Ravi
Nagarajan
submits:
The Rational Walk is pleased to have this opportunity to present an
exclusive interview with Prem C. Jain, the author of the recently
released book
Buffett Beyond Value
which we
reviewed
last week. Prem Jain is the McDonough Professor of Accounting and
Finance at Georgetown University. He has previously taught at the
Wharton School of the University of Pennsylvania and the Freeman
School of Business at Tulane University. His research has been
published in many prestigious finance and accounting journals
including the
Journal of Finance
and the
Journal of Accounting Research.
Professor Jain generously took the time to provide extensive
answers to several questions regarding Warren Buffett, the
evolution of behavioral finance in academia, defining an investing
circle of competence, approaches for investors who wish to expand
their competence over time, and much more.
Please
click on this link
to read the interview in a formatted pdf file.
Q: There are many books covering Warren Buffett's career,
particularly over the past few years. What made you decide to
write a book about Warren Buffett and how is your book
differentiated from Buffett biographies such as
Snowball
?
Most authors of books on Warren Buffett spend a significant part
of their books on narratives about Warren Buffett as a person. They
do not analyze his investing philosophy in enough detail to develop
a good sense of Buffett-style investing. I have tried to fill that
gap. Having taught Buffett's principles for over twenty years and
having personally benefitted from his principles, I have written a
book that is primarily about Buffett's investing principles. My
book is even more valuable to those who already have some
background on Buffett from reading biographical books such as
Snowball.
Q: Much of your book focuses on how investors can learn
from Warren Buffett's techniques and generate market beating
returns. Yet, the usual caveat is that investors must not stray
from their circle of competence. Many investors have trouble
precisely identifying the boundaries of this circle. How would
you suggest that investors go about defining their circle of
competence?
An investor should start with analyzing one industry that the
investor knows the most about. The investor is in his circle of
competence if he is not often surprised by the developments in that
industry. Else, he needs to study it more. As a professor, I have
benefited from investing in education stocks as I understood the
business models of several of those companies. Furthermore, to
precisely identify the boundaries of one's circle of competence,
one must also test one's knowledge in several additional stocks in
the same industry.
It is often the case that an investor would invest in one
company in an industry (say, Wal-Mart (
WMT
)) and would not know much about other companies in the same
industry (say, Costco (
COST
) and others). To understand Wal-Mart well, they should study and
monitor other similar companies as well. This is how I came across
Wal-Mart de Mexico (a Wal-Mart subsidiary in Mexico that trades
independently). Only after developing a good understanding of one
industry, the investor should start investigating in other
industries.
Q: You identify Warren Buffett as a "renaissance
investor" because he was one of the first to blend the "growth"
and "value" styles into a model that has produced consistently
superior results over many decades. Part of Mr. Buffett's shift
toward "growth + value" was due to the influence of Charlie
Munger and others such as Philip Fisher, but part of this was due
to size. As Berkshire (
BRK.A
) grew, the small "cigar butt" opportunities were not able to
"move the needle" for Berkshire. Portfolio size is not an issue
for most small investors. In early 2009, there were many small
stocks selling under "net-net current assets" as defined by
Graham. Does it make sense for small investors to pursue the
"cigar butt" style advocated by Graham or does it make more sense
to emulate Buffett's "growth + value" approach?
Buffett's investing philosophy has evolved over time. An
investor can similarly become a better investor over time. In 1963,
Warren Buffett invested in American Express (
AXP
) because American Express's stock price had declined in the wake
of the infamous Salad Oil Scandal in which American Express lost
money. However, the American Express charge card business was not
affected. After a year or two, Buffett sold those shares as the
price recovered. In this investing approach, which is usually
classified as "cigar butt" investing, the focus is on finding
stocks when declining stock prices can be attributed more to market
psychology than to fundamentals.
The "cigar butt" investing is based on examining numbers such as
P/E ratios or other quantitative metrics. However, even as far back
as 1967, Buffett wrote in his letter to his partners that really
big money tends to be made by investors who are right on
qualitative (as opposed to quantitative) decisions. Clearly,
Buffett's investing style was evolving.
