didn’t work out. BizMart didn’t work out because they openedseven out of 35 stores in Houston. Those were bad. They didn’t getaccess to capital, and they eventually sold out to Office Max. OfficeClub stumbled a little bit, although not as much as BizMart, and theysold out to Office Depot. Staples and Office Depot sort of vied for thewinning position.
Tanous: What happened to Office Max?
Ballen: Office Max was a division of Kmart, so you never got anopportunity to invest in it. But, as I mentioned earlier, the investmentsin these companies went through three stages. We held on throughall three stages, and added at various points. In the initial stages, allfour companies were growing and doing well. Then they started tocompete against each other and against a bunch of other non-publiccompetitors. There was a shake-out period, and you made very littlemoney in the stocks from 1989 to 1991. After 1991, once you gotdown to three or four players, they leveraged their costs and expandedtheir margins, and it became a great industry.
If you were really clever, and we weren't clever enough, you wouldhave sold Office Depot after the initial pop, waited the two-and-a-half years during the shakeout, and got back in. I think the problemwith being so clever is that you might miss the buying points. It’svery difficult to sell at the top and buy right at the bottom. We heldduring that time, and added to our position, because we kept saying,it’s going to happen, it’s going to happen, over and over again. Thenyou made ten times your money from 1990 to 1996. You had plentyof time to get in.
Tanous:Back in 1986 you saw a new industry being born, andsomething about it, something about your analysis told you that theidea of these chains of stores that catered to offices was going to reallycatch on. Right?
Ballen: We knew it was a big market. You just knew it was a $100billion market. You knew it was served by inefficient dealers who hadpoor selection, poor prices, but, nevertheless, some service. And youknew it wasn’t being served by the Home Depots, the Wal-Marts, andthe other big box [large store] retailers out there.
Tanous:So you bought them all!
Ballen: We were the largest investor. We probably owned 5% to
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10% of all four. We had owned Home Depot and made a lot of money;we had owned Costco and gone through different cycles before. Welearned from our experience what to look for. There have been a lotof other big box industries that haven’t taken off.
Tanous:! want to guess at something. Would it be accurate to saythat there were other fund managers back in ’86 who felt as you didthat this was going to be a great industry? Is it fair to say that youare one of the few who believed hard enough to stay with the stocksthrough the shakeout?
Ballen: I suspect that a lot of people saw the shakeout coming butgot smart and sold the stock - and never got back in. A lot of man-agers never look back or revisit an old holding. They have an absolutesell discipline.
Tanous:In your case, though, there is a history of revisiting orstaying through and maintaining confidence in your original decision.As part of that, do you pay a lot of attention to the management ofcompanies? Do you want to talk to them?
Ballen: Yep. We try to do as much of that as we can. We’re activein doing that. In a lot of the investments we hold, we’re the largestshareholder the company might have. So they talk to us on a veryproactive basis. Of course, you want to keep your objectivity as well.
Tanous:So you don’t want to play golf with them.
Ballen: You don’t necessarily want to play golf with them. Let metell you my Jiffy Lube story. This was a company in the fast oil changemarketplace. It came public in the ’85-’86 time period and did verywell. We tripled our money and sold it. We bought it back after thecrash [in 1987]. The reason we were interested in that market wasthat we observed the number of gas stations declining. The EPA[Environmental Protection Agency] was taking a dim view of peoplethrowing that stuff in their back yard after they changed the oil. Itseemed that a service business, like Jiffy Lube, made sense. This wasa royalty-type business, a good business model, a franchise with a40% market share in the U.S. for oil changes. We invested, but itdidn’t work out. We ultimately sold our stock after we lost half ourmoney. So this wasn’t a good story to tell you. The reason we lostmoney in the stock was twofold: (1) We misperceived what the largerplayers were going to do, the Mobil Oils and the gas stations of theworld. In order to get your repair business, the gas stations werewilling to really discount the oil change business. So no one was
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destined to make money in that business. (2) Management didn’tprove capable. | realized that things were not going as well as theycould be. They started to lend money to franchisees who couldn’t payit back. That was the biggest problem. They eventually sold out toPennzoil at a dime a share. Basically, they went bankrupt. So I’msitting one Saturday morning, talking to the president of Jiffy Lube,and he answers all my questions. I hang up. On the surface, everythingwas okay. I felt better. He assuaged my fears.
