Investment Insights from the Monsters of Stock

Last Thursday I attended a conference in New York entitled "Value Investing: Celebrating the Life & Legacy of Benjamin Graham." The occasion was to celebrate Graham’s 110th birthday (of course, Graham is no longer with us, having died in 1976 at age 82). The panel discussions were fascinating and the list of speakers a who’s who of value investing. The all-star lineup included Seth Klarman, Bill Nygren, Chris Davis, Howard Newman, Bill Ruane, Peter Cundill, Walter Schloss, Mario Gabelli, John Rogers, Chris Browne, Jason Zweig, Bruce Greenwald, and Mason Hawkins, among others. (Warren Buffett chose not to attend the conference, although he was in New York at the time. Benjamin Graham Jr. was there, however.)

Whenever value investors get together to talk about stocks, the usual topics come up: margins of safety, intrinsic value, price/book, and economic moats. While those subjects were raised here as well, there were some new insights I gleaned from listening to the masters speak. Here are a few of them.

Catalysts, Management, and Value Traps
Several of the panelists, including Klarman (of the Baupost Group of Boston) and  Gabelli Asset Management's (GBL) Mario Gabelli, talked about the need for a "catalyst" when deciding whether to buy a stock. These catalysts might include a merger announcement, an unexpected earnings increase, a new CEO, etc. Without a catalyst, even a really cheap stock can turn into a value trap.

A value trap is a common problem in value investing. This situation occurs when an investor buys a cheap stock only to watch it get cheaper year after year. For example,  Eastman Kodak  is a classic value trap. This stock has looked cheap for years, but that hasn’t stopped it from declining further. Poor (or lackadaisical) management teams cause most value traps.

Thus, the main harbinger of a value trap is an entrenched management team that doesn’t seem to care what happens to the company, or is set on pursuing a growth initiative that doesn’t make much sense. A poor management team will continue to let the stock languish, or drive it down further. On the other hand, a good management team will find a way to positively surprise investors. This will cause the stock price to rise.

If you find a cheap stock but can't figure out why it’s cheap, move on. It’s often a management issue. If management isn’t on your side, you could end up waiting years for your investment to work out, if it does at all.

Absolute vs. Relative Returns
To quote Seth Klarman: "Successful investing should be absolute, not relative." Over long periods of time, value investors tend to do well relative to the broader market. However, good relative performance should never be a value investor's goal. Instead, a value investor should attempt to generate positive returns regardless of the performance of the stock market. Your relative performance versus a benchmark is just a distraction and should be ignored, or viewed only in the rearview mirror.

To generate good absolute returns, an investor should always insist on a significant margin of safety before purchasing a stock. Adhering to this strategy will provide safety of principal in the event of a market decline. Of course this doesn’t guarantee that an investor will never lose money in any given year, it just lowers the odds that it will happen.

Shareholder Activism
Moderator Jason Zweig of Money magazine launched a discussion of shareholder activism, and the panelists had some good things to say about this topic. In particular, panelist Chris Davis of Davis Selected Advisers presented a lucid argument on why insiders can get away with murder without shareholders taking action to stop it. He cited six reasons:

1. Investors live in glass houses--Most institutional investors are not exactly saints. Criticizing company management teams could open these investors up to criticism themselves. Most investors would rather keep a low profile and vote with their feet (by selling) when they disagree with management policies.
2. Conflicts of interest--It’s hard for a money manager to criticize a company whose pension fund has invested millions into that manager’s fund. Better to keep quiet and vote with the feet.
3. Apathy--Most large investors (one panelist cited the Harvard Endowment Fund) are apathetic. Some of them think the markets are efficient, so management's actions don’t make much difference in the context of one's overall portfolio. Ditto for investors who are highly diversified.
4. Short-term mentality--Fighting management is a long-term strategy. It could take several years of lobbying before a money manager causes a material change in a firm's corporate governance policy. Because the average holding period for mutual funds is about one year, many fund managers don’t care much what happens over the long term.
5. Cynicsm--Investors have gotten used to being abused. They figure this is just part of the game, and many are willing to live with it.
6. Cost--Proxy fights can cost millions of dollars, with no guarantee of a successful outcome. Only the largest investment funds have the resources to launch full-scale battles with management. And without a full-scale battle, management will almost always win, because management can use company resources (money, PR department, etc.) in the fight. Under current U.S. law, the fight is stacked in management’s favor.

Option Grants
Next, the discussion moved to something that has been talked about a lot over the past few years--stock options. Davis made an interesting point: If a company’s stock goes up 8% per year, and the company gives away 4% of its outstanding shares in the form of options each year, then it is giving away 50% of the return on its stock to employees. In other words, the cost isn’t just 4% per year, it’s 50% of the return. Many companies, especially those in Silicon Valley, routinely increase their share count by 2% to 5% each year by issuing options.

Interestingly, over the years, Davis has tracked the prices at which options are issued at many companies. His data shows an amazing trend: Companies routinely issue more options when their stock price is close to its 52-week low, thus setting the strike price as low as possible. Then, these same companies routinely buy back shares close to the 52-week high in an effort to minimize "dilution" from issuing the options. This is tantamount to thievery, and it certainly destroys shareholder value.

Stock Buybacks
In theory, stock buybacks should be preferable to dividends now that the tax ramifications are the same. After all, company insiders should know better than anyone when their stock is undervalued, and should be able to take advantage of an undervalued stock by increasing share repurchases at these times. However, Davis says that companies tend to do exactly the opposite: buy more shares when the price is high, and fewer when the price is low.

The solution: The panelists agreed that the only realistic way to prevent such abuse at some of these companies is to insist that they pay a healthy dividend. By paying out earnings in the form of a dividend, management teams won’t have enough cash sitting around to engage in value-destroying share repurchases.

Chris Browne of Tweedy, Browne Company suggested a radical idea (though he said he’s sure it will never happen in reality): a law that forces management teams to pay out 100% of earnings as a dividend, similar to what REITs must do. After paying out the dividend, management teams could make a case as to why shareholders should reinvest some of this dividend back into the company in the form of new shares. This would put the investment decision in the hands of shareholders, rather than management teams--a concept similar to a partnership where all the business partners make a decision about how to allocate capital.

Treating minority shareholders as business partners? Nah, it could never happen.

Etc.
The first mutual fund, called the Massachussetts Investors Trust, was started in 1924. In 1949, Alfred Winslow Jones formed the first hedge fund. In 1976, Vanguard started the first index fund. More recently, funds of funds, which glue together multiple hedge funds or mutual funds into one package for diversification purposes, have formed. Of course, adding a layer between the investor and the investment often necessitates the addition of another layer of fees to the fees charged by each individual fund.

Today, I am excited to announce that the industry has now developed a new, exciting investment vehicle (thanks to Jim Grant of Grant’s Interest Rate Observer for bringing this development to light at the value investing conference). This vehicle will quickly and conveniently allow the wealthy investor to diversify beyond his or her wildest dreams by holding hundreds of hedge funds at once. How, you ask?

Enter funds of funds of funds. You read that correctly--I didn’t hit the space bar one too many times. These funds, affectionately called F3 funds, are exactly what the name implies: funds composed of a dozen or so funds, each of which is further composed of a dozen or so funds. Thus, using simple multiplication, one can calculate that the F3 investor gains exposure to 150 to 200 different hedge funds in one glorious, ultra high-cost, multilayered package.

Never underestimate the ability of Wall Street to package a ridiculous idea as a hot new product.  Procter & Gamble (PG),  Nokia (NOK), and  Nike (NKE) may be juggernauts in the marketing department, but they have nothing on the creativity of the investment industry.