Inoculated Investor Interview

The Inoculated Investor

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Interviewer: Miguel Barbosa of Simoleon Sense Respondent: The Inoculated Investor

1. When did you first become interested in allocating capital?

The funny thing about me is that I was a value investor before I had ever heard of value investing as a discipline. In my former life I was a commercial real estate professional and one of my duties was to be a steward of my family’s capital. In that role I analyzed hundreds of opportunities to purchase existing buildings or develop new properties. I think it is a testament to my discipline that from 2003 to 2007 there was only one deal that I actually advised my family members to invest in. During that span I had dozens of what turned into contentious discussions with real estate brokers who were desperately trying to convince me that this was a great time to buy and that paying a 4% cap (which is like an earnings yield on a stock) for a Walgreens in Indianapolis made ultimate sense. I feel bad for the people who were swindled by these brokers and bought near the peak of the bubble. Luckily, even before I had heard of Ben Graham I understood that the return you receive has to compensate for the risks you are taking.

When it comes to stocks, the indoctrination into value investing that has led me to want to manage money professionally all started when I read Ben Graham’s The Intelligent Investor. I know it sounds almost cliché, but there is something about the investment philosophy that Graham details in this book that just clicked with me. If you look at my blog site, I have two quotes from prominent investors that articulate my attraction to value investing better than I ever could:

Seth Klarman (Baupost Group): “It turns out that value investing is something that is in your blood. There are people who just don’t have the patience and discipline to do it, and there are people who do. So it leads me to think it’s genetic.”

Mohnish Pabrai (Pabrai Funds): “Warren Buffett has said many times that people either get value investing in five minutes or they won’t get it in five years. So, there is something in the human brain--that for some of us--makes all the difference in the world right away and the patience it requires is part of the wiring process.”

2. Currently you work as an analyst and run the Inoculated Investor Blog. Why did you start the blog? Where do blogs like yours fit in among the financial journalism and equity research spaces?

Well, my days as an official analyst are over, at least until I graduate from UCLA with my MBA. However, I plan to continue working on the blog as much as I possibly can. The reason I started the blog was that I literally had a running dialogue about the markets and economy in my mind. It was actually driving me a little crazy and I badly needed an outlet. Fortunately for me I was able to launch the site with content that was quite unique. I attended this year’s Berkshire Hathaway annual meeting and I was literally the only

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person out of the thousands there who was crazy enough to try to write down every word that Buffett and Munger said. As a result, my meeting notes were more complete than those of others and after I posted them the entire value investing portion of the blogosphere was linking to me. It was a very good way to start off my blogging career.

Since then I have focused solely on adding value to my readers. My goal is to try to make what can be very difficult material accessible to non-professional investors as well as people who work in the markets. I think my particular niche lies directly in between the financial articles you read in the Wall Street Journal and the equity research created by analysts. I often find the articles in the financial publications to be incredibly cursory and that the research barely scratches the surface. On the other hand, in depth company specific equity research is really only compelling to professional investors. So, as opposed to using my blog as a glorified version of Twitter, I try to walk the line between boring readers with too much detail and offering insight that any novice could come up with. For example, I often post links to other sites with commentary so that I can expand on the topics covered by others. But I also have a section of my site that has samples of the actual equity research I presented to my bosses. I like to think that this makes my site somewhat unique.

3. Mark Sellers stresses the importance of clear writing as proxy for clear thinking. You’re a fantastic writer- How does this skill translate into thinking through investment ideas?

What I love about Seth Klarman and Howard Marks is how articulate they are. Something about the way they talk about value investing resonates with me. Along with Buffett, they are my role models as a writer. For me writing is the best way to present my ideas. I readily admit that I am nowhere near as articulate or persuasive when I speak about investing. It is something that I obviously hope to get better at. I have seen firsthand that the way portfolio managers talk about their investment philosophy and discipline can dictate whether investors are comfortable or not.

Until I am fortunate enough to have investors of my own, my focus will be on presenting my ideas in written form. As an equity research analyst, you are only as good as your written research. You have to be able to present your ideas and recommendations concisely without sacrificing the obviously necessary depth. PMs are often very busy and you must avoid wasting their time or even the best idea will get pushed aside. For me, I sometimes don’t even know how I feel about a stock until the write up is complete. Until that point everything is so abstract and the information is so segregated in my mind that I don’t have a complete picture. But, once all of my research is aggregated I feel much more comfortable making recommendations and explaining the investment thesis.

