I’m always watching what Seth Klarman is buying. He is currently one of the world’s greatest value investors. He recently on Feb. 10th via the Edgar S.E.C. Archive purchased a small position in Tronox Inc.
Tronox Incorporated is engaged in the production and retailing of titanium dioxide pigment which is used in paint, coatings, plastics, paper and many other everyday products. The company also offers electrolytic manganese dioxide, which is used as active cathode material for alkaline batteries; lithium manganese dioxide that is used as rechargeable battery material; sodium chlorate for the pulp and paper industry; boron trichloride, a specialty chemical gas, which is used in various products, including pharmaceuticals, semiconductors, high-performance fibers, specialty ceramics, and epoxies; and elemental boron that is used in igniter formulations for defense, pyrotechnic, and air bag industries. Tronox Incorporated and is based in Oklahoma City, Oklahoma.
Witmer: We like companies that have a strong management team that understands how to allocate capital. Little is more upsetting than when they overpay for an acquisition or squander cash by repurchasing shares at too high a price. We also like companies that generate free cash flow and will pay some of it out in the near future in dividends or share buybacks if the stock is undervalued. And we want companies whose balance sheets give them staying power in a crisis.
Last year I recommended Tronox [TROX] at $94 a share. Now it is $125. Tronox manufactures titanium dioxide and is one of five companies with the technology to produce it via the chloride method, which is cost-efficient and environmentally friendly. Tronox recently announced a merger with a division of Exxaro Resources [EXX.South Africa], a South African company that mines titanium dioxide feedstock. This will make Tronox vertically integrated. The acquired business has a 1.5-million-ton stockpile of ilmenite, the feedstock, which is in tight supply.
Tronox hit a high of $165 last year. Shares have backed off due to market turmoil, mixed feelings about the acquisition and uncertainty regarding the economy. Most important, sales of titanium dioxide were slow in the fourth quarter. Investors didn’t understand this was a seasonally weak period. Insiders have been buying shares at Kronos Worldwide[KRO], a Tronox competitor, which adds credence to our theory.
Schafer: Tronox came out of bankruptcy court last year. Why did the company go broke?
Witmer: It was spun out of Kerr-McGee with a lot of environmental liabilities and debt. Then the financial crisis hit. But there have been positive surprises since I recommended it last year. Tronox has tax-loss carryforwards that are worth about $30 a share. And the company has incredible earnings power, in the range of $20 to $30 a share. I had guessed it was around $12 a share. Some think it is overearning because of the tight supply situation, but even using an 11 multiple of my prior estimate and adding the tax assets and the next 12 months’ free cash flow gets you a target price of more than $190 a share. If earnings continue to grow at the current rate, they might be sustainably closer to $20, which gives you a $250 stock.
Here is the link to the S.E.C. reporting document known as a SC13G: http://www.sec.gov/Archives/edgar/data/1061768/000106176812000022/0001061768-12-000022-index.htm
The financial collapse of 2008 highlighted our national predicament. The sudden decline in consumer activity that followed the plunges in the housing and stock markets represented a reasonable – indeed a desirable – response to overindebtedness. Yet the federal government saw this well-advised retrenchment as cataclysmic, because the national economy had grown dependent on our living beyond our means. The imagination of our financial leaders remains so shallow that their response to a crisis caused by overleverage and excess has been to recreate, as nearly as possible, the conditions that fomented it, as if the events of 2008 were a rogue wave of financial woe that can never recur. It is only in Fantasyland that the solution to vastly excessive debt is more debt and the answer to overconsumption is less saving and more spending. Worse still, we have yet to see a serious assessment by policymakers of the causes of the 2008 financial market and economic collapses so that we might take action to ward off a repeat performance. The government’s knee-jerk response to contraction was to prop up economic activity by any and every means possible; the hole in consumer activity had to be materially repaired on the government tab. While Treasury Secretary Timothy Geithner ingenuously professes a belief that the U.S. will never lose its AAA rating, Moody’s recently warned that, absent a change, a downgrading could be just around the comer. Or, in the words of David Letterman, “I heard the U.S. debt may now lose its triple-A rating. And I said to myself, well who cares what the auto club thinks.”
Most of us learned about the Great Depression from our parents or grandparents who developed a “Depressionmentality,” by which for decades people shunned leverage, embraced thrift, and thought twice before quitting their secure jobs to join risky ventures. By bailing out the economy rather than allowing the pain of the economic and market collapses to be felt, the government has endowed our generation with a “really-bad-couple-of-weeks-mentality”: no lasting lessons are learned; the government endlessly intervenes in the economy, and, ironically, the first thing to strongly rebound from the 2008 collapse isn’t jobs or economic activity but speculation.
Benjamin Graham’s margin-of-safety concept – to invest at a sufficient discount so that even bad luck or the vicissitudes of the business cycle won’t derail an investment – is applicable to the economy as a whole. Bridges intended for ten-ton trucks are overbuilt by engineers to hold vehicles of 30 tons. Responsible investors assume their best judgments will sometimes go awry and insist on bargain purchases that allow room for error. Likewise, an economy built with no margin of safety will eventually implode. Governments that run huge deficits, promise entitlements that will be next-to impossible to deliver, and depend on the beneficence of foreigners to stay afloat inevitably must collapse – perhaps not imminently but eventually, as Greece and Ireland have recently discovered.
It is clear, both in the financial markets and in government policy, that no long-term lessons have been drawn from the events of 2008. A friend recently posited that adversity is valuable not for what it teaches but for what it reveals. The current episode of financial adversity reveals some unpleasant truths about the character and will of our country and its leaders, and offers an unpleasant picture of the future that awaits, unless we quickly find a way to change course.
The Demonization of Short-Seller
While we rarely sell securities short – both because of the degree of execution difficulty and theoretically unlimited risk compared to limited potential return – we do believe that short-selling serves a vitally important function. Markets, of course, fluctuate; driven by human emotion, greed, and fear, they can reach significantly overvalued levels. This is bad, both because it can induce some who cannot afford losses to speculate, and because it can lead to an improper allocation of society’s resources. The recent housing bubble illustrates the problem: excessive home prices led to excessive home building, eventually resulting in a price collapse, large loan losses, and great personal hardship. In addition, the decline that follows periods of market overvaluation is bad for the broader economy, for confidence, and for rational decision making; it also frequently triggers government intervention in markets, with all of its inevitable distorting effects. Just as value buyers can dampen downside volatility, short-sellers can dampen the upside excesses. They don’t actually change the eventual outcomes, just help us get there sooner. This makes short-sellers unpopular, as the uninformed masses enjoy high and rising securities prices for the short-term profits they produce, without understanding the societal costs of the future reversal. The less you understand valuation, the more that overvaluation seems like a free lunch – which of course it isn’t.
From our experience, much long-oriented analysis is simplistic, highly optimistic, and sloppy. Short-sellers, by going against the long-term tide of economic growth and the short-term swells of public opinion and margins calls, are forced to be crackerjack analysts. Their work product is usually top-notch and needs to be. Short-sellers shouldn’t be reviled or banned; most should be celebrated and encouraged. They are the policemen of the financial markets, identifying frauds and cautioning against bubbles. In effect, they protect the unsophisticated from predatory schemes that regulators and enforcement agencies don’t seem able to prevent.
