Value Investing

Jeff Gramm, Author And Money Manager, Speaks With GeoInvesting [IN-DEPTH]

As we have talked about in the past, part of the GeoInvesting methodology is to talk with management and smart people.  Jeff Gramm is a smart person.  In addition to running Bandera Partners, Jeff also wrote a book that is required reading for our team called Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism.  This fascinating book shows how the Grandfather of Investing Benjamin Graham started as an activist shareholder, taking on and beating Rockefeller, as well as Ross Perot’s tenure on GM’s Board and several other groundbreaking shareholder battles.

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Jeff Gramm Dear Chairman

I had a chance to to chat with Jeff to learn more about what he does, his investment process and his views on activism. You can see all of what Jeff had to say below, but I’d first like to point out some of the structure and notable moments of the interview.

Topics Discussed:

 

  • A little about Jeff Gramm
  • Investment strategy and definition of activism?’ (Reel time) 
  • Longer-term horizon vs. Sort-term 9
  • Industry Preference 1
  • Research process 
  • The importance of networking 
  • Initial Research Filtering Process 
  • Market Cap Preference 
  • Activism in the small and microcap space 
  • Evolution of activism 
  • Personal Activist “Battles” 
  • Passive vs. Active Investing 
  • What an additional appendix to Dear Chairman would look like

Thank you Jeff

Learning From Your Peers

One of the things we like to do is to find a few of the pearls hidden in the dialogue and bring them to the surface, polish up, and use as conversation starters.  From Jeff’s talk we have a few ideas we think you might be interested in exploring a bit.

Even though Jeff not does consider himself to be an activist, he points out that its part of the game:

Jeff: I think anyone who does a lot of small cap investing, anyone who takes large concentrated positions…you ultimately will find yourself in situations where you either need to get involved or you need to find an activist to get involved.  

We consider ourselves to be activists, but not in the normal sense of just agitating for changes like management changes or capital allocation strategies.  We assist management with suggestions on how to increase sales and reduce risk, and make introductions that can have synergistic effects.  When we decide to take a position, we believe we can maximize our profits (and hopefully our members’) by giving management our talents.

Jeff Gramm: In our business, that’s the kiss of death: when you begin to cut corners.

The longest route is always a shortcut.  We have a responsibility to our Members to always do the right thing and not cut corners in our research process.  We have created additional SOP’s (Standard Operating Procedures) to ensure high quality control in our investment process, and encourage the companies we deal with to do the same.  Never cut corners because it is a slippery ethical slope.

Jeff Gramm: I do think the growth of passive is a threat to corporate governance. 

If you read Sig’s article on active versus passive management, this is a thought you know we have addressed extensively.  We have a deep-seated belief in the value of the research we do, not just for ourselves and our Members but for the investment community in general.  Sometimes it is by exposing the bomb companies out there that can blow up and weaken investor confidence in the microcap space.  Other times it is discovering gems that with some polish will be valuable.  Our information focused approach uncovers opportunities all along the spectrum while promoting a better overall market.

Often you might hear “history does not repeat, but it rhymes”.  One of the best ways to be prepared for the boardroom battles of the future is to study those of the past the way current military leaders study Sun Tzu’s Art of War.  The best tome for this is Gramm’s Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism, and we thank Jeff for investing the time with Geo.

Notable quotes from our interview with Jeff Gramm:

We’re just classic value investors…trying to find a fifty-cent dollar. – Jeff Gramm

… I think anyone who does a lot of small cap investing or takes large concentrated positions… ultimately will find yourself in situations where you either need to get involved or you need to find an activist to get involved. – Jeff Gramm

You can be the best analyst in the world, but it’s pretty hard to avoid situations where you’ll buy into a good company that isn’t run optimally. – Jeff Gramm

So, I view activism as basically getting engaged with your portfolio companies…getting involved with the governance or the management or the strategic decisions and any kind of engagement. – Jeff Gramm

It’s pretty hard to think of a scenario where I know the short term is going to play out a particular way. – Jeff Gramm

But I don’t think that there’s anything that I would never read the 10k. I think there are industries where I know it would be a real uphill battle, but I don’t think that is the same thing as just inherently off limit. – Jeff Gramm

To me the most important step is deciding what to work on. You filter through all your ideas and I think the key decision in any value investing research process is…it’s a time management one. It’s why do you decide to look at stock A and not Stock B? – Jeff Gramm