An evaluation of Buffett's writings and decisions over decades
suggests that he has maintained the principle of not paying
excessively as a value investor (or as a "cigar butt" investor); he
is now willing to pay a fair price as a growth investor. If we were
to think of him as a pure value investor, it would be difficult to
explain him paying about market P/E for several of his stock
acquisitions such as BYD (BYDDF.PK) and Burlington Northern Santa
Fe (
BNI
) or even Wal-Mart. He has clearly evolved into a value + growth
investor over time and has specifically mentioned that value and
growth are two sides of the same coin. An investor should not
ignore "cigar butts" but in this day and age when information is
ubiquitous, cigar butts are not easily found. However, an investor
incorporating the principles of both value investing and growth
investing together is more likely to earn large returns.
Q: Professional familiarity in a field does not
necessarily extend to investment competence. For example, many
doctors have a reputation as terrible investors because they
mistakenly believe that knowledge of technical details of drugs
or medical devices makes them qualified to pick investments. The
same can be true for many in technology and software fields. But
at the same time, it seems natural to invest in areas that
professionals know the best. How can a doctor, for example,
develop an investment circle of competence that would allow for
intelligent investment in companies related to his
profession?
This is a good example of an investor not making good returns
even when he may have a good understanding of a particular product.
The reason is that investment circle of competence requires not
only the knowledge of the products but also the ability to
understand the financial statements and to project future earnings.
Many investors can not translate success of a product into
financial success of the company.
I recommend the following to doctors and others who are
interested in investing. Investor should think whether the company
and not just a product will be successful for a long time. They
should forecast sales and earnings in dollar terms and not only
evaluate a product's technical ability. If they are
financial-statements-challenged, they should join hands with others
who know some accounting and finance. This may prove to be a
fruitful partnership.
Q: Over the past decade, behavioral finance has attracted
much more attention than in the past, perhaps due to several
events over the past 25 years that could not be easily explained
by the Efficient Market Hypothesis. I recall as an undergraduate
student majoring in Finance in the early 1990s that there were
few mentions of Warren Buffett or other investors who have
routinely achieved market beating returns. Most references to Mr.
Buffett tended to dismiss his record as an aberration unlikely to
be replicated. Do you see this attitude changing in Finance
departments today?
Warren Buffett has had tremendous influence on the academia. In
2003, I invited him to Georgetown University to conduct a
question-answer session and the response from the students and the
faculty was overwhelming. The finance discipline now acknowledges
that professors during the 1970s to 1990s overemphasized the market
efficiency paradigm. Fortunately, we have people like Buffett who
constantly reminded the academia that the professors had much to
learn. And professors have learned. For example, in one of the
courses at Georgetown, the first class of the course centers on
what we may learn from Warren Buffett. Thanks to Buffett that we do
not claim that markets are efficient all the time. It is not easy
but if investors work hard, they can beat the indexes and possibly
earn very high returns.
Q: How can investors prepare themselves to mentally deal
with temporary declines in the market value of their investments?
Even if an investor finds undervalued companies, it is obviously
possible for market prices to suffer material declines. We have
seen this in Berkshire Hathaway, for example, over the past two
years. Is the ability to deal with temporary declines a matter of
inherent temperament or personality that cannot be changed, or
can investors find ways to improve their investment temperament
over time?
Knowledge is the best antidote to making bad decisions. For
example, if you know about jewelry and diamonds, all that glitters
is not gold for you. Your knowledge will allow you to pick diamonds
in the rough and hold on to them. In investing, if you know a lot
about certain companies and their managers, you will not become
nervous and sell the stock at the wrong time or when the market
declines. No wonder, Buffett suggests that you should invest only
in companies you understand. Both in 2000 and 2009 when Berkshire
stock prices went down by about 50%, I added to my Berkshire
holdings.
Q: Most individual investors attempt to pick stocks on a
part time basis. How much time per week do you think is required
for part time investors to dedicate to this pursuit? It seems
like spending a couple of hours each weekend reading Barron's or
The Wall Street Journal simply wouldn't be sufficient, yet most
people do not have 15 to 20 or more hours per week to delve in
more deeply. How should investors think about the time investment
required to actively pursue undervalued opportunities?
This is related to an earlier question. If a person has a full
time day job, he should study only one industry at a time. Only
after he understands one industry, he should move to studying other
industries. If he does that, he would not need more than a few
hours a week. After several years, he should end up with 20 stocks
to invest about 5% in each. In the meantime, he can invest partly
in an index fund and party in individual stocks. An average
investor need not hold more than 20 stocks in a portfolio. Buffett
does not invest in a large number of stocks and most of his
holdings are for the long term. In Berkshire, five of the top
stocks have often constituted 50% of its total stock holdings.
