Bruce Greenwald’s bio from the Columbia Business School’s website.
Professor Bruce C. N. Greenwald holds the Robert Heilbrunn Professorship of Finance and Asset Management at Columbia Business School and is the academic Director of the Heilbrunn Center for Graham & Dodd Investing. Described by the New York Times as “a guru to Wall Street’s gurus,” Greenwald is an authority on value investing with additional expertise in productivity and the economics of information.
Greenwald has been recognized for his outstanding teaching abilities. He has been the recipient of numerous awards, including the Columbia University Presidential Teaching Award which honors the best of Columbia’s teachers for maintaining the University’s longstanding reputation for educational excellence. His classes are consistently oversubscribed, with more than 650 students taking his courses every year in subjects such as Value Investing, Economics of Strategic Behavior, Globalization of Markets, and Strategic Management of Media.
I would like to add that Bruce Greenwald has authored several books. He wrote a phenomenal book on value investing titled Value Investing: From Graham to Buffett and Beyond ,and has written several other books on topics including globalization, competition and media companies.
Bruce Greenwald recently was interviewed by Steve Forbes. Bruce Greenwald discusses a variety of topics including Ford motors, Amazon.com bubble, and bubbles developing in China. Greenwald also discusses discounted cash flow and the folly of using it. Greenwald discusses the future of AT&T, Verizon, and the current state of media companies. Bruce Greenwald discusses over and over the concept of economies of scales.
Here are the following topics Bruce Greenwald discusses in the interview:
True Value Investing
Diseased Vs. Diseased
Growth Invites Competition
Wall Street’s Success
Future Of The Media
Telecoms Of The Future
Apple And Amazon Bubbles
China Hindered By Education
Western Europe’s Lagging
The video runs about 22 minutes.
I could only embed a short segment of the clip here. To see the whole video click here
The full transcript of the interview is available.
Hello, I’m Steve Forbes. Our guest is Bruce Greenwald. Bruce is the director of research at First Eagle Funds and the Robert Heilbrunn Professor of Finance and Asset Management at the Columbia Business School.Bruce is bringing some stock picks to the table. He’s not a big fan of Ford, but he likes niche players in the media business, like the Sci Fi channel.
As for the telecoms, he says the future is uncertain, but one thing is for sure — they really need to play nice with the cable guys in order to survive.
Bruce is also worried about what we call new bubbles, including Amazon.com. We’ll tell you why next on Intelligent Investing.
Steve Forbes: Well, Bruce, good to have you with us.
Bruce Greenwald: It’s a pleasure to be back.
Forbes: You are a classic value investor, but as you’ve pointed out in the past, no one says they’re a non-value investor. And just like everyone says they’re disciplined, until the market changes, everyone says, “Well, at heart, I’m a value investor.” What’s your definition of a true value investor?
Greenwald: Okay, I think there are really two elements, or maybe three, to be honest, that distinguish a true value investor. The first is where you look for opportunities. It’s just what your orientation is towards finding securities that are likely to do better than the market. Because I think the fundamental fact about investing that nobody can ever forget is that whenever you buy a stock thinking it’s going to do to well, somebody else is selling it, thinking it’s going to do badly, and one of you is always wrong. Only in Lake Woebegone can all the managers outperform the market. So you always have to ask the question, “Why am I on the right side of this trade?” And this is a value approach to being on the right side of the trade. And it is now rooted in a lot of work on individual investor psychology. And it is, first, you want to stay away from the lottery ticket stocks.
People in every country have always paid for lottery tickets. They’ve always been crappy investments and they’re paying for the hope and the dream. So you want to stay away from that. Second thing is in life, as in investing, people are overly averse to what’s ugly, disappointing, cheap and you really want to go there, which is the corollary to staying away from the big upside stocks. And I think the third thing that really value investors are aware of is that human beings are constituted not to think in terms of uncertainty. If they think there are weapons of mass destruction in Iraq, they’re sure there are weapons of mass destruction in Iraq. Nobody thinks it’s a 60% chance. If they think it’s a good stock, they think it’s 100% chance that it’s good stock. If they think it’s a bad stock, they think it’s 100% chance it’s a bad stock. What that means is that the good stocks are overbought, and the bad stocks are oversold.
