OUS
sistently outperformed the market. That, in turn, leads to the othergreat exercise in our business, particularly with mutual funds, whichis the predictability of future investment success based on past success.I know you’ve done some work on that, too.
Fama: One of my students just finished his thesis on that subject,actually. What he found was that performance does repeat when it’son the negative end! In other words, funds that do poorly, tend to dopoorly persistently.
Tanous:Why couldn't one postulate that the same would be true atthe other end of the spectrum?
Fama: One could postulate it, but it doesn’t seem to be true. Onthe negative end of the spectrum, you have things like turnover andfees and all that kind of stuff, which can explain why you have neg-ative persistence in poor returns.
Tanous: Yes, but good managers trade and charge fees, too. Theymight even deserve them more!
Fama: Poorly performing funds tend to be higher fee and higherexpense funds. In fact, when my student adjusted for fees and ex-penses he could explain most of the persistent under-performance.
One thing I did a couple of years back was take all the funds thatsurvived from the beginning of the Morningstar tapes, which is 1976.Now, funds that survive that long will have a survivor bias built intothe test, because only the successful funds survive. So I split thesample period in half and took the 20 biggest winners of the first 10years, or the first half of the period, and I asked how did they do inthe second half of the period? Well, in the second half of the period,half of them were up and half of them were down.
Tanous:Wow. Half were up and half were down? [That indicatesthat there was no predictive value in the fact that these managers allfinished in the top half in the first ten year period.]
Fama: Exactly half, relative to a risk-corrected model.
Tanous:How did you adjust for risk?
Fama: | used the three-factor model.
Tanous:The three-factor model takes into account market risk;value versus growth styles; and also size, which is the large-cap stocksversus small-cap distinction, right?
Fama: Yes. But since most retail funds have a bias toward growthstocks, the adjustment helped them.
Tanous:So even risk tested, the data came out 50/50 which means
152INVESTMENT GURUS
that the mutual funds that did the best for ten years only had a 50/50chance of repeating their success. I’m curious to know who the biggestwinner was in both periods?
Fama: Fidelity Magellan.
Tanous:What’s the reason for that?
Fama: Obviously, the performance of that fund has been reallygood.
Tanous:It has, to Peter Lynch’s credit. Another issue you have ad-dressed: that old subject, value stocks versus growth stocks. Are stocksof good companies good stocks to invest in?
Fama: They’re good stocks, they just don’t have high expected re-turns.
Tanous:Then growth stocks are stocks of good companies, not goodstocks, right?
Fama: To me stock prices are just the prices that produce the expec-ted returns that people require to hold them. If they are growth com-panies, people are willing to hold them at a lower expected return.
Tanous:As we get into this, I think our readers are going to besurprised to read that value stocks are riskier than growth stocks.That is counterintuitive.
Fama: I don’t know why it’s counterintuitive.
Tanous: Well, we used to think of value stocks as stocks that mayhave already had a decline, that are languishing. We believe we’rebuying value stocks at the bottom and waiting for them to go back upagain.
Fama: Value stocks may continue to take their knocks. Their pricesreflect the fact that they are in poor times. As a result, because peopledon’t want to hold them - in our view because they are riskier - theyhave higher expected returns. The way we define risk, it has to beassociated with something that can’t be diversified away. Everybodyrelates to a market risk. If you hold stocks, you bear stock markettisk. But the stock market is more complicated than that. There aremultiple sources of risk.
Tanous:In our business, we usually associate growth stocks withhigh earnings multiples, and value stocks with low earnings multiples.Multiples are themselves usually an element of risk. So, if a growthstock falters on its anticipated growth path, it declines precipitouslybecause it no longer deserves the multiple that had previously beenawarded to it when its prospects were better. Therefore, a lot of people
153PETER J. TANOUS
think that growth stocks, in fact, are riskier. What’s wrong with thatthesis?
Fama: Just look at the data. It’s true that growth stocks vary togeth-er, and it’s true that value stocks vary together. In other words, theirreturns tend to vary together which means that there is a commonelement of risk there. Now, for growth stocks that seems to be a riskthat people are willing to bear at a lesser return than the return theyrequire for the market as a whole. Whereas, if I look at the valuestocks, which we also call distressed stocks, their returns vary together,but people aren’t willing to hold those except at a premium to marketreturns.