4. Which investors do you admire? Besides these investors who else has influenced you?

The Inoculated Investor

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I have already discussed this to some extent but I am happy to elaborate. In my young career I have been most influenced by Buffett and Klarman. I actually launched my blog with a post in which I discussed my vision of the optimal portfolio. Ideally, it would contain some Buffett stocks (great companies at a fair price) and some Klarman stocks (fair companies at a great price). I think these men frame value investing in a way that no other people can. It is not a surprise that the best quotes I have ever read regarding investing come from these two luminaries. I also lump Howard Marks in that group even though Oaktree does not focus on equities. The fact that Marks’s words strike me as so profound even though he invests in another asset class is more proof that value investing is a universal discipline that does not necessarily require a specific context. It also shows that the language translates well across asset classes and can even teach some very valuable life lessons.

5.

What is it that you like about value investing specifically? In other words, what about it attracts you?

This is an easy one for me. Anybody who knows me is aware that I am a little cheap. I have been so ever since I can remember. While that translates into plenty of backhanded complements in my social life, I think it makes me uniquely predisposed to value investing. I am just not geared toward taking large risks or investing based on an optimistic future. I know that humans are terrible at forecasting and I would rather focus on what a company is worth right now rather than what it could be worth if all these assumptions prove to be right. I think that is why Graham’s analysis was so intriguing to me. He searched for $.50 dollars almost exclusively by focusing on the balance sheet and refused to pay up for growth. I am generally very cautious when it comes to money and Graham’s investing style that focuses on a margin of safety is perfectly suited for a careful and deliberate person like me.

6. What’s your approach to fundamental analysis? What’s your edge?

The development of my edge is a continual process but based on early returns I would suggest that my edge is made up of my willingness to dig and to look where few others are looking. Regarding the former, I don’t look at companies as single entities. Most companies have a number of different operating units or products that have different costs and margins structures. Accordingly, as I dig my goal is to understand each individual business component in terms of what drives profitability, what generates costs and what the opportunities or headwinds are. More and more I have become a margins guy in that I assess the quality of a business based on the operating margins it produces. There is no question that for the company as a whole free cash flow is paramount to me. However, before I can determine whether cash flows are sustainable, I need to understand a company’s competitive advantage. This is an element that I believe can be evaluated using operating margins. Thus, I think it is the granular knowledge that I require in order to be comfortable with an investment that distinguishes me from investors who focus mostly on earnings.

Additionally, I am not foolish enough to think that I can add a whole lot of value to an analysis of Microsoft. I see huge companies that are well covered by the sell side and are widely owned and researched by institutional investors as basic proxies for the S&P 500. In other words, these stocks are by in large going to move with the market, barring extraordinary company specific news. While large cap stocks can

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become mispriced, I think it is better to fish in a pond that is more likely to see lasting and significant dislocations between intrinsic value and stock price. Therefore, I like to look at spin offs and companies that are not covered by many sell side analysts. Plus, I have no problem investing in small and mid caps as long as there is ample liquidity in the stock. If you take a look at the companies for which I have research posted on the blog you will see my bias. Hurco, Movado, Ceradyne, IPC Holdings: these are not necessarily household names but they are still successful companies that at certain times have generated attractive returns on capital. So, this is where I think investors are most likely to find compelling value.

7. Give us an example of your best and worst investments? What did you learn?

Since I am not a portfolio manager, I think it is more appropriate to discuss my best and worst recommendations. As an analyst my job is not to invest for myself but to come up with ways in which my fund or other investors can make money. First, my best recommendations have come in the regional banking sector. The two short calls that proved to be the most prescient were on Wachovia and Guaranty Financial. For those who are not familiar with these banks, Wachovia was forced into the arms of Wells Fargo as the share price neared $0 and Guaranty recently filed for Chapter 11 and the remnants were picked up by Spanish bank BBVA. These stocks were trading in the mid teens and my analysis of their balance sheets and credit deterioration led me to believe that both had the potential to go to $0 (and in fact they both basically did). Neither of these were obscure names. Wachovia was a household banking name and Guaranty had attracted famous investors such as David Einhorn and Carl Icahn. What I learned from my experience with these companies was that if you can develop an edge in a certain industry you can take advantage of the market not fully understanding the prospects or fundamentals of certain stocks. During the boom years investors did not focus on bank credit or capital, they just saw the prices going up, solid ROEs and stable dividends. Accordingly, when things got bad very few people had the experience or the ability to scrutinize the balance sheets of these banks. As a result they either did not sell quickly enough or bought after dips and got clobbered in the end. This showed me that investment opportunities can be hiding in plain sight. It also taught me to never trust that the $100 bill lying on the sidewalk is not actually there just because the Efficient Market Theory says that someone would have picked it up if it were there.

