Fortune profiles Chris Flowers, one of the best-known private equity investors in financial services companies.
My working hypothesis, as I try to expand my manager selection skills from stockpickers to other platforms like real estate investing and private equity investing, is that these other platforms can and should also be viewed through the lens of value investing. Simply put, you evaluate a private equity fund manager the same way you evaluate a hedge fund manager: by trying to predict that individual's ability to generate superior risk-adjusted returns over time.
"Risk-adjusted," in the value investor's dictionary, simply means the combination of the probability of permanent (as opposed to quotational) capital loss and the magnitude of that loss when it occurs. In private equity, adjusting for risk in this way is especially important because private equity relies on leverage. In private equity investing in banks, it's even more important because banks themselves are highly leveraged businesses. Small mistakes in predicting the future by managers become big mistakes to limited partners.
A value investor creates superior risk-adjusted returns mainly by investing with a margin of safety. "Margin of safety" is often defined simply as a bargain price, and it's certainly true that the lower the price of an investment relative to its intrinsic value, the lower its risk according to our definition. I prefer the slightly more elaborate definition contained in Seth Klarman's aptly titled book Margin of Safety because it gets to the epistemological truth about why value investing works as well as it does:
Margin of Safety--investing at considerable discounts from underlying value, an individual provides himself or herself room for imprecision, bad luck, or analytical error (i.e., a "margin of safety") while avoiding sizable losses (my emphasis).
Value investing is ultimately a theory about the future, in particular the future of any given set of cash flows one chooses to predict. Value investors like Klarman see the future, almost intuitively, as subject to imprecision, bad luck, and analytical error, and seek to minimize the impact of this on their investment returns. They do this primarily by looking only for bargains, but also by making sure what they think is a bargain is actually a bargain--by investing only when they can predict the future of a given set of cash flows with relative certainty.
Protecting yourself and your investors from imprecision, bad luck, and analytical error, and making sure you invest only when you can reasonably predict the future--that is, ensuring you have a margin of safety--becomes especially important in private equity because of the leverage involved. Leverage does not change the probability of a given universe of outcomes so much as it magnifies the effect of those outcomes to equity holders. The more leverage, the greater the probability of a great outcome if things go well, but also the greater the likelihood of permanent capital loss is if they don't.
So figuring out whether your PE manager invests with a margin of safety is very very important. This Fortune profile only gives a glimpse of whether Flowers does it. It cites two examples of permanent capital loss, but also gives ample evidence that Flowers really knows his way around a bank. So I can't draw any firm conclusions. And I take no comfort from the fact that Warren Buffett is quoted as saying of Flowers "I think he's a smart guy." In the language of Wall Street, "I think he's a smart guy" is a way of saying something without revealing anything. Also, I'm familiar with the Warren Buffett style of personal testimonials, which he takes as seriously as haiku, and can say with confidence that when Warren Buffett wants to praise someone, he doesn't simply say "I think he's a smart guy." He says something like this:
Jim Kilts transformed Gillette. Before his arrival, the company was a study in self-deception. Great brands were being mishandled, operational and financial discipline was nonexistent, and fanciful promises to investors were standard practice. In record time, Jim excised these business pathogens. I've learned much from Jim. So, too, will readers of this book.
In this book, Adam Smith says I like baseball metaphors. He's right. So I will just describe this book as the equivalent of the performance of Don Larsen on October 8, 1956. For the uninitiated, that was the day he pitched the only perfect game in World Series history.
I knew Ben [Graham] as my teacher, my employer, and my friend. In each relationship--just as with all his students, employees and friends--there was an absolutely open-ended, no-scores-kept generosity of ideas, time, and spirit. If clarity of thinking was required, there was no better place to go. And if encouragement or counsel was needed, Ben was there.
Walter Lippman spoke of men who plant trees that other men will sit under. Ben Graham was such a man.
Because I can't draw any conclusions from the Fortune article, I'll instead close with two more general point about margin of safety in PE, especially famous PE investors with great reputations:
1) It's important to keep in mind that a famous PE investor enjoys a personal margin of safety that his L.P.s do not: If a given fund goes badly, he can always say "bad luck, who could have predicted these macro shocks" and go raise another fund, while if it goes well he'll become extremely rich, or extremely richer. So a given PE investment may pass the personal margin of safety test while failing to provide an adequate margin of safety to his investors.
2) The intuitive understanding of and desire for a margin of safety when investing are independent of a PE manager's pedigree, brainpower, contacts, fame, deal flow, skill at chess*, etc. If you possess all of the latter but lack the former, you may be more dangerous to your investors' long-term wealth than if you possess all of the former but none of the latter. If you put a gun to my head and forced me to say what Buffett meant by his faint praise of Flowers, I would speculate that he thinks of Flowers the same way he thinks of John Meriwether: "I think he's a smart guy, but . . . he doesn't invest with a margin of safety."