It’s not that hard to look at a company, it’s harder to put yourself in a position to find the good ones, because they’re so rare that are good investment ideas vs. a lot of good companies. – Jeff Gramm

So, I find a lot of our business is about being like an investigative reporter: you’ve isolated a business that you think is good, that you think you understand the economics of the industry, but usually you need to talk to someone that knows the industry better than you and try to get them to explain…“I think that this company looks cheap, at the quality of their earnings, but can you really walk me through how they make money.” I just make sure that I’m getting it. – Jeff Gramm

I don’t build a big spreadsheet or look at the comps, trying to figure out ‘well, how come this guy has a 22.8% gross margin when the competitors are at 23.5%. To me…I’m not digging in the numbers that much. I’m trying to find people that know how the business actually works that can give you a sense for the durability of that business and to try to talk to me. – Jeff Gramm

we all have our own way of doing things and I’m not saying this is the way for value investors, it’s the way for me. – Jeff Gramm

It took me a long time to learn about gathering information, but not being affected by opinions. – Jeff Gramm

So, to me, in that initial screen, we’re looking for things I can understand, things that I think I can get a handle on. I’m often thinking about “well is there a reason that the market might be blowing this or undervaluing this.” “Can I really understand this business before thinking about risk. – Jeff Gramm

But I tend to look teeny tiny and we have the luxury of long term investors at Bandera, so we’re not afraid of some illiquidity and I also have that from my distressed debt background too. In distressed debt, the liquidity often just appears in these little clumps: you’ll have a day where something bad happens and if you take a position, you might be stuck in that thing for a while and then it’s just the way that I learned to invest. So when I began to look at equities more, the illiquidity of small cap and micro caps was always something that I had some training with I guess. – Jeff Gramm

It’s hard for boards of directors to govern well. It’s hard for them to ultimately remove under-performing CEOs. There’s all these dynamics in the book that will continue, but I do think the one big theme in the book that evolved as the history progressed was the  increasing sophistication and concentration of the big passive investors and you’re definitely seeing that continue with Vanguard and Black Rock and all those guys and I think that’s a secular trend. – Jeff Gramm

I think over the next twenty years, they (passive institutions) might begin to  cut out the middleman more, to be more proactive on their own account, to take more advantage of proxy access and I think it’s an interesting dynamic. – Jeff Gramm

The end game is a little bit troubling with companies like Vanguard and BlackRock get a huge amount of a power without actual in-house financial analysts researching these companies and management teams. – Jeff Gramm

With short activism, it’s interesting because if you have a stock that a short gets involved with, you probably would applaud the, picking the other side and perhaps magnifying your gains if you’re right and also allowing you an opportunity to buy more in the short term. But if they’re a loud short activist, that is, talking down the business and if there is any part of the business that is confidence based, I could see it being troubling. – Jeff Gramm

As an industry we have not done our job of showing that consumers should choose active managers and I think, over time, more of them will be replaced in the sense that Vanguard and the S&P 500 is a very good product. – Jeff Gramm

If we as an industry continue to just charge away the value of those skills and excess fees, that’s hard to complain about the customers voting with their feet. – Jeff Gramm

But I think there’s always going to be a place for guys like you and me who will do the hard work and the nitty gritty to generate good returns while taking less risks. – Jeff Gramm

I think it would be very fun to take a current proxy fight and to get behind the scenes and discuss why Vanguard voted the way that they did and to essentially address this whole issue of “are the big index funds, informed voters?” I think it would be very fun to take a current proxy fight and to get behind the scenes and discuss why Vanguard voted the way that they did and to essentially address this whole issue of “are the big index funds, informed voters? – Jeff Gramm

The main thing with my book, which I try to tell people, is it’s about activism but it’s not pro activism or anti activism, it’s just about the way that public companies work. It’s a way that a business works and I finished the book in 2014, which was right before there began to be a lot of attention on the Vanguards and the Black Rocks of the world and their voting intentions. – Jeff Gramm

The full transcript can be found below.


FULL TRANSCRIPT

Attendees

  • Jeff Gramm, Author and Money Manager
  • Maj Soueidan, co-founder of GeoInvesting
  • Siegfried (Siggy) Eggert, GeoInvesting Analyst
  • Joe Templin, Bestselling Author & GeoInvesting Contributor

Special thanks to Siggy for making this happen.  Siggy joined Geo last year and Jeff’s book, Dear Chairman, is the first book he recommended that I (Maj) read.

What follows is a summary of our interview with Jeff Gramm.

