Sound advice: Secrets of an Equity Investor
JOSE BAILEN
by Jim Citrin
Posted on Tuesday, November 27, 2007, 12:00AM
Much of the feedback for my recent columns has included the question,
"What does leadership have to do with investing and making money?"
To address this, I sought out the best investor and one of the best
leaders I know: Cliff Greenberg, portfolio manager of the $3.7
billion* Baron Small Cap Fund, director of research for the Baron
Family of Funds, and -- full disclosure -- a close personal friend.
Cliff is widely regarded as one of the country's most skilled equity
investors in growth companies. Since the inception of his Baron Small
Cap Fund (BSCFX) in 1997, he's achieved an annualized 10-year return
of 12.45 percent, compared to 6.55 percent for the S&P 500, 7.22
percent for the Russell 2000, and 3.65 percent for the Russell 2000
Growth Index. His fund's one-year annualized returns have been 22.54
percent, while the three-year returns have been 16.90 percent and the
five-year 18.06 percent.
In for the Long Haul
I spoke with Cliff about his investment philosophy, and asked what
advice he has for individual investors. Here are some highlights from
our discussion:
Q: How would you describe your investment approach?
A: My approach is to try to find special one-off growth companies that
we can own for the long term, as long as we maintain our conviction
that we can earn outsized compounded returns in the stock.
I like to find an industry and a business that I believe will grow
rapidly for a long period of time. Then we do in-depth research to
really get to know the business, management, and industry so we can
project what the company can earn and what it will look like in the
future. From that we determine what we think the stock will be worth
in five years. If that represents an attractive return from today's
price, then we buy it.
We're long-term investors. We've held some of our positions for ten
years. Our portfolio turnover averages only one-third per year. And we
adjust our positions to greater or lesser amounts based on how the
stock price changes and its attractiveness relative to what we believe
will happen.
An Investor's Prerogative
Q: How does this investment strategy differ from value investing?
A: The analysis is similar but the perspectives are different. Both
approaches are based on fundamental research and judgments about what
companies will earn and what they'll be worth in the future relative
to their price today. But classic Graham and Dodd value investing is
when you do the analysis and conclude that a stock is priced cheaply
today relative to its current inherent value. In other words, you
think something is worth a dollar but is only priced at fifty cents.
Our starting point is different. We try to find growing businesses
that are reasonably priced today but that will grow more rapidly than
other companies and than others believe, so that they'll be worth a
lot more in the future. In other words, we assume that it's reasonably
priced today at a dollar but that, based on its earnings growth
potential, we believe it could double in three years and be worth
three dollars in five years.
Q: How do you maintain selling discipline?
A: While we're doing our work, the market is guessing along with us
every day, and often it comes to a different conclusion. The dynamic
reality is that an investment is never what you'll think it will be.
We're constantly adjusting our sights and thinking over our investment
period.
The main reason to sell is that we've made a mistake -- either
management isn't as strong as we thought, the company's prospects are
less attractive, or the industry dynamics have changed. If the
investment plays out faster than we projected and it hits our price
objectives, then we might sell down. We also sell when we find a new
idea that we like better than one we presently own.
If I thought that dollar today was going to increase to three dollars
in five years, but nine months later it looks like it's not going to
get there, we'll be flexible and open to changing our minds. The stock
price constantly plays into our thinking.
Haves and Have-Nots
Q: How would you characterize the current market?
A: Right now it's a have-and-have-not market. More have-not recently.
What's been in vogue has really been in vogue, and what's not has been
shunned.
Those that have been strong may have now run their course, and there
are some solid sectors that have been overly hurt. We're finding
opportunities in out-of-favor sectors, such as commercial real estate
and senior living. Even though residential homebuilding is dreadful --
and we have no opinion as to when it will get better -- this will
modestly affect prospects in commercial real estate and senior living,
but stocks such as CB Richard Ellis have been overly punished.
CB Richard Ellis stock is down over 50 percent from its high, and
although 2008 earnings will be less than we anticipated because of
credit issues, the stock is trading at only 8 times our present
estimate of earnings. Historically, it has traded at 20 times. [Note:
CBG represents 2 percent of the Baron Small Cap Fund's net assets].