Tanous:So you’re saying that I expect to make more money whenI buy value stocks than I do when I buy growth stocks.
Fama: Right. On average. Of course, sometimes you get clobbered.
Tanous:We’ve always associated the risk of getting clobbered morewith growth stocks than with value stocks that have already takentheir lumps.
Fama: The data don’t support that.
Tanous:The other dimension, of course, is size. Now the size effectis very easy for those of us in the investment community to accept.The notion that small companies are riskier than large companiesseems obvious.
Fama: That’s not the reason the community accepts it. What theythink is that small companies pay higher returns because they’re un-known, or something like that. It’s not because they’re more risky.The risk, in my terms, can’t be explained by the market. It means that,because they move together, there is something about these smallstocks that creates an undiversifiable risk. That undiversifiable riskis why you get paid for holding them.
Tanous: What causes that risk?
Fama: You know, that’s an embarrassing question because | don’tknow.
Tanous:Fascinating. I would assume that the risk is that smallcompanies have a lower survival rate than large companies.
Fama: No. That’s not it at all. The good news and the bad newsabout that is that the reason small companies don’t survive is becausesome of them fail, others get merged; that’s bad news and good news.Here’s a fact I always use. First I say I don’t know, but then I say it’sfair. Here’s my example. The 1980s were, supposedly, the longest
154INVESTMENT GURUS
period of continuous growth the country’s seen since the second worldwar. Yet, in that decade, small stocks were in a depression. Smallstock earnings never recovered from the ’80-’81 recession. They werelow the whole decade. The market was fooled every year by that, be-cause in every previous recession, the small companies came back.Why did that happen in the ’80s? I don’t know. But it happened. Andit tells you there is something about small stocks that makes themmore risky.
Tanous:Another question that comes up frequently is if marketsare correctly priced, how do you explain crashes when they go downtwenty percent in one day?
Fama: Take your example of growth stocks. If their prospects don’tgo as well as expected, then there will be a big decline. The samething can happen for the market as a whole. It can also be a mistake.I think the crash in ’87 was a mistake.
Tanous:But if ’87 was a mistake, doesn’t that suggest that thereare moments in time when markets are not efficiently priced?
Fama: Well, no. Take the previous crash in 1929. That one wasn’tbig enough. So you have two crashes. One was too big [1987] andone was too small [1929]!
Tanous:But in an efficient market context, how are these crashesaccounted for in terms of “correct pricing”? I mean, if the market wascorrectly priced on Friday, why did we need a crash on Monday?
Fama: That’s why I gave the example of two crashes. Half the time,the crashes should be too little, and half the time they should be toobig.
Tanous:That’s not doing it for me. What am I missing?
Fama: Think of a distribution of errors. Unpredictable economicoutcomes generate price changes. The distribution is around a mean- the expected return that people require to hold stocks. Now thatdistribution, in fact, has fat tails. That means that big pluses and bigminuses are much more frequent than they are under a normal distri-bution. So we observe crashes way too frequently, but as long as theyare half the time under-reactions and half the time over-reactions,there is nothing inefficient about it.
Tanous:Let’s go back to value stocks versus growth, and large versussmall stocks. Tell us why the three-factor model contributes to ourknowledge of risk in investments.
Fama: The three factors are the market factor, the size factor, and
155PETER J. TANOUS
the distress [value] factor. We distinguish between distress and growth.What we find is that, in addition to the market factor in returns, inother words the fact that stocks move together, it’s also true that smallstocks move together, and big stocks move together, but not in thesame way. The value stocks move together and the growth stocksmove together but the two groups are different from each other. Thereare at least three dimensions of risk: market risk, small stock versusbig stock risk, and distress stock versus growth stock risk. When I sayrisk, I mean that these groups move together. We could have foundthat they didn’t move together, and then it would have been marketinefficiency.
Tanous: What would that have told us?
Fama: It would have told you that you could get a diversifiedportfolio of small stocks, and a diversified portfolio of big stocks,short the big stocks and buy the small stocks, and get a positive returnwith no risk.
Tanous:Why would that be true?
Fama: It would only be true if there weren’t a common factor inthe return on small stocks that caused them to have randomness thatwasn’t shared with big stocks.
Tanous:!’m not sure I follow.