Discussion Topics/Questions

For those who are not familiar with what you do, why don’t you tell us a little about yourself and how got you to where you are today?

Jeff

So, I run a fund called Bandara Partners, which is an eleven year old hedge fund based in New York City. That’s my third job in the industry.  But before that, I worked at a distressed fund called Arklow Capital and before that, a bigger distressed fund called HBV capital. My fund is basically a concentrated value fund.

I don’t really think of myself as an activist.  But we’ll take big positions in companies and serve on boards…we’ll get engaged with our portfolio holdings, but activism isn’t really a core part of our strategy—we’re just trying to buy cheap stocks.

What is your investment strategy and what is your definition of activism?

Jeff

I feel we do what everyone else does, we’re just classic value investors…trying to find a fifty-cent dollar, but trying to find a situation where perhaps the business is of a better quality than the rest of the market perceives, or perhaps the growth prospects are better than the rest of the market perceives, or perhaps it’s a mature business in wind-down mode and we think that we can cull a few more cents than the market perceives. We don’t really have a specific niche, within value investing.  We’re trying to reduce our risk to ideally take below market risk, but we’re trying to get a good return out of it.  And activism… I think anyone who does a lot of smallcap investing or takes large concentrated positions… ultimately will find themselves in situations where they either need to get involved or need to find an activist to get involved.

You can be the best analyst in the world, but it’s hard to avoid situations where you’ll buy into a good company that isn’t run optimally.  This happened a lot when I was in distressed investing. We will Just find yourself in a lot of situations where you might want to influence the board or try to, at least, provide a few ideas to the management team…you might not be right … they might not be good ideas, but when you have a 10% position in your own fund and you think that they’re not doing something right, you’re probably going to tell them about it.

So, I view activism as basically getting engaged with your portfolio companies…getting involved with the governance or the management or the strategic decisions and any kind of engagement.

Maj

Still, if you look at your portfolio, have you actually entered a situation because you wanted to affect change, versus you get into it and find out, ‘wow, this isn’t what I expected.’ Can you comment on that a little bit?

Jeff

Yeah, I can’t remember a situation where we got involved with a specific agenda to get engaged. We’re basically, at least on the investment side, a two-man team, so when you serve on a board of directors, it takes up a lot of time and it takes up a lot of energy and mental focus and so…I think the best activists I know are the ones that it’s pretty much the main thing that they do. When they buy a stock, it’s because they want to be an activist.

When I buy a stock—hopefully it’s because it’s a cheap stock. When we get engaged, usually, it’s not even as much because we see things are going wrong. It’s usually that the position evolved that way, and we’ve got to a very meaningful chunk and then you’re playing defense. So, we own a position in a company called Tandy Leather Factory Inc. (NASDAQ:TLF) where we…so over time, perhaps because of the opportunities afforded us by Mr. market, we got to buy close to 30% of that company and at some point, the board put in a poison pill to prevent us from buying more.

When you own a thirty percent stake in a company, your liquidity is restricted anyway and then with the poison pill, we can’t buy more, so it made sense to go on the board. At that point, the downside of serving on the board was limited, whereas the upside of having a seat at the table, potentially being able to talk them out of some corporate action that we disagreed with made sense. A similar thing happened when I went on the board of PICO Holdings Inc. (NMS:PICO) and the market gave us an opportunity to put on a pretty big position.  There was an overhaul in the board and we got an opportunity to go on and it made sense.  And it’s not that we went on because we were angry…we were pretty supportive of what they were doing, but having a seat at the table does hopefully help with your downside protection.

Maj

Yes, and it’s funny with TLF.…I followed TLF for many years and wanted to talk about it actually, and I’m glad you brought that up because I wanted to ask you about that…Are you still long TLF?

Jeff

Yeah, we’re still on the board and we still own shares.

When you look at companies to invest in, are you taking a longer-term horizon, or are you also looking at a short-term special situation

Jeff

I guess it depends on the situation, but in general, the way that I look at things…it’s pretty hard to think of a scenario where I know the short term is going to play out a particular way. So, usually it’s long term by default.  But, usually if there’s some catalyst for that to play out in the short term, the market is usually pretty good at handicapping those, so we do just tend to be long term.

Are you industry agnostic, or do you avoid certain places?

