Interview with a young value investor

March 4, 2012

Today we’re joined by Duncan, a young value investor and investment blogger.

Duncan started on the graduate scheme at a big bank in Autumn 2008, about a fortnight before Lehman collapsed. Needless to say, he had no idea what was going on but he knew it was significant.

Currently, Duncan is employed by a global bank, whilst managing his own money privately. The views expressed in this interview are completely his own and not those of this employer.

Duncan – an introduction

Duncan, how did you get started in investing? What attracted you to value investing? About how old were you?

I had no real desire to become a professional investor and my interest in the subject only arose as a result of doing a 7 month stretch in Singapore on the Global Investment Strategy team of a big bank about a year into my career. I started to really enjoy the intellectual aspects of investing and the challenge of being a decision maker under uncertainty.

I was not attracted to value investing as much as I was attracted to whatever works. Initially, being at least as avaricious as your average young finance professional, I was attracted to the hedge fund legends who have made billions from their endeavours.

I was struck by the contrast between these enormously wealthy fund managers and the vast majority of private clients and investors who have struggled to preserve their capital over the last decade.

I was also intrigued by the fact that some people had seen the financial crisis coming and had managed to avoid the 50% decline in the indexes or perhaps even profit from events. It sounds simple but I basically just started reading the opinions of the people who got it right.

My interest in investing was magnified because I inherited some money/equities a few years ago and therefore I had a pot of capital sitting which I could use immediately. Had I not had any money maybe I wouldn’t have been quite so eager.

Your investment philosophy?

What would you describe as your investment philosophy? How has it developed over time? Are you a long term investor? When do you buy? When do you hold? When do you sell?

I would hope that I am pragmatic rather than dogmatic regarding my discipline. Bruce Springsteen once said that “blind faith in anything will get you killed.”

I am a value investor at heart because that is the only approach that makes sense to me, buying something for considerably less than a conservative appraisal of it’s true value.

Traditional finance theory, your university professor, your private banker and your average CFA would have you believe that as a security declines in price its risk increases; this is because the standard deviation of returns and the volatility of the price movement have increased. I think this is quite clearly codswallop and in fact the risk has decreased because the downside is now lower, presuming the facts have not changed, and the upside in percentage terms has increased!

What would you buy?

I am also particularly attracted to stocks where I see a highly skewed risk/reward dynamic. I like businesses where there are strong balance sheets and “hidden assets” which hopefully can unlock substantial value over time. The strong balance sheet gives me comfort that you will have the time/flexibility to realize that value.

I have a number of what I call “balance sheet investments”, this is based on a pet theory of mine that analysts are overly focused on the income and cash flow statements but omit the balance sheet from rigorous analysis. I suspect this is because of the shorter (1-6 months) horizons of their recommendations, they believe any balance sheet value isn’t likely to be realized in the short term.

Basically, I believe I have a number of companies that are trading at a discount to the value of their assets on their balance sheet or alternatively stocks that look boring on a P/E basis are actually very compelling when you consider the assets you are getting with the business.

There was one thing I noticed when I first migrated from macroeconomic focused research to the writings of investors who buy equities was that the ones who invest in a vacuum.

The “pure stockpickers”, value or growth focused, who believe that timing economic or business cycles is a fool’s errand had one thing in common – they all got killed in 2008.

Even some of the best were down 30-50%. I don’t find that kind of drawdown acceptable, I don’t have the disposition to deal with it and I don’t think most clients do either. The fact is, no matter how rational you are, if you lose 50% of your net worth you are not going to be able to make optimal decisions.

The Global Financial Crisis demonstrated the true value of “Global Macro”. If you think of investing like a boat race then stockpicking is choosing between the boats. Once in every few years a storm comes along with howling winds and high seas which can capsize boats or leave them stranded way off course. Once in every twenty years a tsunami comes and destroys half the boats. To continue the metaphor, these are the kind of times you want to be waiting in the port listening to the weather report.

This is all a very long winded way of me saying that I consider myself a macro aware, value investor with a strict focus on capital preservation. The natural order of things is growth – trees grow, populations grow, people grow, the intrinsic value of investments tend to grow but like you have to make sure you survive the bad times to participate in the growth.