Then, on that Saturday morning, I sat back and said, gee, I’m callinghim on Saturday morning and if this is what it takes, maybe there’ssomething wrong here. What was wrong was, if you have an invest-ment where you need to be calling the management on a daily basisto find out how the business is, that’s probably not something youshould be investing in. You should have enough confidence in thelonger term promise of the investment. You shouldn’t really careabout this year’s Christmas sales. You should be investing in compan-ies where if Christmas is bad, you would be thinking, that’s a wonder-ful opportunity to buy more stock. But my investment premise thenwas that Christmas was bad, and I’m going to sell the stock. Somethingwas wrong. I try to seek out companies where it isn’t mandatory tobe quizzing them daily, where the longer term trend is powerfulenough to overcome a few short-term setbacks that may come along.If you find yourself feeling that you really want to call a companyon a Saturday morning because you need another daily update, youprobably shouldn’t own the stock. Monday morning, I came in andsold the stock. It went to zero.
Tanous:John, that sounds awfully intuitive. Is there something morethere - a seat-of-the-pants or gut feeling?
Ballen: It combines many elements. One is a vision of the futureand how the company will fit in it. That may allow you to disregard,or put less weight on a particular event, like this year’s Christmassales. Some people don’t think you should be talking to managementsat all, since they always put a cheery spin on things. The importantthing is the valuation of the stock relative to the future of the business.
Tanous:But do you think there might have been something intuitiveabout the decision to sell Jiffy Lube? I mean, as you tell the story, Iget the feeling that you put down the phone on that Saturday morningand you said, you know, something doesn’t feel right.
Ballen: | suppose you're right. That speaks to the intuitive nature
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of the business. There are just so many inputs that you can’t put intothe computer, ranging from the extracurricular activities of the CEO,to how the management treats the employees. There are so manydifferent inputs that don’t fit models. That’s why you can’t just putdata into a computer and expect it to spit out buys and sells. Thereare too many variables with different weightings. In rare cases, theCEO is a crook and you may not be able to see that. Can you sensethat? Sometimes you can and sometimes you can’t. That part becomesintuitive. In some aspects, that’s why the business is structured theway it is. In our firm, and in most firms, you have analysts andportfolio managers. The analysts are meant to be very factually ori-ented and know the day-to-day data. Hopefully, the portfolio man-agers are a lot more experienced and endowed with intuition.
Tanous:So back to Jiffy Lube. You sold the stock and took a loss.
Ballen: Lost half our money. We could have lost it all.
Tanous:Do you believe in maintaining cash reserves? Do you worryabout the market as a whole?
Ballen: You can’t ignore the larger picture. You want to know whenthe market is going to gravitate toward your types of companies, be-cause that’s when you're going to be rewarded. More important, Ithink, is to focus on the fundamentals and make the assumption thatthe market will eventually reward your investments. I focus on thefundamentals, make sure the growth is in the companies. At the endof the year, I check to see if we came through with what we thoughtwe would. I pay a lot less attention to the overall market.
Tanous:Do you ever go into a substantial cash position? How bigis your portfolio now?
Ballen: Close to $4 billion.
Tanous:Might you close it again? [Ballen closed his fund for aperiod from January 1994 to January 1995.]
Ballen: Let me answer the first question about the cash. I use markettiming or what’s happening in the market as a whole. For instance,a recent example is the technology stocks, which have been out offavor from the fourth quarter of 1995 until a few weeks ago [earlyJanuary 1996]. There are a lot of investments | wanted to add to. Butthey’re out of favor and you wonder when it’s going to turn. Thereare a lot of companies that we don’t own here at MFS that, frankly,we thought were going to have poor earnings. We figured the poorearnings would come out before the good earnings. So that gave us
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a time line. The company is going to report disappointing earningsthrough March, so when is the batch of bad earnings going to be re-leased?
There’s one story we called almost perfectly. We figured that Mo-torola was going to be the last bad earnings report. We said that, onthis date, these stocks had a chance of turning. Believe it or not, wewere right there to the hour, aggressively buying on the Motoroladisappointment. You know, we're a $4 billion fund, so we’re not goingto turn the whole fund on. These are things we do on the margin.