Jeff

Yeah. We’re pretty industry agnostic and obviously the longer that you do this, and this could be laziness on my part, but you do build some expertise in particular industries if you do a deal where you get to know a lot of people.  Then you can build a Rolodex in the industry. So, there are some industries where I do feel I look at a lot of companies within that industry.  And there are some that I pretty much…never have, but I don’t think that there’s anything that I would never read the 10k. I think there are industries where I know it would be a real uphill battle, but I don’t think that is the same thing as just inherently off limits.

Can you take us through your research process?

Jeff

Sure… To me, the most important step is deciding what to work on. You filter through all your ideas and I think the key decision in any value investing research process is…it’s a time management one. It’s why do you decide to look at stock A and not Stock B? We don’t have any proprietary screen or put the stocks in any kind of a basket. You’re going with your quick filter and you’re gut with this, ‘the idea that I can get a handle on that might be cheap.’ So that, I would say, is the least process oriented for us is what do you put in the, ‘this might be interesting’ basket. Then from there it really is about…from that point, we’re all on the same playing field. It’s not that hard to look at a company, it’s harder to put yourself in a position to find the good ones, because they’re so rare that are good investment ideas vs. a lot of good companies. My process for once I’ve decided this thing might be interesting, is read the 10K, read the 10Q, read the conference calls and from there, you should hopefully be able to isolate some key questions that you have about the business and the competitive dynamics of its industry and the growth prospects. And once you’ve isolated those key questions, you have to just find someone that knows.

So, I find a lot of our business is about being like an investigative reporter: you’ve isolated a business that you think is good, that you think you understand the economics of the industry, but usually you need to talk to someone that knows the industry better than you and try to get them to explain…“I think that this company looks cheap, at the quality of their earnings, but can you really walk me through how they make money.” I just want to make sure that I’m getting it…

Maj

I think if you actually make a great point…surround yourself with the  people and find smarter people to help you sometimes get your situation …that’s a key and lot of investors, I noticed, are sometimes “afraid” to do.

The importance of networking

Jeff

The funny thing is, when you think about it, the ways to add value to your research… I think the size of your Rolodex is a really big one and I think that’s the reason that you see these expert networks will charge a huge amount of money. Companies like GLG and then at the big funds. I had lunch with some guys at a very well-known big value activist fund and they have a team of, it was eleven or thirteen former investigative journalists, to help the analysts find people to talk to. And so, they had an in-house team to basically facilitate the research process and that facilitation wasn’t in building big spreadsheets or doing customer surveys. A lot of it was just finding experts, finding experienced, smart people. And journalists are very good at that. That’s the nature of their job. It’s…you get on the phone and you learn. I’m not saying this is the way for value investors, it’s the way for me.

I don’t build a big spreadsheet or look at the comps, trying to figure out ‘well, how come this guy has a 22.8% gross margin when the competitors are at 23.5%. To me…I’m not digging in the numbers that much. I’m trying to find people that know how the business actually works that can give you a sense for the durability of that business and to try to talk to me.

Maj

Before we launched Geo ten years ago and as full-time investor, I remember just sitting in my bat cave doing research.  I was not really conversing with other people.  But, it’s funny that, if you let that mentality go a little bit, you find out there are a lot of great sources, people, experts out there that you can lean on. A lot of great our ideas have come from outside sources, including some home runs from our member. I think that’s a great point you’re making here.

Jeff

And yes, this point is important, but it’s also very dangerous, because anyone that you talk to, they’re going to inject their opinion too. And so, if you’re talking to people who have a stock idea, they can influence you when you talk to these experts. It took me a long time to learn about gathering information, but not being affected by opinions.  I remember I used to do lots of distressed restaurants. I would talk to the franchisees, I would talk to people in the industry, and a lot of my best ideas, the ones that made the most money came from this effort. I definitely had moments where a person, who knew more than me, who is very smart, told me “look, this thing is a disaster that you should not buy it.” You need to use these conversations to help you understand the business, to help you understand the problems, but you also need to filter the opinions. It took a while to figure that out and I think it’s even more dangerous when you’re talking to other fund managers.

Anyways, in investing, there are a few key things that are very hard to figure out that you might get 90% there on and then it’s “well I talked to my friend Eddie and he’s a super smart guy and it’s his biggest position, maybe I can cut that corner.” In our business, that’s the kiss of death: when you begin to cut corners.

Maj

From my experience it’s like you said, there’s a fine line: who do you trust, when do you trust, are they selling their book, telling you what you want to hear. I even find it challenging to interview companies on-site. I found myself, during a lot of these exercises, getting very excited, emotional.

