Which Investing Style Is Better, Eddie Lampert or Seth Klarman? – Zeke Ashton

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Zeke Ashton is the founder and managing partner of Centaur Capital Partners. Founded in 2002, Centaur Capital Partners specializes in value-oriented investment strategies. Prior to launching Centaur Capital, Ashton served as an investment analyst and featured writer for The Motley Fool, an investment media company.

From 1995 – 2000, Ashton worked in treasury and risk management consulting, where he worked as a consultant and project manager for various clients in Europe and North America.

Ashton is someone that all value investors should watch closely.

Ashton did an interview with The Manual of Ideas which gives us some great insights into his investing strategy. Pay particular attention to his thoughts on which investing style suits him better, the “home run” investing style of Eddie Lampert or the “high probability” style of Seth Klarman.

Let’s take a look…

This is an excerpt from the interview Ashton did with The Manual of Ideas, you will need to be a subscriber to read the original interview here:

Zeke Ashton of Centaur Capital Partners spoke eloquently on the topic of value investing and risk management at the Value Investing Congress in Pasadena earlier this month. We found Zeke’s presentation enlightening and asked him to elaborate on some of his key points. A week or so ago, we conducted an exclusive interview with Zeke, and it’s our pleasure to bring it to you here.

Before we proceed to the interview, we should point out that Zeke’s approach to risk management has worked. In 2008, the Centaur Value Fund was down 6.9%, trouncing the 37.1% and 40.0% declines of the S&P 500 and Nasdaq Composite indexes.

From inception in August 2002 through the end of 1Q09, the Centaur Value Fund gained 134.6%, net of fees and expenses, versus returns of 15.1% for the Nasdaq Composite and -0.3% for the S&P 500 Index.

MOI: Is there a danger of overreacting to what happened in 2008? After all, many value investors have achieved superior long-term performance because they have avoided the closet-indexing style of a large portion of the active management universe. How do you ensure that risk limits and diversification don’t become unnecessary drags on risk-adjusted performance?

Zeke Ashton: I think there is a danger to extracting lessons that would have been useful in pain avoidance during 2008 that may not be applicable going forward, and certainly could result in sub-optimal performance in the “normal” investing conditions that prevail 95% of the time. However, I don’t think it will cause an unacceptable drag on performance to establish reasonable total exposure and position size limits, appropriate sector limits, or to be prudent in terms of how much of one’s portfolio might be invested in illiquid assets.

Just as an example, we haven’t changed our portfolio structure much as a result of recent experience. It was pretty standard for us to have 50-60% of our assets invested in our top ten ideas prior to 2008, and we aren’t likely to change. In fact, we actually have a bit more than that invested in our top ten long ideas today. Around the edges, though, we might be a little more sensitive to nuances such as balance sheet risk at each idea than we were before, or to correlation amongst our top positions.

But I don’t think 2008 has brought wholesale changes to our ways of thinking about portfolio risk management. It’s mostly been refinements based on having witnessed a real life stress test and learning what helped us and what we might have done better – without changing the philosophy and approach that define us as investors.

The core elements of value investing will still always be about valuing businesses and assessing risk. The environment of 2008 and early 2009 served to shine a brighter spotlight on the risk assessment component of the game.

MOI: You have differentiated between the “home run” and “high probability” styles of value investing. Eddie Lampert has succeeded at home run investing, while Seth Klarman has excelled at high-probability investing. Assuming that each style represents a legitimate approach, what are the key differentiating qualities of a home run investor versus a highprobability investor? Why do you favor the high-probability approach?

Zeke Ashton: My categorization is a bit simplistic, but I do think some investors are naturally wired to take a high-percentage approach to beating the market through the accumulation of small advantages over time.

Others are naturally more inclined to take the proverbial big swings in an attempt to hit the home runs that can really move the needle and drive outstanding performance. As you say, both are legitimate approaches to beating the market.

My preference for the high probability road is mostly because it’s more compatible with my personality and risk tolerance. I find it comforting to know that over a large enough sample of decisions, luck tends to even out and one is left with a track record that more or less reflects one’s skill level.

For the same reason that a skilled sports team playing a less skilled team should prefer to play a seven game series rather than a one-game playoff, we want our results over time to reflect our skills and not our luck. We also have made enough mistakes to know that we are fallible.

We don’t want one or two bad outcomes to define our results for any meaningful period of time. I think it’s important to point out that one factor in favor of the high probability style for Centaur is that we have a co-portfolio management system. My business partner and co-manager Matthew Richey comes up with ideas that are independent of mine.

Matthew would probably be fine with either the home run approach or the high probability approach, but since it is easier for him to adapt to the high probability approach than it is for me to adapt to the home run approach, that’s what we do.

In addition, in 2006 we added a third analyst to our team, Bryan Adkins, and he produces a number of new actionable ideas for us to consider each year. So with three analysts actively hunting for bargains, chances are that we will dig up enough good ideas to populate a 20 or 25 stock portfolio.

Our goal is to deploy capital when we see an idea that we think can allow us to produce a 20% IRR with acceptable risk. If each of us comes up with six new compelling ideas per year, that’s eighteen ideas, not including any previous ideas that are still sitting in our portfolio.