We're also investors in the senior living sector based on demographics
and the fact that many more seniors are coming into this market while
there's not a ton of capacity. This drives higher rates, which allow
earnings to go up a lot, despite a recent lull of move-ins due to the
difficulty seniors are having selling their homes in the current
market.
Nerves of Steel and a Saint's Patience
Q: What's the most common trap individual investors fall into?
A: Often, investors don't understand the actual companies they buy or
at least they don't have a perspective of what's going to happen to
the earnings that drive the stock. It's human nature that if you're
buying a stock you'll love if it's going up and hate it if it's going
down.
But if I own a stock and have conviction in it, then I'll buy more if
the price goes down and will sell when I've made the return I believe
is available. We're constantly asking ourselves, "Is there still
enough return left in the stock?" This is hard to do emotionally, and
isn't intuitive.
Q: Finally, what's your advice to individual investors?
A: Being thoughtful and patient and having a long-term perspective is
the best advice I can give. For an individual investor, there's
nothing wrong with investing in a mutual fund, even if it doesn't
sound particularly sexy.
Find a high performing mutual fund whose strategy makes sense to you.
The funds usually charge a 1 percent fee. While I believe
professionals can invest more successfully than most individuals,
people who watch their investments and who do the homework can also do
well.
Read the financial press each day -- the Wall Street Journal, Forbes,
Fortune, Business Week, and Barron's. Finally, even in difficult
market conditions such as we're experiencing today, maintain your
nerve and stay patient. If you do your homework and take a long-term
view, you should have the courage to add to your favorite positions
when stock falls.
* Figures pertaining to Baron Funds are from the company's web site
raylopez99
> Secrets of an Equity Investor
>
> by Jim Citrin
> Posted on Tuesday, November 27, 2007, 12:00AM
>
> Much of the feedback for my recent columns has included the question,
> "What does leadership have to do with investing and making money?"
>
> To address this, I sought out the best investor and one of the best
> leaders I know: Cliff Greenberg, portfolio manager of the $3.7
> billion* Baron Small Cap Fund, director of research for the Baron
> Family of Funds, and -- full disclosure -- a close personal friend.
promoting his friend--how objective can he be?
> I spoke with Cliff about his investment philosophy, and asked what
> advice he has for individual investors. Here are some highlights from
> our discussion:
>
> Q: How would you describe your investment approach?
>
> A: My approach is to try to find special one-off growth companies that
> we can own for the long term, as long as we maintain our conviction
> that we can earn outsized compounded returns in the stock.
book was written about this) by Edward O. Thorp, an MIT statistician.
But it ignores the Efficient Market Theory [EMT] (it seems to me) and
the commonsense observations that yes, Virginia, volatility is indeed
tied to risk. A stock that yo-yos from zero to 100 is riskier than
one that flatlines at 50, even though both have the same average.
>
> I like to find an industry and a business that I believe will grow
> rapidly for a long period of time. Then we do in-depth research to
> really get to know the business, management, and industry so we can
> project what the company can earn and what it will look like in the
> future. From that we determine what we think the stock will be worth
> in five years. If that represents an attractive return from today's
> price, then we buy it.
>
> Q: How does this investment strategy differ from value investing?
>
> A: The analysis is similar but the perspectives are different. Both
> approaches are based on fundamental research and judgments about what
> companies will earn and what they'll be worth in the future relative
> to their price today. But classic Graham and Dodd value investing is
> when you do the analysis and conclude that a stock is priced cheaply
> today relative to its current inherent value. In other words, you
> think something is worth a dollar but is only priced at fifty cents.
75) lying on the sidewalk. At any decent university nowadays, nobody
would stoop to even pick such a note up, since obviously it's not
supposed to be there (and indeed if you stoop to pick it up, you'll
find a string attached, leading to some social scientist doing some
behavioral research project no doubt, and you'll find you can't keep
the bill anyway, so might as well not even bother stopping).
> Q: How do you maintain selling discipline?
>
> A: While we're doing our work, the market is guessing along with us
> every day, and often it comes to a different conclusion. The dynamic
> reality is that an investment is never what you'll think it will be.
> We're constantly adjusting our sights and thinking over our investment
> period.
peril. If you 'overbet', you can go bust very quickly. As LTCM found
out, leverage is bad.
>
> Nerves of Steel and a Saint's Patience
>
> Q: What's the most common trap individual investors fall into?
