Jean Marie Part 2 - The Interviews

Cover Story

Graham, Buffett and beyond In a two-hour, free-wheeling interview, Jean-Marie Eveillard explains how his investment style has evolved over the years. A Swiss chocolate aficionado, one of his most successful investment calls has been Swiss chocolate maker Lindt. Eveillard insists that his contribution to the company’s sales must be counted as one of the reasons for its success! Mohammed Ekramul Haque & N Mahalakshmi

1970 –At the office in New York City Can you tell us about your investment style in your early days? I ran the fund alone between 1979 and 1986, so, most of the stocks I bought were the Benjamin Graham type. Graham’s approach is less time consuming and in the late 70s, which were terrible for the stock markets, there were quite a few Graham stocks available not only in the US but throughout the world. Later I graduated to Warren Buffett’s style as we added more people and had a bigger team. (Graham’s approach involves picking a basket of cheap stocks based on financials without involving rigorous research on the quality of business. Central to Buffetts’ style is buying concentrated bets in individual companies after thorough research.) Originally, Graham’s book, (The Intelligent Investor), and later the annual reports of Berkshire Hathaway influenced my thought and approach to investing. What got you attracted to Graham? It was a common-sense approach. The idea of order as opposed to chaos, the idea of long-term investing, the idea of intrinsic value made a lot of sense.

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Can you tell us about the kind of Graham stocks that you picked? Most of the time it is derived from the Outlook PrOfit 19 September 2008

balance sheet, with necessary adjustments to the asset side and/or the liability side. There is no attempt to peer into the future as Graham said the future is uncertain. There is not even an attempt to assess the strengths or weaknesses of the business from a qualitative standpoint. So buy equity worth $40 per share based on balance sheet strength at $25 a share, and sit on it. Then at $35, start selling and at $40 you sell it all. That’s what Buffett called the cigar butt type approach. You get one good puff from $25-35 and then it is all over.

is always something that can go wrong and if over the following years the company loses money every year, and after five years the cash is gone, then obviously it is a terrible mistake. The availability of net cash stocks is a good indicator of how cheap the stock market is. If we don’t find any Graham type stocks or Buffett type stocks then we let the cash build up.

Do you look at the macro situation? Value investors are bottom-up investors. But when we establish intrinsic values and update them, we do not assume eternal prosperity but accept How do you arrive at the intrinsic that there is a business cycle. But we value of a stock? say, hey, what are the odds of considerI’m intrigued by the balance sheet-deable economic difficulties for a year, or rived intrinsic value which two, or three? Based on that is basically stock holder’s we may be more demanding When we equity with some adjustin terms of valuations. ments to assets side and li- bought abilities side. I used to look Berkshire, we Did you switch to the Bufat companies which had were getting fett approach because you cash plus marketable secucould not find enough Grathe talent and rities minus financial debt ham type stocks? in excess of the market cap. skills of Buffett Yes, partly that. The main And while valuing securi- without having reason was that as we staffed ties we assume they are liq- to pay for it up we could try the Buffett uidated so we take a cut for approach, but not without taxes. trepidation because I don’t So I would want the net cash to be rehave the skills of Buffett. But my feelally close to market cap, because if the ing was that if it could be done reasonmarket cap is less than net cash I’m ably well, it could be more rewarding. paying less than nothing for the business. The important thing is also to enDo you like to buy holding companies sure that a company should not have where the chances of unlocking secuhad instances of major losses in the rities held may be very limited? past and the business is not in the beWe have seen that some holding comginning of a permanent decline. There panies have been successful in re-