Jeff

You definitely need to filter out the optimism. And when you write things down, you’ll see things: I remember being invested in a company in the U.K. where every time we talked to the CEO, there was glowing optimism…all of this…the vibe was very positive. The content of anything that was unverifiable was positive, but the actual facts, if you wrote them down on paper… “Well, wait a second, all these are negative!” There was so much that we couldn’t verify. So much of our job is about not playing games with yourself and trying to think clearly and there’s a lot of impediments to that.

Filtering Process

Maj

But you have a process…How do stocks enter your basket?

You said earlier that your time is very precious, so you have to manage your time wisely. Some people will narrow down the stock universe and look at just new highs new lows, doing screens…these things. I know there’s no one way and you mix it up a little bit, but how do stocks enter your basket? Is it usually through your conversation with other people, or are you actually setting aside time, reading 10ks?

Jeff

So, the initial basket, before the filter even…so that I don’t know, that’s just a grab bag of anything and everything. You read about it in the paper, there’s corporate action, a friend likes it, if someone else has a letter…

I haven’t looked at that (the new highs or new lows), I haven’t done that in a long time, but I’ve done that before. I would always, when the markets get ugly, do the net net screens and the obvious multiple screens. In times like this, you tend just to see the same names of problematic companies, but they’re really isn’t anything formal and I’m not above just looking at a list. I used to love that Yahoo industries browser where you could basically go into any industry by market cap and read about the company. To me, if the quick filter takes three to four minutes you really don’t have to be too discriminating on what to give the quick filter treatment and you can be happy to look at anything.

Maj

So, you’re a value investor and like many other value investors, is risk is the first thing they look at before potential return; margin of safety.

Jeff

I’ve said that to people, but I’m not above looking at the risk/reward and if you find a leveraged equity that could be a ten bagger, if it works or goes to zero if it doesn’t, you’re risking all of your capital. So, I’m not going to say that I never do those and will sometimes augment our long positions with call options or leaps which is essentially the same thing. If you’re buying an option or a leap, you really don’t know what’s going to happen in two years, so you’re putting some leverage onto some conviction that you have about the future of the company and you’re basically speculating that if it happens within this timeframe, “I’m being compensated for the risk that it doesn’t.”

So, to me, in that initial screen, we’re looking for things I can understand, things that I think I can get a handle on. I’m often thinking about “well is there a reason that the market might be blowing this or undervaluing this?” “Can I really understand this business before thinking about risk.”

Leverage

Maj

And do you leverage mainly through the option markets, or do you actually use margin, or do you usually stay away from margin?

Jeff

No. When I talk about a leveraged bet, I usually would mean that the company is leveraged. My background is in distressed investing and lots of those situations, when you’re essentially a credit analyst of over-leveraged companies, I find that you evolve a comfort with that and a little bit of a higher risk tolerance than other folks, but we don’t use portfolio margin.

Market Cap Preference

Maj

So, while we’re on the subject of risk or perceived risk, in terms of marketcap, do you have a preference for where you usually sit at?

Jeff

I do the little ones, so if you look at the Bandera 13F and see a really big company on there, it’s usually my partner Greg’s, so Google, that was essentially his idea, not mine. So, I tend to try to find the no brainers… a situation where it’s easy to wrap your head around a business and the market is completely blowing the valuation and I have a harder time finding those and in the world is of big caps, so it does happen. But I tend to look teeny tiny and we have the luxury of long term investors at Bandera, so we’re not afraid of some illiquidity and I also have that from my distressed debt background too. In distressed debt, the liquidity often just appears in these little clumps: you’ll have a day where something bad happens and if you take a position, you might be stuck in that thing for a while and then it’s just the way that I learned to invest. So, when I began to look at equities more, the illiquidity of smallcaps and microcaps was always something that I had some training with I guess.

Activism in the small and microacap space

Maj

And so being familiar with these smallcap companies, have you noticed any shift in the type of activism…that there’s more activity going on in these smaller companies, like activist moving down the food chain more. In Forbes, I read an article about that in 2016 and I was wondering if you experience that at all.

Jeff

I really haven’t, there’s just a lot more activism across the board because this is a long bull market and you do historically tend to see this in longer bull markets. My book, it’s obviously a history of shareholder activism and so there are plenty of periods, like the 20s, the 50s and the 80s where I think you saw these blooms of activism and it often just had to do with a pretty long bull market and at the end of the bull market there were less opportunities for passive investors.