Moreover, the short-seller who is fundamentally wrong, who mistakenly sells short an undervalued security, will lose money and, if the pattern continues, will eventually go broke. Short-sellers, like long-only buyers, need to be right more than they are wrong; when they are right, their actions are socially beneficial, not harmful. The only exception to this point, the only danger short-sellers pose to society, is when, in the equivalent of yelling “fire” in a crowded theatre, they spread false rumors that prevent a company that needs regular financing (such as brokerage firms) from being funded. Then, their predictions become self-fulfilling prophecies, enabling them to profit, whether or not they were fundamentally correct; they may actually be able to change the outcome. Yet, even in this situation, one may wonder whether any company – or highly leveraged government, for that matter – should employ a funding model that depends on perpetual access to the capital markets, which are notoriously fickle, volatile, subject to the influence of malicious gossip, and short-term oriented. In any event, mechanisms such as the uptick rule and rules against market manipulation already exist to prevent such misbehavior by short-sellers.
A Framework for Investment Success
Two elements are vital in designing an investment approach for long-term success. First, answer the question, ”what’s your edge?” In highly competitive financial markets, with thousands of very smart, hardworking participants, what will enable you to reliably outperform the field? Your toolkit is critically important: truly long-term capital; a flexible approach that enables you to move opportunistically across a broad array of markets, securities, and asset classes; deep industry knowledge; strong sourcing relationships; and a solid grounding in value investing principles.
But because investing is, in many ways, a zero-sum activity in which your returns above the market indices are derived from the mistakes, overreactions or inattention of others as much as from your own clever insights, there is a second element in designing a sound investment approach: you must consider the competitive landscape and the behavior of other market participants. As in football, you are well-advised to take advantage of what your opponents give you: if they are defending the run, passing is probably your best option, even if you have a star running back. If scores of other investors are rigidly committed to fast-growing technology stocks, your brilliant tech analyst may not be able to help you outperform. If your competitors are not paying attention to, or indeed are dumping, Greek equities or U.S. housing debt, these asset classes may be worth your attention, regardless of the currently poor fundamentals that are driving others’ decisions. Where to best apply your focus and skills depends partially on where others are applying theirs.
When observing your competitors, your focus should be on their approach and process, not their results. Short-term performance envy causes many of the shortcomings that lock most investors into a perpetual cycle of underachievement. You should watch your competitors not out of jealousy, but out of respect, and focus your efforts not on replicating others’ portfolios, but on looking for opportunities where they are not.
Much of the investment business is centered around asset-gathering activities. In a field dominated by a short-term, relative performance orientation, significant underperformance is disastrous for retention of assets, while mediocre performance is not. Thus, because protracted periods of underperformance can threaten one’s business, most investment firms aim for assured, trend-following mediocrity while shunning the potential achievement of strong outperformance. The only way for investors to significantly outperform is to periodically stand far apart from the crowd, something few are willing or able to do.
In addition, most traditional investors are limited by a variety of constraints: narrow skill-sets, legal restrictions contained in investment prospectuses or partnership agreements, or psychological inhibitions. High-grade bond funds can only purchase investment-grade bonds; when a bond falls below BBB, they are typically forced to sell (or think that they should), regardless of price. When a mortgage security is downgraded because it will not return par to its holders, a large swath of potential purchasers will not even consider buying it, and many must purge it. When a company omits a cash dividend, some equity funds are obliged to sell that stock. And, of course, when a stock is deleted from an index, it must immediately be dumped by many. Sometimes, a drop in a stock’s price is reason enough for some holders to sell. Such behavior often creates supply-demand imbalances where bargains can be found. The dimly lit comers and crevasses existing outside of mainstream mandates may contain opportunity. Given that time is often an investor’s scarcest resource, filling one’s in-box with the most compelling potential opportunities that others are forced to or choose to sell (or are constrained from buying) makes great sense.
Price is perhaps the single most important criterion in sound investment decision making. Every security or asset is a “buy” at one price, a “hold” at a higher price, and a “sell” at some still higher price. Yet most investors in all asset classes love simplicity, rosy outlooks, and the prospect of smooth sailing. They prefer what is performing well to what has recently lagged, often regardless of price. They prefer full buildings and trophy properties to fixer-uppers that need to be filled, even though empty or unloved buildings may be the far more compelling, and even safer, investments. Because investors are not usually penalized for adhering to conventional practices, doing so is the less professionally risky strategy, even though it virtually guarantees against superior performance.
Finally, most investors feel compelled to be fully invested at all times – principally because evaluation of their performance is both frequent and relative. For them, it is almost as if investing were merely a game and no client’s hardearned money was at risk. To require full investment all the time is to remove an important tool from investors’ toolkits: the ability to wait patiently for compelling opportunities that may arise in the future. Moreover, an investor who is too worried about missing out on the upside of a potential investment may be exposing himself to substantial downside risk precisely when valuation is extended. A thoughtful investment approach focuses at least as much on risk as on return. But in the moment-by-moment frenzy of the markets, all the pressure is on generating returns, risk be damned.
What drives long-term investment success? In the Internet era, everyone has a voluminous amount of information but not everyone knows how to use it. A well-considered investment process – thoughtful, intellectually honest, teamoriented, and single-mindedly focused on making good investment decisions at every turn – can make all of the difference. Investors with short time horizons are oblivious to kernels of information that may influence investment outcomes years from now. Everyone can ask questions, but not everyone can identify the right questions to ask. Everyone searches for opportunity, but most look only where the searching is straightforward even if undeniably highly competitive.
In the markets of late 2008, everything was for sale as investors were caught in a contagion of selling due to panic, margin calls, and investor redemptions. Even while modeling very conservative scenarios, many securities could have been purchased at extremely attractive prices – if one had capital with which to buy them and the stamina to hold them in the face of falling prices. By late 2010, froth had returned to the markets, as investors with short-term relative performance orientations sought to keep up with the herd. Exuberant buying had replaced frenzied selling, as investors purchased securities offering limited returns even on far rosier economic assumptionss.
Most investors take comfort from calm, steadily rising markets; roiling markets can drive investor panic. But these conventional reactions are inverted. When all feels calm and prices surge, the markets may feel safe; but, in fact, they are dangerous because few investors are focusing on risk. When one feels in the pit of one’s stomach the fear that accompanies plunging market prices, risk-taking becomes considerably less risky, because risk is often priced into an asset’s lower market valuation. Investment success requires standing apart from the frenzy – the short-term, relative performance game played by most investors.
Investment success also requires remembering that securities prices are not blips on a Bloomberg terminal but are fractional interests in – or claims on – companies. Business fundamentals, not price quotations, convey useful information. With so many market participants fixated on short-term investment performance, successful investing requires a focus not on how one is doing, but on corporate balance sheets and income and cash flow statements.
Government interventions are a wild card for even the most disciplined investors. On one hand, the U.S. government has regularly intervened in markets for decades, especially by lowering interest rates at the first sign of bad economic news, which has the effect of artificially inflating securities prices. Today, monetary easing and fiscal stimulus augment consumer demand, increasing risks not only regarding the integrity and sustainability of securities prices but also those surrounding the sustainability of business results. It is hard for investors to get their bearings when they cannot readily distinguish durable business performance from ephemeral results. Endless manipulation of government statistics adds to the challenge of determining the sustainability – and therefore the proper valuation – of business performance. As securities prices are propped up and interest rates are manipulated sharply lower (thereby justifying those higher prices in the minds of many), prudent investors must demand a wide margin of safety. This is especially so because financial excesses contain the seeds of their own destruction. Market exuberance leads to business exuberance – production of more goods and services than demand ultimately justifies. Of course, when market and economic excesses are finally corrected, there is a tendency to over-shoot, creating low-risk opportunities for value investors who have remained patient and disciplined.