shuffling the assets. They may have six-seven minority stakes in several businesses and over time they reshuffle -- sell one asset and buy another. If they are successful, that is reflected in the net asset value (NAV). In such cases there is no reason for a discount to exist. We are more comfortable when the holding company management is intellectually honest and has been reasonably successful in reshuffling assets in the past. The best case is when a company has demonstrated success in reshuffling assets in the past but investors have not recognised it. One of the paradoxes with holding companies is that if the market goes down and if the minority stakes of the company are listed, the value also goes down. Plus, for the holding company, the discount to its NAV too increases. So I may get a double discount: first is the discount to the asset value and second, the prices of individual stocks may be undervalued. Berkshire Hathaway was a holding company, but now is a conglomerate because Buffett has done so many acquisitions over the past few years. When we bought Berkshire Hathaway, we bought it as a holding company at a discount to its NAV. We were getting the talent and skills of Buffett and we did not have to pay for it! Do you need to be convinced about how a stock will play out before you make the purchase? We’re value investors, we think long term, so we don’t need a trigger or a catalyst. There is never genuine visibility: the future is uncertain. What about companies with peripheral assets? Yes, we buy companies with peripheral assets. Sometimes investors tend to ignore peripheral assets such as surplus real estate, portfolios of securities, minority stakes and analysts of the sell side ignore these. In Japanese companies, many analysts ignored that these companies were sitting on a ton of cash. Cash is cash, cash is worth 100 cents to a dollar. What do you do if you buy a stock at 40 per cent discount and it does not go up? If I establish the intrinsic value at 40 and it is trading at 25 and, if over the next few years, I keep updating the intrinsic value at 40-42-45 then I can be very patient and wait for 5-10 years. I would prefer that the intrinsic value increases. A lot of investors will not

touch a company that is not growing. But the truth is that even if the company is not growing it may be worth a lot, it may have a lot of cash, it may be in an industry which is not growing but may have very few new entrants which, can at times, can be an advantage. How different is it to calculate intrinsic value using Buffett’s approach? The Buffett approach is best summarised by Buffett himself when he said he would rather buy a comfortable business at a questionable price than a questionable business at a comfortable price. All value investors would first start with reading the annual reports and then move on to the qualitative aspects. You can easily skip the initial pages of the annual report, like the president’s letter, because in all

from increase in the intrinsic value. Can you give us from your viewpoint, businesses that will thrive in the next 10 years and those that are going to see a secular decline? Buffett made a lot of his money with simple often mundane businesses. Value investors, with exceptions, shy away from technology and capital-intensive businesses because there the returns, in terms, of capital, is low. For instance, we have held the stock of Secom, a Japanese electronic security business, for years. It is a good business and mostly

probability it is written by the public relations firm, so it’s worthless. What is towards the end, especially the 1940 –Jean-Marie with footnotes are the ones to watch out his mother in France for. The qualitative aspect is to figure out the major strengths and weaknesses of the business, and what matters and what does not. commercial (as opposed to residential) What matters are the three or four mawhere it is subscription based. Busijor characteristics of a business that ness corporations pay a small amount would constitute a sustainable comof money every month for electronpetitive advantage or what Buffett ic security and Secom is the biggest calls a moat. electronic security company in Japan. Some 20 years ago we realised that And there are advantages to size and forest products (paper, for instance) scale in that business because they business was actually two businesses, have a central security headquarters not one: first the ownership of timber and if the electronic security system land, which is a great business because works well then the corporation which trees grow and you don’t have to woruses the systems of Secom is unlikely ry about wasting the asset; the second to move to another security business. is the processing of the wood which is The numbers look good too. Unfortua highly capital intensive commodity nately, the management has used the business, a terrible business. So you cash generated by the security busigot to identify what is a good business ness for other endeavors that were not and what is a bad business. successful. Buffett says most of the money that he is going to make in the next 10 years Do you look at discounted cash flows is not from the reduction or elimination to value companies? of the discount to intrinsic value but No, we never use discounted cash 19 September 2008 Outlook PrOfit

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Cover Story flows. Buffett does not consider discounted cash flow either, because the way things work, after 10 years you have a residual value which is often about half the net present value. So not only do you pretend to know what is going to happen over the next 10 years but even beyond. So we never do discounted cash flow, which I think is garbage. It’s as bad as the efficient market hypothesis. We don’t look at price to earnings but we see EV/EBIT. It’s the best form of valuation we could come up with. It’s not perfect but it is much better than using P/E as it introduces the balance sheet into the picture. It is true that interest and taxes have to be paid but value investors don’t like too much debt so the interest costs are modest or nil so often EBIT is equal to pre-tax income. We own a group of Japanese companies that are sitting on a ton of cash that is earning very little income but why should I ignore the cash. Price earnings ratio ignores that they are sitting on a ton of cash.

