Second part of the Bruce Greenwald interview at Advisor Perspectives

Robert Huebscher of Advisor Perspectives continues his superb interview with Bruce Greenwald, with the 2nd part being posted online (Thanks to GuruFocus for bringing it to my attention.)

The first interview was controversial and insightful. And the second interview continues in that tradition. I don't know much about Bruce Greenwald but never knew he was outspoken and expresses his opinions. Bruce Greenwald holds no punches back and even criticizes Warren Buffett's offer to buy Burlington Northern Santa Fe—he even goes as far as saying "he [Buffett] has lost his mind."

I highly recommended the first interview for macro-oriented investors while I recommend the second one for all investors. For those willing to entertain my ramblings, read on for my opinions to some of his thoughts.


Value Investing, You Say?

Again, thanks to Robert Huebscher for conducting such an insightful interview and making it freely available. When asked about how his value investing has changed due to the financial chaos of the last few years:

The first principle is that the quickest way to permanently impair your capital is to overpay for something. So you always want to have a margin of safety.

The second issue is that, you go wrong with your margin of safety because your intrinsic value is wrong. Something happens that surprises you. That is almost always – if it’s a permanent impairment of capital – a company problem, where a product doesn’t work or a competitor comes in, or an industry problem, like newspapers, where they get destroyed. Sometimes it’s a particular national problem, like in Venezuela. But those risks tend to be diversifiable. So the value investors who had always been very concentrated, like Glen Greenberg, who is a wonderful investor, got burned. He had five to seven positions.

For the sake of risk management, you’ve got to have at least 20 to 30 globally diversified positions...

The third rule is that, even within a diversified portfolio, if you have if you have a total loss that affects 3% to 4% of your portfolio, you are asking for trouble. The thing that will convert temporary impairments, which are the macro fluctuations, to permanent impairments is leverage. We’ve always been extremely careful when it comes to leverage.

I think the value community has learned this lesson. The guys like Marty Whitman who got burned were in financial services, where there were enormous amounts of leverage. We’ve learned that if you want to do a stub, which is a highly leveraged position, you want a five- to six-times upside, because the downside is zero. You’ve got to start thinking in those terms. People have learned to think about leverage differently and to be warier of leverage, and only be willing to do it in a restricted part of a diversified portfolio.

The fourth thing we’ve learned is that when you build your portfolio you have to think about macro risks in terms of scenarios. Basically it comes down to two scenarios: You can have stagnation and deflation and a recession for extended periods with inadequate demand, or you can have inflation. You have to know, holding by holding, what your vulnerability is. For example, real assets – real estate, natural resources, and things like that – are going to do very well in an inflationary environment but are going to get killed in a deflationary environment. Fixed income is going to do very well in a deflationary environment and is going to get killed in an inflationary environment.

The first point (paying too much) is very obvious to anyone who has been investing for a while, and is in fact, one key reason some people pursue contrarian-type investing.

I completely disagree with point #2 (about diversification.) Since I'm a concentrated investor, I suspect I will never agree with Greenwald (but I'll challenge this view in a future post if I get time to write it up.) There is some merit in holding investments in 3 or 4 sectors but the notion of "20 to 30 globally diversified positions" is not something I subscribe to. If anything, the recent crash should have shown everyone that so-called diversification didn't save anyone. For example, some of the hardest hit investors are pension funds, who tend to follow passive investing strategies and are widely diversified across many different assets and regions. A lot of pension funds were down around 15% to 30% last year (that doesn't look bad compared to the -40% for the market but keep in mind that these funds are supposed to be "safe" and hold bonds. If you strip out the bonds, they posted horrible numbers even though they were widely diversified.)

The third point about leverage is well worth keeping in mind. Be careful about leverage. I may be way too cautious (I was nervous about Diageo's debt even though it is the #1 player with massive moat) but at least I avoid surprises. I'm not sure what a stub is—the stub I know of doesn't seem like it's related to what he is talking about here—but if he were referring to distressed companies, I would say that high-risk bets should have potential return skewed heavily towards the positive. If you are looking at collapsed stocks, usually the potential returns are skewed (but do note that this says nothing of the probabilities.) This is one reason I usually don't like looking at seriously distressed companies until they have fallen at least 50%. If someone falls 50%, it at least has 100% upside if it were to go back to prior price. If something falls 70%+ then the upside is several times more.