Forbes: So a value investor is not just being squishy by saying 70% chance of rain?
Greenwald: Unfortunately, he’s being accurate because there is never 100% chance of anything. So you want to go where all those factors lead you, which is, you want to look for ugly, disappointing, diseased securities where you have a sense that the disease is more than built into the price, which ultimately means cheap. And that’s the first thing that distinguishes a value investor. The second thing is —
Forbes: So, in essence, you’re saying emotions are your enemy.
Greenwald: Emotions are absolutely your enemy. You want to be a certain kind of mutant who is just completely different in their orientation to what’s an attractive investment for the rest of the market. The second thing is that you want to have even then, when you come to look at these securities, because some of them are terminally ill.
Forbes: Some of them are really diseased.
Greenwald: Right, really diseased. And those you want to avoid. So what you want is, you want a better methodology for figuring out what this security is worth, and that’s where you go back to Ben Graham and David Dodd. So all of the MBAs who are taught to do discounted cash flows, or what is a shorthand for that ratio, or multiple valuations, have been taught what may be a proper thing in theory, but is for three basic reasons a terrible way to value securities in practice. And the first and most fundamental is that when you do a discounted cash flow, you take weighted averages of near term cash flows, which are projections, which are very good information, and distant cash flow projections, which is very bad information, and you add it together. And when you add bad information to good information, you wind up with bad information.
Secondly, they ignore balance sheets. It’s all projected earnings and multiples of earnings. And balance sheets are the most reliable, solid information you have about a company. And the third thing is that if you look at the assumptions that go into a discounted cash flow model, they are profit margins, growth rates far out into the future, costs of capital. Nobody knows what those are for a company like Ford. But there are things you do know about Ford. Is this company going to be economically viable? Probably not. Is this company going to have —
Forbes: Do you short Ford?
Greenwald: No, nobody is ever going to short something that’s as highly leveraged as Ford and still keep their shirt. Because all it takes is a little bit of optimism and you’re going to get killed. But it’s a typical stock that’s in the much too tough to call column. Does Ford have any competitive advantage over the other big, global car companies? And the answer is no. So you’d like a methodology that incorporates those kind of assumptions into your valuation. And that’s what Graham and Dodd developed. Always start with the assets. Then look at the earnings power and see if it’s protected by the assets. And only then, and this is what Buffett taught people to do, look to pay something for growth, because growth is only valuable if the investment in growth earns more than the cost of capital. And if it doesn’t, growth can destroy value. Growth is not a valuable thing as a rule. So, and if you’re going to buy that, you better be very sure of the franchise. So that’s what really constitutes a value investor.
Forbes: Before getting into what you look for, like barriers of entry, you just mentioned something, growth invites competition. Can you elaborate on that?
Greenwald: Oh absolutely. I mean, opportunity invites competition. If you find something new or something old that is attractive, that earns huge returns on invested capital, everybody is going to see it. You can’t hide things in a market economy. And if you’re not protected by economies of scale, by captive customers or by patents and technology that’s not available to the rest of the world, you’re going to get copied. And that’s especially true in rapidly growing markets with a lot of new consumers.
Forbes: Which, by the way, is an argument against antitrust, because if somebody has a monopoly that’s not legally protected, people are going to kill you on it.
Greenwald: I think that’s absolutely right. Antitrust is completely, and has been for years, incoherent. That where you don’t have a natural monopoly, competition will take of it. Where you do have a natural monopoly, having, breaking those up and trying to regulate them is more trouble than it’s worth.
Forbes: Now, you started to mention some of the things that truly constitute a company that won’t be quickly done in by competition. Barriers to entry, you have three others, supply, demand, economies to scale. Can you quickly go through those?
