I look at it, I’m about three years ahead of schedule. Ihave a spreadsheet that shows me the Buffett partnership’s increasein assets over time, and then I did a CPI index delta for inflation fromthen until now, and I think I’m about three years ahead in terms ofassets versus where he was. Amazingly, the returns so far have beenahead, though I think if I end up anywhere close to him, that’d bejust awesome.
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That’s some of the history, but when the fund started, the focus—and, in fact, even my understanding of the Buffett workouts in specialsituations—wasn’t that great. I think I’d read about it, but I never reallygrasped onto the power of the model. I think in the fall of 2000, I visitedone of the authors, Timothy Rick. I had read his book and noticed hewas in Munster, Indiana, which is pretty close, and I just emailed himand said, “If you’d like to get together for lunch someday. . .”I met with him and then subsequently he was the one who reallyhighlighted for me how the special situations route was the way to go.If you look at investing in terms of probabilistic terms, those are theones that do have the highest probabilities, absolute no-brainers,et cetera. So in absolute returns, a buy-and-hold-forever strategy—even if you buy a company at a discount—would, in general, be somewhat inferior to the special situations, especially if you held it forever.The concept is really simple. Let’s say you take a business likeCoca-Cola, and say you buy it at half of what it’s worth and you heldit forever. What would happen is that your eventual return wouldapproximate the return in equity the company was generating. Itwouldn’t matter what discount you bought it at, because over time itwould get to full price. The gains in stock price you would see wouldbe approximately mid-range gains and return on equity.JA: Have people done research on this and proved that to be true for companies over time?MP: It’s intuitively obvious. Let’s say you buy an apartment building for amillion dollars, and let’s say it’s generating $100,000 a year in cashflow for you. Let’s say that cash flow goes up at 10 percent a year; thevalue of the building will track with that cash flow. It will go to $1.1million or $1.2 million, and I’m assuming discount rates are the same,interest rates are the same, and all of that. But if you take all thosevariables out, returns on investment will track return of equity.That’s one edict, and the second edict is that there’s no businesson the planet that can generate returns in equity in excess of, let’s say,30 percent a year and be able to forever redeploy the capital that it’sgenerating. Take a business like Microsoft. Historically, Microsoft’sreturn on equity used to be well over 30 percent, but the problem isthat when they generate all the cash, they’re not able to redeploy itback. That’s why they’ve got such a big cash hoard.So if they’re not able to redeploy the cash back, now that cash isearning one percent. So your return on equity does not compound at
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30 percent a year at Microsoft. It can only compound at 30 percent or35 percent a year for the amount of actual capital deployed in thebusiness, and the actual capital deployed in the business is not able toabsorb all the capital that the business is generating.There is no business that I’m aware of—in the country or in theworld—that can endlessly generate return on equity over 20 percentand redeploy all the cash to generate. From that, you will infer that theupper-limit returns that you can generate, if you made no mistakeswhatsoever, would be 20 percent a year. There’s an upper-limit boundon buy-and-hold-forever, and the upper-limit bound is about 20 percent.In reality, it’s actually less, because when you get to a portfolioand you get to mistakes and you get to management redeploying capital with some mistakes themselves—when you get to all those realworld situations, the real number is much below 20 percent. So let’slook at Sequoia Fund, probably the best research shop on the planetthat I know of and probably the best buy-and-hold investors thatI know of. Sequoia Fund generated 16 percent or 17 percent a year forthe last 32 years.If you take Berkshire out of the portfolio, the returns on theirinvestment excluding Berkshire Hathaway are about 13 percent ayear. So the best buy-and-hold investors, with the best research team,just kick ass in what they do. Look at the portfolio of businesses—they buy amazing businesses—it’s banging out 14 percent or 13 percent a year.And now the flip side. You go to special situations and you just flipthe map, or you just say, “OK, I’m going to buy a dollar for 50 cents, andwhen it gets appraised at a dollar or 90 cents, I’m going to get rid of it.”Now your returns are simply a function of how long it takes to get toconvergence. If you bought a dollar for 50 cents and sold it for a dollar,and convergence took one year, you would generate a hundred percent return. If convergence took two years, you would generate a 37percent or something return. If convergence took three years, youwould generate 26 percent, and if convergence took four years, youwould generate 18 percent. So up to four years of convergence beatsbuy-and-hold. This very simple math became obvious, and the fact isthat buying great businesses is all good because you have a few moretax efficiencies and all of that. But really, the pop in terms of gettingbetter returns on assets is first of all to sell fully priced—or near fullypriced—assets, whether they’re special situations or not, and then goback and buy at 50 cents on the dollar.