I don’t know that I’ve seen more of it. I think especially in the smallcap world there are lots of funds around that have been doing activism forever. There’s a fund around the corner from my office called Stillwell that just does very small public banks. I think that they pretty much go activist in every situation and will have a pretty big portfolio. They’ll have thirty positions or something like that. And they’ve been doing it forever and I think there’s a lot of active investors in very small public companies and I think that there have been for a while.

General Motors

Maj

So, I want to talk to a couple more points on activism, though it’s clear that that’s not what you’re doing, though you clearly have knowledge, with the book about it.  Are you entertained now, at what’s going on with $GM and their inability to continue to compete. I think they had some not so good news a couple weeks ago with their electric car line. It reminded me of your book about their dysfunction that just seems to stay with them over time.

Jeff

Well it’s interesting I do think the G.M. chapter is the best chapter in my book and I think it’s a very fun example. You had Ross Perot, who was this very energetic and popular businessman and he goes on the board of GM to the applause of the financial community and could not get anything done and GM ultimately paid him three quarters of a billion dollars just to walk away. And so that was a fascinating thing to write about. It was historically important because it affected a lot of these big institutional investors that had historically been passive and then they sit there and they watch this company that they’ve been a passive holder of for decades die.

Perot got paid to weaken their board of directors and so this was a real turning point for a big public company and that was a very fun thing to write about and the interesting thing about business history is how much of it flows through GM like all the offered Sloan stuff is fascinating. The history of the pension fund, as we know it now, is a GM creation. The history of what activism for corporate social responsibility was forged by Ralph Nader with the campaign. GM was a great thing to write about, but I’m not sure that it was all that instructive for understanding the GM of today. It is interesting because when I researched that chapter, I read all of the historical GM books and so I couldn’t help but read the newer ones.

There’s a book by Ed Whitacre about it, there was that Rattner book about it, so there’s all these books about the G.M. bankruptcy too and the efforts to tame the bureaucracy to make it a more streamlined and modern company and I don’t know to what extent they have been able to pull that off, we’re not close enough to the situation to know. So, I don’t know. I don’t have that much intelligence to say about the operations of GM. I’m not sure that anyone does…

Evolution of activism

Maj

So, when you look at the evolution of activism over time, and you do a great job doing that in your book, any idea of where you think it might be going? The chapters are still being written. Do you think that minority shareholders are going to get more power, moving forward or things like this?

Jeff

In some ways, they’re are consistent themes throughout the whole book that will clearly be perpetuated: that when you have control of a company you’re probably going to do things to advantage yourself at the expense of the minority shareholders. It’s hard for boards of directors to govern well. It’s hard for them to ultimately remove underperforming CEOs. There’s all these dynamics in the book that will continue, but I do think the one big theme in the book that evolved as the history progressed was the increasing sophistication and concentration of the big passive investors and you’re definitely seeing that continue with Vanguard and Black Rock and all those guys and I think that’s a secular trend.

I think that that power will continue to gather into their hands and the past twenty years or so, they’ve been the big passive institutions, the big pension funds have been content to be the arbiters in activist disputes and to be the ‘behind the scenes’ supporting hedge fund activism when it suits them and I think over the next twenty years, they might begin to  cut out the middleman more, to be more proactive on their own account, to take more advantage of proxy access and I think it’s an interesting dynamic.

The end game is a little bit troubling with companies like Vanguard and Blackrock get a huge amount of a power without actual in-house financial analysts researching these companies and management teams. If you look at TIAA-CREF, they are a big institution, but for any company in the S&P 500, they’ll have a bunch of analysts who have looked at it a long time. They meet or talk with the CEO probably every quarter and they’re a very well informed on how the company is executing compared to what they’ve been promised. I think at places like Vanguard, it’s a lot more reactive, so it’s proactive on bigger picture things: perhaps diversity in the boardroom and things like that, but it’s probably reactive on individual companies that shareholders think the CEO is not performing. So, it’ll be interesting to see how they wield that power and how effective they can be when they’re a reactive voting shareholder versus someone like TIAA-CREF that is in touch more with the company.

Activist Battles?

Maj

So, in terms of in your investment career, have you have had to butt heads with activists who don’t agree with what you’re doing or maybe even a short activist who’s come in and maybe attacked your idea.