Tanous:In fact you had cash reserves and you used them.
Ballen: You have reserves. You recycle some money from otherindustries. We’re not omniscient, but when the market had done verywell from 1991 to 1993, we got to the beginning of January 1994and made a list of stocks we wanted to buy. It was a very short list.We thought the valuations were fully reflected in the fundamentals.We closed the fund on January 15, 1994. Our signal to investors was,we're going to close the fund. Existing investors can reinvest butwe're not going to market the fund, because we don’t think the oppor-tunities are there. That proved to be a good decision. We kept makingthat list up religiously for the next four quarters. We got to the fourthquarter of 1994, a difficult year, and saw the list grow and grow.About then, we decided that the opportunities were there again. So,we did a big road show, did some promotion, and reopened in Januaryof 1995. And 1995 was a great year. So that proved to be good timingfor everybody. We didn’t get people in and disappoint them.
Tanous:How’s your list look today?
Ballen: Our recent list is ample. There’s no reason to close againnow. Given where valuations are, we see some good times ahead.
Tanous:John, let’s switch focus a little bit. Something that is ofgreat interest to me is the “great debate.” The academic community,which has contributed tremendously to our understanding of how in-vestments work in the modern world, is pretty much of one mind aboutone important thing. They maintain that you can’t beat the marketover a long period of time. One reason I’m here in Boston talking toyou is that you are one of the people who seemingly disproves thatwidely held contention. Let’s talk about that. The academics are, ofcourse, aware that people like you exist, but to them you are the out-liers on the distribution curve. The question is whether or not thereare people like you, who can systematically beat the market, or
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whether or not they just got lucky. Many academics think that you’rejust a lucky guy. How do you answer that?
Ballen: The first thing I’d say is, look at my background. I workedat the National Bureau of Economic Research, I published some articleson economics for them, I’m an economist by training, I studied eco-nometrics, at Stanford Business School, I studied the Sharpe modelsand all the rest and was about inches away from becoming an aca-demic. I was accepted in the Harvard Ph.D. program in economics.
Tanous: That is interesting. Just think, John, you could have beenone of those very same people who don’t believe in people like you!
Ballen: I was pretty close to being one of them! So I fully appreciatewhere they are coming from. The other thing Id say is, it has gotteneasier to beat the market, not harder, over the last five years. Thereason is that, in some sense, the market has gotten more irrationaland random. There are a lot of new players out there, especially onthe momentum side, who create great disparities and huge volatilityin the market. You can notice that, with stocks up 50% or down 50%,in one day. Those become opportunities. From volatility emerges op-portunity.
I would contend that, in a lot of sectors, the market has become alot more volatile. I don’t know how you measure it, but I believe thatthe volatility has added to opportunity. I know a lot of the peopleyoure interviewing. There is a good correlation that the people whooutperform year-in and year-out seem to consistently outperform,and the people who underperform continue to make the same mistakesyear after year. All the academics will say, if you look at the models,and there is a stringent view and a non-stringent view, that if youhave information that other people don’t have, that is a reason foroutperforming. It’s not necessarily inside information or non-publicinformation; some of this information involves the experience levelof the person who has dealt with the investments before, as well asall the research that that person may or may not be doing.
Tanous:So, basically, what you’re saying is that you don’t believeat all in the efficient market hypothesis - that all of the public inform-ation is in the price of the stock at any given time. What you’re saying,and there are other examples of this, is that there is a body of inform-ation out there, available only to a select few people who are (a) smartenough to get it, and (b) smart enough to analyze it. Is that a fairstatement?
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Ballen: | think the information is out there but people choose toignore it. The information is 90% out there, but most people don’tknow how to interpret it or use it. There is 10% that is just hard-sweatwork. But the information is out there.
Tanous:So it is not, therefore, reflected in the price of the stocknow if most investors have not used the available information fullyor properly.
Ballen: Exactly. The information is not being used properly. That’swhy you see the volatility. I can give you case after case where, whenyou look back, you'll say, of course, how could we have missed this?