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JA: What do you think of Buffett’s saying, “My favorite holding periodis forever”?MP: I think Berkshire has the model. The problem with special situationsis you have to continuously be able to find these opportunities totake advantage of the market—what I would call market anomalies.If you have a huge pool of capital, it becomes a problem because youcan put a lot of capital to work in a company like Coca-Cola, American Express, or Gillette, but the Finovas, the MCIs, or the First Industrials of the world—those sorts of investments are very random.They’re not very good to look at in a portfolio that is a hundred andfifty billion.Generally speaking, you’ll have a very hard time trying to put thatamount of capital to work in these sorts of situations. Typically, a lotof the special situations are going to get just thinner and thinner as themarket caps go higher. I think Munger said that the first few hundredmillion at Berkshire Hathaway came from running a Geiger counterover everything. You know, you’re at the beach trying to find metalunder the sand, and you’re running over everything and find something. But he says that subsequent billions have come from making afew select investments. I think if you have unlimited capital, then thespecial situations isn’t going to work so well because you will not beable to deploy capital.Buffett made a statement two years back. He said, “If you gave mea million dollars of capital to manage, I would pretty much almost guarantee that I will make 50 percent a year.” For a guy who’s very humble,that’s a pretty cocky statement. But I think the reason he makes thatstatement is he would just make 100 percent doing special situations.JA: How do you go about, right now, finding special situations?MP: You don’t. You let the game come to you. So basically, you do nothing,just read and think, and occasionally, you read the paper and you’llsee something. For example, I think I made an investment in a company called Front Line. Front Line was a case where the value of thecompany was, I think, $14 or $15 a share. It was losing money inthe near-term market, and the price went from $15 to $3, and so therewas mispricing.Basically, you’re looking for market anomalies. Whenever there’sextreme fear in some sector, or whenever there’s some big cloudsover some companies, you’re likely to get mispricing. The question is,“Am I able to see through the clouds, and do I know the business well
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enough to be able to see beyond the temporary negativity of an industry or a company and see what the value of the business is versus theprice at which it’s being offered, and if it is enough of a delta, step in?”If you look at broad-based special situations, like a Front Line, orI bought a funeral services company three or four years back calledStewart Enterprises for less than two times cash flow—there wereclouds over those businesses when they were bought, and they’re OKbusinesses. I mean, Front Line is not such a great business becauseit’s eventually a commodity. Stewart has some mood around its business, but in both cases, the primary driver for buying the business wasan ultra-cheap price and a huge discount to what it was worth.JA: What were the valuation parameters? How did you analyze it?MP: Well, let’s go through Stewart for example.This is going further back. The thing with Stewart is that therewas a big rollup in the ’80s and ’90s of these funeral services operators, and the three big ones were Service Corp., Stewart Enterprises,and Carriage Services, and in the glory days, they took on a lot ofdebt, issued a lot of stock, and bought a zillion companies—smallmom-and-pop funeral homes. Stewart ended up with like a thousandfuneral homes, about a billion [dollars] in revenue, and about abillion in debt.The debt load was such that they had—in the year 2000, Ibelieve—a $500 million note coming due in 2002, about 22 or 23months away. The company was generating about a hundred milliona year in cash after all interest payments and everything. So in twoyears, they were generating $200 million, but they were still $300 million short, and there was no clear answer as to exactly how that notewould get settled. The existing lenders in that space had taken somany losses in that area that they were not willing to make any additional loans or roll over existing debt. So Stewart would have to refinance, pay the debt off or find another lender.The Street had just witnessed one bankruptcy out of these threebig players, and so they painted them all with the same brush, and allthe funeral-services stocks collapsed. In fact, Stewart went from, Ithink, $28 to $2 a share in about an 18-month period. I looked at it at$1.91 a share. This was a company that was generating a hundred million in cash flow, after all, and it had a market cap of a $190 million.So you could buy a business for less than two times cash flow, whichis unheard of, right?