Jeff

I’ve never been involved in a situation where there has been an activist short. Like that would be interesting if it ever happened. We have been involved in situations with activists where we have voted against the activist… so I can think of at least three, off the top of my head, where we knew a company well. We thought that the activists will basically not have any ideas that management was not already trying. So, we definitely have voted against activist funds before and we’ve voted against activist funds that we had a very good relationship with and were friendly with. So, that definitely has happened, but more often than not, if an activist gets involved in anything that we’re in, we’ll probably agree with them and support them.

With short activism, it’s interesting because if you have a stock that a short gets involved with, you probably would applaud the, picking the other side and perhaps magnifying your gains if you’re right and also allowing you an opportunity to buy more in the short term. But if they’re a loud short activist, that is, talking down the business and if there is any part of the business that is confidence based, I could see it being troubling.

In 2008, what happened to Lehman Brothers and to think it was a screaming buy…when David Einhorn got involved as a short, on the one hand he was pointing out they’re aggressive treatment of their balance sheet, et cetera, were things that he seemed to be correct on, but at the same time it was a confidence based business. I’m sure that Lehman lost some customers because Einhorn publicly shorted. If you’re a hedge fund who will prime broker through Lehman, I’m sure if David Einhorn is saying, Lehman is insolvent, that you’re thinking twice about moving your assets away. It adds to the insolvency problem, so if you were really a believer in the long-term value there, and if you thought “well man, if they can just remain through this crisis, it’s going to be a screaming buy,” I can see being extremely frustrated at a short seller that went public.

Maj

We’ve been on both sides of the coin here. We played a pretty big role since 2010 having exposed some China fraud companies, and that was an interesting time. We had some people on the ground in China and so we has a pretty good idea of how things were going to play out over time and it was a pretty quick and very confident bet (if you will) on the short side in China, but what happened there, was a very specific time and that wasn’t the norm.

Jeff

And I think that lots of those Chinese verse mergers weren’t confidence businesses, they were on paper…these were very real business that turned out to be B.S. So, it’s like that company that did the digital advertisements, China Media Express(CCME)…it’s that if you’re publicly calling it a fraud, it’s not going to hurt the business in the way it could have, like a bank fraud or something like that. I think that a lot of those were the kind of businesses that the shorts didn’t damage the prospects for those businesses. They were frauds anyway. If you were long CCME and believed in the durability of the business and the prospects and if they hadn’t been a fraud, you would have enjoyed the shorts being there.

Short Game Has Changed

Maj

And CCME went from, I think, 6, 7, 8 dollars and over 20 bucks, so being short is not all about being right, there’s a timing issue too. I think the game has changed a little bit: it was very successful during that period of time to some degree because, as you short and compete, you get a reputation, and actually people start believing in you.

But now I notice, it’s a much more difficult environment now. It’s what it used to be probably, it’s more of a longer-term short, if you want to get dynamic returns and you have it play out over time. What you’re saying, if you’re a long investor, taking advantage of these shorts, getting involved in your name might not be so bad.

Jeff

Yeah and I think a lot of it also is when you’re trying to find an individual short idea there’s a lot out there, but it takes a lot of work, you have to do a lot of digging and then it takes a lot of time for them to play out, but then historically you’ll look at these huge thematic ones that become bonanzas like the Chinese reverse mergers, they were a real gift from the heaven. So, I think there’s compelling shorts out there. They’re some thematic ones that are playing out, like the Canadian housing market, but when you get a really big one, like the mortgage bust or the Chinese reverse mergers and the telecom bubble, those things are the ones where the shorts can really do awesome. It’s more tough to compare today to that, because those will come back there will be others there’s no doubt, and there could be some brewing now, but just because there’s not a super easy one, I don’t think it’s gotten harder in a secular way.

Maj

Ziggy, Joe, are you guys still there? Do you have any questions or any commentary?

Passive vs. Active Investing

Ziggy

Actually, one question that I want to ask that I was very interested in. We were talking a little bit about passive and active investing and that’s a big secular trend that I spend a lot of time thinking about. What are the implications for active mangers? What are things that an active manager can do to not be replaced by an index fund soon or later?

Jeff

I think they’re two aspects to the passive active debate. There’s the governance aspect where I do think the growth of passive is a threat to corporate governance. You can envision a future where these big institutions get pressured by special interests where they don’t help corporations govern effectively so on the governance side, I think there are a lot of big issues. But then, there’s the actual investing side that you’re asking about and I think a growth of passive will not get so big that it will dramatically distort the efficiency of the markets.