Tanous:How about an example?
Ballen: Let’s go back to United Heathcare, one of our largest posi-tions, a company that dominates the health care area. They sit rightin the middle of the trend toward lower costs, HMOs, health caremaintenance, Medicare, Medicaid, and negotiating with hospitals, etc.I don’t think anyone would deny that. Last year, on the margin, youhad a slight uptick in medical costs and a flattening in their premiums,so they missed the quarterly earnings that Wall Street was hopingfor. Not once, but three times in a row. These were small misses. Whathappened each time was that the stock went down, down, and down.When the stock got down to $34 a share, they had $17 of cash pershare on the balance sheet.
Previously this company had grown 25% to 30% a year. It wasselling, at an adjusted basis for the cash, at 8 x earnings - half themultiple for the premier company in a growth industry with 25%growth going forward. But it still went down and down. Wall Streetdeserted it. There wasn’t an analyst on Wall Street who was recom-mending it so far as we knew. The market felt that, with each disap-pointment, it must take the stock lower. Even though these weren’tbig earnings disappointments; these weren’t big disasters. I’d say thatmost people looking at that situation then would have said, that stockis a buy. Why did it get so low? Because people sold it because of thedisappointment. They said there’s another disappointment in earningscoming, so it’s got to go down, no matter how low it is already. Itbecame a self-fulfilling prophecy. Stock’s going down, I have tosell...Stock’s going down, | have to sell...But they ignored the factthat the slightest bit of positive news, even if it was minor news tothe company, could just change the psychology tremendously.
The company didn’t change, but a piece of positive news comes
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out and the stock goes from 34 in, probably, June of 1995, to closeto 64 in early 1996. Up almost 100%. The mistake we made is thatwe started buying too early. We started at 40 on the way down to 34.We got more aggressive as time went on and built a large position.We are one of the largest shareholders in United Healthcare. Presentedin retrospect, most people would say that the stock never should havegot down to 34, but, at the time, people were selling it because therewas another piece of bad news. “It must go down; it has to go down...”
Tanous: Your point is that all of the available information at thetime suggested that the viability of the company was not affected justbecause quarterly earnings were a few cents off; that everything aboutthe company suggested that it was going to continue to be successful,despite the little setbacks. Did you become a value investor all of asudden?
Ballen: We had no incremental information that wasn’t readilyavailable to anybody. It was all out there. People did not interpret it.They chose to ignore it.
On the other point, I find that the value guys and the growth guysare looking for the same thing. I feel best when I have the same stockin the portfolio that Michael Price [page 33] has. I feel we both havea successful investment because I have a valuation that makes senseto me, and I’ve got the growth, and he’s got a valuation that makessense from his point of view. So I’m always very comfortable whenI see that we’re owning the same types of stocks together. Too muchis made of the differences between value and growth. The goals arethe same. No one wants overpriced securities, and no one wantscompanies that aren’t growing. Basically, we’re all looking for growthat a reasonable price.
Tanous:Except that the value guys are buying cheap assets, at leastto them.Ballen: Hoping that there will be growth from those assetsor the earnings will be recognized, or that value will be created.
Tanous:The academics maintain that the value stocks are riskierthan the growth stocks.
Ballen: I believe that. One of the riskier things about the valuestocks is they tend to go out of investors’ minds quicker, and therefore,when they’re out of favor, they go really out of favor. Especially thesmall ones. The other factor is that you have no salvation from thecompanies themselves, because they’re not growing out of theirproblems. With growth companies, as long as the growth is still there,
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there is always a market for those particular securities or even for thecompanies themselves. So we have investments that, if they don’t getrecognized, tend to get bought out. We have several buyouts in ourportfolio every year. Managements get frustrated that the value oftheir company isn’t being realized in the market, so they sell the stockto another company for a higher price.
Tanous:When you buy a stock, you are generally buying a largeposition. Are there any industries, or theories, or ideas, that arecompletely excluded from your consideration? Are there industries inwhich you are inherently not interested?
Ballen: One of the exercises I like to go through is to ask, is therea comparable company or a comparable industry that has been asuccessful investment? There are some industries and some companieswhere, frankly, it’s a lot more difficult to make money, where thebusiness model doesn’t make much sense. There are some very capital-intensive industries where it is very difficult to have sustainable re-turns over the longer term. So, we’re not going to say you never canmake money in a particular industry.
