CHAPTER 9
Playing the Hand
Fundamental value investors will aggregate toward the lower end of the activity range when it comes to day-to-day trading in their portfolios. The primary reasons the stocks they favor are undervalued—market neglect, company-specific operating troubles, an out-of-favor industry—tend to be situations that work themselves out over longer periods of time, making patience a virtue.
That said, the embrace of a traditional buy-and-hold mentality—particularly in a market that in recent years has been characterized by high share-price volatility—is by no means universal. As much as we all would love for subsequent events to conform beautifully with our original expectations, that rarely happens, and the best investors can well articulate how they prepare and execute their responses. Some, through activism, look to take the resolution of outstanding or evolving issues that impact shareholder value more into their own hands.
TRADING MENTALITY
We don't know what kind of investor poker legend Amarillo Slim (born Thomas Austin Preston) was, but we have often found investing insight in his musings. One of our favorite quotes: “The result of one particular game doesn't mean a damn thing, and that's why one of my mantras has always been ‘Decisions, not results.' Do the right thing enough times and the results will take care of themselves in the long run.” As important as the decision to buy a stock is, events dictate that a variety of new decisions be made about that stock during your ownership of it. While many investors' frequently conclude as those events unfold that doing nothing is the right decision, others see actively trading around positions as central to their success.
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Our turnover is usually in the low teens—last year it was 8 percent, versus an average for small-cap value funds followed by Morningstar of around 70 percent. This is driven by the belief that if you've truly done your upfront research well, you should have the patience and courage to let ideas work. I don't believe you can explain 70 percent turnover or more without assuming people are buying many things they don't really know and dumping them when they get a negative surprise. We're not immune to missing things, but its rare that unexpected risks come up so quickly that we reverse course before the thesis has had a chance to play out. This obviously only works if you pay the right price going in, to the point where the downside is truly low.
—Preston Athey, T. Rowe Price
Our turnover is typically in the single digits. It's great when something goes up 50 percent in a year, but if you sell it you've got transaction costs and taxes and then need to find an incrementally better use for the money. We've never been very good at trimming and adding and, if we're right about buying the long-term compounding machines we want to buy, it doesn't make much difference. In general, we think a lot of trading around positions overvalues what you think you can know.
—Christopher Davis, Davis Advisors
It's just very hard to trade in and out of positions successfully over the long-term. It's only possible when you can have unusually high confidence in the precision of your intrinsic-value estimate. The most common reason we sell is when we find a better opportunity—that naturally takes us out of some higher-valued stocks that might be most prone to a correction.
—Brian Bares, Bares Capital
We try to take a page from the Weizmann Institute, a leading scientific research center based in Israel. Weizmann has a world-class reputation, a result of their having the largest patent and royalty stream of any academic institution in the world. If you talk to the scientists there, they believe very strongly that their success comes from being able to do their work without having to worry about how their science will translate to commercial profit—even though in the end it quite often does. By focusing on long-term goals, they eliminate day-to-day distractions and are more likely to work through problems that inevitably arise.
We want to have a similar mindset. We know our investors are going to worry about their portfolios over short time periods, but we explain to them that we won't. We try to look at short-term market gyrations as nothing more than opportunities to smartly enter or exit a position, subject to valuation and fundamentals.
—Steven Romick, First Pacific Advisors
We practice the Taoist wei wu wei, the “doing not doing' as regards our portfolio. We are mostly inert when it comes to shuffling the portfolio around, with turnover that has averaged in the 15 to 20 percent range. Many funds have turnover in excess of 100 percent per year, as they constantly react to events or try to take advantage of short-term price moves. We usually do neither. We believe successful investing involves anticipating change, not reacting to it.
—Bill Miller, Legg Mason Funds
We're constitutionally set up to be inactive, following the Warren Buffett idea that you should always judge how you're doing in any given year relative to if you'd done nothing. As long as we've made good decisions and our investment cases are intact, that creates a bias for inactivity.
—Don Noone, VN Capital
One lesson borne of experience is that the best course in investing is often to do nothing. Given the propensity most of us have for tinkering, that's a hard lesson to apply in practice.
Edward Studzinski, Harris Associates
We have a five-year average holding period. Particularly in a volatile market like today's, people are trying to zig and zag ahead of every market turn that they're hoping they can forecast with scientific precision. We like to plant seeds and then watch the trees grow, and our portfolio is often kind of a portrait of inactivity. That's kept us from making sharp and sometimes emotional moves that we eventually come to regret.