Yet another long-term risk confronts investors: the government’s fiscal and monetary experiments may go awry, resulting in runaway inflation or currency collapse. Bottom-up value investors would not wish to bet the ranch on a macroeconomic view, but neither would they be wise to ignore the macroeconomy altogether. Disaster hedging – always an important tool for investors – takes on heightened significance in today’s unprecedentedly challenging environment. Yet, as this insight is not unique to us, the cost of insurance is high. There are no easy ways to navigate these turbulent waters. But because the greatest risks are of currency debasement and runaway inflation, protection against a currency collapse – such as exposure to gold – and against much higher interest rates seem like necessary hedges to maintain.
Either is fine. a) is better for small sums. b) is better for large sums
[Mr. Buffett, on June 23, 1999 you shared with Business Week:
If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.]
[At a talk to Columbia students in 1993 you shared:
When I got out of Columbia the first place I went to work was a five-person brokerage firm with operations in Omaha. It subscribed to Moody’s industrial manual, banks and finance manual and public utilities manual. I went through all those page by page.
I found a little company called Genesee Valley Gas near Rochester . It had 22,000 shares out. It was a public utility that was earning about $5 per share, and the nice thing about it was you could buy it at $5 per share.
I found Western Insurance in Fort Scott, Kansas. The price range in Moody’s financial manual…was $12-$20. Earnings were $16 a share. I ran an ad in the Fort Scott paper to buy that stock.
I found the Union Street Railway, in New Bedford, a bus company. At that time it was selling at about $45 and, as I remember, had $120 a share in cash and no liabilities.]
[Along similar lines, in late 2005 I understand you explained to a group of Harvard students the following:
Citicorp sent a manual on Korean stocks. Within 5 or 6 hours, twenty stocks selling at 2 or 3x earnings with strong balance sheets were identified. Korea rebuilt itself in a big way post 1998. Companies overbuilt their balance sheets – including Daehan Flour Mill with 15,000 won/year earning power and selling at “2 and change” times earnings. The strategy was to buy the securities of twenty companies thereby spreading the risk that some of the companies will be run by crooks. $100 million was quickly put to work.]
[The “1987” Fisher Approach -The following excerpts from an article written by Carol Loomis published on April 11, 1988 in Fortune provide interesting clarity on the modus-operandi of Berkshire circa 1987:
Unusual Profitability (High ROE with Low Debt; i.e. high ROIC) – …But in his 1987 annual report, Buffett the businessman comes out of the closet to point out just how good these enterprises and their managers are. Had the Sainted Seven operated as a single business in 1987, he says, they would have employed $175 million in equity capital, paid only a net $2 million in interest, and earned, after taxes, $100 million. That’s a return on equity of 57%, and it is exceptional. As Buffett says, ”You’ll seldom see such a percentage anywhere, let alone at large, diversified companies with nominal leverage.”
Unusual Growth (Opportunities for Reinvestment of Retained Earnings) – …Some folks of the right sort, by the name of Heldman, read that ad and brought him their uniform business, Fechheimer, in 1986. The business had only about $6 million in profits, which is an operation smaller than Buffett thinks ideal. …A few hundred miles away at Fechheimer ( …1987 sales: $75 million)
Paying for Quality – …By 1972, Blue Chip Stamps, a Berkshire affiliate that has since been merged into the parent, was paying three times book value to buy See’s Candies, and the good-business era was launched. ”I have been shaped tremendously by Charlie,” says Buffett. ”Boy, if I had listened only to Ben, would I ever be a lot poorer.]
[CM: If See’s Candy had asked $100,000 more [in the purchase price; Buffett chimed in, “$10,000 more”], Warren and I would have walked — that’s how dumb we were.]
[Ira Marshall said you guys are crazy — there are some things you should pay up for, like quality businesses and people. You are underestimating quality. We listened to the criticism and changed our mind. This is a good lesson for anyone: the ability to take criticism constructively and learn from it. If you take the indirect lessons we learned from See’s, you could say Berkshire was built on constructive criticism. Now we don’t want any more today. [Laughter]]
The qualitative [evaluating management, competitive advantage, etc.] is harder to teach and understand, so why not just focus on the quantitative [e.g., cigar butt investing]? Charlie emphasized quality [of a business] much more than I did initially. He had a different background.
It makes more sense to buy a wonderful business at a fair price. We’ve changed over the years in this direction. It’s not hard to watch businesses over 50 years and learn where the big money can be made.
Even when you get a new important idea, the old ideas are still there. There wasn’t a strong line of demarcation when we moved from cigar butts to wonderful businesses. But over time, we moved.
We started out this snowball at the top of a very long hill. My advice is either start very early or live very long. I guess I’d do it the same way: maybe I’d start with small companies and buy good businesses. Or little pieces of ‘em called stocks.
[CM: The first $100,000 is probably the hardest part. Staying rational and significantly underspending your income helps, too.]
If we were to do it over again, we’d do it pretty much the same way. The world hasn’t changed that much. We’d read everything in sight about businesses and industries we think we’d understand. And, working with far less capital, our investment universe would be far broader than it is currently.
There’s nothing different, in my view, about analyzing securities today vs. 50 years ago.
We formed our first partnership 50 years and two days ago, on May 4, 1956, with $105,000. If we were starting again, Charlie would say we shouldn’t be doing this, but if we were, we’d be investing in securities around the world. Charlie would say we couldn’t find 20, but we don’t need 20 – we only need a few that can pay off very big. We’d also be buying [stocks in] smaller companies.
If we were planning to buy [entire] businesses, we’d have a tough time. We’d have no reputation and only $1 million.
Charlie started out in real-estate development because with only a little capital, brain power and energy, you could magnify the returns in real estate unlike in other sectors.
I’d just do it one foot in front of the other over time. But the basic principles wouldn’t be different. If I’d been running a little partnership three years ago, I’d have started out 100% in Korea.
Munger: You should find something to invest in and then compare everything else against that. That’s your opportunity cost. That’s what you learn in freshman economics, even if it hasn’t made it into modern portfolio theory. That’s why modern portfolio theory is so asinine.
Buffett: It really is.
Munger: When Warren said he’d put 100% of his fund in Korea, maybe he wouldn’t quite do that, but pretty much. Most people won’t find a lot of great things [to invest in]. Instead, you’ll want to find a few things that are much better than anything else. Act on these.
[RE: How Buffett Would Invest with a Small Amount of Money]
If I were working with a very small sum – you all should hope this doesn’t happen – I’d be doing almost entirely different things than I do. Your universe expands – there are thousands of times as many options if you’re investing $10,000 rather than $100 billion, other than buying entire businesses. You can earn very high returns with very small amounts of money. Everyone can’t do it, but if you know what you’re doing, you can do it. We cannot earn phenomenal returns putting $3, $4 or $5 billion in a stock. It won’t work – it’s not even close.
If Charlie and I had $500,000 or $2 million to invest, we’d find little things we could do, not all of it in stocks.
Munger: But there’s no point in our thinking about that now.