On the flip side my worst recommendations had to do with underestimating the extent of the financial crisis and consumer spending downturn. I remember after the $120 a share Harman buyout by Goldman and KKR fell apart I thought the broken deal could lead to an interesting opportunity. The stock was around $70 and looked like quite the bargain when compared to buyout price. Well, the stock is $27 now as companies who rely on auto sales have been absolutely crushed. My biggest mistake was becoming anchored to the $120 offer price as if that were a measure of intrinsic value. I now understand that the presence of excessive leverage (hence the term leverage buyout) can skew the price of any asset. Additionally, despite the fact that I had a negative macro outlook, especially when it came to discretionary auto sales, I thought Harman had a stable business model that would not be harmed by the coming recession. Accordingly, I failed to adequately follow Klarman’s strategy in which he invests bottom’s up but worries top down. As a result of this and other similar mistakes I am now fully aware that even value investors cannot completely ignore what is going on in the broader economy. In other words, there are very few companies whose fortunes are completely independent of the business cycle or wholesale movements in the stock market.

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

8. How do you look at risk & uncertainty?

To me, risk is nothing other than the potential for permanent capital impairment. Risk is not volatility. If a stock goes down 50% it likely is not more risky than it was at the higher price. If your favorite cereal is on sale for 50% off at the grocery store you don’t refuse to buy it because the price has fluctuated. As long as you still like it you should be comfortable buying twice as much. In this way stocks aren’t a whole lot different from boxes of cereal. My goal as an analyst and investor is to avoid situations that involve obvious risk or capital impairment but to take advantage of uncertainty. Uncertainty comes about when market participants have very little visibility into a company’s future and it can lead to severe dislocations between price and intrinsic value. Whether fear is caused by potential government regulation, concerns about demand, or changes in management, value investors who have in depth knowledge regarding companies can often find ways to benefit from uncertainty. What you don’t want to do is buy something that looks certain because you are likely to pay a premium price.

9. Given your background, how do you look at real estate?

I know this is going to sound a bit strange to people who only started looking at real estate during the boom, but I look at real estate more like a bond than a stock. In other words, instead of thinking of real estate as a rapidly appreciating asset, I look at rental income as being similar to coupon on a bond. When my family invests in real estate, we don’t think about how much more we are going to sell it for in the future. What we try to figure out is how much we can rent it for, what kind of yearly increases we can negotiate, and how much time and capital need to be put in on an ongoing basis. Obviously, during the boom people weren’t interested in stable tenancies and leases that protect against the downside. They looked at real estate as if it were as liquid as stocks and thought properties should appreciate as fast as equities often do after a market correction. However, in periods when there is not excessive speculation and leverage entering the real estate market, these assets are slow growth vehicles. In theory, they should not grow any faster than the rate of increase in rents. Accordingly, when commercial real estate and housing finally do bottom, people should not expect values to recover for many years. Anyone who is holding onto a piece of real estate until the market “comes back” will likely be waiting a long time unless the Fed is able to create another asset bubble.

10. What has the financial crisis taught you, especially when it comes to investing? How have you evolved as an investor?

I think when I look back on this period of my career, I will be very thankful that I cut my teeth in such adverse market circumstances. It’s much better to learn certain lessons now (when there are only a few zeroes involved) than when the stakes are much higher. The crisis has just reinforced my view of the role of a manager. As Howard Marks so eloquently says, the duty of a money manager is to protect capital and manage risk. It is really that simple. If you focus on a margin of safety, have disciplined buy and sell requirements and strategically hedge downside risk, you are fulfilling your fiduciary duty as a money manager. Along the same lines, it is imperative to remember that leverage is a killer. The common

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denominator in every bubble I have ever examined is excessive leverage. I am currently reading a book called Funny Money (by Mark Singer) that is about the oil lending boom in Oklahoma and Texas that led to the notorious failure and bailout of Continental Illinois. This episode represented the beginning of the too big to fail era among banks that obviously still exists today and basically defined what moral hazard would look like going forward. I’m sure you will not be at all surprised to learn that root cause of the bank’s flameout was too much and too rapid lending combined with inadequate analysis of credit. Does that sound familiar?