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This is a very predictable business because you know exactlyhow many people are going to die each year. Maybe they’ll charge 300basis points more or whatever else, but someone will be willing tomake this loan because the economics of the business are so solid. SoI said, “First of all, I don’t believe that this debt is not yet settled.”Second, I said, “Even if there’s no lender on the planet willing to lendto them, it’s not a single street plant. It’s 1,000 different funeral homes,each of which has the same brand it had when it was born.”So what I decided is I need $300 million. I can go to the first: I justput 200 funeral homes on sale, go back to the people I bought themfrom, and say, “I’ll sell it back to you at half the price I paid you.” Ithink that easily two or three hundred of these guys would take thatbusiness back in a heartbeat. So my sense was that they could sellthese funeral homes pretty much back to the people they bought themfrom, get the cash, pay the debt, and move on, and still retain a lot ofvalue in the business and still be underpriced.So we put assets into Stewart, and literally less than two monthsafter I made the investment, the company announced that it was goingto sell all its international funeral homes. They had about 300 funeralhomes overseas, and they said that those funeral homes, because theywere in so many different countries, were not generating any cashflow to the business. So the hundred million a year they were generating would be unaffected by that sale, and they estimated that thatsale would bring in three or four hundred million at least. The stockwent from $2 to $3 on that news.Another few weeks later, they said there were three definitivebuyers fighting over who would be able to buy the 300 homes, and thebidding had gotten the price up to five, six hundred million. The stockwent to like $3.50 or something, and then when they closed the transaction, it went to about $4.50 a share. Stewart subsequently went tobetween $6 and $8 a share after that. So that was a classic no-brainer,no-downside, significant upside investment.JA: Let’s say you’re the average retail investor right now. Other thanreading the newspaper, are there any other techniques that you canuse to try to find these opportunities?MP: I do look at the New York Stock Exchange every day, and I look fornames that are familiar. Then if something piques my interest, I’ll doa drill-down. In general, you want to look at stuff that’s hated andunloved, like I had bought Level 3 bonds. That’s another classic—
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well, actually amazing—special situation because that one is going togive you like a 45 percent return a year for seven years, which is justunheard of.JA: Did you buy prior to Buffett getting in?MP: Yes, about a year before. There was a rumor circulating at that timethat he might have invested, but it was confirmed a year later when hedid the convertible issue with Longleaf and Bill Miller. I felt goodabout being ahead of the Messiah.[Laughter]JA: On a slightly different topic, basically these are mostly Graham-Doddstyle plays as opposed to the ’70s or ’80s Buffett-style plays, when hedid Coca-Cola, for instance. How do you reconcile the fact that mostof Graham’s money he made actually on Geico, which was more orless a buy-and-hold-forever play for him completely outside theboundaries of how he normally can add value?MP: Most of the money on Geico was made because it was a great business. But if you look at, again, if you look at Buffett’s purchase ofGeico, a huge portion was bought when Geico was under severe distress. He was buying at like about a buck a share. Geico’s veryunusual, and to find those sorts of investments is very rare. This wasa company that was available undervalued, and some would argueeven today that it has a sliver of the market share that it eventuallywill. It’s got an ability to grow its business pretty dramatically over avery long period of time.From my point of view, there are a couple of things that come in.One is, can you actually see it? Coke is a good example. If I look atthat business independently, I just won’t be able to see a long, hugerunway and all that growth ahead of it without hitting blips and othermajor issues along the way and even changes in consumer behavior.All these issues would cloud my judgment about something likethat. So I think that if you can identify a Geico—but I’m thinking if youlook at Graham, how many did he find?JA: One.MP: Exactly. And when the investment in Geico was made, it was at a timewhen Geico was undervalued.I think that sometimes it’s dumb luck. From my perspective, I thinksitting around trying to find a Geico and just waiting until you make that