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2008 - With wife Betty (right) and daughters Suzanne and Pauline (second from right) at Chicago university

Do you have a benchmark for EV/ the recent times. EBIT? Your call on the stock was primarily It is somewhat arbitrary. But we use based on the share price, or was it beeight for an average business and for cause of the strong product? a terrific business, for intrinsic value, There were two advantages: It had a we may go up to 15 times. superior product, plus the In the case of holding com- The problem stock was cheap. But the panies, we use this for the one disadvantage was that components of the holding with sum-of-the- the management was mecompany and for the hold- parts is that even diocre. Even if the maning company what matters if you go slightly agement was mediocre, it is the discount to the sum- wrong in your would not have led us to of-the-parts. lose money, because we estimation of bought the stock really Can you tell us about a few the asset value, cheap. of your successful calls, you can end up how they panned out? Can you tell us about losing terribly Many years ago we bought some of your worst calls? Lindt chocolate business. Again, it was a Swiss stock, The company had gone public in the Swissair, which eventually went bankmid-80s but the IPO was not very sucrupt. We did a sum-of-the-parts - they cessful. The company was at that time owned airlines, hotels, caterings, run by Rudi Sprungli, who was a memsurplus real estate, and some twober of the family who controlled the three aviation-related businesses. We business. He was a difficult man and a thought the market was not taking mediocre manager, but he never cominto account those peripheral assets, promised the quality of the product. but at the same time there was a lot The stock was going very cheap so I of debt too. The problem with sumwas willing to buy it. of-parts is that even if you go slightly The stock did nothing for three-five wrong in your estimation of the asset years because Rudi Sprungli was value and the company has a debt, you at the helm and, on top of it, he marcan end up losing terribly. For examried an American woman who was the ple, if I come up with a value of assets member of a cult. In Switzerland they at $50 and if $40 is the debt, then equity are not well disposed to such women. value is $10. If I’m wrong on the asset The family got tired of Rudi Sprungli value by 10 per cent and it’s not diffiand his wife) and fired him and hired cult to be wrong by that much, then an American man who ran the Johnassets are only $45. So the value of eqson & Johnson business in Europe. He uity is now $5. With just a10 per cent has transformed the business for the mistake in the value of assets one ends better, and the stock has done well in up with a 50 per cent decline in equity Outlook PrOfit 19 September 2008

value. It works both ways, if the asset is $55 then equity is $15, again, that’s what leverage does to you. Leverage works both ways and it reduces your staying power. In my call, two things went wrong – I overestimated the value of the airline and, secondly, there was an accounting problem – there was more debt than the consolidated balance sheet indicated and eventually it resulted in bankruptcy. We lost 7075 per cent. As someone once said the value of assets is contingent, but debt is forever. What has been your success factor? We value investors play the game of bridge and the others play pokers . The big difference is that there is much less luck in bridge than in poker. I think the secret of success of most value investors is that when times became difficult they stuck to their guns and did not capitulate. Which books do you recommend apart from Security Analysis and Intelligent Investor? Seth Klarman has written a great book The Margin of Safety and Martin Whitman’s books are interesting too. If you had not been in investment where would you have been? My mother, who is 92, says I got lucky because I got the only job where I could be half decent. In any other activity, I would have been a miserable failure. And I think she is right, though mothers can be extremely critical sometimes! p

Incredible India Vinodh Nalluri, vice-president and research analyst with First Eagle, was in the country for a month, meeting executives of more than 40 companies. Nalluri plays a key role in helping the illustrious investor decide on stock picks. An MBA from Columbia Business School and an MS from Arizona State University, Nalluri has been with First Eagle for three-and-a-half years following a five-year stint as engineer with Texas Instruments. Here’s Nalluri’s first impression of Indian equities… N Mahalakshmi

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We find that average companies, in India, have limited free float and even that is tightly held by institutions.

Can you tell us a bit about your funds? We are an absolute return fund. As Jean-Marie would say, at the end of the day, we eat absolute returns not relative returns. Investing is about ensuring that your purchasing power stays ahead of inflation. And that is the objective of our fund.   What’s your first impression about Indian markets? We missed the bus to the Indian markets as we did not participate in the big rally that happened in the past five years. The Indian market looks more reasonable after the recent correction. Currently, one-year forward multiples are around 16 to 17 times for BSE 100 companies. Mid-caps look even more interesting. At these levels, the Indian

market cannot be ignored any longer. If you look at the American economy, corporate earnings have grown roughly in line with GDP, over long periods. Assuming something similar in India, an earnings growth of 7 per cent to 10 per cent for Indian corporates over the next decade implies pretty decent returns on stocks at these levels. However, the challenge is that India is not a deep market. We find that average companies, in India, have limited free float and even that is tightly held by institutions. So trying to build a position can be quite difficult. And for us, unless we take a position that constitutes at least 50 basis points (roughly $150-200 million); it doesn’t make a significant difference to our performance. Over three years, a 15 per cent return on a large-cap stock is thus 19 September 2008 Outlook Profit

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Cover Story more meaningful for us than a small stock that is a potential multi-bagger. And as promoters begin to understand that holding 51 per cent or 75 per cent makes little difference when it comes to the control you have on the company, liquidity should improve. But the real challenge is picking the right candidates, because people are not really overlooking stocks out here, especially the large-sized stocks that we are interested in. So we have to look for the right price to emerge – either because of behavioral aspects or unfavorable business conditions or other temporary problems that could depress valuations.