11. What financial issues concern you the most?

Oh my, I really don’t want to depress the readers! Anybody who follows me knows that I am quite bearish in the short run but am also legitimately concerned about the long run ability of the US economy to remain vibrant and innovative. I think we have structural imbalances that need to be addressed and it makes me sick that the leaders of this country seem unwilling to face these issues. You have to remember that I am not an economist so this is not my specialty. However, it seems to me that America became a “too much and too many” country over the last 30 years or so. We have too much debt, too many stores, too many banks, too many dodgy loans, too many cars and too many big houses. We use too much energy and we pollute too much. Unless the Fed and Obama can find a way to prolong the necessary day of reckoning, I believe we may soon find ourselves living in a “too little and not enough” country. In retrospect it will be clear that we saved too little, put too little money into Social Security, invested far too little in education and did not do enough to address climate change and health care reform. I really hope that I am wrong but I am not as optimistic as Buffett is that future generations of Americans are guaranteed to enjoy a better standard of living than we do.

12. Do you have an opinion about inflation/deflation?

I think this is probably the most fascinating debate going on right now and the eventual outcome will likely be the main determinant of what asset classes perform and underperform over the next decade. My current view is that at least temporarily we have seen a bizarre combination of commodity price increases, severe credit contraction and wage deflation. This seems to me to be a particularly insidious cocktail and is why Main Street is struggling so much. In the short run, despite the Fed’s attempts to pump liquidity in the system I see deflation as a much more relevant risk. But in the long run it is hard for me to see the Fed exiting their money printing in a smooth way that somehow prevents inflation and simultaneously avoids stifling a recovery. The Fed is kind of like a bull trying to walk out of a china shop. Yeah, maybe it doesn’t break all the plates but it sure leaves some collateral damage in its wake. I guess I don’t share the blind faith that the Fed can be precise in its monetary policy. So, I’m not sure if Marc Faber and Jim Grant are right about the possibility of hyperinflation, but it is hard for me to see how the dollar and our purchasing power are not the eventual casualties of the Fed’s doubling of its balance sheet.

The Inoculated Investor

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13. Where do most value investors screw up?

I like to think that the recent turmoil in the markets will separate true value investors from what Klarman calls value pretenders. The latter are investors who only knew appreciating markets, never really considered intrinsic value and thought that buying dips was the same thing as value investing. In a Darwinian kind of way this crisis could have a silver lining, at least in terms of separating the truly skilled from those who benefitted from the rising tide.

When it comes to legitimate value investors, I think there are two common mistakes. The first is thinking that a stock can really be market agnostic. When there is either excessive euphoria or extreme fear in the markets, stocks that should not be correlated to one another seem to move in the same direction. The appropriate lesson is not to become a closet macro fund and try to time economic cycles. The answer is to be like Klarman: focus on company specific analysis but make sure that the macro environment is not unambiguously going another direction. Second, I think that value investors are often too quick to trust the markets to close the gap between intrinsic value and price. I am not suggesting that we all become technical analysts, but it is important not to forget that certain exogenous forces can have a tremendous impact on the markets. Last year we saw what forced and panic selling can do to stock prices and this year we have seen how Federal Reserve liquidity injections can turn a market speculative just about overnight. So I think it is useful to be at least aware of ways that overall market distortions can affect the process of value realization, especially with the number of players out there who have the incentive to manipulate the market.