Many times, we have way more qualifying ideas than we have room in the portfolio, so new ideas often are competing with existing ideas for capital. I think that is a healthy dynamic. I also happen to think that the high-probability style is better suited to managing other people’s capital than the home run style.

For example, let us say you happen to be a young Eddie Lampert and 2008 was your first year as a fund manager. You have a five stock portfolio, and you are unlucky and have a -60% year.

You probably don’t get a second year, unless you managed to convince your investors to give you a three or five year lock-up. On the other hand, let’s suppose you are a young Seth Klarman and your portfolio has enough ideas in it to allow your skill to work for you a bit more. You probably didn’t have a great year, but you also likely beat the market.

So it’s not a great way to start, but you probably get a chance to stay in the game for another year or two. This is a critical difference — you can’t succeed in the long term if you don’t stay in the game.

MOI: When it comes to stock selection, what are the key criteria you look for in long positions versus short positions?

Zeke Ashton: I think we are similar to most other value investors in terms of what we are looking for — we are looking for dollar bills trading at a discount, like everyone else. We tend to emphasize finding undervalued businesses based on low multiples to free cash flow or book value since those lend themselves a bit easier to analysis.

But we are flexible and are always looking for stocks that may not appear to be cheap statistically but are nevertheless trading at significant discounts to true underlying business or asset value.

We very much prefer our ideas to take the form of high quality businesses with excellent management that can grow value over the longer term, but we will buy mediocre assets if the price is right. We think being generalists can be an advantage, as we have the flexibility to go digging for bargains in whatever sector we think might be most out of favor or neglected at any given time.

On the short side, we are looking for the polar opposite, though our short ideas tend to fall into a few broad categories. Businesses that chronically burn cash represent one category that has worked for us over time, as are those businesses that have taken on more debt than the cash produced by the business can support.

Finally, we will short fad companies, companies that are aggressive with the accounting and thus over-stating their economic value, or even good companies that are simply egregiously overvalued.

In general, we typically have anywhere between six and twelve individual shorts in our portfolio at any one time.

MOI: How do you generate investment ideas?

Zeke Ashton: We get ideas from all sorts of places. We used to get a sizable number of leads from statistical screening, and we still use screens, but we have found them in recent years to be more productive in sourcing short ideas rather than long ideas. Nevertheless, we still scan through lists of stocks that appear to be cheap from a statistical basis and occasionally we find a good one.

One of our major idea sources these days is from the inventory of the many ideas we’ve owned or researched at some point in the past – many times, after we’ve sold those stocks, the price will come back down to a level that makes them very interesting again. Since we generally already know the company, it is just a matter of getting quickly up to speed with the latest developments to determine if it is actionable.

We also find occasional ideas by doing industry overviews to get to know a number of players in a specific sector or niche that we think may be out of favor or neglected for some reason. Often we will find a gem or two.

Finally, we get some ideas through our network of value investing contacts, and through a number of specialized research publications that we have found are compatible with our approach, of which your own publication would be one example.

But no matter the source, the ideas are merely candidates until we’ve actually produced a piece of internal research that covers the bases and gives us confidence that we understand the business, can reasonably value it and also gauge the risks factors involved. And of course, the stock has to be cheap.

MOI: What is the single biggest mistake that keeps investors from reaching their goals?

Zeke Ashton: That’s a tough question. There are a probably an infinite number of ways one can screw things up. But I think one can capture a very large percentage of the possible mistakes under one broad roof by saying that a lack of a coherent investment strategy that makes sense and can be followed with discipline and perseverance is the biggest mistake investors make. Without an intelligent framework for making decisions, it’s awfully hard to succeed.

MOI: What books have you read in recent years that have stood out as valuable additions to your investment library?

Zeke Ashton: In my opinion, the most important investing book to come along in many years has been Fooling Some of the People All of the Time by David Einhorn. In writing a story about a “garden variety fraud” at a company called Allied Capital and his efforts to expose it, this book sheds a lot of light on the ugly realities of our financial regulatory system and how that system has become so terribly dysfunctional.

The system is particularly unjust to short sellers who do the difficult and thankless work of uncovering fraud or excess risk at publicly traded companies.

To those who wonder how a fraud on the scale of that perpetuated by Bernie Madoff could have gone undetected for so long, this book provides some answers. As an aside, it took a lot of courage for Mr. Einhorn to continue his struggle against Allied Capital and to publish this book, as the personal risks to his business and reputation were very real. For that, he has my respect and admiration.

The investing book I read most recently was More Mortgage Meltdown by Whitney Tilson and Glenn Tongue of T2 Partners. The book is a very readable and accessible discussion of how the mortgage crisis happened, and more importantly, offers some very good perspective on how the credit crisis may develop from here.

In addition, there are a number of timely investment ideas presented in the form of detailed case studies that will be valuable for both beginner and advanced investors.

I should disclose that Whitney and Glenn are friends of mine and that my firm manages the Tilson Dividend Fund through a joint venture with T2 Partners. So while I am no doubt a bit biased, I enjoyed the book and found it very stimulating food for thought.

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