Bio: Tom Au (TA): I am the author of A Modern Approach to Graham and Dodd Investing . I also run a small fund (just under $1 million), and write for the street.com and other sites such as financial sense.com, based on the principles outlined in the book. My work on seeking alpha also reflects this bias. I am part of a two man outfit called R.W. Wentworth & Co., which is looking to “restart” by becoming part of a larger umbrella outfit; we’re in discussions with several other firms.
Jacob Wolinsky(JW): What inspired you to write the book?
Many well-known hedge fund managers are also philanthropists, and many of them have their own foundations. Seth Klarman of Baupost is one of those with his own foundation, and he invested in a handful of hedge funds through his foundation. This list of Klarman's favorite hedge funds is based on the Klarman Family Foundation's 990 Read More
Tom Au (TA): The fact that the 1990s internet craze reminded me of the 1920s radio craze, and the “Roaring Nineties” seemed a lot like what I had read about the “Roaring Twenties.” When this happened, I said to myself, “I know how this story is going to end: with the modern 1929.”
But it was Warren Buffett who said, “Predicting floods doesn’t count; building arks does.” So I wanted to do both, predict the “flood” that I “knew” was coming. (It came in 2008, four years after the book’s 2004 publication), and build an ark. And the thinking was, “No need to reinvent the wheel, just dust off Ben Graham’s old model from the original 1930s.”
JW: Is that where we are today?
TA: We had our modern 1929 in 2008 and early 2009; a more than 50% decline in the Dow from the peak, followed by a severe recession.
JW: Does that mean that we’ll have a Depression?
TA: Not necessarily, although I can’t rule it out.
JW: Why not?
TA: This year or next, could be the turning point, as was the case in 1931. In that year, we were actually on a recovery path in the United States. But events overseas intervened.
JW: Which were they?
TA: In 1931, it was the collapse of the Credit Anstalt bank in Austria, which was the largest offshore bank of GERMANY. This destroyed the German economy, then the second largest in the world, and unfortunately brought Hitler to power.
This time, my fear is of a major collapse in China, today the world’s second largest economy, perhaps through some offshore bank like HSBC in Hong, or one in Korea, Taiwan, you name it. By the way, Jim Chanos, the very astute short-seller who called Enron, agrees with me in principle, perhaps not in detail, with major fears of a Chinese real estate bubble and collapse, possibly transmitted through the banks.
JW: Why value investing, which is contrary to human nature? Who influenced you most in your strategy?
TA: The obvious influences are Warren Buffett, and his teachers, Benjamin Graham and David Dodd. But the most important value investor in my life was someone I met when I was seven years old. She was an old woman named Clara Weber Lorenz, whom my parents hired to take care of my sister and me. We called her Lorie, and she was born in 1896, two years after Ben Graham, one year after David Dodd. As such, she was very representative of her fellow members of the so-called Lost Generation. She convinced me that we would have another Great Depression sometime in my lifetime: “I may not live to see it, but you will.” Lorie was a very smart woman without the benefit of a college education, but I graduated with a BA in Economics and History from Yale University, and an MBA in Finance from NYU before working in securities analysis and portfolio management for over twenty years at the investment arm of Cigna, the insurance
company, Unifund, an emerging markets firm, and Value Line.
JW: How did these mentors influence your development?
TA: Mine started off as a Warren Buffett-like “GARP” (growth at a reasonable price) strategy, and evolved into an asset-based strategy that looks at assets first, dividends, second, and earnings third. “Graham and Dodd” is a very “pure” form of value investing, designed during, and for the 1930s.
Value investing is the safest form of investing, because you are buying stocks based on what you can see (assets, dividends, recent earnings), rather than based on guesses as to what the future will be.
JW: Where are you today?
TA: Warren Buffett, Ben Graham and I are all value investors. But if you take a football field and divide it into the “value” and “growth” sides, Warren Buffett would be at the 40 or 45 yard line of the value side of the field. Ben Graham would be deep in value territory, at about the ten yard line. I’d be somewhere between the two, but much closer to Graham, at the fifteen or twenty yard line.
JW: Warren Buffett just bought all of Burlington Northern for what many would consider a very full price. Would he invest the same way if he had less money?
TA: No. I published my own piece on seeking alpha that described his evolution. He started out as a Graham and Dodd small cap investor, then fell into being a GARP investor when he could get mid-cap growth companies like Washington Post and GEICO at deep value prices. Now his company is of such a size that he can only meaningfully buy the largest stocks in the U.S. or foreign indexes, so he is now something of an index tweaker.
JW: Of today’s value investors, would Graham be more like Seth Klarman, David Dreman, Joel Greenblatt, Tweedy Browne, Martin Whitman’s Third Avenue Management team etc.