Just because there will be always a huge profit incentive to make the market…to do some part to bring efficiency in and buy cheap stock. I think that will always be there. To the bigger question of “Will active managers be replaced by passive investors?” I just think that you have to look at the industry and say “well look,” the convenience, the tax efficiency, and the good returns of the index funds are a powerful value proposition and I think the financial services industry as a whole and particularly the active managers that have not covered themselves in glory…This is a thing that Buffett wrote about in the 50s that professional active managers as a group, they tend to  suck and to the extent that they don’t suck, they tend to find a way to extract their value through fees.

The emergence of the hedge fund industry as essentially a way for the talent in the industry to charge more…as an industry we have not done our job of showing that consumers should choose active managers and I think, over time, more of them will be replaced in the sense that Vanguard and the S&P 500 is a very good product. It’s a hard to beat the product. But I think there’s always going to be a place for guys like you and me who will do the hard work and the nitty gritty to generate good returns while taking less risks, but if we as an industry continue to just charge away the value of those skills and excess fees, that’s hard to complain about the customers voting with their feet.

Siggy

I understand that it’s an interesting aspect, the corporate governance aspect, but the aspects of the index fund that provides everything in terms of pricing and markets need pricing to be efficient is interesting. You said that you don’t think that this is something that’s troubling to you. You don’t see index funds making the market a lot less efficient just because they don’t contribute enough in terms of size. What do you think would be a kind of a cut-off investors should become a little more anxious of and say maybe this…I’m just thinking to myself, proportion of people that blindly follow other people without doing fundamental analysis and making a judgment of those companies are skeptical enough is troublesome idea…so when do you think this would actually be becoming a systematic problem, how big does the index fund industry have to become?

Jeff

Yeah, I’ve thought about that and I don’t now and I don’t even really know how to think about what that number would be…even if I sat down with a calculator I and looked at the liquidity of the S&P 500 stocks. I don’t know how to answer that question and clearly you see dislocations especially in the smaller cap stocks and there’s a time honored tradition in investing of looking at the index additions and deletions and the little dislocations will always be there and they’re good for people like you and me and… to me, to the extent that the big index funds begin to distort intrinsic value in the S&P 500 and the companies that just fall outside of it, I think that those will be opportunities for people to make money. I welcome those if they happen. Those will be good for us, not bad for us.

Siggy

I think, similarly the secular trend is probably an opportunity for people, in order to take advantage of it. But I think that those are all the questions that I had. Joe, do you have any questions?

What If?

Joe

Actually yes, I do have one question: so, if you were to republish your book today and add an appendix to Dear Chairman, what would be the one company that you personally would be writing that letter to?

Jeff

So, if I were going to do a paperback and add a few chapters, I would definitely do a chapter, a fly on the wall chapter focusing on Vanguard, or maybe State Street if I couldn’t get in the door at Vanguard. But I think it would be very fun to take a current proxy fight and to get behind the scenes and discuss why Vanguard voted the way that they did and to essentially address this whole issue of “are the big index funds, informed voters?” and it’s an interesting question because it’s a twenty-person team and there’s this whole process… it would be pretty fascinating.

And then I would probably do a chapter on social responsibility…there’s been lots of interest in corporate social responsibility, so I think there is not lots of clear thinking on that topic and often activism gets the blame for corporate behavior so perhaps a chapter on Valiant or a thought about doing a chapter on Pacific Lumber, which was a situation in the 80s that got lots of attention…I think index funds for one chapter and then social responsibility for the other, with a focus not on saying that they’re bad or good, but just trying to think clearly about key issues.

The main thing with my book, which I try to tell people, is it’s about activism but it’s not pro activism or anti activism, it’s just about the way that public companies work. It’s a way that a business works and I finished the book in 2014, which was right before there began to be a lot of attention on the Vanguards and the Black Rocks of the world and their voting intentions.

Joe

Thank you.

Jeff

Thanks for having me on this thing.

Maj

Thanks Jeff! I really enjoyed this conversation. We got to do it after a couple months of going back and forth.

Maj

I really hope to meet you one day. Maybe a cup of coffee…

Jeff

Yeah, well where do you guys live?

Maj

I’ve spent a lot of my time in Fort Lauderdale, but most of my help and analysts are in the suburbs of Philadelphia and I’m in New York a lot.

Jeff

The next time that you’re here, let me now.

Maj

Great.

Jeff

Thank you Maj, Thank you Ziggy, Thanks Joe!

Article by GeoInvesting

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