>
> A: Often, investors don't understand the actual companies they buy or
> at least they don't have a perspective of what's going to happen to
> the earnings that drive the stock. It's human nature that if you're
> buying a stock you'll love if it's going up and hate it if it's going
> down.
>
> But if I own a stock and have conviction in it, then I'll buy more if
> the price goes down and will sell when I've made the return I believe
> is available. We're constantly asking ourselves, "Is there still
> enough return left in the stock?" This is hard to do emotionally, and
> isn't intuitive.
Countryside Financial today? Not with the present CEO idiot at the
helm I wouldn't.
>
> Q: Finally, what's your advice to individual investors?
>
> A: Being thoughtful and patient and having a long-term perspective is
> the best advice I can give. For an individual investor, there's
> nothing wrong with investing in a mutual fund, even if it doesn't
> sound particularly sexy.
btw.
> Read the financial press each day -- the Wall Street Journal, Forbes,
> Fortune, Business Week, and Barron's. Finally, even in difficult
> market conditions such as we're experiencing today, maintain your
> nerve and stay patient. If you do your homework and take a long-term
> view, you should have the courage to add to your favorite positions
> when stock falls.
closely if you diversity, as it will make you panic.
RL
JOSE BAILEN
>
> On Nov 28, 12:10 pm, "JOSE BAILEN" <jose.bai...@gmail.com> wrote:
> > Secrets of an Equity Investor
> >
> > by Jim Citrin
> > Posted on Tuesday, November 27, 2007, 12:00AM
> >
> > Much of the feedback for my recent columns has included the question,
> > "What does leadership have to do with investing and making money?"
> >
> > To address this, I sought out the best investor and one of the best
> > leaders I know: Cliff Greenberg, portfolio manager of the $3.7
> > billion* Baron Small Cap Fund, director of research for the Baron
> > Family of Funds, and -- full disclosure -- a close personal friend.
>
> Oh hell, another John Maudaline(sic) financial author wannabe
> promoting his friend--how objective can he be?
Right.
> > I spoke with Cliff about his investment philosophy, and asked what
> > advice he has for individual investors. Here are some highlights from
> > our discussion:
> >
> > Q: How would you describe your investment approach?
> >
> > A: My approach is to try to find special one-off growth companies that
> > we can own for the long term, as long as we maintain our conviction
> > that we can earn outsized compounded returns in the stock.
>
> This is another post on the approach "pioneered" (or acted upon, and a
> book was written about this) by Edward O. Thorp, an MIT statistician.
> But it ignores the Efficient Market Theory [EMT] (it seems to me) and
> the commonsense observations that yes, Virginia, volatility is indeed
> tied to risk. A stock that yo-yos from zero to 100 is riskier than
> one that flatlines at 50, even though both have the same average.
It would be intereresting to check the volatility of the returns of
this fund. If the volatility is higher than average, then higher
returns could be consistent with the EMT. Even if this is not the
case, one could also calculate what is the return distribution and see
if the higher risk-adjusted excess returns are statistically
significant or not.
> > I like to find an industry and a business that I believe will grow
> > rapidly for a long period of time. Then we do in-depth research to
> > really get to know the business, management, and industry so we can
> > project what the company can earn and what it will look like in the
> > future. From that we determine what we think the stock will be worth
> > in five years. If that represents an attractive return from today's
> > price, then we buy it.
>
> Again, refuted by the EFT.
Not necessarily, it all depends on the riskiness of the portfolio of
this fund. If it is riskier than average, they can get higher returns
than average, and this could be consistent with the EMT.
>
> >
> > Q: How does this investment strategy differ from value investing?
> >
> > A: The analysis is similar but the perspectives are different. Both
> > approaches are based on fundamental research and judgments about what
> > companies will earn and what they'll be worth in the future relative
> > to their price today. But classic Graham and Dodd value investing is
> > when you do the analysis and conclude that a stock is priced cheaply
> > today relative to its current inherent value. In other words, you
> > think something is worth a dollar but is only priced at fifty cents.
>
> But that's impossible says the EMT. It's like a $50 euro note (USD
> 75) lying on the sidewalk. At any decent university nowadays, nobody
> would stoop to even pick such a note up, since obviously it's not
> supposed to be there (and indeed if you stoop to pick it up, you'll
> find a string attached, leading to some social scientist doing some
> behavioral research project no doubt, and you'll find you can't keep
> the bill anyway, so might as well not even bother stopping).