—Matthew McLennan, First Eagle Funds
We set an upside target for each holding, which is not the maximum expectation we have, but the level at which we reasonably expect to be able to sell in the future. When we're right, we'll generally hold until the shares reach that upside. The reality is that we can't do the level of due diligence we want on each idea and also turn the portfolio over quickly by constantly trading out good ideas for better ones. So we typically hold companies an average of five years.
—Steven Romick, First Pacific Advisors
We believe the most important contributor to the long-term investment performance of the companies we own is earnings growth, not a change in valuation. Because growth is driven by earning high returns on capital and successfully reinvesting cash flow, we tend to be very long-term investors—our average holding period runs about seven years—in order for this virtuous process to bear fruit.
—Eric Ende, First Pacific Advisors
To compound returns at a high rate over a long time, it's going to happen because a relatively small number of your stocks go up massively. If we're right on the long-term trends, our bias is to stay with a trade for many years to allow that to happen. We try to avoid getting itchy every time something hits a new high—a stock that goes up a lot over time, by definition, is frequently hitting new highs.
—John Burbank, Passport Capital
Given the tax implications of selling, the cost of trading, and the challenge of getting two appraisals right, John Templeton used to have what he called the 100 percent rule, meaning the upside should be at least twice as high before swapping out one position for what you consider a more attractive one. We similarly want to improve our position materially when we trade an undervalued business.
—Mason Hawkins, Southeastern Asset Management
It's always been fairly easy for me to stay focused on the long term, but with 30 years' experience reinforcing the importance of that, it's easier to stay patient. In 2008 that patience didn't serve me so well. When the problems started to get attention, conviction that things would be fine in the medium to long term kept me from trying to time the cycle. In the short term, a lot more selling would have been a good idea. Hopefully that was a one-in-50-year event.
—Robert Robotti, Robotti & Co.
Buy and hold shouldn't really be part of a value investor's vocabulary. All we know is price and value—if price meets value, whether in three months or three years, there's no justification for just sitting there.
—Charles de Vaulx, International Value Advisers
One thing I learned from [Tiger Management's] Julian Robertson is the concept that there are no holds. Every day you're either willing to buy more at the current price or, if you aren't, you should redeploy the capital to something you believe does deserve incremental capital. I sometimes hear, “If my target price is $45, why should we sell at $43?” The answer is simple—I believe we have better uses for that capital than getting the last few percentage points in the move from $43 to $45.
We distribute every day something we call the Sheet of Shame. It shows our ten largest losses, cumulatively from the inception of the position, year-to-date, month-to-date, and yesterday. It's a way of focusing our attention on what's not working. There are only two ways to get something off the Sheet of Shame—which people are eager to do—either eliminate the position or increase the position and be right, earning some of the losses back.
—Lee Ainslie, Maverick Capital
We're paid to measure risk and reward. But evaluating risk and reward is a continuous process, not once a year or once a month. So our percentage holdings of names in our portfolio will run up and down based on relative attractiveness.
For example, we may love Stock A as a long-term investment. We buy it at the start of the year at $30 and within less than a year it's up 50 percent. We're just as excited about the three- to five-year prospects today as we were—in fact, probably more so because we've seen that our thesis is on track. But the growth isn't at as reasonable a price now. So in a company like this that we know well, we think it's right by our investors to buy low and sell high as often as possible. It's hard work and we run up trading costs, but we believe over time it dampens volatility and adds return, and that's our job.
—Larrry Robbins, Glenview Capital
We've taken a more active view [since 2008] on adjusting position sizes so they best reflect our level of conviction and return expectations. We're not at all becoming market timers, but we're much less apt today to let a 5 percent position through appreciation become an 8 percent position unless its prospective return has commensurately improved as well. We've also scaled back the maximum position size we're comfortable with to 8 to 9 percent of the portfolio, from 12 to 13 percent or higher before the crisis.
—Michael Winer, Third Avenue Management
You always want to use your capital as efficiently as possible and I think we're fairly good at sizing positions based on the revaluation opportunities present. A lot of value investors may buy at $20, buy more at $15, and then won't purchase another share all the way to $40 or $50. We're not afraid to buy on the way up: If the probability of being right has gone up, the probability-adjusted return can improve even as the share price increases.
—Alan Fournier, Pennant Capital
We generally expect to hold something for a long time in order to realize the value we believe is there. But one thing I learned from [SAC Capital's] Steve Cohen is to be sensitive to when the market over-appreciates something in the short term and to harvest some of your gains. Markets inevitably react to data points that you don't think are truly relevant. Trading around that is a profit opportunity and helps you better manage risk.