Fama: If there’s no small stock risk, and I take a diversified smallstock portfolio, | would be able to explain its return entirely in termsof the market risk. So there’s nothing left over.
Tanous:I see. We’re comparing small stock returns to the marketas a whole. What you’re saying is that small stock returns have riskthat’s not explained by the market. And this higher risk is the sizerisk you talk about in the three-factor model? Is that correct?
Fama: Right. Take a diversified portfolio of value stocks. Thosestocks will move together. That portfolio’s return will not be perfectlyexplained by the market even if it has a few thousand stocks in it.
Tanous:/f that’s the case, wouldn’t growth stocks mirror the marketas a whole?
Fama: Growth stocks do come closer to mirroring the market as awhole.
Tanous:So once you’ve decided to take the market risk, creatingyour portfolio seems to come down to deciding what your overall risklevel is, and then you allocate by size, and between growth and value,to achieve your risk/reward goals.
156INVESTMENT GURUS
Have there been any studies that have ever impressed you aboutactive management in any capacity? I mean, has there been anyevidence that would suggest to you that all of the Wall Street analysts,gurus, salesmen, and research departments are anything but a completewaste of time?
Fama: You used the key word: salesmen. I might be willing to saythat the people who get pointed at consistently, who have shownconsistent performance even after they have been pointed at, reallydo have something. These are always the same people, Warren Buffett,Peter Lynch, and then who?
Tanous:Okay. You talk to Rex Sinquefield, and he’ll tell you thatin any normal distribution you’re going to get those outlying orang-utans.
Fama: I put it carefully. I said if you identify them, and in the futurethey continue to do well, then I’m starting to believe it. This soundslike the frustrations of my college days when I found that the systemthat worked on the old data didn’t work with the new data!
Tanous:So, in fact, there may be a Lynch and a Buffett effect outthere somewhere?
Fama: There may be, but the non sequiturs that people jump toafter that is to say, aha! Active management pays!
Tanous:No, it means that Peter Lynch and Warren Buffett pay! Andwhat is it about them that we can clone? Where’s the next one?
Fama: Yeah. I don’t think that’s something you can teach anybodyor anything like that. The Magellan Fund [once managed by PeterLynch] by any risk-adjusted model, is off the map. But there are onlyone or two like that.
Tanous:Isn’t it interesting that the last three years’ performance atMagellan Fund isn’t Peter Lynch’s? Jeff Vinik’s performance was alsogood. I presume because he made a big bet on technology stocks andwon.
Fama: Another thing I found when I looked at Magellan was thatit had a greater small stock bias when it was a smaller fund.
Tanous:Are you working on anything now that you could sharewith us?
Fama: We're trying to extend the three-factor model internationally.The scientific approach is always to say: does it work out of sample?In other words, does it work on new data, in this case, foreign stocks?PETER J. TANOUS
So, what we are doing is trying to use international data to see if wecan come up with a global view of risk and return.
Tanous:How does it look so far?
Fama: The problem is that the international data stink. You can’tget the kind of data we can get here in the U.S. going back to 1926.We also have good accounting data going back to the early sixties.Internationally, you don’t really have returns before 1988. And youonly have a sub-sample of stocks.
Tanous:How much data do you need to get a valid sample?
Fama: You never know that until you do it, because it’s a functionof how variable the returns are. The problem with stock returns is thevariability is so high. It takes long samples to really document any-thing. But, so far, the new data turn up the same kind of risk factors.
Tanous:! guess we still haven’t found a way to predict the future.
Fama: That kind of reasoning will get you closer to my way ofthinking!
Tanous:The trouble with you academic guys is that you all approachthis with such religious zeal that I feel like a heretic if I disagree withany of you. Like I’m going to be excommunicated any second.
Fama: No. We'll just throw you out of the scientific community.You get to stay in the active management community.
Tanous:Gene, you’re very well known in our business for your workon returns. Do you do much work in the private sector?
Fama: Not a lot. I’m a little lazy! Most of the outside work I do isin a forum framework. | mean how am I going to manage to do allthat if I go windsurfing every afternoon?
Tanous:How’s your windsurfing coming along?
Fama: I’m probably the best in the world over age fifty!
Tanous:Who knows, Gene, maybe you’re the millionth orangutanon the surfboard, the fifty-year-old outlier who wins the worldchampionship.