TA: My guess is more like Third Avenue Fund symbol TAVF because it is the most asset-oriented of the three. I think that Graham would buy into the notion that certain “fixed” assets, such as commercial real estate, could be treated almost like relatively liquid inventories. I have a small holding in TAVF by the way, and don’t own any other value funds.
JW: How would Ben Graham invest if he were alive today?
TA: I would guess that it would be a lot like yours truly. This is being said without my having met the man, so I don’t REALLY know how he thinks. But what I will say is that I’ve made a conscious effort to replicate his investment style, updated for the times. If I’ve succeeded, I am doing what he would have done.
JW: How does your version of Graham and Dodd investing differ from the original?
TA: The main thing we’ve done is to make it just a bit more flexible. Graham and Dodd wanted stocks that would meet tests of asset value AND dividends, AND earnings. That’s asking a lot. We would be pleased with stocks that satisfy just one of the metrics, or a combination of all three. In other words, a stock might not be cheap on assets or dividends or earnings alone, but it would be cheap if you add the scores for the different categories together.
The other thing is that accounting has changed a lot since Graham and Dodd’s time. The income statement is a lot more detailed, instead of just being a line item, and the third financial statement, the cash flow statement that we now use, didn’t exist during the 1930s.
JW: It’s true that accounting has changed a lot since the time of Graham and Dodd. Are there any accounting books that you would recommend?
TA: The classic textbook used in MBA programs is “Principles of Corporate Finance with S&P bind-in card” by Richard Brealey and Stewart Myers. Perhaps a more useful exposition is Professor Edward Altman’s “Corporate Financial Distress and Bankruptcy,” which covers the kinds of situations that you don’t want to be victimized by, rather than the ones that happen every day.
But the main thing is common sense. Whitney Tilson, whom you did an interview with, is self-taught. So is Jim Chanos, a short seller who, like me, went to Yale, where there isn’t much of an accounting program. If anything, the most important thing is not the ability to read financial statements per se, which are put out by managements, but rather to the ability to detect and decipher management bs. I’d say it is this ability that distinguishes a true professional investor like Chanos or Tilson from a well-trained amateur.
JW: Why is value investing so hard for so many people?
TA: It goes contrary to a part of human nature that looks forward to things. People like to focus on stocks that have ALREADY risen, because this represents a “promise” that it will go up further. What people forget is that when a stock rises, some of its value has already been “used up.” There is that much LESS left for future investors. A simple example will illustrate the point.
Lorie introduced an annual summer family treat. It was a one gallon jug of lemonade concentrate that could be mixed with water to make lemonade. There was one jug of concentrate purchased around Memorial Day, and it had to last ALL summer, until Labor Day. There were no refills, no second bottles. Halfway through the summer was July 15th. So if the bottle was half empty by the end of June, that was bad. If it took until the end of July before it was half empty, that was good, because the rest would be spread over August and early September. In this example, you want to look at how much concentrate is LEFT in the jug versus how much time passed, not how much was already taken out.
I would say that value investing is particularly hard for AMERICAN investors. This is a country where “the sky is the limit.” Another way of putting it, is “there’s lots more where that came from.” That is the mentality of a growth investor.
Although American-born, I am the son of immigrant parents from a rather poor country (China). I was schooled by this Lorie person, who, although American-born, was the daughter of German immigrants at a time when Germany was a poor, upward struggling country. People with that kind of mentality believe there is a LIMIT to how much a stock is worth, just as the final value of a bond is capped at par. We then look to buy for the largest possible discount from that limit, or “par” value.
JW: You don’t have any bank stocks in your portfolio?
TA: They are basically to be avoided, not forever, but for about five years or so, just like the telecom stocks of a decade ago. Banking is a uniquely bad industry, just like the telcos were earlier, and for essentially the same reason.
JW: What is that?
TA: The problem with the telecom companies was that they wanted to be like the tech companies, in the so-called TMT sector. In fact, they ended up being HANDMAIDENS to the tech companies, spending themselves broke, without enjoying commensurate growth. A classic example was Global Crossing, which spent itself into bankruptcy, in large part because a charlatan named Bernie Ebbers of Worldcom, was telling the country that Internet usage was doubling every 100 days (it actually doubled in the WHOLE YEAR of 2000).
The commercial banks fulfill this “uniquely bad” role today. That’s because all their bankers wanted to be investment bankers, and ended up being “handmaidens” to those investment bankers; originating crummy mortgages that the investment bankers packaged and sold. To their credit, the commercial banks survived the resulting crisis, and the investment banks didn’t, except, like Goldman and Morgan Stanley, by becoming commercial banks. But in one form or another, all these banks have subprime junk in their viscera, which they won’t be able to expel for at least five to ten years. Maybe some well-run community banks were “immune” from this, but not many.
JW: What are your views on the economy? Does that affect your value investing style?