Again, it all depends on the riskiness of the portfolio. For small
caps, besides the risk that is measured by the price volatility with
respect to the market portfolio -beta- you also have to consider the
small company risk factor, as described by Fama and French.
> > Q: How do you maintain selling discipline?
> >
> > A: While we're doing our work, the market is guessing along with us
> > every day, and often it comes to a different conclusion. The dynamic
> > reality is that an investment is never what you'll think it will be.
> > We're constantly adjusting our sights and thinking over our investment
> > period.
>
> Evasive answer. BUt truth be told, the Thorpe method is fraught with
> peril. If you 'overbet', you can go bust very quickly. As LTCM found
> out, leverage is bad.
Agreed. He says nothing about how they sell stocks, most likely they
don't have clear rules and they follow an ad hoc strategy instead.
> > Nerves of Steel and a Saint's Patience
> >
> > Q: What's the most common trap individual investors fall into?
> >
> > A: Often, investors don't understand the actual companies they buy or
> > at least they don't have a perspective of what's going to happen to
> > the earnings that drive the stock. It's human nature that if you're
> > buying a stock you'll love if it's going up and hate it if it's going
> > down.
> >
> > But if I own a stock and have conviction in it, then I'll buy more if
> > the price goes down and will sell when I've made the return I believe
> > is available. We're constantly asking ourselves, "Is there still
> > enough return left in the stock?" This is hard to do emotionally, and
> > isn't intuitive.
>
> Yeah, and if your information is bad, you go bust. Invest in
> Countryside Financial today? Not with the present CEO idiot at the
> helm I wouldn't.
> >
> > Q: Finally, what's your advice to individual investors?
> >
> > A: Being thoughtful and patient and having a long-term perspective is
> > the best advice I can give. For an individual investor, there's
> > nothing wrong with investing in a mutual fund, even if it doesn't
> > sound particularly sexy.
>
> Right on about that. And mutual funds don't practice Thorp's method
> btw.
The problem with actively managed funds like the one managed by this
guy is that, on average, they don't get better returns than the
risk-adjusted market returns (there is plenty of empirical evidence
about this) and, once you adjust by the fees and expenses charged by
these guys, you actually get substantially lower long term retuns.
That's why I think that individual investing -if you diversify well
enough, and you are aware of the risk-returns trade offs- beats mutual
fund investings.
>
> > Read the financial press each day -- the Wall Street Journal, Forbes,
> > Fortune, Business Week, and Barron's. Finally, even in difficult
> > market conditions such as we're experiencing today, maintain your
> > nerve and stay patient. If you do your homework and take a long-term
> > view, you should have the courage to add to your favorite positions
> > when stock falls.
>
> Makes no sense. Bogle of Vanguard says not to read the news too
> closely if you diversity, as it will make you panic.
Actually, this "stay patient" advice is pretty reasonable. Stock
market investing is for the long term, and as long as you remain
diversified and have enough liquidity -if you don't have it, you
shouldn't be in the market in the first place- you should stay cool
and don't overreact to news which are not likely to affect a company's
performance over the long term.
> RL
> >
>
JOSE BAILEN
-Warren Buffett's portfolio- which contradicts it. As we calculated a
while ago -Sharpe ratio-, the risk-adjusted returns of Berkshire
Hathaway have been higher than the market's for a period long enough
-forty years now- , so this overperformance is statistically
significant.
raylopez99
passive but an active investor--he has a say in how companies he
invests in are run. As such, he is privy to legal "inside
information".
RL
raylopez99
theory, is Minsky's theory of how the economy works. Thinking of
water boiling at 101C rather than 100C (happens), when it becomes
supercritical and the smallest perturbation will make it suddently
turn to steam.
Chaos theory vs traditional steady state models. Both are useful.