—Robert Jaffe, Force Capital Management
When I started in the business, a stock might move 25 cents if there was a sound reason. Today, there's too much information out there and people are misusing it. This creates short-term valuation extremes, which you should often act on. Buy and hold doesn't make as much sense when stocks are hitting price objectives quickly. If we buy at $10 with a two-year objective of $15 and the stock reaches $14 within two weeks, we're not doing our job if we don't take money off the table to buy another stock with a 30 percent discount right away.
—Robert Olstein, Olstein Capital Management
2008 was really quite profound for me as an investor. It increased my resolve to hold only companies I deeply believe in because you never quite know when forces outside of your control set off a tidal wave across markets that shakes everything to its foundation. During a crisis, the less conviction you have about something, the more likely you are to handle it poorly and the more likely the company in question is vulnerable.
I have put forever to rest my longstanding profile of never selling anything ever. I am over that. One outcome of this exercise has been to more pointedly question the enduring nature of the status quo and to not hesitate in reducing portfolio holdings when the uncertainty is too high.
—Thomas Russo, Gardner Russo & Gardner
DEALING WITH ADVERSITY
A key occupational hazard of the value investor's trade is buying into a beaten-down stock that in relatively short order falls another 20 to 25 percent in price. As long-time value hunter Robert Olstein of Olstein Capital Management puts it: “When you buy on bad news, it often doesn't just stop on a dime; there's usually more bad news before things start to turn. You could probably make 20 percent a year by tapping into my phone line and shorting my initial buys of every stock. That's how good I am at timing.”
Discerning between timing mistakes and just plain mistakes when something has gone against you is a top-of-mind issue for most successful investors. Says Richard Pzena of Pzena Investment Management: “Making the right decisions at these moments adds more value, in my opinion, than the initial buy decision.”
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We're going to make another decision when we're down 25 percent in a position. Did we just completely blow it? Are we right, but the market is just insane? Or is it somewhere in between?
I believe the biggest way you add value as a value investor is how you behave on those down 25 percent situations. Sometimes you should buy more, sometimes you should get out, and sometimes you should stay put. I've never actually looked, but we probably hold tight 40 percent of the time, and split 50/50 between buying more and getting out.
—Richard Pzena, Pzena Investment Management
I'm catching a falling sword in almost every situation I'm in, and I'm trying to figure out if it's falling from the 2nd floor or the 10th floor. But my capital base is big enough and my appetite to stay concentrated strong enough that, if warranted, I can patiently, over the course of three to six months, make the price bottom by buying a little stock every day even as it's going down.
—Jeffrey Ubben, ValueAct Capital
When a stock moves sharply after an earnings announcement, the question I want the analyst to answer is whether something in today's earnings report impacted the value of the company in 2015. Are we three years from now going to look back at today's earnings as a seminal moment in our understanding of the business and its competitive dynamics? That can be the case, but more often than not what's perceived as a bad quarter doesn't impact the value of the enterprise. That often means adding to existing positions.
—Win Murray, Harris Associates
My threshold for pain is high as long as I believe I'm still right. Historically, we've made a lot more money on the long side when what we thought we were buying cheap went down another 30 percent before finally going up—we always buy more if our thesis hasn't changed.
—Francois Parenteau, Defiance Capital
During difficult periods we have always been willing to add risk as the rest of the market is removing it by reducing valuations. I remember sitting in my office on October 19, 1987, when the market was crashing and getting a call from [Royce & Associates founder] Chuck Royce—who was one of my brokerage clients then—asking me what stocks I liked and why. I walked him quickly through three or four of my best ideas, he asked a few questions that made it obvious he knew the companies at least as well as I did, and then he told me to put in orders to buy 10,000 shares of each, with additional buy orders of 10,000 shares for every 1/8th of a point tick down in the price.
You can only show that kind of resolve with great conviction in your process and your discipline, which increases every time you come through a tough period successfully. It's that process and discipline that is fully under our control—in the end, that's all you should really worry about.
—Whitney George, Royce & Associates
We're a long-term, low-turnover manager, so the office routine doesn't change much [in bad markets]. Outside the office may be a different story, say, with respect to sleep patterns and eating habits. But we always say, “When the going gets tough, the tough do research.” One of my biggest jobs is to keep everyone focused. Don't stare at the red numbers on the screen—call companies, call industry contacts to hear what's really going on, dig for new ideas, and just look to take advantage of the volatility.
—Jeffrey Bronchick, Reed, Conner & Birdwell
My mistake in 2009 was that in March—when I should have been buying—I felt things were completely unraveling and started selling my longs and increasing my shorts. I've spent my career trying to think only for myself and in this instance I was so influenced by the external world that I blew it with the type of market call I rarely make. All I wanted to do was take risk off the table, when what I should have done was cancel my Bloomberg subscription and focus on the businesses of the companies we owned. That would have been a far better use of my time.