TA: When I was portfolio manager (in emerging markets, for the investment arm of Cigna), macro(economics) was THE thing to do. There was no point in investing in a country unless either the macro economic environment was stable, or the company sold a commodity whose price was denominated in say, U.S. dollars, and would therefore be helped rather than hurt by a local currency devaluation that lowered its costs in dollar terms.
Global macro trends are now more important to the U.S. economy than most American investors believe, or, more to the point, want to believe. For instance, the key events of the modern era took place in 1991, the victory in the Persian Gulf War and the collapse of the Soviet Union. That caused a decade of artificially low oil prices and a huge inflow of foreign funds that fueled the bull market and tech bubble. Plus the creation of a “new era” mentality.
JW: How does this relate to Graham and Dodd?
TA: Graham and Dodd was originally considered a methodology for identifying individual stock selection. I stood the methodology on its head by using it to inform the macro situation, specifically by identifying the fact that the turn of the century market was over valued. For instance, in the year 2000, the Dow went all the way up to almost 12000, while my proprietary “investment value” model said that it was worth just over 3000. That’s an overvaluation of between 3 and 4 to 1. The Dow is now worth just over 7000, and what was a 3-plus to 1 overvaluation is more like 3 to 2.
JW: So the market is still overvalued?
TA: I’d say so, although less egregiously than before. Similarly, Felix Salmon posted a piece on seekingalpha about how housing prices were still at 134 (on an inflation-adjusted index). That was off a 2006 high of 202, but compared to a historical average 104, and a low of about 70 in the 1930s. The danger is that the stock and housing markets could get back at least to the historical trend line, and possibly 20%-30% below.
JW: Why is that?
TA: People don’t realize how wild and “wound up” the markets got during the 1990s and early 2000s, and how much unwinding it will take to restore things to normality. We are maybe halfway through the pain cycle, but others think that we’re closer to the end of the tunnel than I do.
JW: Will there ever be a new bull market? If so when and how?
TA: The Dow could go sideways for another decade while its underlying value doubles again, so that there will be a 3- to 4 undervaluation. That would be the signal for a new bull market.
JW: If and when this bull market occurs, do you plan to stay locked into the Graham and Dodd style or do to expect to evolve as a value investor over time?
TA: I adopted the Graham and Dodd style because of my very specific forecast of a return to the 1930s environment for which Graham and Dodd was ideally suited. Logically, if we are headed for the modern version of the 1930s, we should invest as if we were already there. I expect to remain a Graham and Dodd investor for the duration of this crisis, but not necessarily thereafter. I will always have a value bent, but expect to evolve into more of a “GARP” or Warren Buffett investor as the U.S. and global economies evolve. That is to say, I might head more toward the 50-yard line from the value side of the field. When we get out the desert and into the Promised Land, that is.
JW: What Valuation Metric Do You Use?
TA: The basic valuation metric is what I call investment value: book value plus ten times dividends.
That’s because you can do two things with earnings. You can either may them out as dividends, or you can retain them for reinvestment and future growth. The model considers both uses.
Ten times dividends just capitalizes the dividend stream at 10%, a discount rate that Warren Buffett and others use. And historically, the return on U.S. stocks has been just over 10%.
On the other hand, book value is just retained earnings plus the initial, or “subscribed” capital. As book value increases over time, so should the stock price.
JW: What about stock buybacks?
TA: Stock buybacks reduce retained earnings, and hence book value. On the other hand, they are a distribution of capital, so they can be analyzed almost like dividends. In theory, these effects should be a “wash,” but in practice, they can be either wise or foolish, depending on the price of the bought back stock relative to book value, dividends, and prevailing interest rates.
You don’t take growth into account?
There are two components to growth, one of if which is much more important than the other. The first component of growth is the retention, and addition of capital, which is taken into account by book value, and is used to fight inflation. That’s the main growth driver.
The second is growth over and above this, which Bill Gross of Pimco has calculated at 0.6% a year for blue chip stocks over the 20th century. So the “real” growth of stocks (over inflation) is a lot lower than most people realize.
That’s why Ben Graham felt that stocks should be analyzed and bought like bonds, except with an inflation kicker. That is, in fact, the principle behind TIPS (Treasury Inflation Protected Securities). So blue chip stocks are really fancy TIPS.
What about small cap stocks?
That’s a somewhat different kettle of fish. Here you do have a chance at real growth, which is why the private equity people and venture capitalists make money. On the other hand, their size (lack thereof), weak balance sheets, and lack of dividends make them less safe than many Graham and Dodd investors can accept. But if you find a “large” small cap stock (at least $500 million to $1 billion), with a good balance sheet and a decent dividend, and a low price, then you also have chance to “get lucky” with growth. We don’t mind growth, we just don’t want to pay for it.
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