You have to find your passion in life. I would choose the same job. I enjoy it. It is a terrible mistake to sleepwalk through your life. Unless Shirley MacLaine is right, you won’t have another one. My dad had a business with [investment] books on his shelves, and they turned me on. This was before Playboy. If he was a minister, I’m not sure I would have been as enthused. If you have obligations, you have to deal with realities. I tell students to go work for an organization you admire or an individual you admire, which usually means that most MBAs I meet become self-employed. [laughter] I went to work for Ben Graham. I never asked my salary. Get the right spouse. Charlie talks about the man who spent twenty years looking for the perfect woman and found her. Unfortunately, she was looking for the perfect man. If you are lucky, you will be happy and as a result, you will behave better. It makes it easier.
CM: You’ll do better if you have passion for something in which you have aptitude. If Warren had gone into ballet, no one would have heard of him.
WB: Or would have heard of me very differently. [laughter]
[Q – With small sums of money, what strategies would you pursue?]
WB: If I were working with small sums of money, it would open up thousands of possibilities. We have found very mispriced bonds. We found them in Korea a few years ago. You could make big returns but had to be of small size. I wouldn’t be in currencies with a small amount of money. I had a friend who used to buy tax liens. I’d look in small stocks or specialized bonds. Wouldn’t you say that, Charlie?
[Q – If you were starting a $26 million fund, what would you do differently with a smaller asset base? How many positions would you hold, and what kind of turnover would you have? What would you do if some investments lost 50% and some gained?]
Buffett: We would hold the half-dozen stocks we liked best. We would do the same thing if they lost 50%. Cost has nothing to do with it. We look at price and think about what something is worth. Keep it in the few you know.
Munger: He [Buffett] has tactfully suggested you adopt a different way of thinking. [laughter]
[Comment: As Buffett stated, cost basis has nothing to do with investment judgment (apart from tax considerations). Nevertheless, many investors (like the questioner) pay way too much attention to what they’ve paid, rather than its value.]
Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.
You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.
Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.
The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn’t have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.
I know more about business and investing today, but my returns have continued to decline since the 50’s. Money gets to be an anchor on performance. At Berkshire’s size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.
Attractive opportunities come from observing human behavior. In 1998, people behaved like frightened cavemen (referring to the Long Term Capital Management meltdown). People make their own opportunities. They will be frozen by fear, excited by greed and it doesn’t matter what their IQ, degrees etc is. Growth of 50% per year is with small capitalization, not large cap. The point is I got rich looking for stock with strong earnings.
The last 50 years weren’t unique. It’s just capitalizing on human behavior. It’s people that make opportunities when others are frozen by fear or excited by greed. Human behavior allows for success if you are able to detach yourself emotionally.
In 1951, I got out of school at 20 years old. At the time there were two publishers of stock information, Moody’s and Standards and Poor’s. I used Moody’s and went through every manual. I recently bought a copy of the 1951 Moody off of Amazon. On page 1433, there’s a stock you could have made some money on. The EPS was $29 and the Price Range was from $3-$21/share. On another page, there is a company that had an EPS of $29.5 and the price range was $27-28, 1x earnings. You can get rich finding things like this, things that aren’t written about.
A couple of years ago I got this investment guide on Korean stocks. I began looking through it. It felt like 1974 all over again. Look here at this company…Dae Han, I don’t know how you pronounce it, it’s a flour company. It earned 12,879 won previously. It currently had a book value of 200,000 won and was earning 18,000 won. It had traded as high as 43,000 and as low as 35,000 won. At the time, the current price was 40,000 or 2 times earnings. In 4 hours I had found 20 companies like this.
The point is nobody is going to tell you about these companies. There are no broker reports on Dae Han Flour Company. When you invest like this, you will make money. Sure 1 or 2 companies may turn out to be poor choices, but the others will more than make up for any losses. Not all of them will be good, but some will and those will make you rich. And this didn’t happen in 1932, this was in 2004! These opportunities will be there in the next 30 years. You’ll have streaks where you’ll find some bad companies and a few times where you’ll make money with everything that you do.
The Wall Street analysts are brilliant people; they are better at math, but we know more about human nature.
In your investing life you will have several opportunities and one or two that can’t go wrong. For example, in 1998 the NY fed offered a 30-year treasury bonds yielding less then the 29-½ year treasury bonds by 30 basis points. What happened was LTCM put a trade on at 10 basis points and it was a crowded trade, they were 100% certain to make money but they could not afford any hiccups. I know more about human nature; these were MIT grads, really smart guys, and they almost toppled the system with their highly leveraged trading.
This was definitely a good time to act.
I was misquoted in that article. I get together with about 60 people every couple years and get their expectations of returns. Of those investors, I think there’s a half dozen who could get those kinds of returns – but they’re only going to find those returns in small places.
I stumble onto those things occasionally but I’m not looking for them. I’m looking for things that Berkshire Hathaway can do.
Baupost Annual Meeting – October 29, 2009
• First annual meeting since founding of the firm.
• Many of the largest University Endowments in the crowd.
Seth Klarman – Portfolio Manager
• They recognized 18 months ago that the opportunities were about to get really good. This was as they started seeing panic sellers and limited buyers.
• They were able to source large lumpy offerings for securities.. Especially mortgages.
• There currently is a large and GROWING supply of distressed securities.
• Typically illiquid and highly complex.
• In early 2008 it was an advantage to have a large amount of assets under management.
• Feels it is the most interesting time in his career to be an investor.
• Risks continue to be numerous and enormous. Makes for great opportunities.
• Cards of the economic future have not been dealt yet.
• Stimulus will eventually have to be removed.
• In this environment they prefer debt to equity – less risk.
• Cash is building in the fund – around 30%. May raise more in the future.
• With the market rallying, it is creating a huge amount of pressure on the investment community to perform and keep up. This will create opportunities as people chase returns – not Baupost’s game – will not play it.
• It has been hard to stay away from the crowd.
• Baupost’s Goal – remain excellent.
• Value approach – always looking for bargains.
• Over the long run, the crowd is always wrong.
• Hold cash when opportunities are not presenting themselves.
• Great investments don’t just knock on the door and say “buy me.”
• What is their edge on a name?
o Must have superior information.
o Ability to be long term.
o Well founded contrarian view.
o Complexity – limits competition.
• Flexible approach – will look at ALL asset classes.
• Like to have a catalyst – reduces dependence on the market.
• Distressed debt inherently has a catalyst – maturity.
• EXCESSIVE DIVERSIFICATION DILUTES RETURNS.
• Not market neutral.
• Risk management must be a 24/7 365 job.
• Risk is NOT volatility.
• Volatility is GOOD.
• NOT true that higher risk leads to high returns.
• And.. NOT true that high returns only come from high risk.
• Risk is the probability of losing money and the amount you can lose.
• They don’t worry about career risk.
• As Jean-Marie Eveillard says.. they would rather lose half of their clients than lose half of their clients money
• No forced selling anywhere right now.
• In down markets they sow seeds, in up markets they harvest.
• Future always unpredictable.
• Need a margin of safety.
• Limit Risk with:
o Deep analysis.
o Bargain purchase.
o Sensitivity analysis.
o Don’t use any recourse leverage on the portfolio.
o Need a catalyst.
o Great majority of personal assets in the fund.
• It is crucial in a sound investment process to search a mile wide than a mile deep with they find something – also.. never stop digging for information.
• In employees, he values investment curiosity and intellectual honesty.
