnings, but it’s always important to be mindful that businesses may change and sometimes for the worse. Technology, the internet, has revolutionized what’s 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 question- I’m intrigued that very few value investors ever comment on portfolio construction, in particular …understanding correlations is very important, especially in a global world where there’s a lot more debt in the system than in the past. We’ve seen the global nature of banks.
  • 10. 10 ofPage 87 Another thing that’s not discussed enough is position sizing. I think I’ve made my point about us not being big fans at all of running concentrated portfolios. I don’t 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 there’s 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 it’s 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 that’s at the expense of the company. It’s 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 di”wors”ification, 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 don’t 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 don’t 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 there’s no requirement to be fully invested, which should be obvious if you’re 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. There’s another concept that I enjoy, which I’ve read in one of Ben Graham’s 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
  • 11. 11 ofPage 87 a whole is quite expensive, you should keep some cash and/or bonds on the side, maybe 20%-25% of the portfolio. You’re 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 low- return environment. How do you best preserve purchasing power over time? de Vaulx: That’s 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 there’s 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. Today’s 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% equity- type return that one typically would expect out of equities. bonds, these things yield close to zero and after inflation they yield less than zero. If you look at the ten- year 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 ten- year 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 you’re 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. 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% equity- type return that one typically would expect… That in itself would argue for some caution, but then again, the trouble is, if you’re not fully invested in equities, what do you do with the rest of the portfolio? If it’s cash and
  • 12. 12 ofPage 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 it’s here in the U.S. or in India or China or if it’s 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 you’re 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 don’t 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 there’s inflation or hyperinflation that’s the best way to be protected. At this time, we have not made a call either way- deflation versus inflation- and have positioned the portfolio as such. If you look at our portfolio today you’ll notice that some of what we have would be good if the deflationary forces were to gain strength, for instance, which could happen if there’s 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 top- notch 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 non- capital 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. Gold, you could argue, is only a hedge against inflation. We’ve 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 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 there’s 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 the’70s. Deflation can be good for gold. Conversely, what is typically bad for gold is disinflation. …gold becomes very desirable when you have deflation because there’s 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.
  • 13. 13 ofPage 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: I’ll give you an example from the past and a more recent example. I remember in the late ‘90s we bought McDonald’s [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], Murdoch’s media company. They had the scandal associated with their tabloids in the UK. The stock came down and, yet, we were comfortable building a decent- sized 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 today’s businesses, BSkyB, Fox, there’s 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 it’s 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 today’s businesses, BSkyB, Fox, there’s very little print, in the sense of being threatened by the Internet.
  • 14. 14 ofPage 87 One stock we’ve bought over the past six, nine months is a French company called Teleperformance [Paris: RCF]. One stock we’ve bought over the past six, nine months is a French company called Teleperformance [Paris: RCF]. They run corporate call centers, and that’s a case where all of the earnings pretty much come from the United States. They’re very powerful in the U.S. In fact, for all practical purposes, the company should be headquartered and listed here. It’s sort of an accident that it is listed in France. The French founder happens to live in Miami, and it’s an interesting case where the French operations are losing a lot of money. It’s 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 there’s a prospect that it’s just a cyclical downturn, not a secular change in the business. So we’ve often been doing some of this in the past. 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. don’t 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 don’t need to invest internationally. Instead, you can do it through Coca-Cola [KO] or McDonald’s or Microsoft [MSFT] or Colgate [CL]. In terms of understanding the companies, we think it’s 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 they’re in. They typically will tell you if they 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. We’ve 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
  • 15. 15 ofPage 87 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. 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 it’s fair to say that there are still risks in international stocks. I’ve 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, doesn’t get too big. the Procter & Gambles, the Coca- Colas 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 ideas—by 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 it’s a Korean company. Korea is not known for the greatest corporate governance, and it’s 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 we’re 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 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 it’s a Korean company. Korea is not known for the greatest corporate governance, and it’s a regulated business where you are at the mercy of the regulator…
  • 16. 16 ofPage 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 you’ve 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 you’ll find companies in overly competitive businesses where it’s hard, or even worse, you’ll 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 cheap- looking stocks of both categories is that it’s 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. It’s 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. I’ll 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… There’s not much in the way of author rights. That’s 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 there’s 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 company’s 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 it’s a Google, an Expeditors International [EXPD], 3M [MMM], and we keep them in mind and we have a tentative intrinsic
  • 17. 17 ofPage 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 they’re too expensive for us to catch, but once in a while, especially during an economic downturn, we’re able to buy them. Even L’Oreal [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 don’t 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 don’t want it, the deep value guys don’t want it. It sits in limbo, and that’s when we’re able to get those things. So it’s not much in the way of screening. It’s 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 we’ve 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 there’s 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 that’s 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 Graham’s 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 di”wors”ify the way they used to in the ‘80s leading up to the bursting of the Japanese bubble, but we’ve seen many Japanese companies year after year keep most of the free cash flow that’s 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. There’s one called Shingakukai [Tokyo: 9760]. It trades below net cash and the business is profitable. Even L’Oreal [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 don’t 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. …there are many small- cap Japanese stocks that are quite cheap. There’s one called Shingakukai [Tokyo: 9760]. It trades below net cash and the business is profitable.