QUALIFICATION Vinodh Nalluri earned his MBA from Columbia Business School in May 2005. CAREER From 1998 through 2003, he worked in product development for Texas Instruments. During the summer of 2004, he was part of the equity research team at Lions Gate Capital At First Eagle, Nalluri is responsible for capital goods, chemicals, consumer products, engineering, forest products/paper, services, shipping and shipbuilding, software, technology and telecom equipment MARKETS COVERED Spain, Portugal, Asia ex-Japan and Taiwan.

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In India, normally companies tend to depreciate their assets over nine years which is lower than the economic life of the assets. To that extent, book value may be understated, and multiples exaggerated

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Outlook PrOfit 19 September 2008

and processes they have are truly impressive. The downside though is if banks are allowed to sell securitised products, then they will face an assault from banks. Some other names I can think of are Nestle, which we own, Colgate Palmolive in the consumer space and companies like Shriram Transport Corporation. More importantly, most of the managements out here understand their business models thoroughly and have a proper plan to spearhead their business. We were a bit sceptical about Tata Motors, where we have a substantial position, because of their Jaguar/Land Rover acquisition, but after meeting with the management, we feel a lot more comfortable. We also like their commercial vehicles business where they have created a strong franchise.

So where do you see value? There are several pockets of value, but then many of them also face their set of challenges. Companies in the auto sector, for example, seem to offer value In a market like India will you pay because the near term outlook is weak. a price above book value for banks, Similarly, public sector banks are tradconsidering the growth? ing below book value and look cheap, Growth per se is not meaningful. What but then the challenge for them is how matters is profitable growth. For examwell they will be able to navigate in the ple, today in India, it is not difficult for competitive space, going forward. a bank to produce a return on equity in The government owned excess of 13 to 15 per cent. oil stocks are also trading So, even if a bank generat less than 50 cents to a Banks like ICICI ates an ROE of 15 per cent dollar. But then, those are Bank, which have or so, and grows at 30 per not exactly attractive can- been aggressively cent, you are not going to didates because you know money on the stock chasing growth, make there are valid reasons why if you pay more than book they are going cheap. But, have caused a value. Banks like ICICI as a Grahamian approach lot of pain for Bank, which have been agwould dictate, if you buy shareholders. gressively chasing growth, a basket of undervalued have caused a lot of pain stocks, it can potentialfor shareholders. In their ly deliver good returns. So instead of pursuit for growth they have taken buying individual stocks, a portfolio of unnecessary exposure to certain secsuch stocks can offer decent returns. tors like real estate, and that combined with significant asset-liability misA lot of stocks trade at below book match puts them in a vulnerable spot. value out here. Do you recognise On the contrary, HDFC Bank, has rethem as value? frained from unprofitable growth and Price to book value can be a starting focused very well on shareholder valpoint to ascertain the value in a comue creation. And that eventually gets pany, but you got to look at what is acreflected in the valuations as well. tually in the book. In India, normally companies tend to depreciate their What do you think of India’s assets over nine years which is lower outsourcing story? than the economic life of the assets. I think companies like Infosys have To that extent, book value may be ungood potential for the next decade at derstated, and multiples exaggerated. least. They are no longer just a cost But, I think earnings multiples are arbitrage-based business model. more relevant in the Indian context. They are moving up the value chain. As growth rates in the industry come Have you come across any Buffetdown, existing relationships will matkind of stocks out here, in terms of ter a lot more than ever, and that gives business model? the top players a clear advantage. AlThere are several stocks which have though the rupee appreciation imimpressive business models and have pacts the companies negatively, we the moat that Buffet talks about. HDFC feel given the high returns, and longis one stock that has a great business run growth rates in excess of about two model. The franchises they have cretimes GDP, the Indian outsourcing stoated in this country and the systems ry still seems intact. p