• Need to rigorously separate fact from fiction.
• Team based collaborative culture.
• Avoid organizing investment team into silos.
• Team of generalists.
• Always look for forced urgent selling.
• Don’t short many stocks. Instead they hedge for tail risk with CDS and options.
• They are happy to incur illiquidity.
• Illiquidity risk is a risk they LOVE.
• Comfortable holding cash for tomorrow’s opportunity.
• They find it is hard to un-train people so they try to hire young.
• Learning organization.
• Can’t let client pressures or market pressures distract them.
• An understanding that their clients expect certain times of underperformance.
Herb Wagner – Head of Public debt and equities
• Very focused on RMBS, CDS of all kinds, Distressed corp. debt, and equities in US and Europe.
• When your team is organized into silos, people only recommend ideas in their silo.
• Find ideas from – reading, sell side analysts, buy side friends, and existing investments.
• Best ideas are internally generated.
• Once they have an idea, it flows up to the team leaders. As part of weekly meetings they discuss everything. Everyone knows what each other are working on.
• They have traders in the office 24 hours a day. Eyes and ears of the firm.
• The edge they have is figuring out what organizations are having to sell certain securities.
• Existing Portfolio
o 60% public
o o5-8% equities
o Rest is Debt
• Structured Finance 22-25%.
• Next few years will still provide great debt opportunities.
• 1 trillion corp. debt maturing in next 4-5 years. Lots will be extended and refinanced, but lots will default.
• Loves RMBS – Most of these bonds will not trade back to par. Limits the buyers.
• The previous stretch of financial stability lead to more risk being taken. History screwed everyone. I.e. the experts modeled historical returns for home prices. How many times did you hear “home prices don’t go down”?
o Technology systems are extremely important in analyzing.
o Need to have a good sense of where housing markets will bottom.
o They started in this space by shorting RMBS in 2007 and 2008.
o INTEX is the best software for analyzing RMBS.
o During the dislocation calls would come in Friday at 4pm from the dealers who were liquidating mortgage portfolios for mutual funds. They would give them 3 hrs to bid.
o Need to understand structures.
o Most mortgage experts don’t even understand the structures. Very confusing.
o Analyzed housing in different collapses.
o Looked at affordability than stressed it another 20%
o Used a rental yield of 10%
o Attended distressed real estate auctions in CA.
o March 2008 Peloton blew up and that was their first purchase of RMBS – was too early.
o They bought these bonds 20% below their mark the previous day.
o But.. this established Baupost as a player in the market.
o Bought many mortgages without competing bids.
o There is still a huge shadow inventory of homes that are still to hit the market. Will drive prices down more.
o Case Shiller makes people think that home prices have flattened out. Misleading.
o No slowdown in delinquencies.
o Prices will trade below affordability levels.
o On the RMBS they have been buying, home prices can still go down another 40% and they will recover 56 cents on the dollar.
o Modifications are a huge wild card.
• Bought IO mortgages in the spring – been a big winner.
• SIV’s – this is the first firm I have heard talk about buying SIVs.
o Basically a CDO with highly rated assets.
o Borrowed short and lent long.
o Purchased significant medium term notes of SIVs with yields of 15-50%.
o A SIV is like sausage. Just a bunch of scraps of assets.
o 200-400 different underlying items.
• Auto Finance companies
o They invested 1.8 billion and made 1.2 billion in profits.
o Ford Motor, Chrysler Finance, and GMAC.
o First started buying at mid teen yields.. kept buying and in the heart of the crisis they were buying at 50% yields.
o They love to buy bonds as prices are plummeting. They will just keep buying.
o Seth has said to the team: “It is not us who is having the bad day as we are buying at lower prices than original purchase. … it is the guy who is selling that is having the bad day”.
o They found that people pay their car loans. Loss rates remain low. Downside protection pretty good.
o GMAC was the worst of all. Ford is the best.
o Try to hedge if they can.
o Rarely short stocks.. currently not short any stocks.
o Not L/S fund.
o Seek to be dollar denominated.
o Buy insurance when it is cheap.
o They like hedging interest rates .
o CMS caps and if we get double digit 10 yr rates, they will make a 10X return on the hedge.
Q and A with Seth: Conducted by Roger Lowenstein
Q: Origins of Baupost
A: He bought first stock when he was 10 yrs old. Early on in college worked for Michael Price at Mutual Shares. Baupost was first going to be a family office. Started firm in 1982. Almost 30 yrs old.
Q: Is this crisis different than others you have seen?
A: Stands out in terms of magnitude of what happened. Decades of easy credit. Cats and dogs were getting credit cards. The government intervention is different than previous crisis’. It is huge. Gov won’t even let a garden variety recession happen. More bailouts increase risk. Sooner or later that will blow up as well. Big question keep asking himself is “was it really that easy to just print 2 trillion dollars and solve all the problems”?
Q: Interest rate risk? Has the government solved crisis or just taken on all the problems and setting us up for the “Big One”?
A: Impossible to know what they have brought upon us. A sudden and complete melt down is off the table because of their backstop. As long as they can print money we will be ok. All he cares about is being able to buy when others are panic selling. Usually the forced sellers are index funds and mutual funds.
Q: Do you worry about the dollar?
A: Spent a week in NY a few weeks ago. People were oddly optimistic. Money managers play a funny game. In that they are always trying to make money for clients. Baupost plays a different game. Only buy when the markets are getting beat up.. a long term game. Now.. he thinks there is a third game in town. A macro game. People are trying to time markets right now more than he ever remembers.
He has always worried about Fiat Currency. All governments will print money. Jim Grant influenced him greatly on being nervous about fiat currency. Baupost will own call options on Gold sometimes. He is deeply worried now but does not think it is his mandate to own bullion and miners. Will leave it up to his investors. Interesting because bonds, stocks, and gold are all saying different things. The markets are not agreeing.
Q: Last year people said that stock picking did not work. Only macro mattered. Agree?
A: Bought Ford Motor credit bonds at .40 on the dollar when in a depression they modeled getting .60 on the dollar. The main point is how much did people make this year relative to the amount of risk they took. People don’t care about risk adjusted returns anymore.
He thinks it is a tough job for consultants to sort through who was lucky this year.. vs. who was good.
Q: How did you have the courage to buy after the LEH blowup? And .. what did you do?
A: Was buying before Lehman.. after Lehman.. and since than. Also selling here and there. So many money managers need complete liquidity. He does not care if the market opens or not. Has always assumed that with the right type of issue, the market could close for months.
They bought lots of debt during the LEH crisis. Lots of Auto Finance.
Q: Any investments that stood out or “screamed” at you?
A: Only on the debt side. Equity markets were still expensive. No screaming stocks. If March 9th was really the bottom, it was a very expensive bottom relative to prior cycles… so he stuck with debt.
There was a subsidiary of AIG that was only in the mortgage business. He called them the “Thursday” bonds because he bought them on that Tuesday after the AIG collapse at .47 on the dollar. They matured at par TWO DAYS later.
Also bought another bond at .15 on dollar that has already returned .15 to him in cash and they think is worth .60. pays monthly. It is a structured product that is the senior most piece in the pool. 50% IRR for 5 yrs.
Q: Anything that did not work?
A: Does not see a bargain becoming bigger as a bigger problem. Biggest mistake was holding certain stocks into the crisis. Made them look stupid.
Q: Housing turning?