*As an aside, I hate it when skill at chess is presented as a metaphor or proxy for competence in general, especially when applied to investors. It is factually untrue. Chess masters and grandmasters have been studied to see if their skill at the game translates into skill at anything else, or IQ, or other measures of intelligence. Generally it does not: skill at chess implies only that you are skilled at chess. The most you could say is that skill at chess is a proxy for the ability to practice hard enough to get good at a mental exercise like chess. That aside, judging investors by their skill at chess, or bridge, or other games of skill, is like judging offensive linemen by their bench presses at the scouting combine.
Disclosure: Long Berkshire Hathaway.
Update: The Public Buffett Giveth, the Private Buffett Taketh Away. Check out page 2 of Rice MBA student John Reuwer's notes from his class trip to Omaha. If the link ever breaks, here is the money quote:
[For Bank of America] to pay anything for Merrill was silly. Everyone knew Merrill would be basically free one day. It's not smart to pay a premium when you don't have to. The Fairness Opinion from Chris Flowers was a joke. I want to write a Fairness Opinion about the Fairness Opinion.
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To evaluate investors one must evaluate how they evaluate their investments. One of the things I look for is what I call "elegance" in valuation. It' s hard idea to define; you kind of know it when you see it. Warren Buffett rarely discusses valuation, but when he does he almost always demonstrates this quality.
I guess what I mean by elegance is the ability to restate a problem (in the context of investing, the problem is most often "what is this asset worth?" or "is this asset undervalued?" or "what is the expected return of this asset?") in such a way that the solution presents itself with disarming clarity. Think of the legendary story of a precocious German schoolchild daydreaming in class in the 18th century. The dour schoolmaster commanded his students to sum all of the integers from 1 to 100, expecting the tedious calculation to occupy at least a half hour of his students' time. Instead our precocious schoolchild, the youngest in the class, almost immediately blurted out the correct answer, making the dour schoolmaster even more dour. The child was Carl Friedrich Gauss, who became one of the greatest mathematicians ever, and he solved the problem not by his ability to calculate 1 + 2 + 3 +. . .+ 100 faster than anyone else, but by recognizing immediately that the problem could be restated in a way that made the solution easy: the list of 100 integers could be grouped into 50 pairs, each of which sums to 101 (1+99, 2+98, 3+97, etc.), so the correct answer was simply 50 x 101 = 5050.
There are many professional investors who can "sum the integers from 1 to 100" the hard way, by outworking everyone else or by using technology. But the very best investors are almost invariably elegant in their thinking; they have the Gaussian ability to simplify problems so that the difficult process of evaluating an investment becomes much easier.
A recent example of elegance in valuation caught my eye. It's maybe not up to the level of Gauss' trick but it is elegant nonetheless. My friend and editor John Mihaljevic recently interviewed Brian Gaines of Springhouse Capital for his Portfolio Manager's Review publication, and posted an excerpt on his blog. The excerpt included the following discussion of Netflix, a company whose traditionally high P/E ratio and new business model made it unpopular among value investors:
What made this analysis elegant was Gaines' ability to restate the "is Netflix undervalued?" problem in a different way, by substituting business reality for accounting "reality." According to GAAP, subscriber acquisition costs must be treated as an expense on the income statement (I vaguely remember this rule coming about in the mid 1990s and it caused AOL to trade way down). For a growing enterprise that does a lot of marketing, this will depress GAAP earnings, the E in the traditional P/E ratio, which will in turn raise the P/E ratio beyond the reach of most value investors. Gaines' insight was to treat subscriber acquisition costs not as an expense, but as mostly an investment in future growth, similar to a capital expenditure. Only a portion of this expenditure, analagous to maintenance capex, was to be subtracted from the pro forma income statement, as it represented the cost of maintaining then-current volumes.
Gaines' insight had the effect of significantly increasing the profitability of the non-growth portion of Netflix's business, which in turn lowered its operating P/E to a very value investor-friendly 5-6x. Having determined that Netflix's product was performing well, having calculated that he wasn't paying anything for the company's future growth, and having assumed that its heavy investment in future growth would likely earn a good return (or else would dramatically be curtailed), Gaines turned a growth investor's speculation into a value investor's investment, with a significant margin of safety, and was well rewarded. Elegant.
My real estate self-education project continues. Again, I'm trying to see if I can apply value-oriented manager selection to real estate investing. There will likely be a lot to do in real estate in the next few years, both in public and private markets. Many new funds have been and will be formed to take advantage of all the bargains that are widely assumed will be available. My suspicion is that many of those hoping to take advantage of the bargains will be the same people who "took advantage" of all the non-bargains in the last days of the boom by buying overpriced properties. I want to stay away from those people.