—Carlo Cannell, Cannell Capital
It's the bias of the information age that people feel isolated when they're not in touch with what's going on. To me it's a good discipline to often say, “I don't really care what goes on in the market today.” When you do that you can actually get something useful done. Even something simple like saying you'll only answer e-mails in the morning, at lunch, and at the end of the day sometimes can go a long way toward avoiding unhelpful distractions that tend to arise.
We're very big on what we call battle plans, in which we map out how we'll behave at various price points in the market. John Templeton used to talk often about taking that kind of pre-commitment down to the level of individual securities. Because you've already decided what you should be doing, it allows you to focus your attention in a very useful way when the market is falling to pieces.
—James Montier, GMO
We have periodic devil's-advocate reviews of all our large holdings and a separate analyst is charged with presenting the negative case. It's more than a debate society—the devil's advocate should genuinely believe the negative argument is the right one. We obviously make plenty of mistakes, but that discipline helps us reduce the frequency and severity of them. In investing, that's half the battle.
—Edward Studzinski, Harris Associates
If an individual position decreases by 10 percent from our cost, we conduct a formal review. The focus is on understanding why something has gone down. If the reason is that the sector is down, or pessimism over a short-term trend has increased, we'll typically buy more if we believe the story is still intact. If the reason the stock is down makes our thesis wrong, we'll sell. What happens more than I think people are willing to admit is that we have no real idea why the stock is down, which is a problem. There's no pat answer for those situations, but we're apt to sell when that happens as well.
—Christopher Grisanti, Grisanti, Brown & Partners
A guideline that's helped us control risk is to require a full reassessment of our investment thesis when we've marked down a company's intrinsic value by roughly 15 percent or more. If you have to mark down intrinsic value, you probably made a mistake somewhere. The question is whether what caused the mistake is lasting or temporary, which deserves a fresh look.
—Steve Morrow, NewSouth Capital
We have a rigid rule that if a position is down at least 15 percent from our cost, we force ourselves to either buy more or sell. Human nature in such situations is just to hold, but if our conviction on the idea is intact, we're happy to see it down 15 percent so we can buy more. If that isn't the case, we sell. The down-15 percent positions in a portfolio aren't great, but they're manageable. What we want to avoid are the down-15 percent ones that turn into down-40 percent ones—that's where you really start to blow a hole in your capital that's hard to get out of.
—Joe Wolf, RS Investments
For stocks going against us, we also have three triggers that force a decision: if a stock moves 20 percent or more against us on a trailing 45-day basis, if a long costs us 25 basis points in a month, or if a short costs us 15 basis points in a month. It's almost never a surprise when something gets flagged, but we force ourselves to decide whether this is a great opportunity or whether we've made a mistake and should move on. The majority of the time we end up adding to the position.
—Steve Galbraith, Maverick Capital
We don't have many rules, but when a stock is down materially relative to its peer group we assign another analyst to formally review it and then force ourselves to buy more or get out. Not surprisingly, the analyst who originally recommended the stock is the last person to want to sell it.
—Jeffrey Bronchick, Reed, Conner & Birdwell
We have a formal review process if a stock declines by 20 percent or more from our original point of purchase. The analyst responsible for the idea reviews it fully with the entire team, with everyone focused on identifying what we may have missed. There's no forced action at that point, but if we do decide to average down, we only do so once. Averaging down repeatedly in stocks that are tanking is a great way to destroy a portfolio.
—Brian Barish, Cambiar Investors
We've done research on all of our buy and sell decisions and—based on 20/20 hindsight—isolated how each one adds or detracts from the overall value of the portfolio. We found that we generally did a good job of selling losers and of holding on to winners. Where we didn't do so well was in buying more of things that were falling in price—which is interesting, given how much we as value managers love averaging down. We still have more to learn about this, but I would say we've become even more mindful when looking at whether to buy as something gaps down.
—Mariko Gordon, Daruma Capital Management
You have to be willing to double down when you invest in the types of companies we invest in, where things often get worse well before they get better. I don't want to leave you with the impression, however, that it always works. In the late 1990s I had about a 12 percent portfolio position in Superior National, a big player in California workers' compensation insurance. I increased my position in a rights offering and it got as high as 20 percent of my portfolio. When the workers' comp business in California fell apart, the company turned out to be too leveraged and the shares went from $22 to zero. The lesson wasn't not to be aggressive, but not to be overweighted in anything that's so leveraged that it really has the risk of going to zero.