  • 18. 18 ofPage 87 The reason why there aren’t 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. I’m not suggesting that these stocks are overpriced. I’m saying that they don’t 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 there’s too much of a soft landing in China. So even though emerging market stocks have come down, we don’t 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 it’s smaller businesses, oftentimes, although the example I’ll give you is not so small. Our largest holding in Japan is Astellas Pharma [Tokyo: 4503], which is Japan’s second-largest drug maker. The market cap is in the billions of dollars and what’s interesting with Astellas is that over the past seven years they bought back 19% of their shares outstanding, which is unusual, it’s very un-Japanese. Companies typically don’t 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 company’s 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, there’s 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 there’s 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 that’s, at best, what the locals see. Our largest holding in Japan is Astellas Pharma [Tokyo: 4503], which is Japan’s second-largest drug maker. The market cap is in the billions of dollars and what’s interesting with Astellas is that over the past seven years they bought back 19% of their shares outstanding, which is unusual, it’s very un- Japanese.
  • 19. 19 ofPage 87 The company has been very good at their core business. They have a pipeline that’s 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. That’s 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. We’ve 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 don’t 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 we’re 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. Switzerland has so many great businesses, whether it’s 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 & Sprüngli [Swiss: LISN], as I’m sure you know, makes delicious chocolates, and so it’s our bias to its quality that oftentimes has led us to Switzerland. Adecco [Swiss: ADEN] is a leading temporary 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 L’Oreal — 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.
  • 20. 20 ofPage 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. There’s a stock we don’t own now but we’ve owned in the past. It’s become somewhat of a darling, Essilor [Paris: EI]. They are, by far, the leading company worldwide that manufacturers lenses for glasses. 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, family- controlled companies because they have a long term vision and often times do great things. The final point I want to make about France, and it’s 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. That’s 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 aren’t 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 there’s not that much available in the stock market, and some of the other countries in Europe — Spain, 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. 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. We’ve owned in the past Bureau Veritas. It’s a little bit like ISS [Group] in Switzerland. It’s an inspection service company and they have big market shares in many specific niches. It’s 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 MOI: You recently initiated a few small positions among large global bank stocks. What is the rationale for this, and why now? de Vaulx: Let’s keep things in perspective. We’re 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 you’ll reach the conclusion that the bank is more than adequately capitalized.
  • 21. 21 ofPage 87 The rating agencies, as a rule, don’t 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. They’ll 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 five- year 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]. I’m 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 it’s 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. They’ve reduced their stake in Legrand. They’ve reduced their stake in Bureau Veritas. They’ve shed other assets, so the balance sheet has improved greatly and these bonds are, in our mind, very safe. I wouldn’t say extremely safe, but very safe and now the yields have come down tremendously, but these bonds still yield in excess of 5%. So it’s still a pretty reasonable yield in a zero return world, and so we’re very comfortable with Wendel. Now, you may argue that 5% is not exactly an equity-type return of the 7-9%, but it’s a pretty safe piece of paper, so we’re 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, it’s 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, it’s 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.
  • 22. 22 ofPage 87 that gold also should be viewed as a hedge against deflation. Let’s 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 there’s deflation? Because when there’s deflation, there’s 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, it’s 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, you’ll 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 — there’s 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 don’t 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. Going forward, if stocks and bonds became dirt cheap — we don’t 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 world’s 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 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 2009- 10, 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 don’t view them as dirt cheap today — say, if stocks fell 20%, we would not need to own as much gold as we do.