Steve Roth of Vornado alluded to this in his 2008 letter to shareholders, under the heading "Price Does Matter":
If the way it works is this stark, ideally you want to invest with someone who
a) Knows exactly when the first half of the cycle is about to become the second half
b) Does his buying only during the first half, and
c) Does his selling (and his golfing, fishing, traveling, etc.) during the second half.
An unattainable ideal, but that's why the margin of safety was invented.
Margin of safety is especially important in real estate because almost all real estate is bought with leverage, often a lot of it. In real estate investing, skill at building the right side of your balance sheet is as important as skill at building your buildings. Because leverage magnifies returns both on the upside and the downside, and because of the idea expressed in the Steve Roth quote above, the stakes are very high when it comes to evaluating a real estate investor's use of financing. It's often said that the secret to getting rich as a real estate developer is to use Other People's Money. Don't forget the corollary: the secret to getting rich investing with a real estate developer is to remember that Other People's Money to him is Your Money to you.
Wednesday's Wall Street Journal featured a long article about the Cababie family, one of Mexico's most successful real estate developers (who I'm sure trace their routes to the Jewish quarter of Aleppo, Syria, which isn't so Jewish anymore, if you know what I mean. It sometimes seems that if you fled from Aleppo to Latin America there was something wrong with you if you did not become extremely rich). To finance their move into US real estate, the Cababies crossed an investing Rubicon by issuing personal guarantees on two major real estate deals, a huge condominium project in downtown Miami and a portfolio of 56 office buildings in Southern California.
A personal guarantee is just that--an individual or family personally guarantees to repay a loan if it cannot be paid back otherwise. The WSJ elaborates:
To a value-oriented manager selector like me, an investor who issues personal guarantees, even if it backstops money you yourself are investing, is a red flag. Not automatically bad, but something to take a close look at. Manager selection requires you to create a kind of psychological profile of the investing temperament of the person to whom you're giving your money. A personal guarantee on the right side of an person's own individual balance sheet can be revealing. If it's guaranteeing the 250th enormous condominium project built in downtown Miami (not even on the beach!) in the last few years, then it's very revealing. The combination of boom-time psychology, optimism, and testosterone that leads someone to expose their own money to that kind of risk must make you suspicious about what they are exposing your money to.
The same principle applies to REITs or other real estate corporations, and even corporations as a whole. The mix of recourse vs. non-recourse debt, as well as cross-guarantees and cross-default provisions, must be evaluated carefully, as it is a key factor in the shareholder's margin of safety equation. Warren Buffett, who has been a closet genius at using leverage his entire career, pulled back the curtain a little in his 2005 letter to shareholders, in the section called "Debt and Risk." Read the whole thing, but the guiding principles are that the more debt you take on, the more secure the income stream (not asset value) to service it must be, and significant debt must always be non-recourse to the rest of the enterprise. John Malone, who has been an out-of-the-closet genius at using leverage his entire career, has used the nautical metaphor of the compartments of a ship's hull, separated by bulkheads--if the hull is breached in one compartment, it may flood with water, but the bulkheads prevent water from penetrating the other compartments, which could take down the entire ship. Even during TCI's most heavily leveraged days, Malone was always careful to use as much non-recourse debt as possible, so if water flooded one "compartment" (i.e. an individual cable system could not service its debt) it would not threaten the entire ship (TCI and its shareholders as a whole).
The Times (of London) profiles Cooper Union's endowment and its head John Michaelson.
"Men never do anything well except through necessity," wrote Machiavelli, a charter member of the Consigliere Hall of Fame. The fact that Cooper Union charges no tuition and must rely on its endowment for 70% of its expenditures has concentrated Michaelson's mind on two simple goals: "no material losses" and "a constant cashflow to meet expenses."
The other endowments mentioned in the article, which rely on endowment income for only about a third of expenditures, all follow the Yale Model of illiquidity-embracing strategies like PE, VC and hedge funds, which promise neither of Michaelson's two guiding principles. They thought they'd be compensated for this over time in the form of higher returns, in some cases correctly, and consoled themselves that their ancient institutions could handle short-term declines in endowment value with equanimity. What they did not count on was that during times of crisis, short-term declines in the endowment are correlated with things like the willingness of parents to afford high tuition, the propensity of faculty and staff to resist strongly any layoffs or strict cost control measures, and the propensity of alumni to make up any shortfalls with increased gifts. It was a political and psychological miscalculation more than an investment miscalculation. In a sense then, the dynamic faced by the sophisticated endowments of the more famous universities was more similar to Cooper Union's dynamic of discipline enforced by necessity than they realized.