—Robert Robotti, Robotti & Co.
What's the definition of a long-term hold? A short-term buy that went down.
—James Montier, Société Générale
We're big believers in the notion that losers in this business are the ones who make big mistakes and winners are those who make small mistakes. For that reason we try to be unsentimental about our positions, particularly those going against us. We do not average down after a position gets hit, for example. That's counterintuitive to most value investors, but because there is always a fair chance we'll be wrong, we don't want to compound mistakes. One reason I think indexes beat active managers is that you never see an index averaging down. If we're doing our job, we can always find another idea that gives us the same potential upside or better, and we'd rather go with that.
—James Shircliff, River Road Asset Management
There's an interesting section in Outliers, by Malcolm Gladwell, in which he describes how disasters like plane crashes or the Three Mile Island nuclear accident are rarely because of one big mistake. They're more likely to result from a series of small mistakes, any one of which, if avoided, would have kept the disaster from happening. Many investing mistakes we've made have been in companies where a bunch of little things went wrong, which when added together made a big problem. Those types of situations can creep up on you, so I'd say one lesson is to not ignore minor setbacks and to be very aware if they start to pile up.
—Paul Sonkin, Hummingbird Value Fund
We don't interpret meaning in how stocks are priced. People tend to think if a stock falls 30 to 40 percent, it must mean things are worse than they realize. We don't think that way and just stay focused on our estimate of intrinsic value. It can happen that a stock falls 30 percent but we think the business value is down 50 percent, so we sell. More often the stock price falls 30 percent and we think the business value may have fallen only 5 to 10 percent, giving us an opportunity.
—Chris Welch, Diamond Hill Investment Group
With investing, focusing on what's already happened is generally a bad strategy. The decision at any point should be only about looking forward. Just adjusting how you set up your spreadsheets and what you track on reports could help in this regard.
—Dan Ariely, Duke University
If someone has a material piece of information to share about one of our names, I always ask that they first step back and review with me our current shared viewpoint on the stock. That helps us put in context the importance of the new information and to better discuss the extent to which it may alter our conviction and/or target stock price. Someone rushing into my office and blurting out the latest news without putting it into broader perspective increases the possibility we'll make a rash trading judgment.
—Michael Karsch, Karsch Capital
I honestly don't feel any of the emotional ups and downs from the market's day-to-day activity. I just don't worry about short-term volatility.
—Ed Wachenheim, Greenhaven Associates
We lost some longtime clients during the crisis, one of which delicately referred to me as a “washed-up All-Star” as the market was going down. It's not possible to avoid it eating at you emotionally when the market is going against you. One critical thing I've learned, however, is that whenever I'm the least bit emotional, I don't make decisions. We can all feel the same emotions as the small investor—when you're in that state of mind, don't do a thing.
—Robert Olstein, Olstein Capital Management
Sometimes going for a walk or meeting a friend for lunch when the market is down 200 points is a lot better then staring at the screen trying to figure out what to do. You don't have to do anything and most of time you shouldn't. I'm absolutely convinced that regularly clearing your mind helps you make better decisions.
—Aaron Edelheit, Sabre Value Management
Humor is an important part of our culture. That's not to say we're cutting up all the time or that we're even that funny, but in a deadly serious business like ours if you can't find humor in what you're doing, it's going to kill you. Having a sense of the absurd eases tension and puts things in perspective when things are going against you. Without that, people burn out or tend in their desperation to roll the dice. That's the last thing we want to do.
—Robert Kleinschmidt, Tocqueville Asset Management
When we buy a stock we write down exactly why we own it, which we should be able to lay out in three or four sentences. To the extent those assumptions are no longer valid, we'll sell regardless of how cheap it gets. We're fighting the natural tendency to come up with new reasons to own something, for the simple reason that we've found in our post-mortem work on mistakes that one of the best ways to lose money over time is by owning stocks with changing investment rationales.
—Ragen Stienke, Westwood Management
We tend not to average down. I think this is a common mistake, when you don't realize there's something out there you're missing and you compound the problem. We've instituted a soft stop-loss that is triggered whenever a position causes a 1% loss on the overall portfolio from cost, say a 5% initial position falls 20% from where we bought it. We don't automatically sell, but there's a high bar to keep something in the portfolio, let alone add to it.
At the end of the day, markets are too efficient to totally ignore price action. If we're going to be wrong, we usually know in the first year and can cut our losses. Better to admit it then rather than later.
—Stephen Goddard, The London Company
One thing that helps us maintain perspective through difficult times is that we outline specifically in writing what our investment thesis is and what we expect to happen. If what is happening with the business is in line with our thesis and expectations, that gives us the confidence to stick with something or buy more if the share price tanks.