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investment is somewhat foolish because it’s very, very hard to find. Youare going to learn more about the business after it becomes part of yourportfolio. And I think Geico is that type of company.In fact, the very best investments are great businesses that arebought at times when they are under severe distress. So Buffett didthat with American Express, right? He put 40 percent of his partnership assets into American Express in the ’60s, right? But again, hesold it out. He never kept the stock through all that run.My sense is that any special situation is fine as long as your mathis giving you two-to-one returns in two or three years or less. In somesliver of them, you actually buy great businesses—and I look for that.The ideal situations are the ones that actually have an underlyinggreat business, because then there’s a decent chance that you’ll haveincreases in intrinsic value while you’re holding the business, whichmeans that you never get to the point where it gets all valued. Ideally,the thing is going along at a slight discount to what the market priceis. And that works out great.But most of them are what the market’s going to do. If you look atFront Line, for example, it went from $15 to $3 a share. When it gotclose to $12 or $13, I was selling. It’s close to 40 bucks a share today.JA: Wow.MP: So if you had a Geico in your portfolio and it was worth $15 and wentto $3 and you sold at $15, that would look like a reasonable decision.And then subsequently the Street takes it to two times intrinsic value.What do you do then, right? From my point of view, it’s better to sellit rather than trying to play mental games.JA: You brought up an interesting point about American Express: howBuffett put 40 percent of his assets in that situation, something whichGraham almost certainly would never do in terms of that size of hisportfolio. What are your feelings on diversification?MP: I am not confident enough to put 40 percent into a single asset—mainly because I think I’m not Mr. Buffett. I feel that I want 10 bets,ideally uncorrelated, in 10 different industries, and I’m very happy toleave it at that. I know if I take 10 down to eight, my returns will go up.I just feel that there are macro factors and even macro events thatcannot be analyzed. I’m just not willing to go above 10 percent.
C H A P T E R 12
P/E Ratios, MarketTiming, andthe Fed Model
hile Warren Buffett is usually considered the “world’s greatestvalue investor,” he has repeatedly stated that simple indicators—such as P/E ratios, P/Book ratios, and so on—are completely useless.Despite this, fund managers, investors, and the media, have repeatedlyhopped on the price/earnings (P/E) bandwagon when making macro predictions about the direction of the markets. For instance, a recent bookabout investing has asserted that the U.S. markets are “in a bubble” becausethe trailing 12-month ratio of the S&P 500 is 25. Analysts and pundits havealso pointed to the 1974 and 1982 bear market bottoms when the marketP/E ratio was less than 10.Assume that the 50-year average P/E ratio is 15 and that the markettends to mean-revert, as asserted by all the people who claim P/E ratios aretoo high at any given point. I did the following experiment in order to testif Buffett’s claim that P/E ratios are meaningless is true.Since 1900, this simulation uses the S&P 500 total return index (theindex plus dividends) and uses P/E data compiled by global financial datato buy the S&P 500 whenever the P/E ratio is lower than 10 and to sellwhen it is higher than 20. See Exhibit 12.1. P/E ratios are in the top pane andthe S&P 500 total return index is in the bottom pane.
W
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EXHIBIT 12.1
Source: Fidelity Investments. Charts created by using Wealth-Lab Developer software.
The five trades that occurred were all successful, as shown inExhibit 12.2.And it is interesting to note that the “system” caught most of the bullmove of the 1920s, the 1950s, and bought at the bottom in the 1970s. However, this method underperformed the method of simply buying on January1, 1900, and holding until now by a factor of 6,000.
