Monday, December 25, 2006

The Warren Buffett of Mutual Fund Investing?

No, I am not talking about Peter Lynch, although Mr. Lynch is arguably one of the best mutual fund managers and investors of his era. Nope, the gentleman I am referring to runs a mutual fund company that is quite simply unique amongst its peers. Consider the firm's statement of principles found on the first page of the prospectus:

1. "We will treat your if it were our own."

2. "We will remain significant investors with you..."

Sound familiar? Buffett and Munger subscribe to the same principles at Berkshire Hathaway by "eating our own cooking." Mutual funds are not exactly known for their high insider ownership, although a few diamonds in the rough can be found.

The fellow I am referring to is none other than Mason Hawkins, investment guru extraordinaire and chairman of Longleaf Partners, a value oriented mutual fund family. The word partner in the company name is richly deserved...each investor in Longleaf is viewed as a long term partner.

I must admit, I have known of Mr. Hawkins for some time now, but it was only recently that I discovered where Mr. Hawkins earned his MBA...the University of Georgia. As a current MBA candidate at UGA, I was euphoric that UGA boasts as an alumnus one of the greatest money managers of our time....who adheres to the value principles espoused by Ben Graham. Needless to say, my recent discovery sent me on a search to learn as much as I could about Mr. Hawkins and the his wonderful canvas, Longleaf.

To really appreciate Mr. Hawkin's partnership approach with his investors, all you need to do is consider how Longleaf came to be. Longleaf was basically started by Mr. Hawkins in 1987 when he introduced it to Southeastern Asset Management. Since 1975, SAM was a respected value oriented firm. Longleaf was created so Mr. Hawkins could essentially pool his money alongside his clients without creating the conflict of interest that can arise when money managers buy and sell for their own accounts. Mr. Hawkins bought all the same securities held by SAM and then put all his and his colleagues money into it. If that ain't eating your own cooking, I don't know what is. Mr. Hawkins went even further when he prohibited Southeastern's employees from investing in any of their bonuses and profits outside of about a true partnership with your clients.

I recently uncovered a gem of a paper written a few years back about Longleaf and Mr. Hawkins that really illustrates the viewpoints of Longleaf and its founders:

When Mr. Hawkins was a high school senior, he read Graham's "The Intelligent Investor" and remarked,

"The single thing that Graham talks about that allows for success is establishing firmly what a company is worth. Only if you've done rigorous analytical work that has a high probability of being right can you control your emotions and act against the collective mind-set of the moment."

Staley Cates, a colleague at Longleaf aptly says,

"We believe risk goes down when you put your money only in the investments you understand very well."

The folks at Longleaf have been compounding money in excess of thier respective benchmarks for a long time. With a track record like that, Longleaf would have no problem attracting funds. Instead Longleaf decided to close out two of its funds several years ago and forgo all those lucrative asset management fees. When Mr. Hawkins decided to close the funds to new investors, he was doing so at peak performance and could have attracted capital at the snap of a finger. Instead, as all true intelligent investors do, he chose not to.

"If we'd kept the Funds open, we could have maximized our fee income but we would have damaged our record and impaired our ability to compound our own capital as well as our customers'. So we closed them."

Mr. Hawkins will only reopen the funds when the economics are right to put more assets to other words when stocks are cheap. Indeed since 1995 when Mr. Hawkins closed the Partners Fund to new investments and in 1997 when he closed the Small Cap, Mr. Market has created pockets of opportunities to reopen them and as a result, both new and existing partners have been handsomely enriched. While there are several mutual fund outfits that align their interests with those of outside shareholders, I haven't come across any that are as methodical about it as Longleaf.

It's really important to consider that Mr. Hawkins and his team could have gotten very rich a lot quicker by running their funds geared at maximizing short term profits, but instead they choose to get rich slowly alongside their partners. According to Charlie Munger, "why should it be easy to get rich?" And that is exactly how it should be.

Each year Longleaf hosts a annual shareholder meeting that gives their investor's a chance to get their questions answered. Like Berkshire, Longleaf strives to treat their shareholders fairly and in the process, Mason Hawkins, like Warren Buffett, is beating the pants off mutual fund managers.

Thursday, December 14, 2006

The Art of Deep Value Investing

Charlie Munger said it best when he remarked that, "All intelligent investing is value investing." Quite simply, value investing can be defined by two fundamental metrics:

1. Look for a business trading below its intrinsic value.

2. Invest with a margin of safety.

In other words, pay attention to price. A fantastic business is not a fantastic investment if the price is wrong. In my obsessive pursuit of understanding the true mechanics of Grahamian value investing, I went looking for some insights into the complex art of deep value investing. I found some wonderful words of wisdom from Seth Klarman, value investor extraordinaire and founder of The Baupost Group, a value driven hedge fund. Mr. Klarman has been compounding money at over a 23% clip for the past two decades. At a recent talk at the Columbia Business School, Mr. Klarman shared his thoughts....

If only one word is to be used to describe what Baupost does, that word should be: ‘Mispricing’. We look for mispricing due to over-reaction,”

Markets are never completely efficient. There will be times when Mr. Market goes crazy and offers to sell dollar bills for fifty cents. Taking advantage of these opportunities can generate enormous returns. But to do so, you have to constantly be working and working and working...why should it be easy to get rich?