One of the things that made HFS a great investment was the factthat the motel and hotel industry was out of favor at the time. Peopleconcluded that it was an industry you never wanted to be investedin. The reason was that, from 1985 to 1990 the companies wentbankrupt. Prime Motor Inns is a good example. A high flying growthstock hits the skids and goes bankrupt. They owned a lot of real estate;the cycle turned on them; they had a lot of debt; the company goesunder. That gave a big black eye to the whole industry. No buildingin the hotel and motel industry, no investment, everyone had writtenit off.
Comes HFS in December 1992, and there hadn’t been any hotelbuilding for five or six years. No lending, low occupancy, low prices,but the industry was about to turn. One of the things that propelledthat investment was that it came out just as the industry was aboutto turn. On top of that, because it was such a bad industry, when theywent public, you were able to buy it at 13 x earnings, a very lowmultiple. So a double effect - of getting the company just when theindustry was turning, and the valuation was low.
Tanous: What mistakes do investors make?
Ballen: One of the mistakes people have made over the last fouryears is not investing in the stock market, because they thought the
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economy was weak. The recovery, since 1991, has been the weakestrecovery in the last 40 years. Yet it’s the second best profit period. Itis exemplified by companies like AT&T laying off 40,000 workers.It’s been the second best profit period because corporations are out-sourcing, downsizing, and right-sizing. So the mistake people havebeen making recently is saying, I’m not going to invest in the stockmarket, because the economy is just so-so. This story foutsourcing,downsizing, right-sizing] may be a book in itself, because the U.S. isdoing it and the rest of the world is behind. That’s the reason the U.S.markets, I would say, are doing as well as they are. As Peter Lynch[page 111] said, most money has been lost, not by people buying themarket and having it go down, but people not buying stocks andhaving them go up. The reason some people have not been investingis the economy, but the companies are doing great.
Tanous:This is a question I probably won’t ask anyone else in thebook. I’m posing it to you because you are probably the youngestperson I’m interviewing. It’s the old job interview question. What doyou expect to be doing 10 years from now?
Ballen: Probably working on the 20-year record. The businessmoves quickly. In some sense, you might conclude that it has becomea more difficult business. You see a lot of successful people retiringearly. Peter Lynch is an example. I don’t think there’s anything elsefor me that provides the day-to-day stimulation. This is a toughbusiness. It’s a game of inches. While it’s easy to tell stories of owningstocks that have worked out for years, the fact is that you are lookingat these companies every day. There’s a lot of pressure and hard work.People burn out.
On the other hand, it’s hard to imagine doing anything else. It’s soexciting and you learn so much every day. When we interview people,what we look for is not someone who knows everything on day one,but people who will learn from their mistakes, who will learn fromtheir Jiffy Lubes, and apply what they learn to other companies;people who aren’t destined to make the same mistakes over again. Ifyou stop learning, you have probably outlived your welcome in thebusiness. It won’t be me who decides not to stay in the business. It’ssuch a hard business that, once your performance turns down, forwhatever reason, either the firm or the investors will vote with theirfeet, and you go on to something else. A lot of people chose to get
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out at the top. A lot of people burned out. A lot of people have beenasked to leave. It’s a tough business.
This meeting gave us quite a bit to think about. Ballen shared hisapproach to picking successful stocks, which revolves around whathe calls the “business model” of his prospective company. Return oninvested capital is the key to his interest in a company. Microsoftversus Sun Microsystems was a good example of two very successfulcompanies where one, Microsoft, has been a much more successfulstock, primarily, according to Ballen, because Sun is a capital-intens-ive business and its returns have been lower.
As to his other selection criteria, I found his approach to selectingthe stocks within a market segment he likes fascinating. After all, ifyou are prescient enough to see a new, high-growth industry emerging- like mass market office supply - which company in this emergingindustry do you bet on? Simple. Ballen bought them all. Then, as thecompetitors slugged it out, he waited and concentrated his bets on thesurvivors. I think his “business model” approach has a lot going forit. Once again, it involves the discipline and intelligence of the man-ager, as well as his skills in evaluating the information at his disposal.