EXHIBIT 12.2Entry Date
Entry Price
Exit Date
Exit Price
% Change
12/1/19073/1/19237/1/194010/1/19477/1/1974
0.150.481.252.7942.67
3/1/19213/1/19303/1/19464/1/19617/1/1987
0.321.823.0423314.34
116.81275.19143.46724.92636.6
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Changing the parameters didn’t result in anything better. I tried makingthe higher parameter 25, 30, and 35. I changed the lower parameter to 15.At the risk of curve-fitting, I tried stepping through the parameters in anattempt to “optimize” the result. Nothing beat the buy-and-hold method.Nor did shorting help. In the above example, if you had shorted rather thansold the market every time P/E ratios hit higher than 20, the result wouldhave been five unsuccessful short trades.Does this mean buy-and-hold is the best strategy? Absolutely not. Forone thing, there were several periods of longer than 10 years (the most recentbeing from 1964 to 1981) where the market was completely flat and almostany other investment would have been better. But it does mean that P/E ismostly useless when not taking into account any other aspect of the market.Buffett has said that he is not a market timer. For instance, in his 1992letter to shareholders, he wrote:We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believethat short-term market forecasts are poison and should be kept lockedup in a safe place, away from children and also from grown-ups whobehave in the market like children.And yet, as excellent Buffettesque investor Whitney Tilson1 has pointedout, Buffett has made market calls no less than six times.
MARKET CALL #1In 1969, Buffett “retired” from the hedge fund business, and returned hisinvestors’ money with the statement:I just don’t see anything available that gives any reasonable hope ofdelivering such a good year and I have no desire to grope around, hoping to “get lucky” with other people’s money. I am not attuned to this
1
“Buffett’s Prescient Market Calls,” Whitney Tilson, 1999, Motley Fool Web site(www.fool.com).
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market environment, and I don’t want to spoil a decent record by trying to play a game I don’t understand just so I can go out a hero.Over the next six years the market returned −11.8 percent, topping offa huge bull market run that essentially ended in the late 1960s.Although his market call was dead on and he left the hedge fund business at this time, I do think his bearishness was more excuse than reasonfor his decision. He was already the controlling shareholder of BerkshireHathaway and he had already decided that the economics of insurancewere much better than the economics of running a hedge fund.In a hedge fund you only get 20 percent of the profits. In insurance,assuming the cost of float is kept to a minimum (and to his great credit,Buffett over the past 40 years has been particularly good at this), the owners of an insurance company get to keep 100 percent of the investing profits. By 1970, rather than having to split the profits with the limited partnersin his hedge fund, Buffett was now the majority shareholder. Only one percent of the profits of Berkshire Hathaway in 1970 came from textiles, therest was from insurance, banking, and investments.
MARKET CALL #2In 1974, Buffett made his famous quote to Forbes, “I feel like an oversexedman in a harem,” when referring to all of the buying opportunities out there.1975 was one of the biggest bull market moves ever, with the S&P going upover 70 percent over the next two years.
MARKET CALL #3Tilson reminds us of Buffett’s quote in the August 6, 1979, issue of Forbeswhere he states:Stocks now sell at levels that should produce long-term returns farsuperior to bonds. Yet pension managers, usually encouraged by cor-
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porate sponsors they must necessarily please, are pouring funds inrecord proportions into bonds. Meanwhile, orders for stocks are beingplaced with an eyedropper.Can better results be obtained over, say, 20 years from a group of 91⁄2percent bonds of leading American companies maturing in 1999 thanfrom a group of Dow-type equities purchased, in aggregate, at aroundbook value and likely to earn, in aggregate, around 13 percent on thatbook value?. . . How can bonds at only 91⁄2 percent be a better buy?In typical self-deprecating fashion, Buffett referred to this market callin a July 2001 speech when he said,Now, if you had read that article in 1979, you would have suffered—oh, how you would have suffered!—for about three years. I was nogood then at forecasting the near-term movements of stock prices,and I’m no good now. I never have the faintest idea what the stockmarket is going to do in the next six months, or the next year, or thenext two.