14. You have a reputation as a diligent & structured investor. Tell us about your use of checklists.

I am a huge fan of checklists. I soon need to sit down and write down every metric that I evaluate about a specific company. Right now my checklist exists in my mind and on an Excel spreadsheet template that I use for just about every company. Don’t get me wrong, this is not a DCF model with specific assumptions about growth and an arbitrary terminal multiple. I clearly understand the false precision that comes with such models. I just like to aggregate all the quantitative information--from margins to insider ownership to valuation metrics—in one place. It really helps me frame the company before I engage in a longer write up in which I include the qualitative factors as well. The benefit of this strategy is that it forces me take a very comprehensive view of a company. For example, let’s say a company has an interesting product or division that you think is under appreciated by the market. Without calculating the operating margins for each subsidiary you might not notice that this very profitable division is being dragged down by a low margin business that just sucks up capital. So, even though the number of items on the checklist can lead to a bit of informational overload, I firmly believe that it helps me avoid overlooking important characteristics.

15. What single trait is most important to cultivate in order to be a successful investor?

The Inoculated Investor

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Without question being a successful value investor requires a certain temperament. It is very hard to be greedy when others are fearful. Humans are not wired to be contrarians. We like the safety of the herd. Value investors measure the magnitude of an opportunity based on how sick they feel when they make the actual investment. The more consternation establishing a position causes, the better the returns are likely to be. Accordingly, developing an even temperament in which you don’t get excited when stocks are going up or get downtrodden when your positions are moving against you requires a significant amount of discipline. While I do think some people are predisposed to being able to control their emotions and stick to their investment philosophies, it absolutely takes practice. Even some of the best investors became paralyzed during the free fall in equity markets during the early part of this year and the ones who have been the most successful loaded up on stocks they had strong convictions about during that period. So, as Warren Buffett has said: “By far, the most important quality is not how much IQ you’ve got. IQ is not the scarce factor. You need a reasonable amount of intelligence, but temperament is 90% of it.” Along the same lines, I don’t know if I can take credit for making this up but my mantra is to be passionate about the markets but to invest dispassionately. I think if I can follow that I will end up being an accomplished investor.

16. What is the hardest bias for you to overcome?

In my case, I am constantly fighting to avoid becoming a victim of confirmation bias. I am definitely guilty of searching out information that agrees with my philosophies and views on the markets. I also often too easily dismiss opinions that are contrary to mine and too readily accept those that mesh with my views. Accordingly, I make a concerted effort to read anything I can find that offers the other side of an argument. Even though it feels just as painful as being outside of the herd, it forces you to understand the contrarian position in a way that can help you make better decisions.

17. Where do you see yourself after business school?

My goals are very simple. After I graduate I hope to have the opportunity to work for a value fund in which I have access to a portfolio manager who is willing to be my mentor. I anticipate that my research skills will get better with more practice. However, I have never had the luxury of being able to watch a skilled valuefocused manager navigate the markets. It is not hard to analyze individual stocks. Managing my own portfolio is a challenge, but nowhere near as nerve wracking as managing other peoples’ money. Thus, if I am lucky I will be able to find a job with a value manager in which I can spend a lot of time observing and learning how to run a portfolio day to day. Eventually my goal is to be a portfolio manager myself and the dream is to run my own fund. I am aware that I am probably many years from reaching that milestone and have more to learn than I can possibly even describe. But I look at business school as a conduit for developing relationships that will help me along the way. I also plan to continue doing a significant amount of company specific research outside of the classroom so I can continue to further my skill set.

18. What message/advice would you give to readers of SimoleonSense?

The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

My advice to readers is to look in the mirror before you decide how to allocate your precious capital. Investing is black and white in one way: either you have the skills and time to become a professional investor or you don’t. Honestly, while I hope I am qualified I am still working every day to figure out which camp I fit in. The truth is that it is OK if you don’t have the time, the temperament or the skills. You have plenty of wonderful value managers that you can entrust with your money. You can also buy an index and do better than most mutual fund managers. Managing a portfolio of individual companies is a full time job. Please, never forget that. The attention to detail and time required to follow and understand a portfolio of stocks are not trivial. If you cannot perform deep and comprehensive bottom’s up analysis on specific companies I would suggest that you are better off letting someone else manage the equity portion of your portfolio. I worry that CNBC and Jim Cramer lead far too many people to think this is a game that anyone can play. It is unquestionably not. Just like you wouldn’t want someone performing open heart surgery on you after watching a TV show about doctors, you should not be trying to pick individual stocks after doing a minor amount of research. Let someone who will act as your fiduciary do that for you. 19. Thank you very much for taking the time to interview with us. Thanks for the wonderful opportunity to present my ideas. I hope everyone finds my responses valuable. I look forward to having another chance to share my thoughts with your readers.