If subsequent events indicate our original thesis is wrong, we make every attempt to ignore the temptation to keep a stock because it's so cheap or because we can come up with new reasons to own it. That rarely works out well.
—Edward Maran, Thornburg Investment Management
Our bias toward buying and holding has at times made us too quick to rationalize a problem that hits one of our companies as temporary and already priced into the stock. If the problem turns out to be more long term and fundamental, it's likely not fully discounted into the current price at all. We've been blind at times to fundamental changes in a company's business because we think the quick 25 to 30 percent drop in the share price makes the stock too cheap to sell.
One technique that helps me avoid that is to regularly look at what we own and ask as objectively as possible if we would buy the exact same portfolio if we were starting over from scratch with the same amount of money. For positions where the answer is probably no, the likely reason is that the company's situation has fundamentally changed, but I just haven't fully admitted it yet.
—Francois Rochon, Giverny Capital
When something spooks me, I should more often take advantage of the liquidity of the market to get out and finish the work on whatever the new issues are. If you determine the problem is a big one, you can avoid a lot of pain. If you conclude the problem is only temporary, you can usually get back in at a lower price.
—David Eigen, Post Road Capital
I've been at this long enough that I can keep things in perspective. Ben Graham said it well: He said to succeed in the investment business it helps if you're smart and it helps if you work hard, but what's most critical to success is that when you have conviction, you stick with it.
The fact that you go through times when you're out of sync or out of favor, that's good, you should expect that and even welcome it. That's where opportunity comes from. If we'd given up on our conviction in early 2007 [betting against financially vulnerable companies], we would have missed a huge opportunity. That we didn't was a game changer for us.
—Prem Watsa, Fairfax Financial
TAKING A STAND
Shareholder activism has come a long way from its modern rise in popularity in the 1980s. Back then, says one of today's foremost activist investors, ValueAct Capital's Jeffrey Ubben, what passed for activism was little more than “buy shares today and tomorrow throw a hissy fit.” While that basic strategy has not gone away, more prevalent is a constructive effort over time to influence company management and boards to make changes meant to increase shareholder value. It's not for everyone—and one can certainly be a successful investor without an activist bent—but many of the best investors in the business see their willingness to push for change when appropriate as a valuable arrow in their investing quiver.
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Most shareholders of undermanaged or poorly managed companies vote with their feet rather than push for changes in management, board composition, or strategy. So, poor management persists because shareholders aren't willing to do anything about it, which we think is an abdication of responsible ownership and fiduciary duty. But even if big shareholders have a willingness to take on a public company, most firms don't have the experience, resources or skill set to do so. We think the fact that we have that ability when others don't is a big opportunity.
The private equity business was built around taking over companies and doing what shareholders should have gotten done. Most private equity firms do not possess secret sauce in terms of management expertise—they're financial engineers. The amazing thing is that the same shareholders who do nothing to effect change at a poorly managed company before a private equity firm comes in to take over line up to pay a stupid multiple for the company when it comes public again.
—Jon Jacobson, Highfields Capital
Michael Price [CEO of Mutual Series from 1988 to 1998] was at the forefront of shareholder activism. His and our attitude became that just selling if you weren't happy wasn't the right conclusion. As the owners of the company, shareholders really deserve full credit for what companies are worth. It's not just our right, it's our obligation to do all we can to see that we get that credit. For us, a continuing dialogue with management—public or not—is an important part of what we do.
—Peter Langerman, Mutual Series Funds
What we try to do is buy high-quality businesses at a price that is not reflective of the intrinsic value of the business as it is, and certainly not reflective of what the intrinsic value would be if it were run better. That allows us to capture a double discount. That's a benefit we can have over private equity. They can buy a company and run it better to extract incremental value, but they're typically paying the highest price in a competitive auction, so they don't get that first discount. We don't control, but because we have a track record of making money for other investors, we can often exert enough influence to make an impact.
—William Ackman, Pershing Square Capital Management
We absolutely want to be constructively engaged shareholders. We have 10 to 15 percent of our capital in each of our core companies, so I think it's imperative that we make our views, particularly with respect to capital allocation, clear. For the most part, management appreciates the faith we're placing in their business and in them to get the stock out of the valuation hole it's in. When management is unresponsive, we work to change that.
—Alexander Roepers, Atlantic Investment Management
The basic reason our investment strategy adds value is that board members are classic agents, not principals. The information board members get about what shareholders want comes from the CEO. However well intended, board members mostly lack enough fundamental knowledge about the business to challenge the CEO on the performance of the business or new strategies to create value. Almost always, they don't have enough money on the line to have the sense of urgency we have as owners. It's a blueprint for inertia.