Greenwald: Okay. Barriers to entry are exactly the same thing as incumbent competitive advantages. Because if you’re, the newest guy has the competitive advantage. It’s just hyper competition. So it’s got to be an incumbent competitive advantage. What can the incumbent do that entrants can’t do? And the first thing is, they can have access to demand that entrants can’t replicate. And that’s called customer captivity, they own their customers.
Forbes: For example?
Greenwald: Second — oh, for example, your doctor. If you’re satisfied with your doctor, you’re not going to leave. If you’re satisfied with your health insurance company, and most people are, it’s, they’re very reluctant to change, it’s a complicated process, there are big switching costs.
Forbes: Your IT systems.
Greenwald: Your IT systems, Coca Cola, you have a repeat taste. I mean, when you go to a Mexican restaurant, you may order Mexican beer, but you don’t order Mexican Coke because you have a taste for uniformity and that constitutes customer captivity. Second thing is you can have technology they can’t replicate. Patents, or some sort of process factor, that they can’t replicate, or some particular very specific asset, like a terrific mind that they can’t replicate. And the third thing, and in a way, the most important thing is, you can have a scale of operation, usually locally, that they can’t replicate. So when Wal-Mart dominates a regional market, it builds an infrastructure.
If somebody wants to compete with them in that regional market, they’ve got to duplicate that infrastructure. To make it pay, they’ve got to get a share comparable to Wal-Mart’s. And given habit formation in local shopping, that’s going to be essentially impossible to do.
And those are the three basic competitive advantages. If you don’t have those, and information is also an advantage in financial markets. But in most markets, if you don’t have those three, you make a bad mistake to pay for growth.
Forbes: So why did Wall Street do so well? Huge profits and a lot of bright people around.
Greenwald: Right. And the question is, did Wall Street do that well? If you take the losses, what Wall Street does is, and I think a good example is AIG. AIG makes a lot of money while they’re writing these derivative contracts that are essentially insurance. If I’m an insurance company, and I write an insurance policy on your house, I have to reserve against the losses.
Greenwald: If I’m a financial company, and I write a policy against your portfolio, so I write a credit default swap, the market falls apart, is going to go way up and protect your portfolio, I don’t have to reserve against the losses on that. I write the whole premium as profit. Well, if insurance companies did that in the good years, they would make unbelievable amounts of money. And then they’d go bankrupt in the bad years. And guess what happened to Wall Street?
Forbes: So doesn’t that argue that like rules of the road, I mean, when cars came along, you had to put in, you know, rules. You don’t drive when you’re drunk, speeds limits and the like. When derivatives, like credit default swaps, they’re, in essence, like futures, we’ve had them forever, put margin requirements on them, things like that.
Greenwald: You can do that. You can do accounting reporting, so they have to basically establish a reserve for losses.
Greenwald: I mean, they had, there are a lot of things. But mostly, and this is, again, getting back to value investing. People are predisposed to do stupid things. That when they think markets are going well, they’re sure, like long-term capital management was, that risk has gone away. It’s not just, by the way, in housing markets. If you look at credit default swaps on sovereign debt in 2007, Dubai sovereign debt was trading at four basis points.
That is, you could buy insurance against a default on Dubai sovereign debt for four one-hundredths of a percent. That means you were betting that there was less than a chance, if you wrote that insurance, in 2,500 years that a country like Dubai, in the most unstable region of the Earth, based on the most unstable commodity at a peak price, had a less, had a one chance in 2,500 years of defaulting. I’d love to know who wrote that contract. And I think they wrote it because nothing bad had happened for a long time. People extrapolated and they forgot that there are probabilities. And, you know, subsequently, Dubai sovereign debt trades at, you know, the CDS, the credit default swaps trade at 600 to 1,000 basis points.
Forbes: So I’d have been better off with Indonesia.
Greenwald: Of course. And I don’t know how you stop that. I mean, I think that you want to arrange the people who make those mistakes pay the price.