“Investors can not predict when business values will rise or fall. Valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value and other methods.”

A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world,”

Consider the Washington Post Company in the early1970's. At one point, the market cap of the Post was around $80 million yet the media and publishing assets of the company could have easily fetched $400 million in a fire sale liquidation. Eighty cents for four dollars sounds like a pretty good margin of safety. Valuation is not an exact adequate margin of safety, usually 50%, helps cushion against "volatility" and "bad luck."

Look at investments as "fractional ownerships."

How else should you look at buying shares in a business?

Ultimately, investments generate profits in three ways:

1. From the free cash flow generated by the underlying business, which will eventually be reflected in a higher share price or distributed as dividends.

2. From an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price.

3. Or by closing the gap between share price and underlying business value.

So how do you find profitable investments?

"Value investing requires a great deal of hard work, unusually strict discipline and a long-term investment horizon"

Seth Klarman wrote a book, Margin of Safety, that is a blueprint for a sound investment approach. Unfortunately, the book is out of print and last time I checked, a copy was fetching over $1300 on eBay. However, most university libraries ought to have a copy or should be able to be able to point you in the right direction.

Friday, December 1, 2006

A Thought On Investing

Author's note: I orginally wrote this article several years ago in response to the puzzled looks I got when I was telling my friends (I was 22 at the time) about value investing and this guy in Omaha, Nebraska that was beating the pants off Wall Street practicing it.

Fact: Between 1984 and 1999, a great bull market in America, 90 percent of mutual fund managers underperformed the Wilshire 5000 Index, a relatively low bar to beat.

Ninety percent. Think about this for a moment. Only one out of ten “expert” mutual fund managers generated a return higher than that of the overall general market. Why does this happen? How is it that an overwhelming majority of intelligent professionals fail to produce a par result for their investors? The answer is two-fold: First, mutual fund managers tend to focus on short-term results and second, they tend to follow the herd. Mutual fund managers define their investment strategy with particular styles such as “small-cap value” or “small cap growth” to isolate the parameters that guide their portfolio selections. Any business that does not fit into the particular investment focus of the fund is screened out, regardless of its suitability for investment. The reason mutual-fund managers limit themselves to a particular class of equities is doing so appears rational and is therefore seen as the safest option. Who wants to ever appear irrational? This rationality (or lack thereof) is how mutual fund managers are able to justify their performance to their investors.

Investors, wanting evidence that a mutual-fund manager’s decisions are reasonable, compare his decisions and performance with his peers. Mutual fund managers, knowing this investor behavior and anxious to protect their jobs, simply mimic their peers. This mimicking destroys whatever informational advantage they had leading to a shortage in investment possibilities and any informational advantage they had to begin with. As John Maynard Keynes wrote in The General Theory of Employment, Interest and Money, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” What does all this say about mutual fund managers? That, in their goal of wanting to do what seems to be safest, they follow the crowd, resulting in performance below that of the general market by sticking to the same investments as their peer groups.

Fortunately for investors, they have some options: Two options are index funds and what legendary investor Warren Buffett terms “super investors.” While the focus of this article is on the latter, a simple word on the former. Index funds are a great way to mimic the market without the necessary (sometimes outrageous) fees of a mutual fund. These low cost passively managed funds are, in general, far superior investments to mutual funds in many asset classes. However it is possible to have consistent marketing beating returns—by a healthy margin at that. When you think about trouncing the market, names such as Bill Ruane of the famed Sequoia Fund, Warren Buffett of Berkshire Hathaway, Peter Lynch of Fidelity, Walter Schloss, and Rick Guevin come to mind. Mr. Guevin never attended business school; Mr. Schloss never even went to college (I am not suggesting avoiding an education, something this author values tremendously, but merely to suggest that a pedigree MBA does not necessarily give you an advantage). Some of these names stand out more than others, but all of them and dozens like them have amassed equally astonishing performances year after year through bull and bear markets. And they did it in their own way. Walter Schloss owned stocks that Bill Ruane did not own that Peter Lynch did not own and so forth. The common thread amongst these super investors is their relentless pursuit for quality investments at attractive prices, otherwise known as value investing. Warren Buffet beautifully illustrates this idea as “buying dollar bills for fifty cents.” This discipline, coupled with patience and total lack of emotion from the daily market swings, has served these investors amazingly over decades.

Ben Graham, the dean of value investing and a mentor to the some of the greatest investors, has said “investing is most prudent when it is most business-like.” A simple concept, but one that very few mutual fund managers practice. When you purchase a home, you hunt for a good price, safety, and a quality neighborhood and neighbors. You do your research and then purchase the most attractive home giving strong consideration to these factors. Investing and investment managers must be the same way, so as not to be mistaken for speculation. You want a bargain, safety, and a quality business and management. While I certainly cannot expect all investors to manage their own money—I would have no job or livelihood if that were the case—investors must demand market-beating performances from their financial gatekeepers if they are to justify the fees that they pay them to manage their money. Thankfully for us, we are fortunate to have some money managers and investors who don’t follow the herd.

Sham Gad, a 2007 MBA candidate, is currently working to establish Gad Investment Partners, an investment partnership inspired by the work of Graham and Buffett. I welcome all comments and suggestions to