—Jeffrey Ubben, ValueAct Capital
We prefer a much quieter form of activism, but every now and then we need to do more. To get on my soapbox for a minute, I'd argue that the unwillingness of institutional investors to take more of a stand against poor management or corporate governance helped contribute to the 2008 crisis. Silence was not the best response to some of the bad behavior going on, particularly in financials.
—David Winters, Wintergreen Fund
If you think about where the corporate system has fallen down in the U.S., it's when the actual capital has gotten far removed from the enterprise, and the agency relationship between owners and management has gotten so broad and wide. That's when you have disconnects or conflicts of interest. Everything we do tries to shrink the distance between the capital and the enterprise.
Activism to a large extent is trying to truncate risk by eliminating the misallocation of capital, which is less likely when those responsible truly act as if they're spending their own money. When making a decision on a new factory or product launch or hiring plan, people should feel the weight of the capital they are entrusted with. Understandably, given the corporate form, many people running corporations don't operate that way. So when that isn't happening, the ability to improve those decisions through activism is a key way to create shareholder value.
—Michael McConnell, Shamrock Capital Advisors
If our capital base were permanent, we'd probably only do active investments. But it isn't, so the fact that I don't ever want to be forced to sell an active investment in the course of an engagement means we also need to hold passive positions. Historically, around 55% of our portfolio has been in active investments, 15% or so has been in cash, and the balance has been passive.
The 55% of our capital in activist investments has produced more than 90% of our returns. One primary reason we're working hard to increase the amount of permanent capital we have is to devote as much of the portfolio as possible to active positions. Doing that should enable us to earn higher returns over time.
—William Ackman, Pershing Square Capital Management
ATTRACTING ACTIVISTS' ATTENTION
Value investors frequently zero in on situations in which a company by its own devices has veered off course, resulting in lagging performance that is nonetheless perceived as fixable. Nonactivists and activists alike count on the fixes being made, with activists looking in varied ways to shoulder more of the load to insure that happens.
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Every investor wants to find well-managed companies, with defendable market positions, that generate a lot of free cash flow that is reinvested intelligently. The problem is, those companies typically don't have valuations we can accept as value investors.
So we look for businesses that qualify on a few of the ideal characteristics and that we think can improve on the others. In most cases either the management is lousy or the company has had a very bad record in terms of capital allocation. To us, those are the easiest things to fix.
—Jon Jacobson, Highfields Capital
Our interest starts first with the quality of the business. We're not looking for trouble, for quick deals to be made, for fixes, per se, or even for board seats. We buy good businesses at good prices, where we're willing to take on the short-term risk—the near-term negative data point—because we think the long-term gain is compelling. If the stock goes up, we look like traditional value investors who made a nice investment.
But probably half the time things don't work out that way. We're 18 months in, with a full position, and the stock is where we bought it or lower. But we've proved out the industry structure, we've proved out our investment thesis, and we really believe in the asset. It's at that point we go to the board and management and say we've been your default buyer, we own 5 to 10 percent of your company, and we'd like to buy more but we won't do so without a board seat. The stock is underperforming, we believe we have a deep understanding of your business, we have a deep knowledge of capital markets, and we want all the information that's available to board members to help craft a strategy that creates value for all shareholders.
We don't pick fights. But when the train goes off the track, you need to do something about it.
—Jeffrey Ubben, ValueAct Capital
Our front-end screening is fairly automated, looking at both performance laggards and where implied expectations are pessimistic. We start with the proposition that the market is right about a company's valuation. If these assets, with this management, with this strategy, in this environment are worth $20 per share, can we identify changes in that composition that would make the market value much higher? More traditional investors might stop there, but we then try to figure out how likely the actions we've identified are to be taken and over what time frame, and, most importantly, how capable we are of helping to make them happen.
—Ralph Whitworth, Relational Investors
In the typical situation that attracts us, we engage with management in order to try to get them to rein in spending on failing growth initiatives, refocus on the good core business, improve cash flow, and put in place a greater level of discipline with respect to return on invested capital.
—Jeffrey Smith, Starboard Value
If I learned anything as a management consultant, it was the importance of identifying where a business has its greatest competitive advantage and then focusing the growth and development of the business on that nexus of advantage. Companies consistently lose sight of that for a variety of reasons, often resulting in what we call “de-worsification.” It's a very common issue for us.
People issues are also common. These are very difficult decisions for companies to make, often involving many subjective and emotional variables. When necessary, we try to bring a reasonable and rational approach to difficult decisions that need to be made on both hiring and firing.