A couple of things struck me about this discussion. You might ormight not agree, but I thought I sensed a much more open attitudefrom Gene about market efficiency, the concept he developed. I feltthat his was not the extreme version of the efficient market theorythat some others adopt, but rather an open-minded attitude whichsays that, yes, market efficiency is there and chances are you willnever do better than the markets, and as a rule, active managementjust doesn’t pay.INVESTMENT GURUS
On the other hand, the door seemed open a crack to the reality thatthere are the occasional Peter Lynches and others who achieve trulygreat performance records over extended periods of time. The termthe academics like to use for this is “persistence.” Yes, these guysexist, but there aren’t that many. Still, the sobering example Famaused that throws cold water on the performance expectations is thestudy he did on mutual fund performance over a ten year period since1976. He then took the top performing funds in the group and ana-lyzed them for the following ten years. The result: the top performinggroup only had a 50/50 chance of staying in the top half in the secondten year period. What are you going to do? I think it’s time we talkedto another active manager.BRUCE SHERMAN
Private Capital Management which is run by Bruce Sherman is nota typical money manager. The firm started out as the family office ofthe wealthy Collier family, at one time among the largest landownersin Florida. Besides their sage real estate purchases, the family alsowas lucky and smart enough to attract Bruce Sherman, a CPA bornand bred in New York, to join the family business and, eventually,manage money. Originally intent on a career in accounting, Brucewas so successful at managing the Colliers’ money, that he and theydecided to expand their scope to include outside clients who mightbenefit from Bruce’s successful style of investment management. Thus,was born Private Capital Management.
How successful is his style? For the five years ended in 1995,Private Capital Management’s returns were 25% per year, versus17% for the S&P 500 over the same period. All right, you say, I’mgetting jaded. You’ve already shown me managers who do that wellor even better. Right. But Sherman achieved these remarkable resultswithout incurring any more risk than holding the S&P 500 would.To put it in perspective, over those five years Private Capital Manage-ment’s standard deviation was 9.6 while the S&P 500’s was 9.1.That, my friends, is a real achievement.
Private Capital Management is located in Naples, Florida, a bucolic,not to say sleepy, town on the west coast of Florida, where retirementis a growth industry. We met at the company’s offices, located in oneof the Collier family’s office buildings, on U.S. 41.
Tanous:How did you first get interested in stocks?
Sherman: My father, whom I lost a couple of years ago, was anengineer. For my Bar Mitzvah present, he gave me 10 shares of Polar-oid. By the time I turned 21, Polaroid had grown from about $20 ashare to $180. It was at that point that my father gave me possessionof the shares. I sold it all the day I got it. My father asked why? I said,I read the annual report; I had taken a business course in college; Itook some accounting, obviously; and I sold it. I asked myself whyshould something sell at 50 to 60 times earnings, let alone 100 timescash flow? I don’t think it ever saw that price again.
A better indication of my interest in the stock market: I used to goINVESTMENT GURUS
with my dad to the Dupont Glore Forgon office in Great Neck eventhough I lived in Little Neck, to watch the tape. That got me interested.
Tanous: You have a background as a CPA, don’t you?
Sherman: My brother was the one who went to the Ivy Leagueschool and became a doctor. I was the third son. My mother said, ifwe're going to pay for business school for you, you have to take anaccounting degree so you can become somebody when you get out.So I went to a good accounting school, became a CPA, and it was agreat experience. Most young people on the Street think they knowaccounting, but they really don’t. When you start talking to themabout management’s fungibility in making earnings per share, it maybe a little like Greek to them. They don’t worry about the deferredtax liabilities on balance sheets; they don’t worry about companiestrading revenue for prepaid advertising and some of the incongruentaccounting artifacts that can make or break earnings.
At Arthur Young [the accounting firm], | was diligently doing theaudits for a lot of big public companies, like a good manager. Some-times the partner would come down and say, we're going to take areserve of $100 million. They used to call that “big bath” accounting.And I'd say, well, what’s it for? He’d say, well, we have a list but wecan’t show it to you. And then, over the next five years, I saw howthe company would live off the reserve by charges against the reserve,thereby inflating earnings.
The best experience, and I don’t want to ramble on, was in mytwenties, when I spent about two years in the report review departmentat Arthur Young.