MARKET CALL #4Tilson quotes Buffett from the 1986 annual meeting:I still can’t find any bargains in today’s market. We don’t currentlyown any equities to speak of [except for the core holdings of GEICO,the Washington Post Co., and Capital Cities/ABC].Although he more or less cruised past the crash of 1987 because of thisprescience, it was during this period that he figured he could weather amore than 10 percent correction by making “pseudo” equity investments inthe form of convertible preferreds. He did this with Salomon, Gillette, andChampion, where in each case he was able to get a preferred stake in eachcompany paying between 9- and 10-percent yields and convertible intoequity should the stocks rise. Happily, they all did, at different points overthe next decade. (See more on this in Chapter 7.)
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MARKET CALL #5
Tilson reports that in the 1992 annual report Buffett writes:Charlie Munger, Berkshire’s vice chairman and my partner, and Iare virtually certain that the return over the next decade from aninvestment in the S&P index will be far less than that of the pastdecade . . . Making [this] prediction goes somewhat against ourgrain: We’ve long felt that the only value of stock forecasters is tomake fortune tellers look good. Even now, Charlie and I continue tobelieve that short-term market forecasts are poison and should bekept locked up in a safe place, away from children and also fromgrown-ups who behave in the market like children. However, it isclear that stocks cannot forever overperform their underlying businesses, as they have so dramatically done for some time, and thatfact makes us quite confident of our forecast that the rewards frominvesting in stocks over the next decade will be significantly smallerthan they were in the last.Tilson prophetically concludes this market call with the statement:“The next three years will have to be pretty grim to validate Buffett’s prediction.” His article was written in 1999 and up to that point, the decade following Buffett’s 1992 call was outperforming the prior ten years.However, the next three years did turn out to be pretty grim, and withthis prediction Buffett was also correct. From December 1992 to December2002 the S&P 500 was up a sliver below 100 percent. From December 1982to December 1992 the S&P 500 was up 210 percent.
MARKET CALL #6In the November 22, 1999, issue of Fortune, Buffett predicted that thestocks were about to “fall dramatically.” When he wrote that the Dow wasat 11,194 and two years later it was at 9,900.
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MARKET CALL #7Buffett wasn’t through yet and the December 2001 issue of Fortunereprinted a speech he had given at the July 2001 Allen & Co. Sun Valley Conference. In it he stated his reasons for being somewhat bearish on the market for the next 17 years and reaffirmed his belief that over the next decadewe can expect to see seven percent annual returns.So you can’t really have it both ways. Buffett might not make specificinvesting decisions based on market timing (for instance, there is no evidence he uses puts or any hedging techniques to hedge his portfolio whenhe thinks the market is going down). However, he does make macro-levelportfolio decisions or even huge personal life decisions (his decision in1969 to close his fund) based on his feelings about the market. One canargue that this is not the case: When the market is frothy it is evident in hisportfolio from a bottoms-up approach—that is, his investing for those yearsis scarce simply because there are fewer opportunities. However, divinginto his July 2001 speech, as reprinted by Fortune, it is evident that Buffettdoes at least develop macro-level explanations for why there might be adearth of investment prospects.Specifically, he notes first that the stock market is not necessarilyrelated to growth in the economy. For example, from 1964 to 1981, whenthe market gained “one-tenth of one percent” over a 17-year period, henoted that the gain in gross national product (GNP) during that time was373 percent as opposed to only 177 percent from 1981 to 1998 when themarket went up over 9,000 percent. To quote Buffett:So what was the explanation? I concluded that the market’s contrasting moves were caused by extraordinary changes in two critical economic variables—and by a related psychological force that eventuallycame into play. Here I need to remind you about the definition of“investing,” which, though simple, is often forgotten. Investing is laying out money today to receive more money tomorrow. That gets tothe first of the economic variables that affected stock prices in the twoperiods—interest rates. In economics, interest rates act as gravitybehaves in the physical world. At all times, in all markets, in all parts
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of the world, the tiniest change in rates