A: Still huge supply. Prime borrowers have homes that are way below loan value. Will be a long time before market recovers. Base case is another 20% decline… worse case scenario in their mind is 40% down from here.
Q: Stocks are flat for 10 years. Why don’t you own stocks?
A: Try to remain agnostic to stocks or bonds. Only buy stocks when they are cheap. Never got cheap.. certainly not cheap right now. 18X adjusted earnings. Debt however did get cheap.
Q: Do you feel that you have less of an edge in stocks?
A: Always have more of an edge where others aren’t looking or care about. Commercial R/E will get really interesting. Will just go where other aren’t. Stocks are expensive and competitive.
Q: Cash. Why?
A: Cash is more accepted now after last year. Endowments learned lessons on not having any cash. Cash is not a market time call. He uses it to buy assets.
Q: Does the cash position mean that you have too much money under management?
A: Don’t think so. Goal is not to make the highest return possible all the time. Managing 20 billion. Thinks there are advantages to size in this market. Helps in Commercial R/E and Mortgages. The negative is obviously that small ideas don’t move the needle. Will return capital at some point.
The endowment consulting business is screwed up. Endowments all benchmark themselves against how they are doing against each other. … what percentile they are in. this is dangerous because it forces everyone to chase each other and they end up taking too much risk.
The consultants only know how to measure return. They need to focus on risk adjusted return. It is all about generating returns with less risk. That is where the cash comes in.
Q: Do you have a benchmark for your fund?
A: Walked out of a meeting with a client when they wanted to talk with him about what benchmark to use for Baupost. Thought it was a waste of his time and he could not add any value there. He does not want to think about any benchmark other than risk adjusted returns.
Q: Should endowments hedge on their own or leave it to their managers?
A: Hard job for endowments. They have to spend a lot of time worrying about the character of their managers. This is a waste of their time. Its too bad they have to do this because a few bad apples.
Wall Street exists to “rip peoples eyeballs out”. Don’t try hedging yourself. You will get screwed. Also committees are entirely too slow. They will screw it up because they usually want to hedge at times that they feel they need it. This is all wrong. You hedge when you feel you don’t need it. That is when insurance is the cheapest. You want to sell your insurance when others are desperate to buy insurance. This is hard to do.
Finds it interesting that endowment kept adding to their VC and PE managers when it was obvious that it was not a good time to do it. They did it so they would not lose their slot. These asset classes are only good to invest in when people don’t want to be illiquid.
Q: From a public policy standpoint is there anything the government can do to reduce risk?
A: Having a risk regulator makes him laugh. No one will see the risks when things are good. No politician will be able to slow things down when it looks as though everything is good. If anyone would have tried to slow down housing in 2005/2006 they would have been looked at as crazy. Politicians will never take away a punch bowl.
Too big to fail is a disaster for the world. He thought that one positive to the pay czar is it could cause people to not want to be bankers. They need to make higher capital ratios and banks less profitable.
Q: So.. does that mean that JP Morgan should be told it cannot be in the derivative business?
A: The US needs to let AIG go bust. They need to do it NOW. Interventions were well intentioned but highly arbitrary. Let CIT fail, but GMAC gets another loan? That is fishy..
In the past, the reason the US was such a good place to invest has all been wiped over the last 12 months: rule of law, unions benefiting over creditors.. this is hurting our credibility.
General Q & A:
Q: How do you invest your cash
A: Short treasuries
Q: More thoughts on liquidity?
A: thinks it is a great time to make illiquid investments. There is a bubble in people fearing illiquid investments. This is the time to do it because no one else wants to.
These are notes taken from a Columbia Business School conference presented on October 2, 2008.
Seth Klarman at CIMA Conference 10/2/08
1. Biggest fear was buying too soon and on way down, from up in over-valued levels. Knew market collapse was possible and sometimes imagined I was back in 1930. Surely there were tempting bargains and just as surely would have been crushed after decline of next 3 years. A fall from 70 to 20 and fall from 100 to 20, would feel almost exactly the same. At some point being too early becomes indistinguishable from being wrong.
2. Getting in too soon brings risk to all investors. After a stock market has dropped 20% – 30% there is no way to tell when the tides will change. It would be silly to expect that every bear market will turn into a great depression. Yet fair value from under-valued can’t be predicted, and would be equally wrong.
3. As market descends you are tempted with purchasing companies. You will be bombarded with tempting opportunities. You never know how low things will go. When credit contracts and tide goes out on liquidity. At these times recall the wisdom of Graham and Dodd. At this time, you should not market time, but stick to your value convictions. You will see tempting bargains and value imposters. Ignore macro and look to buy cheap.
4. In a market like we have been experiencing. Most investors lose their rudders. They become unwilling to part with cash. They start working on macro economic level. Investors look to pull out of market and wait for a clear signal of change. Value investors should be able to keep their focus and remember Graham and Dodd of 1934.
5. If you can maintain your focus, resist business pressures and have a multifaceted tool kit, you can expect to prosper, even in difficult times.
A. Always recall road map of Graham and Dodd. Revisit this road map when times get difficult. Maintain discipline and value with a margin of safety. This doesn’t mean you won’t lose money. It means if there are drops in price, you have even more of a bargain.
B. Avoid highly leveraged stocks, junk bonds and shaky financials.
C. Look for bargains in various industries and nations.
D. Look at value, not great companies and great management.
E. Listen to Warren Buffett when he states you should buy a stock as if the market would close for a long period of time after you bought the stock.
6. Remain focused on the long run. Graham and Dodd motivate our diligence. They are like silent sentinels. Navigate the best you can and Graham and Dodd are the North Star for value investors.
7. Stand against the prevailing winds, selectively and resolutely. Yet for a while a value investor will under-perform. Interim price declines allow you to average down. Do not suffer the interim losses, relish and appreciate them.
8. Value investing at its core is the marriage between a contrarian streak and a calculator. Buying what is in favor is ensuring long-term under-performance.
9. It is critical to remind your clients, investment team and as often as necessary yourself, that you can only control your process and approach. Understand that you cannot control or forecast the vagaries of the market. Then you should invest in what you believe and what your research dictates. Be indifferent if you lose your short-term oriented clients, remembering that they are their own worst enemies.
10. Controlling your process is essential.
A. Be focused on process, not outcome.
B. Do not judge a decision based on its outcome.
C. During periods of under-performance it is easy to change your process.
D. When a firm is worried about tempers, second-guessing and fear, the process will fail. Look for long-term results; anything else will corrupt the process.
11. Value investing is an art and not a precise science. It is dealing with the fact that we do not work with perfect information.
12. Mechanical rules are dangerous. Graham and Dodd principles should serve as a screen.
1. How do you see current investment climate?
A. James Grant – Look at some MBS and beaten down bonds. Some are priced to yield teens. They are priced for a further 25% decline. Also unsecured debentures of nations top retailers. These are priced at 5% to 7%. Hence, short the retailers at 6% and go long the beaten down mortgages.
B. Seth Klarman – Unusual amount of forced sellers, via margin calls. This could breed opportunity. Sees a lot of money managers staying on the sideline. He finds this as an opportunity to buy. Buy when others react to news or false news. His experience is when people give away stocks out of need, due to fear or margin calls, that sounds like a great buying opportunity. In this environment you are playing against very smart people.