As market time horizons continue to shrink, the patience we'll demonstrate to companies that are disappointing us has been similarly telescoped. We're not rude or abusive, but we are expressing our points of view and building coalitions to drive change earlier, more frequently and perhaps more forcefully than we have in the past.
—David Nierenberg, D3 Family Funds
Invariably the companies we zero in on have poor corporate governance, but we're far more interested in how the board makes decisions than in the tick-the-box governance items like whether they have a poison pill or a staggered board. Not enough boards think of themselves as shareholder representatives. That particularly manifests itself in setting compensation plans, which don't focus enough on return on investment and often just reflect what management wants rather than what true shareholder representatives would require. In virtually all of our companies compensation is a central topic of discussion.
—Ralph Whitworth, Relational Investors
Our preference would be to have a constructive conversation with management leading to a positive resolution. I don't think going immediately for the jugular, as some other activists do, is the best way to succeed. If you embarrass people and attack them personally, you're much less likely to have a rational discussion. But we've made it clear that we aren't going to go away.
—Phil Goldstein, Bulldog Investors
Activists need the capital base, experience, and credibility to follow through—by buying the company or going on the board to help fix it—if steps aren't being taken to address their concerns. You need to be more than a yeller and screamer whose biggest asset is that you don't care what anybody thinks about you.
—Jeffrey Ubben, ValueAct Capital
There is growing sentiment that a shareholder perspective in the boardroom is helpful, which was not the case 25 years ago. I'd like to think we've moved past the corporate-raider phase and that most activism today is done professionally with the interests of all shareholders in mind.
Companies have also increasingly realized how unproductive it is to resist shareholder input. When activists show up, management for the most part behaves responsibly and respectfully. That results in healthy, constructive dialogue about how a company should operate. That type of dialogue is absolutely in the best interest of all shareholders.
—Jeffrey Smith, Starboard Value
There's a certain trendiness to activism, driven by the fact that the opportunities for activism aren't always there. In the 1980s you heard a lot about it, but then as valuations changed in the 1990s you didn't hear much about it at all. Now it's popular again, but we've always considered a willingness to be active as just another weapon in our arsenal.
—Barry Rosenstein, JANA Partners
I will say that I have in the past fallen into what I call time traps, where I've spent too much time trying to resolve problem investments. We will pick our battles, but usually we're better off helping our best investments maximize opportunities than trying to perform brain surgery on dogs.
—David Nierenberg, D3 Family Funds
One mistake we made with our investment in Borders Group was taking an active role at the company's request. Given the direction the industry was heading and how hard it was to make anything happen, it wasn't worth the time and energy. Paraphrasing Warren Buffett, when you find yourself in a sinking ship, sometimes the best thing to do is to switch boats rather than keep bailing.
—William Ackman, Pershing Square Capital Management
We prefer to avoid public confrontations with management for three main reasons. First, we're a young enough company that I don't want to run the risk of our entire reputation being tied to a public battle with this or that company. Second, we've greatly benefited as investors from forming partnerships with our portfolio companies. We want to maintain that same access, which requires that when we sit across from management they understand we're a constructive force and not a potential headache. The third thing is just from a legal perspective, being an activist is very time-consuming and expensive.
Activists are, generally speaking, well researched and well informed in their positions and most of the time are fundamentally right. They may have an issue with the free riders benefiting from their work, but the good ones are doing everyone a service.
—Larry Robbins, Glenview Capital
I've got a full quota of righteous indignation and a lot of things turn me off about corporate America, but I've never had the personality for being confrontational. I talk to management at times, both to complain and to offer suggestions, but I'm hesitant to be public or loud about it. If I pushed on an issue and someone called my bluff, I know myself well enough to question whether I'd follow through with a lawsuit or whatever the next step might be.
—Wally Weitz, Weitz Funds
We like to invest with management that gets it and is doing what we think they should. Some investors want to buy cheap stocks where the businesses are run by morons and then force them to do something different. That's not a bad strategy, but that's not how we tend to do things.
—Wayne Cooperman, Cobalt Capital
The fact is, when I feel I have to write a letter and make noise, that almost always means I've made a mistake and the more productive use of my time is to sell and move on.
As a buy-and-hold investor, the perfect outcome is when a company earns high returns on their equity capital for as long as I live. I can hold and have the earnings compound in a tax-efficient way. So, as opposed to agitating for a fight, I'm better off hooking up with people who are great at what they're doing—and are going to keep being great at it for a long time.
—Thomas Gayner, Markel Corp.