Forbes: One thing on that, talking about barriers to entry being obliterated, media companies. You’ve never been a big fan of them anyway because —
Greenwald: I think that is not necessarily true. I think it’s like all things. There are media companies with extraordinary monopolies.
Forbes: You point out that a lot of them haven’t done very well.
Greenwald: Right. And then there are media companies that everybody thinks should have monopolies, like content companies.
Forbes: So, Bloomberg versus —
Greenwald: Well, or Comcast, which has a monopoly cable. It’s only competitive with the phone company. And if they can get along, it’s a duopoly, versus the movie business where everybody can get into it, and you can see it in the movie business. This ought not to be a surprise. So everything that could go well for the movies goes well for the movies. They get DVD distribution. They get cable distribution. They get foreign rights in a serious way.
Revenues grow at eight and a half percent a year for a very long time. Costs grow at 11%, because they bid for the stars, they produce more movies and the entry eliminates the profitability. And content is king? I don’t think so. Unless there are barriers to entry in producing that content, so you’ve got to get a scale like Bloomberg and the kind of customer captivity that Bloomberg has.
Forbes: So looking at the media landscape today, what do you see unfolding?
Greenwald: Okay, first thing is that you’ve got to break it up into parts. So the first part is just content production.
One-off content production, where every little thing like records, or movies or books is an individual production, has no barriers to entry, it’s going to be a crappy business. Fortunately, it’s always been a crappy business. Now, it’s worse a little bit because of piracy.
Forbes: So if it wasn’t for hobbies, that would have dried up a long time ago.
Greenwald: Right. Specialized continuous information content, where you’re probably going to have one provider, providing bond prices for the Turkish market, say, are going to do really well, because for a long time, they’re going to be able to keep people out. They’re going to be the only provider, they’re going to have local economies of scale, and people are going to depend on them.
In wholesaling, again, people who put together specialized content, like the Sci-Fi Channel, are going to do much better than people who do generalized content and are competing with eight or nine channels. Finally, on the distribution end, the people are going to make money there are, of course, not the old physical distribution people, but the people who own the electronic wire, and that’s the telcos, to the extent they do it, and Comcast. And those are going to be hugely valuable monopolies. When we all live in caves for global warming or whatever reason, that wire is going to be our lifeline. And if those two guys can cooperate, a large share of our income is going to go to that.
Forbes: So do companies like Verizon and AT&T have a future?
Greenwald: If two things happen. One is they have the infrastructure to provide fast Internet accesses essentially. And that will be a cost-free infrastructure, it’ll be a fiber backbone, and it’ll be over the air transmission, so it will never break, and will be completely software defined. So nobody will work there, and it will be hugely valuable, because it’s a huge fixed cost. That’s the first thing. If they can get that infrastructure in place, they’ll do really well.
Second thing is they have to be able to get along with the cable companies. Because that’s a shared monopoly, and if those guys are testosterone-crazed jackasses, and compete with each other, they will convert it into an unprofitable, competitive business. If they can get along, implicitly, they will make a ton of money.
Forbes: So, what areas do you like right now, as a value investor?
Greenwald: Well, I mean, I think cable is much despised. Telcos are much despised all over the world.
Greenwald: And you want to do the work to see which are the telcos that are likely to, first, be in a position with this basic infrastructure, which is going to be universal. And I think there are foreign telcos that look like they’re able to do that. I mean, France Telecom may eventually get there. Turkey Telecom has got a lot of fiber infrastructure and cable infrastructure, and may get there. So you want cheap telcos with a future, because the future is essentially, they’re essentially trading it, like, eight to 10% dividend yields, as if they’re dying, and some of them are not. And the other one is the cable companies. I think Comcast is —
Forbes: So, if you’re on the highway, collect the tolls.
Greenwald: Of course. Exactly. And if you’re on the highway at a really low price, because everybody else thinks the highway is going to fall apart and be really expensive, that’s a lovely place to be.
Forbes: So what bubbles do you see out there in the financial market?