RL
From "Charles Whalen has written a very clear essay. He is from the
The Levy Economics Institute of Bard College which is a nonprofit,
nonpartisan public policy research organization"
Financial Instability versus Market Efficiency
While Keynes clearly stated that he thought conventional economics was
unsuitable for studying the accumulation of wealth, the dominant view
in contemporary finance and financial economics is an extension of the
approach Keynes rejected. A core concept of conventional finance, for
example, is the "efficient market hypothesis." According to that
hypothesis, even if individual decision makers get asset prices or
portfolio values wrong, the market as a whole gets them right, which
means that financial instruments are driven, by an invisible hand, to
some set of prices that reflect the underlying or fundamental value of
assets. As finance professor Hersh Shefrin writes, "Traditional
finance assumes that when processing data, practitioners use
statistical tools appropriately and correctly," by which he means
that, as a group, investors, lenders, and other practitioners are not
predisposed to overconfidence and other biases (Shefrin 2000, p. 4).
Instead of believing in the efficient market hypothesis, Minsky
developed what he dubbed the financial instability hypothesis (FIH).
According to Minsky's theory, the financial structure of a capitalist
economy becomes more and more fragile over a period of prosperity.
During the buildup, enterprises in highly profitable areas of the
economy are rewarded handsomely for taking on increasing amounts of
debt, and their success encourages similar behavior by others in the
same sector (because nobody wants to be left behind due to
underinvestment). Increased profits also fuel the tendency toward
greater indebtedness, by easing lenders' worries that new loans might
go unpaid (Minsky 1975).
In a series of articles that followed his 1975 book, and in a later
book titled Stabilizing an Unstable Economy (1986), Minsky fleshed out
aspects of the FIH that come to the fore during an expansion. One of
these is evolution of the economy (or a sector of the economy) from
what he called "hedge" finance to "speculative" finance, and then in
the direction of "Ponzi" finance. In the so-called hedge case (which
has nothing to do with hedge funds), borrowers are able to pay back
interest and principal when a loan comes due; in the speculative case,
they can pay back only the interest, and therefore must roll over the
financing; and in the case of Ponzi finance, companies must borrow
even more to make interest payments on their existing liabilities
(Minsky 1982, pp. 22-23, 66-67, 105-06; Minsky 1986, pp. 206-13).
A second facet of the FIH that received increasing emphasis from
Minsky over time is its attention to lending as an innovative, profit-
driven business. In fact, in a 1992 essay, he wrote that bankers and
other intermediaries in finance are "merchants of debt, who strive to
innovate with regard to both the assets they acquire and the
liabilities they market" (Minsky 1992b, p. 6). As will be discussed in
more detail below, both the evolutionary tendency toward Ponzi finance
and the financial sector's drive to innovate are easily connected to
the recent situation in the U.S. home loan industry, which has seen a
rash of mortgage innovations and a thrust toward more fragile
financing by households, lending institutions, and purchasers of
mortgagebacked securities.
The expansionary phase of the FIH leads, eventually, to the Minsky
moment. Trouble surfaces when it becomes clear that a high-profile
company (or a handful of companies) has become overextended and needs
to sell assets in order to make its payments. Then, since the views of
acceptable liability structures are subjective, the initial shortfall
of cash and forced selling of assets "can lead to quick and wide
revaluations of desired and acceptable financial structures." As
Minsky writes, "Whereas experimentation with extending debt structures
can go on for years and is a process of gradually testing the limits
of the market, the revaluation of acceptable debt structures, when
anything goes wrong, can be quite sudden" (Minsky 1982, p. 67).
Without intervention in the form of collective action, usually by the
central bank, the Minsky moment can engender a meltdown, involving
asset values that plummet from forced selling and credit that dries up
to the point where investment and output fall and unemployment rises
sharply. This is why Minsky called his FIH "a theory of the impact of
debt on [economic] system behavior" and "a model of a capitalist
economy that does not rely upon exogenous shocks to generate business
cycles" (Minsky 1992b, pp. 6, 8).
JOSE BAILEN
investor, in the sense that everyone rebalances his portfolio from
time to time. The portfolio turnover of BRK is pretty low 15-20%, so
in this sense they are more a "buy and hold" passive type of investor.
In fact, if you look at their holdings, they held stocks like Coca
Cola for decades. The issue is that Buffett follows a clear strategy:
he identifies undervalued stocks, then he keeps them in his portfolio
unless he becomes convinced that he made a mistake in the first place
(but because of his wisdom, he makes very few mistakes).
I agree that his strategy cannot be replicated by any of us, because
he has this legal insider information. But he has a disadvantadge:
because of his size, he cannot invest in small companies by
definition.