I am still young, only 26 and I have a huge library of books to get through over the next few years – ask me these questions then and I might give you totally different answers. That would be another example of growth being the natural order of things.

When would you sell?

Regarding my time horizon I am agnostic. I hope I hold things for a long time because I hope intrinsic value grows just as fast as the share prices. I know Warren Buffett says you shouldn’t buy something unless you would be happy to hold it for 5 years or the rest of your lifetime, but that’s easy to say when you’re in your 80’s and you are the richest man on the planet!

If your time horizon is long enough this is nonsense. I’m a big believer in capitalism and in creative destruction. Nothing lasts forever. There is no such thing as a permanent competitive advantage.

A book called The Living Company: Growth Learning and Longevity in Business studied the life expectancy of companies and arrived at the conclusion that after a company has reached the stage of Fortune 500 scale, it has an average of 20 years before it will cease to exist. That is incredible.

So basically I would say I am married to no positions and I have no qualms about selling things if they have gone up or gone down. I’ve been involved in 2 stocks I would consider event driven situations this year too – where I have purchased with a distinct near term event in mind which I thought would realize value.

I hope to sell at the top; but hope is not an investment strategy! I can think of 4 situations where I would sell and a 5th lesson learned:

  • It has moved closer to my estimate of intrinsic value and therefore represents less a less compelling risk/reward payoff
  • The position has become too big (this is what is known as a high class problem because the stock must have appreciated substantially)
  • Something material has changed at the company that alters my view
  • I am selling to switch into something which I believe is trading at a more compelling valuation.

Going into Q4 2011, I had a large weighting to “Old Tech” in the US – Microsoft, Dell, Cisco, Western Digital. I became very nervous about the macro situation and decided that I would exit Cisco and Western Digital because they are quite sensitive to capital spending budgets which are quite cyclical.

I sold both at nice profits and thought this was a prudent risk reduction, both stocks were still cheap and solid balance sheets however. I even said I might revisit ownership at a later date. Well they are both up around 50% and 20% respectively since I sold – more fool me. The lesson I learned from this is that if you own cheap stocks which you like, you have to be willing to ride out your nerves a little.

Your track record?

Well my track record is on my blog but at the moment it’s very short and therefore tells you nothing.

I guess the first time I thought “you know I could be good at this” was when I got into Gold & Silver in late 2009 at $900 and $17 respectively then rode them both all the way up. I sold out of just silver at $42 and $45 before it imploded in the middle of 2011 because the market was developing bubble characteristics – once the chart goes exponential what else can happen but the trend reverse?

I guess my willingness to include assets like gold in my “circle of competence” is another thing that differentiates me from die-hard value investors. I’m far from alone however, value investors like Jean Marie Eveillard, David Einhorn, Sebastian Lyon and Dylan Grice all have substantial gold holdings.

What has been one of your biggest investing mistakes? What have you learned from it?

A mistake I would mention was a very small “speculation” I made in a mining company called Norseman Gold. These companies are not investments, unless you do A LOT of due diligence. Operationally they were just a disaster and kept missing targets and needing to raise cash.

I thought insider ownership would protect me but it didn’t. Thankfully it was a tiny holding and I am now resolved to do much more work on companies before I buy them and probably to limit exposure to direct mining like that. It’s the kind of industry that attracts crooks, a bit like banking!

From the financial crisis I learned that 95% of the practitioners in the industry are no more skilled at investment than the average client they serve. They are nearly as uninformed, just as emotional, just as reactionary. The fact that investing is an imprecise discipline, an art if you will, has led to it evolving into a petri dish of Charlatanism, bullsh*t and pseudoscience. The most important thing I learned was that the incentives are totally skewed in the industry.

Investment research

How do you typically find ideas and what is your selection process before an idea gets added to your portfolio? What types of questions are on your investing check list?

I could get my ideas from anywhere. I subscribe to maybe a hundred investment/ finance/economics blogs and some research publications where people just like me with a “Go Anywhere” approach or specialists are constantly putting out content with their thoughts or ideas on themes, countries, sectors, stocks etc.