The fourth point surprises me but I'm seeing more and more of it. For some unexplainable reason, many value investors are paying attention to macro all of a sudden. I find this bizarre because my impression is that value investing has historically not placed much weight on macro issues. Furthermore, value investors are not good at making macro calls—there is nothing to say they are good at it all of a sudden—and it remains to be seen if they can beat macro-oriented investors if they enter the game—do note that investing is competitive and you are constantly competing.

Best Overall Investments

Robert Huebscher: Which assets give you the best overall protection?

Bruce Greenwald: The assets that are most attractive are the franchise businesses that have pricing power, because you can pass along inflationary price increases and you are not subject to competition from excess capacity, the way you are in industries like autos and steel. You have much more control on the downside.

Like a lot of things in investing, what sounds easy is very difficult in practice. I'm sure nearly all value investors would agree with the statement above. After all, didn't Warren Buffett himself allude to the view that franchise businesses with pricing power are the best?

Well, the reality is that it is very hard to find so-called franchises at good prices. Even when you find one, it's never clear how big their moat is. For instance, the classic franchise is something like McDonald's. Seems simple enough. But do you know how many other fast-food competitors there are? How can you be confident that McDonald's is going to do well and not Harvey's? Or Burger King? Or Taco Bell? Or KFC? Or whatever? No one has said this but how can you be sure that McDonald's doesn't face "overcapacity"? After all, when there are 5 restaurants in every major block, isn't that overcapacity?

Anyway, the franchise investment Bruce Greenwald mentions is John Deere, the farm equipment maker. I'm not sure I agree with Greenwald's perception of John Deere. He says (not quoted on this page) that it didn't post a big loss but how much of that is from the commodity boom? My feeling is that John Deere's performance should be ascribed to the commodity boom, and not the franchise-like characteristics.


Having said all that, there are many investment strategies that can work depending on your skill. One such stategy that goes against the franchise suggestion above is the contrarian tactic of buying cyclicals when they are out of favour. Benjamin Graham suggested in The Intelligent Investor (click here for my summary of the book) that buying cyclicals near a trough can be a worthwhile stategy. So, although autos and steel are bad businesses to own for the long run, buying them near a trough can be far more profitable than buying and holding franchise companies. This cylical-purchase strategy is very difficult because it is difficult to separate negative secular effects from cyclical effects. For instance, a lot of investors misjudged homebuilders—recall how Bill Miller was buying them a few years—and forestry stocks (you may remember Fairfax and Third Avenue buying forestry stocks that, subsequently, suffered massive declines.)

Bullish On American Express

Greenwald says he likes Microsoft and American Express. The latter is a very risky bet. He isn't happy with the CEO and openly criticizes him:

American Express is unbelievable. It has sustainable earnings of a minimum of $3/share. If they manage their costs at all – and that could happen if Ken Chenault leaves the company – they could easily make another $2.50/share pre-tax by cutting costs. You’re talking about making $5/share after-tax in sustainable earnings. When the price is $10, that’s two times earnings – a 50% earnings return.

If you think it is $3 or $3.50 with a potential of $5.00, you’re talking about an earnings return on American Express that’s 10% and up. They’ve got some organic growth because they earn 1.1 % on their billings [through merchant fees] without any significant impact on receivables. Rich people are clearly doing better than poor people, as they have for the last 40 years. The surprise is that these stocks, which you would not think are ugly or obscure, are this cheap. People have just gotten scared.

Bruce Greenwald sticks to his value investing knitting but by doing so, he misses what macro-oriented investors like me perceive as the biggest risk. The problem with Amex isn't its earnings; rather, it is the credit exposure to the consumer. You have to get the credit card default projection right or else you are toast. The fact that Amex had to turn itself into a bank and get government aid sort of illustrates the reason why investors have been fleeing this company. None of this means that this is a bad investment but I do think that it isn't as clean an investment as it seems.