Greenwald: I mean, aright, I’ll do the one that I’ve been wrong on for years. I’ve always thought Amazon is a bubble. They have no customer captivity. They don’t have enough scale that it’s hard to replicate. They occupy a really big market. They’re not specialized at all.
Forbes: So how have they done so well for so long?
Greenwald: Well, first of all, they’re, I think if you actually look at their reported profits, they haven’t done that well.
Greenwald: What they’re selling is this idea that they’re going to continue to grow and they’re going to have negative working capital. Negative working capital’s an invitation to competition, right? So why they think that ultimately is not going to be competed away is beyond me. So that, I think, is a bubble.
I mean, I’ve been semi wrong about Apple, which I think is a bubble, because we have a lot of experience with consumer electronics companies. We have a lot of experience with cell phone companies. And that experience says that there are no barriers to entry to consumer devices. Now, in the computer market, they may do much better for longer, because brand names are more persistent there. That Dell, for example, has had a dominant position in the corporate market, and direct sales to that market for years. But ultimately, I think that’s an area where competition is going to tell. And paying the multiples people are paying for Apple is absurd.
The other one I think, and this is along the lines of growth not always being valuable, people are paying a lot of money for companies in Brazil and in China that are subject to competition.
Chinese manufacturers have to compete with other Chinese manufacturers. And the growth just gets competed away by entry, like it did for the movie business. So I think you would be well advised, especially given the political uncertainties, and everything else in the fundamental economics, not to pay a ton of money for China. And I think there’s something else that is going to kill China too, which is that if you remember, if we had been sitting here in 1989, everybody thought the United States was going to consist of people who flipped burgers at Disneyland for Japanese tourists.
Forbes: I didn’t, but others did.
Greenwald: Others did and they were wrong. And they were wrong, because the Japanese were in manufacturing. And manufacturing is an area where productivity growth is much higher than demand growth, and it means, like agriculture.
Forbes: Make a quick point on that. Caterpillar, Deere and others, make the money not selling moving equipment so much as servicing it, which is local markets.
Greenwald: Exactly. Which is local markets that they can dominate. Global making markets are subject to what happened to agriculture in the 1920s and ’30s, which is, everybody left it. Everybody could do it. Productivity growth was enormous, and it died.
And I think Japan has basically had this very long period of malaise because they have decided they’re going to be the preeminent manufacturer in the world. It’s like in 1940, the United States deciding they’re going to dominate the world by being the preeminent agricultural producer. And that would’ve led no place. And I think China’s in the same game. So, I think you’re going to have real trouble in China.
Forbes: Elaborate just on that one minute on China. Authoritarian government, huge success so far. Are you saying they don’t have the kind of flexibility and the true, free market that allows the economies to like we’ve done over time?
Greenwald: I think it’s not so much that, although I think there’s an element of that to it. First of all, on the huge success, they still have an output per capita that’s probably a third to a half of Taiwan’s. So the direction is good, but the level is still nothing to write home about.
Greenwald: Secondly, I think that they have done it by specializing in industries which are manufacturing industries and it’s a manufacturing, export-driven economy that are going to get automated. If you go into a Japanese factory today, I mean, and this is the problem with Japan. There are more people on the loading dock than there are in the factory. And the loading dock is this service function that you talked about with Caterpillar, and so on. There is no evidence yet that they’ve moved into developing a vibrant, innovative service sector.
And there is equally, I think, little evidence that they’ve actually developed leading edge manufacturing compared to the Japanese. They’ve done better at the low end than anybody expected, but they’re not the star manufacturing companies that the Japanese are. And a lot of good that’s done the Japanese. And I think the third and most important thing is what you’re talking about. That ultimately to support a standard of living that’s high in this environment, you not only have to have a service infrastructure, but you have to produce intellectual capital. And the striking thing about the Japanese is they did not produce great universities. And I don’t see any evidence that the Chinese are producing great universities either because the truth is, and this is related, I think, to the political system, that the very best graduates who come to the United States, and a lot of them come, all want to stay here.