I have no qualms about admitting to “standing on the shoulders of giants” as Isaac Newton might say. I monitor hedge fund filings to see what the best investors in the world have been buying or selling over the last quarter, that’s always very interesting.

The buys show what they like and the sells sometimes show why a stock has been weak. If a big hedge fund is liquidating a position it can really move the price, if they are selling for non-economic reasons, to meet a redemption for example it might be an opportunity.

I read a lot of fund factsheets and commentary to get a handle on what all the best houses are looking at from a macro perspective and how they are letting that influence their stock selection.

Do you use any specific metrics like ROE, P/B, ROC, other when evaluating equities? Which don’t you use?

I like to look at the Piotroski Score and the Greenblatt Magic Formula. There is a lot to be said for these quant screens for idea generation. They have phenomenal track records. It shows the arrogance of most investors that they think they can “add value” to the mechanical processes of these screens which have been so successful. The painful reality is that we probably can’t!

I find it very difficult to look past the evidence that demonstrates that Low P/E and Low P/B stocks consistently outperform higher valued stocks. Therefore my portfolio is full of Low P/E or Low P/CF stocks.

I don’t really like calculations like EV/EBITDA because frankly I’m not bright enough to understand them. I don’t like DCF calculations too much because it reminds me of my CFA exams and because of their sensitivity to the inputs – garbage in, garbage out. It’s a little bit like the Hubble Telescope, move the variables an inch and all of a sudden you are looking at a different galaxy.

I think GMO’s definition of “High Quality” is always worth bearing in mind when considering a business. High margins, low leverage, low earnings/revenue cyclicality.

From a broader market perspective I keep a keen eye on metrics like the Shiller P/E, Market Cap/GDP and the Q Ratio. These have very poor predictive power in the short term but extremely good predictive power over the course of 5 years or more. To return to my earlier metaphor, this is part of the weather forecast and high valuations here tell you a storm is coming.

Any sector preferences, currently?

Do you invest wherever you see value?

Yes, absolutely. Institutions have become obsessed with specialism and benchmarking and pigeon-holing fund managers. I think being a good investor or allocator of capital is as much a mentality or a state of mind as anything else. The skill set is almost certainly transferable across asset classes and across sectors.

If you have a good manager why constrain him unnecessarily? He is more likely to uncover a true gem if he turns over 10,000 rocks in the global equity market than if he is only allowed to look at only the Dow Jones 30.

I think the real value is most likely to be found in the places where no-one else is looking and that’s what attracts me to smaller companies and to spin-offs.

What company do you find interesting at the moment and why?

Since Dividend Income Investor.com is a dividend focused website and it’s aimed at UK investors I’ll discuss a UK based stock in my portfolio.

JZ Capital Partners ticks a lot of boxes for me. It yields around 2.2% which is good but it’s not why I own it. It’s not covered by the sell side and it’s quite small, about £250m, so most of the large institutional firms can’t own it due to liquidity constraints and the fact they’d have to own half the company to move the needle for them. It’s in listed private equity too so that’s at least another 50% of the potential investors ruled out because this has got to be one of the “ickiest” sectors in the market currently.

JZCP trades at around a 40% discount to NAV which is pretty wide, especially since the two managers have a pretty good track record throughout their career and even over the last few years of profitable investments and realizations.

The thing that got me really excited is when you look at the underlying portfolio of the fund there is about £160m of Gilts and cash, £50m of listed US equities and so you are getting £210m of private equity investments for near free. Given they just sold one stake for $40m in November that seems like a good deal.

Portfolio management

How many positions do you typically have in your portfolio and what are your ideas concerning portfolio composition? Do you follow any key risk-management guidelines in managing your portfolio?

At the moment I have 24 positions and around 30% in cash. I’d say a “full position” is 3% and if I have particular confidence in a position then it would be 5-6% but I would keep the number at that size small.

Berkshire Hathaway (3% position) is a stock that I think is looking pretty cheap currently, with Buffet’s buyback comments last year putting a quasi-floor about 5% below the current price, you could run Berkshire as a 20% position and be able to sleep at night. Nothing is set in stone.