  • 23. 23 ofPage 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, it’s an attempt to get equity- type returns, and so when we buy high-yield corporate bonds, sovereign debt, and distressed debt, it’s trying to get an equity- type 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. It’s 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 manager’s inability to find enough cheap stocks. As a value investor, if you’re 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 I’m sure you’ve 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. 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 it’s 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 what’s 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, it’s 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 don’t 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 company’s 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. It’s 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 manager’s inability to find enough cheap stocks.
  • 24. 24 ofPage 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. There’s a mistake both from people that overtrade on the one hand and those who have too much of a buy- and-hold mentality. 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? de Vaulx: Well, specifically 2008- 2009, the answer — and I don’t 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 Grant’s Interest Rate Observer or Gary Shilling’s deflation pieces – and having paid attention to the macro helped us identify that there was a big credit bubble happening and, as 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. 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. Say a company has a core intrinsic value of 50, the stock’s 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. That’s the big improvement — to have worst-case intrinsic value 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. 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. 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
  • 25. 25 ofPage 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. I’m 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 Bernstein’s 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, there’s a wonderful historian who passed away a year or two ago, Charles Kindleberger, who many people 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. 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 Kahneman’s books should be read along with Poor Charlie’s 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, 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 it’s 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.
  • 26. 26 ofPage 87 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 Morningstar’s equity research effort. He led the development of Morningstar’s economic moat ratings as well as the methodology behind Morningstar’s 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. It’s a fascinating topic because economic theory suggests that all companies should just revert to Exclusive Interview with Pat Dorsey It’s 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 that’s not the case. mean over time. Competition shows up, capital seeks excess profits, and you drive returns down. But, both empirically and intuitively, we all know that’s 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 Porter’s Five Forces model, which is very useful and a great starting point, but it’s 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, it’s all about maximizing the assets that you have. As investors, we have a different challenge. We’re 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.
  • 27. 27 ofPage 87 Exclusive Interview with Pat Dorsey The smartest manager in the world will not make an airline have the economics of a software company or an asset manager; it’s physically impossible. MOI: Let’s start from the beginning. Can you define what you mean by moat? Dorsey: When you think of an economic moat—and let’s be clear I stole the term from Warren Buffett; he’s the one who coined it. If you’re going to steal, steal from the smartest guy around—a moat is structural and sustainable. I think those are the two key things for investors to think about. It’s structural in that it’s inherent to the business. The Tiffany brand is inherent to Tiffany [TIF]; you can’t 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 it’s 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. There’s a wonderful quote from Buffett on this: “When management with the reputation for brilliance meets a company with a reputation for bad economics, it’s the reputation of the company that remains intact.” But there’s 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.” That’s 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; it’s physically impossible. Smart management is a wonderful thing to have; I’d 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 don’t suddenly overnight become wonderful businesses. Software companies don’t overnight become bad businesses, whereas managers can come and go. It’s hard to make a confident bet, in most cases, absent high managerial ownership or a family position, that the guy who’s in charge today will be there five years from now.
  • 28. 28 ofPage 87 CoStar Group, which is basically the FactSet or Bloomberg of commercial real estate. If you’re C.B. Richard Ellis, you can’t live without CoStar’s 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… 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 that’s 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: That’s 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. That’s typically the case because there’s only one Tom Cruise; there’s 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 it’s reasonable to say that was a factor in Southwest’s 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 it’s hard to say; the two go together. I would say that corporate culture as an economic moat is very fuzzy, and unless you’re 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 they’ve been there forever. How do moats actually come into being? How are they born at a company? Dorsey: You can build moats over time. We’re not talking only about businesses that have been around for 50 years, like a Coca-Cola [KO] or Procter & Gamble [PG]. It’s 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 you’re 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. You’re 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, it’s a stickier proposition. That’s what you would do if your goal is to create a network effect. A good example here might be CoStar Group [CSGP], which is basically the FactSet [FDS] or Bloomberg of commercial real estate. If you’re C.B. Richard Ellis [CBG], you can’t live without CoStar’s 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. That’s not always what you want from a company, but given the moat they were trying to build, it made sense for them.