Interesting, wasn’t it, that Ballen almost became an academic? Hiskeen intelligence and methodological approach to his craft reflect histraining and professionalism. We’re not talking about gunslingers orwild market traders here, just a strong commitment to the nuts andbolts of investing. And it really pays off.
I believe that Ballen shed some new light on the efficient markettheory. He said that, in his opinion, the market had actually becomemore irrational and random over time. He thought that the informationis indeed available to investors, but how they interpret it varies; pre-sumably some are better than others at doing that and the ones whoare more successful will have better returns.
Personally, I think his insights are visionary and we will discussthem in the final chapters of the book as we move toward a conclusionon how best to beat the market, if beating the market is even possible.
270ROGER F. MURRAY
Close your eyes and let your mind wander back, way back to theGreat Depression. We are now in the early ’30s. Young Roger Murrayhas just graduated from Yale with high honors, and he is fortunateenough to be one of the very few members of his class, or any othergraduating class, to get a job. He will rise to become the youngest vicepresident in the history of Bankers Trust Company before, eventually,deciding on a career in academia. He is recruited to be an associatedean at the Columbia Graduate School of Business where he auditsthe class taught by Benjamin Graham. When Ben Graham retires, hisclass will be taught by Professor Roger Murray. We are there at thebirth of value investing. We are there with the masters themselves,Benjamin Graham and David Dodd, and their successor, Roger Murray.
If you have already read my interview with Mario Gabelli (page77), you know that Mario, in his shy, retiring manner, quietly sugges-ted that maybe, just maybe, I had not interviewed the right academics.So, armed with his gentle suggestion, I sought out Roger Murray, whois now retired. What a discovery! Professor Murray was not only thesuccessor to the most famous value instructor of all time, he is theco-author of the most recent edition of Graham and Dodd’s SecurityAnalysis. Believe me, no one in the world of investing risks ercommu-nication by referring to this book as the bible of investing.
Do you happen to have an IRA account? Thank Roger Murray. Heoriginated the concept and saw it to fruition in Washington when itwas enacted as part of ERISA. In 1993, he was the recipient of theprestigious Nicholas Molodovsky Award, which has been conferredonly eleven times, to individuals who have made contributions of suchsignificance as to change the direction of the investment profession.Benjamin Graham was a previous recipient of the award, as wasNobel laureate Bill Sharpe. Now sit back, open your eyes again, andtreasure the words of one of the masters.
Tanous:How did you get interested in stocks?
Murray: As an undergraduate at Yale, after taking my first econom-ics course, I did a summer project for my instructor, who then gaveme some extra credit for Economics 101. I did an analysis of severalcompanies and their equity securities. This gave me a chance, in thePETER J. TANOUS
summer of 1930, to do my first analysis. Fortunately, no one was re-lying on my conclusions! Although the Harvard Economic Societyhad informed us that the decline in economic activity had run itscourse by the middle of 1930, we found out later that it was only thebeginning.
Tanous: You said this was in 1930. So we're talking about a fewmonths after the 1929 crash?
Murray: That’s right. But in the spring of 1930, there was a wide-spread view that the market crash was behind us, and now that it wasover, we would resume long term economic growth, and all was well.
Tanous:Is that scary?
Murray: The market rallied in the spring of 1930. What happenedin 1931 was that the British went off the gold standard, and the Ger-man banks collapsed. These events had not been foreseen.
One of the securities | analyzed was Missouri Pacific convertiblepreferred stock. It was a very good exercise in understanding andanalyzing the conversion feature. The only trouble was that the con-version feature was quite irrelevant - the stock was wiped out in thesubsequent bankruptcy of Missouri Pacific. That’s how I got my firstexperience in the market.
Tanous:Even though you are very well known as an academic,Professor, you didn’t start out that way. In fact, you had a pretty il-lustrious career in business before you turned to academia, didn’tyou?
Murray: Yes, I did. In the spring of 1932, if you had any hopes ofgetting married, you had to go to work. That is, if you could possiblyfind a job. Happily, I was able to do that. That enabled me to saveenough money to get married in 193