Greenwald: Of course. Wouldn’t you? And you talk to them, and you say, “You want to go back to China?” And they say, “Not if I can help it.”
Forbes: So does that mean India has an advantage over China that they are more mind-oriented and not to mention the rule of law?
Greenwald: I think there are two reasons. I mean, we’re, first is, that they are much more service oriented. And I think that’s going to help them.
They’re not committed to doing the kind of, sort of mindless manufacturing that the Chinese are doing, or blindly pursuing that alley. And secondly, I think that, yes, the politically vibrant culture that’s there is going to make a big difference. On the other hand, if you look back 70 to 80 years, the dominant universities in the world today are the dominant universities then. So I think India is not going to necessarily succeed in displacing the great American and the few great European universities. But the Indians ultimately want to go back in a way that the Chinese don’t necessarily want to.
Forbes: And talking about Europe, why has Western Europe been such a laggard? I mean, they should’ve been at the forefront.
Greenwald: Again, I think that there are two reasons for that. And they’re exactly the reasons we’ve talked about. I mean, that in a sense, the future is services, which are locally produced and consumed, and production of intellectual capital. And those are both state-dominated sectors. And they have not produced successful universities because they have egalitarian overlays on things that mitigate against the kind of excellence that you have at Oxford and Cambridge and in the U.S. universities.
So they haven’t been producing the kind of intellectual capital they need to produce. And it’s not so clear that they’re going to be good at that. And the second thing is that services, and the big services are, of course, education, medical care and housing, are government dominated. Either run with very tight zoning restrictions, or they’re directly run by the government, and I don’t think that helps you.
Forbes: So, quickly looking at the U.S., if we want to continue to be a real leader, shouldn’t we be going to opposite direction on health care? Opening it up to entrepreneurs and get a real rip in innovation and production and like we do everywhere else?
Greenwald: I mean, I, of course, I think that’s true. I mean, and if I can say something about the United States, because I think it’s important. There are in the world two basic ways you control human behavior and have societies function. One is material incentives. And that includes, obviously, not just money but, you know, all sorts of material sanctions. And the other is social incentives. And the U.S. is an economy that has been selected for not having social incentives because if you were an Italian, and you didn’t like the social restrictions in your village, you came to the United States to do well. And what that’s done is created a culture because you don’t have to enforce more obedience in the schools the way they do in Europe, that is a wonderful culture.
I mean, in the United States, you can screw up till you’re 35-years-old. And if you’re hard-working enough and smart enough at that point, you’ll do well. In France, or in Germany, or in England, or in Japan, or in China, if you screw up by 19, and in France, don’t get into a grand ecole, you’re finished for life. And there is no equivalent of Animal House or the huge literature on high school and college experience in the United States both in films and books in Europe. I mean, school is a grim experience in Europe. And I think that it is that attribute of U.S. society that we don’t want to kill in any dimension.
Forbes: So even though a lot of our especially inner city schools mess up, if the kids are playing games, their mind develops?
Greenwald: It’s not just that. I mean, there, look, there are people who develop at 15, I mean, there are people, there’s a famous investor called Seth Klarman, I knew him when he was an MBA student at Harvard. He was the same then, he was as capable then, he was as brilliant then as he is today. He developed very early in life. But there are other people who develop much later in life. They develop not at 15, but at 20, at 25, at 30, at 35. And I think trying to force everybody into a European mold, where if you aren’t doing well by 19, we’re going to write you off, is crazy. I mean, I would let those people out of school, and let them come back to school later. It’s funny, I talked to somebody here who started out, she left home at 16, to be a rock star. And she tried that for four years and then she went to NYU and obviously did well and she works for you now as a journalist.
That is not possible in Europe. And I think that’s one of the glories of the United States that you want to make sure is not eliminated by trying to pursue a European model of service and welfare provision. I mean, there’s a downside to it, but I think there’s a wonderful upside to it.
Forbes: Bruce, thank you very much.
Greenwald: Thank you.