C. Bruce Greenwald – Take a deep breath. All the doomsday talking is not being reflected in stock prices. Stocks are basically down 25%, but unemployment is not great like early 1940’s. You need to put this into perspective like 1991 or 1982.
2. Klarman discussed buying one security at a time. Not everything is a bargain out there. Be selective. Many of us have seen opportunities now, and history says to buy them. We bought knowing that banks are going to fail, that real estate would drop, but that certain mortgage backed securities were under-valued. Never leverage, where you can have an opportunity to buy and not be able to take advantage of it because of leverage.
3. James Grant – Treasuries are yielding less than expected future CPI. Treasuries are now being priced as a macro-economic play. Treasuries are not intrinsically safe. They are not safe based on valuation.
4. What factors do you look at in sizing a position?
Seth Klarman – He thinks this has been missed over the last 15 years. Most of the diversified risk is done via 20 to 25th position. We have had a 10% or so concentrated position about a dozen times over the last 20 years. Most of the time we have 3,5 and 6% position. We will take it higher if we see a catalyst for increased value. We would not own 10% position in a common stock, only because it seemed under-valued. We would have a greater than 10% position if there was a margin of safety. I see managers make mistakes with concentrated positions in similar industries. Small positions of say 1% are nonsensical. We do not use macro views, yet when we hedge, we will use a macro view. We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don’t own gold as a commodity. We won’t disclose our inflation hedge, yet with enough work, you can find true inflation hedges.
State-run Petrobras’ “monstrous” new oil find has wide-ranging implications for the South American country, the oil majors, oil services providers, and beyond.
In a recent radio broadcast, Brazil’s President Luiz Inácio Lula da Silva said he’s convinced a “higher power” has taken a shining to Brazil. That, he said, might explain the providence of state-run oil company Petrobras (PBR), whose colossal new oil discovery could transform Brazil from a barely self-sufficient producer into a major crude exporter.
Petrobras announced Nov. 8 it has found between 5 billion and 8 billion barrels of light oil and gas at the Tupi field, 155 miles offshore southern Brazil in an area it shares with Britain’s BG Group and Portugal’s Galp Energy. Tupi is the world’s biggest oil find since a 12 billion-barrel Kazakh field was discovered in 2000, and the largest ever in deep waters. Perhaps more important, Petrobras believes Tupi may be Brazil’s first of several new “elephants,” an industry term for outsize fields of more than 1 billion barrels.
Initially, Tupi will produce about 100,000 barrels a day but may ramp up to as much as 1 million before 2020—more than the biggest U.S. field in Alaska’s Prudhoe Bay, says Hugo Repsold, Petrobras’ exploration and production strategy manager. “It’s monstrous,” says Matthew Shaw, a Latin America energy analyst at consultant Wood Mackenzie in London.
Given the discovery’s magnitude, Tupi already is changing how Brazilians think about their oil riches. It even tempts the kind of oil nationalism that has prompted Venezuelan President Hugo Chávez to expropriate oil reserves and production infrastructure in Venezuela from oil majors ExxonMobil (XOM) and Chevron (CVX).
Indeed, a day after Petrobras announced the Tupi discovery, Brazil said it would remove 41 oil exploration blocks, located near Tupi, from an upcoming auction of potential oil fields open to private oil companies. Brazil still plans to offer 271 blocks for bidding, however, the government said it’s reanalyzing whether, and how, to share Brazil’s new oil riches with private companies, after a decade of relatively open concessions.
Brazilian oil regulator ANP says it’s drafting a new oil bill to present to congress that would change energy laws, perhaps limiting the role of private companies in Brazil’s subsalt. Additionally, Lula says Brazil should join OPEC once Petrobras begins oil output from Tupi, around 2011.
“This looks to have triggered a major debate about the role of state vs. private oil companies here,” says Sophie Aldebert, a director at Cambridge Energy Research Associates. “But Brazil is going to want to continue working with private companies.”
Despite its size, the Tupi field poses significant engineering hurdles that will drive increased costs in tapping the field. Petrobras currently pumps 1.8 million barrels daily from its Brazilian fields and expects to boost its $112 billion in planned spending over the next five years to assume the Tupi project.
For one, the oil lies some 4.5 miles beneath the ocean’s surface. To reach it, Petrobras will have to run lines through 7,000 feet of water and then drill up to 17,000 feet through sand, rock, and a massive salt layer. A decade ago, geologists lacked the tools to glimpse beneath these salt layers, which can be more than a mile thick offshore Brazil. Today, with the help of data-crunching supercomputers, 3D imaging of ultradeep subsalt layers is illuminating billions of barrels of new oil. Geologists say the discoveries challenge one of the notions of the peak oil theory, which claims oil companies already have found nearly all of the world’s usable oil.
Petrobras is already one of a handful of big oil companies, including Royal Dutch Shell (RDSB), BP (BP), Chevron, and ExxonMobil, with vast experience in deepwater drilling. Much of Brazil’s oil production is in deep water, but none yet comes from below the salt canopy.
The prized light crude Petrobras is finding may soon place Brazil “somewhere between Nigeria and Venezuela” in terms of proved reserves, Petrobras CEO José Sérgio Gabrielli said last week. Nigeria now holds around three times Brazil’s 12 billion barrels of proved oil and gas, while Venezuela has around seven times as much.
In one rough estimate, Petrobras’ Repsold says the company might need to drill 100 wells to develop Tupi. Shaw believes that means Tupi may cost between $50 billion and $100 billion to develop. A first well at Tupi cost $240 million and required two years to drill. “But we’re getting much faster,” Repsold says. Subsequent wells have cost around $60 million apiece and taken six months or less. Petrobras declined to estimate what it will cost to develop Tupi, saying more study and drilling are needed.
“Nobody ever produced oil at these depths,” says Cambridge’s Aldebert. “Petrobras will do everything in its power to be the first, but any major dip in world oil prices could hurt the plans.”
For now, with oil prices near record highs, the new discovery is good tidings for both Brazil and companies in Texas, headquarters for the industry that builds and leases offshore drilling rigs capable of reaching underneath massive offshore salt, to depths of 30,000 feet or more. Only about 40 such rigs exist in the world today, operated by Texas companies including Transocean (RIG) and its merger partner GlobalSantaFe (GSF), Noble Corp. (NE), Diamond Offshore Drilling (DO), and Pride International (PDE).
Before oil production starts at Tupi, companies that build and service massive offshore oil platforms—from shipyards in Singapore to Texas, and engineering firms and drilling experts such as France’s Technip or Houston-based Schlumberger (SLB) and Halliburton (HAL)—may also reap its rewards. If Tupi pumps roughly 1 million barrels a day, it may require five or six of the largest capacity offshore platforms available, which currently cost more than $1 billion apiece. Petrobras’ largest offshore platform can now handle 180,000 barrels per day.
Geologist Roberto Fainstein, whose seismic imaging work at oil-field services company Schlumberger helped Brazil to discover its massive new reserves, says the subsalt find will “lead to a rush in this kind of drilling worldwide.” Brazil’s discovery may quicken subsalt drilling in the Gulf of Mexico by oil majors and Mexico’s state-run oil giant Pemex. A salt layer offshore West African countries including Angola, Gabon, and Equatorial Guinea is “virtually identical to Brazil’s,” Fainstein says, “so companies will race to begin drilling it.”