On Burlington Northern Santa Fe

Bruce Greenwald does not like Berkshire Hathaway's bid for Burlington Northern Santa Fe. He thinks it is a bad investment. I hope I'm not breaking any fair-use laws by quoting the entire answer:

It’s a crazy deal. It’s an insane deal. We looked at Burlington Northern at $75 and I’ll give you the exact calculation we did. You don’t have a high earnings return. They are paying 18 times earnings, but it’s really much worse than that. They report maintenance cap-ex very carefully. They report depreciation and amortization, and they report only about 70% of the maintenance cap-ex. So they are under-depreciating, and their profit numbers are lower than the true profit numbers – and in a bad way, because the tax shield for the depreciation is undergone too. Their profitability is much lower than it looks.

Buffett’s paying 18-times [at $100/share] and at $75 he was paying 16-times. Our calculation is he was paying 21-times.

Secondly, there are two kinds of assets. There are the rights-of-way, which you can’t get rid of. So there’s no issue about having to earn a return on them because you have to keep it in the business, and because there’s nothing they can do with those rights-of-way. If you look at the asset value of the non-right-of-way equipment, and you write it up because it’s more expensive than it was originally, you get an asset value that’s very close to the earnings power value. We didn’t see a lot franchise value or hidden asset value.

The other thing is that if you try to calculate sustainable earnings, you have to cope with the fact that earnings are up enormously since 2003, when oil went up. There is a simple calculation you can do, which compares the cost-per-ton-mile for freight for a truck versus a railroad. If you build the increase in the price of diesel fuel into the post-2003 experience, when revenues suddenly start to grow, what you see is that the entire growth of the revenue is accounted for by the energy advantage that the railroads have and therefore how much business they can capture from the truckers, and how much pricing they can get because the competition is now more expensive.

There is nothing special about the railroads. It’s entirely an energy play.

If you look at what their margins should have gone up by, given the energy efficiency, the margins go up by only about half of that. So you don’t have a good aggressive management over these five years producing outsized returns.

We looked back at when they did the merger with Santa Fe, because then they did increase margins. But they got bored with it, and margins started to come down. The same thing happened recently. We don’t see a lot of hidden profitability in the culture of the company.

It looked to us like an oil play. He has a history of making bad oil play decisions. And that was at $75/share, we thought there were better oil plays. At $100/share we think he has lost his mind.

I looked at railroads a few years ago (before I had a blog) and I didn't like them because they were largely a play on the commodity boom and the trade boom. Bruce Greenwald also suggests that BNSF's strong performance in the last decade was largely due to the oil boom.

I agree with Greenwald that Warren Buffett is not very good with oil (or macro trends in general.) The latest news reports suggest that Berkshire Hathaway is buying ExxonMobil and, I'm not sure if that is a Buffett decision or someone else within the firm, but it looks like another bad bet.

Overall, the BNSF deal is a mystery. But so was the Coca-Cola purchase in the late 1980's and everyone thought Buffett was overpaying for a saturated business. The critics ended up being wrong.

The Media Industry

Bruce Greenwald apparently has written a book about the media industry (I haven't read it) and he offers his thoughts on it. Interesting thoughts but I disagree with some of it:

When you look at the media business, there are three parts to it. There are the content providers (who never made any money), which are the production houses in the movies and the imprints in the record houses. There are no barriers to entry there. If you look at the last 20 years, everything went right for the movies. First they got VCRs, then cable, then DVDs, then good foreign distribution. Revenues grew by about 8.5%. Costs per movie grew by about 9.8% and the number of movies grew by 1.2% annually. There are going to be good years and bad years. So, when everyone says content is king, remember that content production is not king.

The second part of the business is the aggregators. The movie companies and the record companies used to do the aggregating. For example, the record companies pressed the records and shipped them to the stores in bulk. What kept their advantage, and why there were four majors, was because it’s expensive to do that. It’s hard for an entrant to do that. That went away with electronic distribution.

Once you can do that electronically, that advantage is gone, and they got killed. If you think about the aggregation of newspapers, the same thing happened. They had to put the news together, print it, and so on. Electronic news distribution destroyed their business model.