Tanous:What’s report review?
Sherman: All you did was read annual reports, proxies, and 10Ks.I did very well in there. | loved doing it. My job was to look at thehard numbers to see if everything reconciled. Did the fund statementreconcile to the balance sheet? If the inventory went from 100 daysto 125 days, you could ask the partner: Did you really audit the in-ventory? You had the ability to ask any question you wanted aboutthose financial statements and you had as much time as you neededto do the work. In essence, you were auditing and reviewing andasking things like, is the fully diluted earnings per share calculationright? Why isn’t there disclosure on the preferred stock issue? Thesewere all disclosure-type questions, which ultimately led to what I lovetoday - which is discretionary cash flow analysis.
161PETER J. TANOUS
Tanous:At some point in your life, you made a jump to where youare now. Tell me about that. Also, about Private Capital Management,which also has an unusual history.
Sherman: I’ve only had two jobs. When I hire people, I try not tohire people who have had a lot of jobs. I was a principal in the NewYork office of Arthur Young and, one day, a search firm called. I wasan impressionable 29-year-old and the person said, a large asset-basedcompany with a small staff is looking for a chief financial officer,experienced in venture capital, investments, real estate, tax planning,etc. I had a lot of real estate experience with clients, albeit I didn’tknow what I didn’t know. I had always been around taxes. I had alot of investment experience.
The client turned out to be the Collier family, so I went to meetthem. Miles Collier had been looking for somebody for about a year.We're very different. I went to Rhode Island; he went to Yale. I gotmy MBA at night at Baruch; he went to Columbia during the day.He’s a brilliant, hardworking individual, who just has a differentbackground than I do. I invested a considerable amount of time andeffort getting to know him, and he did likewise. So I came to Florida,and to Collier County.
Tanous:I presume the name is not a coincidence.
Sherman: Not a coincidence. The county is named after the Collierfamily who, at one time, owned almost all of Collier County - whichis bigger than the State of Delaware. They owned over a million acres.This was the third generation.
I soon realized that the staff at their company was very small andthe asset base was very large. Miles has a lot of experience hiringprofessional money managers. I had to earn my stripes. I sat on theNaples Daily News board of directors, and I sold the company toScripps Howard. I was on a couple of their venture capital boards,too. | wasn’t afraid to take an aggressive stance about where | thoughtthey should put their money and where they shouldn’t. I did someinvesting alongside their professional money managers in New York,and earned the opportunity to become a money manager and growour operation internally. If you grow a money management firmsuccessfully enough, you can have it for almost nothing, because thefees you get for managing outside money cover your costs. So, in1985, we founded Private Capital Management.
Tanous: You’ve expanded the company to take outside clients.
162INVESTMENT GURUS
Sherman: Right. We started out running $50 million. We neverhad more than one marketing person. I don’t do a lot of marketing,because I think that would take away from what we’re attempting todo. Now we’re up to an organization of 15 people - 4 security analysts,the rest support staff - managing $1 billion.
Tanous:Let’s talk about your approach. Yours is a small-cap, valuestyle. Right?
Sherman: I would say small- to medium-cap depending on yourdefinitions. Up to $1.5 billion in market capitalization would be mid-cap. Small-cap for us starts at $50 million in capitalization.
Tanous:Most small-cap and mid-cap managers are growth man-agers. You happen to be a value manager. As you know, most man-agers define value stocks as high book-to-market stocks. I suspectyour definition is broader.
Sherman: Good question. Book, to us, is a starting place. It ismeaningless. America has written off book value left and right.Property, plant and equipment may show underutilization of assetsand returns. So our definition of value is intrinsic value - the privatemarket value that someone would pay for the business, coupled withthe discretionary cash flow that the business generates. I can put allbusinesses on a discretionary free cash flow generation basis, whereasearnings per share are different in different industries. A bank and athrift generate discretionary free cash flow, if reserves are statedproperly. A media company doesn’t have a lot of capital requirements,at least in the television media. A manufacturer has heavy capitalrequirements. The market, using Value Line statistics [as simplisticas that may sound], sells at about 30 x to 35 x free cash flow.
Tanous:Now might be a good time to define free cash flow.