Subsea salt layers are present in all three of the world’s biggest offshore oil areas: the Gulf of Mexico, West Africa, and Brazil. So far, subsalt oil production has been executed only in the Gulf of Mexico, near the Texas and Louisiana coast where companies including BP, Shell, ExxonMobil, Chevron, and Anadarko Petroleum (APC) have all made significant discoveries.
In the last decade, private oil majors have invested several billion dollars to find oil offshore Brazil, but none have discovered reserves remotely as large as Tupi. “If Brazil takes its new oil off the table for international oil companies, it will send shock waves through the industry,” says Wood Mackenzie’s Shaw.
Contrary to the price-hawk position of Venezuelan President Chávez, who recently said oil-producing countries should try to “stabilize” oil prices near $100 a barrel, Lula said he hopes Brazil’s new oil will someday help to bring global oil prices down from their current levels, allowing poor countries to buy more of it.
“Brazilians are right to be euphoric,” says Peter Hakim, president of Washington-based think tank Inter-American Dialogue. Because Brazil has discovered its new oil after the country’s economy has been largely diversified and industrialized, “Brazil can avoid the oil curse, the dependency on one resource that dominates countries like Nigeria and Venezuela.”
How did you decide value investing was for you?
I was fortunate enough when I was a junior in college — and then when I graduated from college — to work for Max Heine and Michael Price at Mutual Shares [a mutual fund founded in 1949]. Their value philosophy is very similar to the value philosophy we follow at Baupost. So I learned the business from two of the best, which was better than anything you could ever get from a textbook or a classroom. Warren Buffett once wrote that the concept of value investing is like an inoculation- — it either takes or it doesn’t — and when you explain to somebody what it is and how it works and why it works and show them the returns, either they get it or they don’t. Ultimately, it needs to fit your character. If you have a need for action, if you want to be involved in the new and exciting technological breakthroughs of our time, that’s great, but you’re not a value investor and you shouldn’t be one. If you are predisposed to be patient and disciplined, and you psychologically like the idea of buying bargains, then you’re likely to be good at it.
What traits in Heine and Price influenced you?
Max Heine was great at not looking at what something was called, what its label was. He looked at what it actually was. For example, back in the late ’70s, Mutual Shares was buying the bonds of bankrupt railroads, and I think a lot of people would have said, “They’re bankrupt,” and “Who needs railroads?” Max and one of his partners knew how many miles of track the railroad had, what the scrap steel on the track could have been sold for and which railroads might have wanted pieces of those networks. They also knew what the real estate rights above the terminals were worth.
Michael Price was fabulous at pulling threads. He would notice something, and then he would get curious and ask questions. And one thing would lead to another thing, and that would lead to another thing. I remember a chart that Michael made of interlocking ownership of mining companies that was an extension of a thought where one good idea led to another and had the potential to lead to many more if the threads kept being pulled. That was a great lesson — to never be satisfied. Always be curious.
Value is your mantra.
We don’t even think of ourselves as a hedge fund. We see ourselves as basically long-only investors. Unlike hedge funds, we don’t leverage the portfolio — never a nickel of portfolio leverage. We have a minimal amount of shorts, currently less than 1 percent of the total assets. We’re not the stereotypical hedge fund in terms of an idea a minute. We’re very bottom up, not top down. We don’t come into the office with a view that interest rates, the dollar or the economy are going to do this or that. We come in with a view that this particular asset or security is trading for less than it’s worth and we want to buy it. We have a different approach than a lot of, quote, “hedge funds.”
What were some of your best value investments?
Distressed-debt investments where we owned the senior debt. That is a favorable place for a value investor. You have a margin of safety since, as things go bad, people who are junior to you are the ones who lose value before you do. Second, the bankruptcy process itself is a catalyst. A cheap stock can stay cheap forever, but if you own a bankrupt bond, the process of emerging from bankruptcy and distributing new securities offers a practical catalyst to realize the value. Back in 2001, 2002, we successfully invested in the debt of funeral home companies like Service Corp. International and Stewart Enterprises. We were investors in Xerox Credit Corp. debt.
There are too many examples that we could say, “Ah, that was right in our sweet spot, and we should have had it.” All investors need to learn how to be at peace with their decisions. We as a firm are always going to buy too soon and sell too soon. And I’m very at peace with that. If we wait for the absolute bottom, we won’t buy very much. And when everybody’s selling, there tends to be tremendous dislocation in the markets.
What’s the secret to success?
Every manager should be able to answer the question, “What’s your edge?” This isn’t the 1950s, when all you had to do was buy a corner lot and build a small drugstore and it gradually became incredibly valuable land or you owned a skyscraper or you built a small shopping center and it became the big regional mall. The market’s very competitive; there are a lot of smart, talented people, a lot of money chasing opportunity. If you don’t have an edge and can’t articulate it, you probably aren’t going to outperform.
Why do some hedge fund managers fail?
Their clients are pressuring them for short-term results, or they think their clients want short-term results. That’s probably the biggest problem for professional money managers. It makes it very, very hard for an investor to hold a stock that’s going down, to take a contrary viewpoint. I also think leverage is a great risk. If you look at hedge fund failures, virtually all of them were on the back of excess leverage.
Are you worried about the hedge fund industry becoming too crowded?
If you took some of the people in your [Hall of Fame] group and compare what they do with what we do, there would be no overlap of positions. Probably ever. So are there too many? No. It’s not competition for us, but yes, more and more money has gone into the kinds of strategies many hedge funds follow. On the other hand, there are also some bad hedge funds — overleveraged hedge funds — and those are the causes of tremendous selling opportunities. When they get in trouble, they may be forced to sell at bargain prices.
Is it getting more difficult to find value?
Sure, but I can’t worry too much about things I can’t control. If suddenly tomorrow I got the conviction that all securities were efficiently priced, that nothing was dropping to levels where I cared about it, I would be happy to close up shop. But human nature makes it hard for the markets to be efficient. As recently as earlier this year, there were days when it felt to a lot of people like the world was ending, that we were staring into some kind of abyss of financial distress, and a lot of buyers weren’t buying. Those were interesting days. We were looking for bargains, and the Fed massively intervened, and people decided it was safe to invest again, and the markets worked out. So the question is not, Are people smart, are people sophisticated, do they have clever ways of looking at things, are they looking in the right areas? The question is, Are there periods when none of that matters because their human natures get the best of them?
What’s your opinion on hedge funds going public?
It’s a terrible mistake. One of the worst days for the hedge fund industry was the day the first one became public. As an investor, you do best when you think about what’s in your client’s interest, which is managing a reasonable amount of money that will earn a good return with limited risk. When you go public, you change that risk-return equation and start thinking about how much money you can make. It becomes a business where the client relationships don’t have to be longer than the next quarter and the talent can leave and the clients can leave.
Name one of the most pressing issues the world faces today.
It would be great if we got a long-term energy policy in this country, because if we could put a floor under the price of oil, we could enable alternatives to spring up. We can’t risk oil going back to $40, and we’re just so shortsighted and stupid about that. We could have a global war over energy if we’re not careful.
What’s your philosophy when it comes to philanthropy?
I’m not a big fan of giving to endowments, because people in endowment situations tend to give away the minimum. I believe problems are compounding faster than the money, so spending more money sooner rather than later is more likely
to address a problem. I’m interested in situations where you get a sizable bang for the buck, where it’s proven that intervention is effective and where even a relatively small amount of money or a relatively targeted amount of money can change the game.
— Interview by Stephen Taub