I probably have smaller positions currently than I would under “normal circumstances” because of my particularly pessimistic macro/market view. If I was more bullish and was fully invested the number of positions would be slightly higher but the average position size would be closer to 3%.

Risk is not a number, it is not standard deviation, it is not volatility, although I confess to being more disturbed by volatility than many value investors. Risk is taking risks you don’t know you are taking, risk is having the wrong frame of reference (resources are finite and the Chinese are buying lots of them = Rio Tinto is a bargain at £70); risk is a permanent impairment of your capital due to selling at a loss or material changes in a business you have not foreseen or accounted for.

Who are your top investment heroes?

Which value investors do you admire most and why?

You’ve asked for it now! Let me split them into two types of investors whom I let colour my thinking…I read or watch absolutely everything these guys produce, there are almost certainly a dozen I’m forgetting.

Macro – John Hussman, Hugh Hendry, John Mauldin, Gary Shilling, Dylan Grice, Albert Edwards, Richard Koo, Tim Bond, Jonathan Ruffer, Sebastian Lyon, Bond Vigilantes, David Rosenberg, Niall Ferguson, John Burbank, Edward Chancellor, James Grant, Chris Pavese, PIMCO

Investing – Jeremy Grantham, Warren Buffett, James Montier, Crispin Odey, Whitney Tilson, David Yarrow, Robert Rodriguez, Harris Kupperman, David Einhorn, Daniel Loeb, Larry Robbins, Leon Cooperman.

To make it onto my list there are probably two things you have to have done – produce a very good track record over the years and secondly have foreseen the financial crisis. I am deeply skeptical of so many of the elder statesmen of our industry because I believe that many of them surfed a wave of leverage and beta to get to where they are today.

Which book(s) would you recommend an aspiring value investors should read, and why?

Marc Faber once said that if you don’t read for 3 hours a day then you are kidding yourself if you think you are well informed.

Investing is zero-sum, for every buyer there is a seller, someone with the complete opposite point of view and definitively, one of you is wrong. So you have to do a lot of work to make sure that you aren’t the patsy!

Again, I’d split the books I recommend into two topics.

Macro:

These two books provide you with a great insight into the big picture. They suggest that we are in a great delevetaging process and we face at the very least a few more lean years with shorter, sharper business cycles before we can embark on any sustained recovery

Investing:

These two books are a treasure trove of insights and quotes that distill much of the value investing mindset in easy bite-size chunks. The Montier book has some fantastic data which proves as much as is possible that value investing works under almost any circumstances and on a variety of time horizons. Both books are quite readable and even funny in parts!

If you have actually read and taken in and internalized the contents of these 10 books, all of which are quite readable for the interested investor there is no doubt in my mind you will be light years ahead of the average investor and better prepared to manage your own investments.

Final wise words?

As a private investor your biggest hurdle is finding a wealth advisor who’s interests are aligned with your own. You will be searching a long time if you are looking for a “broker” or private bank that will make you rich. After extreme and misguided diversification, the fees, the wrapper costs and transactions for the sake of being seen to be “proactive” – you will never do well. Over time, you will be lucky to keep up with the indexes.

The two options for the private investor are to spend the hundreds of hours it takes to learn how to manage their own money and hope they are good at it. The other is to find a person, firm or fund who’s assets will be invested alongside yours in a way that focuses the mind of the manager and makes sure your interests are in sync.

Your wealth manager will tell you that it is “time in the market and not timing the market” that matters. They will point out that dividend yields are higher than bond yields and that cash isn’t earning anything in the bank. This is nonsense and is an excuse for their own inability to buy low and sell higher. Value is absolute not relative. We should not compare mouldy apples to mouldy oranges.

To quote Seth Klarman, “Why should the immediate opportunity set be the only one considered, when tomorrow’s may well be considerably more fertile than today’s?”

Bearing that in mind, you should realise that there is no reason to be fully invested at all times. Your cash position is essentially the reciprocal of the quality and breadth of the opportunity set available at the time.

Thank you very much Duncan.

Follow Duncan’s blog.

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