Sherman: It’s defined as cash from operations, minus capital ex-penditures. That’s after all expenses and everything that workingcapital has to absorb, like inventory, receivables, whatever. That’sfree cash flow. It’s right on the company’s financial statement.
You can take a cable company, and someone may say that thecable company is selling at 12 x cash flow. Well, if they have to spend$100 per subscriber to upgrade their wire, you’ve got to take thatnumber out. Now, maybe it’s selling at 15 x to 16 x cash flow. Ifsomething is selling at 15 x to 16 x cash flow, and it’s a 6% yield,that means I can have a business that’s going to grow, yielding 6%.That might be attractive.
163PETER J. TANOUS
Conversely, there may be companies that are selling at low earningsmultiples, but the capital expenditures requirements are so high thatthe company may not have any ability to generate free cash flowover a three year period. Free cash flow allows a company to buyback its own stock, pay down debt, or buy incremental new businesses.So, in any business, | evaluate how much free cash flow a companycan generate over the next three, five, or ten years. We measure ourown personal lives by how much free cash we have in the bank; weshould evaluate companies the same way. We will pass up companiesthat have good earnings momentum and a good earnings story if allthe cash is getting sucked up by capital expenditures unrelated toexpansion, or being sucked up by receivables, inventories, or prepaids.You can fudge it on the income statement just so long. Eventuallythe problems start to show up on the balance sheet.
Tanous:So every company you look at goes through this evaluationprocess?
Sherman: Yes. And my associates know to look for it. Just theother day someone brought me an idea, Mikasa china. It’s selling at11 x earnings; it’s been beaten up. It went public a year or two ago.My problem is, why are they building a $70 million distribution facil-ity? What’s wrong with the one they have? Isn’t that going to suckup cash?
It reminds me of Haggar, which was a good non-buy when thestock was 20. It had just earned two or three bucks; it looked cheap;so I went to visit the company. I said, if you could generate all thatfree cash, why would you sell the business and go public? [Companiesoften go public to raise capital, but sometimes go public for otherreasons.] Finally, management indicated that, if they could generatelevels of cash flow equal to earnings, they wouldn’t have.
Tanous:Some of the other value managers I talked to, Mario Gabelli[page 77] and Laura Sloate [page 133] come to mind, have a preceptabout value stocks and the kind of analysis you go through. But bothof them add a factor they call the catalyst. In other words, it’s greatto have all these cheap stocks, but aren’t you worried they’re goingto stay cheap forever? Do you look for a catalyst?
Sherman: Not necessarily. There are a lot of lousy companies sellingbelow book value. Unitel Video is a great example. The stock is sixbucks; we’ve never owned a share. It had $12 or $13 per share bookvalue before their recent write-off. That looks cheap. And they make
164INVESTMENT GURUS
a little money! But it’s all video post-production editing equipment.The reality is that the technology changes every three or four years.Guess what, fellas? They’re under-depreciating their assets.
Most of America under-depreciates their assets. Twenty-five yearsago, one of my clients, American Standard, had a big foreign opera-tion. They made their units report replacement cost depreciation ontheir internal financial statements even though, for the public, theywere reporting economic depreciation [which was much less]. 1 don’tthink accounting standards have improved that much in this countryover 25 years. The quality of auditing certainly hasn't.
But you asked about a catalyst. Free cash flow will become acatalyst. The money will pile up. The company will use those fundsfor something good. If nobody recognizes the stock value, they willuse that cash to buy their own stock.
Tanous:Your approach is grounded in what you grew up with,which is accounting. It’s obviously been successful, but I also happento know that you frequently visit companies. I would have thoughtthat somebody with your background would be so comfortable withthe numbers and so comfortable in doing these analysis, that youprobably wouldn’t care about visiting the companies.
I'll give you an example: one of the people I interviewed, who is avery successful young fund manager, is Eric Ryback [page 197]. Hemanages the Lindner Dividend Fund. He follows the precepts of hismentor, the late Kurt Lindner, who approached investing in almostthe same way you do, with one difference. They never visited compan-ies! They never talked to managements! They don’t care about visitingcompanies because, they say, all those guys are going to do is snowyou, and put their own spin on things.
Sherman: As an auditor, by definition, you visit companies. In thelast ten years, I probably visited 250 companies. I like several thingsabout company visits. One, you are totally immersed in that company.In the motel the night before,