The aggregation profits now are in the cable networks. To do a cable network, you need a full slate of programming. If you dominate a specialty niche, like Discovery does, it’s hard for others to pay for that programming. If you have the best distribution for that kind of programming, you get the best prices and all the advantages of economies of scale.

But if that model evolves to where you have all the content on a web site, such as the Discovery Channel web site, everyone just picks and chooses, and all of a sudden that barrier to entry is way down We’re very leery of these businesses. We want high returns – much higher than the NBC-Universal deal – on the aggregators, because the history has been that the aggregators can go away, just as continuous content has gone away. It used to be that nightly news or the soaps were a big thing that you had to do every day, and they were hard to produce. Now people can make one-off soaps.

...

The content business was never very profitable and the aggregation business went away with electronic distribution, so you are left with the final distribution – the pipelines. They ought to get correspondingly more valuable. They are Comcast and Verizon. They have local monopolies. Nobody is going to build infrastructure to compete with them.

No offense to Greenwald but this looks very much like looking in the rear mirror. I could be wrong but what if content, which he says wasn't very profitable, becomes valuable all of a sudden?

Also, the profitability of the aggregators may change but I'm not sure they will dissapear. I remember one of the arguments heavy metal band Metallica were making against Napster almost a decade ago was that the music studios act as financiers for emerging artists. I would say that, in some sense, the record companies are like venture capital. If they dissapear, who takes their role? Who will finance a new artist who has zero sales and spend money on marketing and promotions? ITunes, for example, has shifted the profit to itself, and away from the studios, but I have a feeling it will shift back towards the venture-capital-like firms. (Do note that this doesn't necessarily mean that an existing studio will do it. It could be a newly founded entity but the point is that someone has to provide a few hundread thoursand to an artist before they have a single sale.)

Greenwald says he likes Comcast:

The one that we like best, even though they break our hearts with their stupidity, is Comcast, which is trading at a 13% earnings return because they are way over-depreciating. We think they ought to have huge pricing power.

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What will happen is that you will have a cable wire into your house, and then everything will be wirelessly distributed. In that world, their costs go to nothing. If they keep their prices up – and they can probably charge $300/month, because it will cover your cell phone, regular phone, internet access, and on-demand programming – and they collaborate, they can charge a lot and make a ton of money.

Greenwald's view sort of parallels the consensus view (at least based on some random articles and analyst reports I have read.)

The risk is that the distribution companies require very high capex and are vulnerable to technology advances. Obviously cable investors are expecting the buildout of cable/high-speed-networks/etc to be a one-time thing but it remains to be seen. If someone asked around 15 years ago, many would have probably said that telecoms had the advantage but that's not true right now. What if cable goes the same way?

The pricing power also seems questionable. I already seem a developing backlash against cable companies in Canada—one just needs to read user comments at newspapers sites—and I don't know how much longer they can continuously keep increasing rates without any improvement. The figure cited by Greenwald for full service ($300/month) also seems quite high to me. I pay around $120 but I'm in the lower income category and only have moderate speed cable, low-end mobile phone, etc. The vast majority of the population are closer to me than the high end. Even if you assume his figures are for a family of 4 (mine are just for one person), I'm not sure if such costs can be maintained. There is a real possibility of prices deflating, especially if technology keeps advancing.

Greatest Danger

Robert Huebscher: What is your greatest fear?

Bruce Greenwald: The killer would be inflation. Normally, for inflation to take off you need expectations, which there are, and you need wage pressures, which I don’t see. But if inflation takes off, policy is going to be emasculated. The view that output demand can be stabilized by government policy is not going to be true any more. It’s going to be painful. The nice thing is that our natural-resource and franchise businesses can really do well in that environment.

But, in terms of a macro fear, that’s really going to be painful. If you get stagflation at these levels of unemployment, watch out.

My biggest fear would be deflation. Although high inflation won't be pretty, I think policymakers, economists, investors, businesspeople, and citizens understand it much better. On top of the power of any potential deflation—deflationary forces are great because debt is very large and there is massive overcapacity in China—the scary thing about deflation is that policymakers don't have much understanding or the tools to combat it. The only solution to deflation appears to involve printing large amounts of money and dropping them from helicopters—and this isn't guaranteed to work either!