Staying on the Right Side of the Trade

This are my notes from Bruce Greenwald's interview on the Value Investing with Legends Podcast.

• Investing is a zero sum game.

  • If you are in the upper half of performance someone has to be on the lower half.

  • So you have to ask “What is putting me on the right side of the trade? Why am I going to win and another presumably smart person is going to lose?

• In what areas are you most likely to be a winner?

  • You have to have a good search strategy to concentrate your efforts on opportunities where you’re more likely to be on the right side of the trade.

• Specialization is really important to increase your odds of being on the right side of the trade.

  • In Ben Graham’s day there were almost no fundamental analysts. Now there are a lot of them. Finding value is harder. You need to specialize now to be on the right side of the trade. You need to know more than anyone else.

  • Even Buffett specialized to some degree. He started in local insurance and branched out as opportunities evaporated.

  • It’s not a bad idea to just spend a year learning about an industry and not buying anything. Just getting smart. If you force it you’re gonna get in real trouble. Your default strategy should be cash or an index if you don’t have anything good to do.

  • Paul Halal is a good example of someone who specialized. And as areas in one area dematerialized he spent time learning new areas to look for opportunities

  • Ben Graham realized early on that people love lottery and glamor stocks. You are better off looking at things that are out of favor.

• Assume you found a bargain from your search function. Now you need to do your evaluation to determine what you can pay for it.

  • One-size DCF valuation is just wrong. DCF only makes sense if there are well-defined payoffs (like a bond or special situation). Securities with long time horizons makes DCF basically impossible. Future cash flows become way too blurry.

  • Two concepts that help valuation are earnings power value and asset reproduction value.

  • If earnings power value is less than the value of assets you have bad management. They aren’t using the assets to their full potential.

  • If you have earnings in excess of assets you have to be very careful about paying for them. This will interest competitors and if a competitor invests in the assets they can start eating into those earnings and the excess earnings will evaporate.

• If you earn more than your cost of capital then that means you are protected from competition. You must have some moat that protects this dynamic.

  • Basically you have to understand if you are in a competitive business or if you can find a way to keep people out. You have to figure out how to do the latter. What is the basis of your moat?

  • Growth can be an oasis because if you’re in a competitive market growth does nothing for you because all it does is attract competition and will evaporate. You have to be very cautious about paying for growth.

  • Short term companies growing rapidly are going to be difficult to value

• If management isn’t paying out earnings, then they are re-investing it in some way. It’s important to evaluate their ability to reinvest that capital

  • This is active investing on the part of the management. What is the rate of return on the earnings they are re-investing?

  • Some fraction of earnings will need to be re-invested just to keep the business going and support organic growth. Organic growth won’t be more than 3% over GDP growth in the long-term

  • Any incremental growth is coming from active management

• You aren’t going to understand every aspect of the business. You’ll get lost in information. You need to know what few factors really matter to your valuation and get to the bottom of those questions