(Image Credit, institutionalinvestor.com)
One investor I like to follow closely, is Bruce Berkowitz.
In 2010, Berkowitz was named as the 2009 Domestic-Stock Fund Manager of the Year by Morningstar as well as the Domestic-Stock Fund Manager of the Decade (2000-2009), also by Morningstar. Most recently, he was named 2013’s Money Manager of the Year by Institutional Investor Magazine.
Berkowitz founded The Fairholme Fund in 1999, and founded Fairholme Capital Management in 1997. Prior to founding Fairholme, Berkowitz was a Managing Director and Senior Portfolio Manager at Smith Barney, Inc. from 1995 to May 1997, and a Senior Vice President and Portfolio Manager at Lehman Brothers Holdings, Inc.
For this article I pulled together parts of some of his best interviews so that we could better understand his investing strategy. I love his insights on trying to kill a business as part of his stock picking analysis.
Let’s take a look…
The following excerpt is taken from an interview Berkowitz gave to Kiplinger in 2009, titled A Bargain Hunter Stands Tall, and an interview he gave to the Winter 2009 Newsletter of Graham and Doddsville titled, If Not Now… Then When?
Let’s see what he had to say:
Kiplinger: A lot of well-known value investors fell on their faces the past year or two. Why did Fairholme hold up as well as it did?
BB: Maybe it’s because I don’t invest in things I can’t understand. Eighteen years ago, after the financial stocks got killed, I was a big buyer of Wells Fargo, Freddie Mac and MBIA. They were simpler businesses then — and they were cheap and understandable.
You could read an annual report or a 10-K and you knew what you were getting. Or take American International Group. If you looked at an AIG annual report six or seven years ago, you saw one paragraph on derivatives. You look at an AIG annual report today and you see 15 pages on derivatives. I don’t think company insiders fully understand what’s going on, let alone outsiders. So if I don’t understand something, I’ve learned to walk away.
Kiplinger: How do you find opportunities?
BB: By ignoring the crowd, we find opportunities in stocks that people are running away from. Earlier this decade, when oil and gas prices were much lower and people were very down on the sector, we found a few companies that we thought did exceptionally well in almost all price environments. We focused on Canadian Natural Resources. It wasn’t well known in the U.S., but it was run by a man named Murray Edwards, who is a human computer.
Kiplinger: Do you pay any attention to earnings?
BB: No. I look at free-cash-flow yield.
Kiplinger: And free-cash-flow yield is?
BB: The free cash a company generates divided by its market capitalization. If we can get a double-digit free-cash-flow yield, I’m interested, especially if we can’t kill the company and especially in a world of 3% or 4% risk-free yields.
G&D: Is killing the company a mindset that you employ when you analyze a business, or is it a separate process you take on after you have analyzed a business or when you are talking to experts? You’ve described it before as a role-playing exercise.
BB: I think killing a business is the research process. We tend to start off looking at industry sectors and businesses that are under stress. And by stress, I mean that their stock prices and their market values have fallen off a cliff.
Then we try to understand the current free cash flows of those businesses and try to understand how much free cash flow can be maintained. Or if it can’t, what level can be maintained assuming that they will be able to maintain the business at some level. Also, how are those free cash flows going to get to the owner?
After all, they are owner earnings as Benjamin Graham would say. Are we going to see dividends or buybacks or is the money going to be funneled back into the business for growth? Or is it going to be, as Peter Lynch used to call it, “de-worsification”? Are the executives going to piss away the money? We had a company called WellCare in which—for reasons beyond my understanding— a past CEO decided not to report an overbilling.
G&D: When you think about how much a business can earn in a normal environment, how do you think about what a normal environment will look like? Has your view on that changed in recent months?
BB: We’ve gone further than that now. We no longer think about a normal environment, we think about an abnormal environment. We focus on a difficult and continuing environment where credit markets are still rigid. They’re just not working.
If the current difficulties keep going for another year or two years or more, I want to understand whether or not a company can survive. Just look at what is going on with the banks and the brokers. For years, we could not understand what they owned and what they owed.
It was nearly impossible for the insurance companies or any financial institution that had a large or not-so-large derivatives book. Today it’s not even clear to me who owns them. I can’t tell you who owns Citigroup. My default answer would be that the government owns Citigroup.
It is pretty obvious with the auto companies that some combination of bond holders and retirees have owned the big three auto companies for quite a long time, so the stock prices of GM and Ford never made sense to me. It just seemed to be a fallacy. And we are going that way now with our large banks.
The amazing thing is that people just don’t seem to learn from history. Difficult times correct problems. Companies are tightening up, losing the fat, becoming more efficient, learning very tough lessons about leverage, and relearning about the sanctity of the balance sheet.
They are learning that you should not play Russian roulette even if the gun may have a thousand chambers and only one bullet because if you hit that bullet, you are dead. Much of the probability and statistics work—for instance, Monte Carlo simulations—are based upon thousands and thousands of spins of the wheel.
But if you kill yourself that one time, you can’t spin again. I don’t know where that is addressed in the statistical courses. Now we know it. Now we have books about black swans and fat tails, and we understand that a bad thing can happen more often than you think.
In life as in investing, what kills you is what you don’t know about and what you’re not thinking about. Today investors are focused on most of the ways in which you can die, which is a great signal for the future. It is when you’re not thinking about it that you get hurt.
It is when you pay that optimistic price. It has always paid to be very greedy when everybody else is quite fearful of the environment, because that fear factor is priced in. You tend to get a relatively decent margin of safety based on the price you are paying for a given level of free cash flow.
That is where we are today. What better time is there? If not now, when? Was it a better time to invest three years ago? Six years ago? And the answer is no. What is happening today, as in most bear markets, is that people either don’t have the cash or they don’t have the stomach—hence the low valuations.
G&D: Shifting gears to your interaction with your analyst team: How does an analyst convince you that he or she really understands the business?
BB: It is based on this process of trying to kill the business. Once a person has an idea, we then start whacking at it. We invert the concept. Instead of trying to prove a person’s idea, we try to kill it, and if we can’t kill it then the person is onto something.
Whether it is my own idea or someone else’s idea, that is the process we go through. We will then talk to experts with 20 or 30 years of industry knowledge,and we will try to attack it from every way that we know how. After a period of time as we go through our checklist and we’ve been through all the ways that we can kill an institution, we decide that maybe we can make some money.
Much of investing is about not losing just as much of life is about not dying. It is avoiding those places where you can die.
That’s why I’m not a really big fan of parachuting.
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