Finally, if a person is very busy and does not have any time to
find good stocks, he should simply invest in an index fund such as
the Vanguard S&P 500 index fund.
Q: If an investor decides that he has no particular
circle of competence or lacks the time to dedicate to the
pursuit, does it make more sense to invest in index funds or in
mutual funds such as Fairholme that are run by proven value
oriented managers? In your book, you recommend against investing
in hedge funds due to the asymmetry that is common in the "2 and
20" compensation models. Does the same caveat apply to value
oriented mutual funds? Although they are more cost efficient,
certainly index funds remain far cheaper.
For a person who has no particular circle of competence but has
decided to invest in the stock market, I recommend investing in an
index fund and not in mutual funds. An investor is less likely to
sell an investment in an index fund when the market goes down than
if he were to invest in a mutual fund. I am afraid that the
investor would blame the manager for not performing well in a down
market and sell all his holdings at the wrong time. It may not be
the manager's fault at all but the investor may not be able to see
through the effect of the market on an otherwise well run mutual
fund. Even the best of managers does not outperform the market in
all the years. The only time a busy investor should invest in a
mutual fund is when the investor is extremely comfortable with the
manager's style of investing and has examined it in great detail.
It is not enough to simply examine a manager's past performance and
invest with the manager.
Q: One of the most difficult decisions involves when one
must sell an investment at a loss. You cover this topic in the
book and suggest that investors should be willing to sell at a
loss if subsequent events lead the original investment thesis to
be invalid. This is perhaps the most difficult aspect of
investing for most people because selling at a loss involves
admitting a mistake and making it "permanent". Is this just a
matter of inherent "stubbornness" or can investors take any steps
to mentally allow them to sell at a loss with more philosophical
detachment?
I think we are hard-wired not to admit mistakes. Selling at a
loss is indeed difficult. Or, we are optimistic and hope for an
improvement in the stock price. I recommend two specific steps.
First, one should write detailed notes whenever a purchase decision
is made. Periodically, as the company makes earnings announcements
or other important announcements, the notes should be updated. I
have benefited from this practice a lot. When individuals are
forced to write their thoughts on the paper, they can more easily
see the right thing to do. For example, if one has a good knowledge
of the company's products, managers and financial statements, a
decline in the stock market may be a good time to invest more in
the stock market. Second, they should compute a stock's intrinsic
value periodically. I discuss the concept of intrinsic value in
detail in my book. When the intrinsic value is below the current
stock price, they may find it easier to sell.
Q: Berkshire Hathaway is often misunderstood by the media
and characterized as Warren Buffett's "hedge fund". This leads
many investors to worry about succession at Berkshire. Do you
have any views regarding who Mr. Buffett's successor will be and
how confident are you that the success will (a) be able to retain
Berkshire's unique culture and (b) continue Mr. Buffett's capital
allocation track record? It seems like the next CEO will have
impossible shoes to fill. Could this result in a "shooting for
the moon" attitude that could introduce greater risk at
Berkshire?
If the Berkshire board decides to have only one person at the
top, I think Ajit Jain is the right person. After all, Buffett
talks to him every day, insurance is the most important part of
Berkshire, and he has been at Berkshire for about 25 years. (This
has nothing to do with the fact that I have the same last name. I
don't know him at all.) The two other names often mentioned are
those of Tony Nicely of GEICO and David Sokol of MidAmerican and
NetJets. It will, however, not matter much if any one of the three
is the CEO. After all, the Berkshire CEO does not interfere with
the subsidiary CEOs.
Yes, the culture! What is the culture at Berkshire, I have often
asked myself. Once we reflect on some of the unique features of the
Berkshire culture, we are less likely to be concerned about the
future of Berkshire even if the next CEO is not as good as Warren
Buffett. There are at least two important features of the Berkshire
culture. First, the subsidiary CEOs (and employees) are compensated
according to what is most meaningful. Buffett has often talked
about compensation based on return on assets or other appropriate
metrics. This creates a sense of fair play resulting in high
productivity. Second, subsidiary CEOs are given independence to
make all decisions at the subsidiary level. Hence, Berkshire will
continue to do well after Buffett because of its decentralized
management structure. The capital allocation process may not be as
good as it is today under Buffett but there are many people who
have been close to Buffett and my guess is that the new CEO will
continue to do a good job for a long time to come.
Professor Jain, this has been very insightful. Thank you
very much.
See also
How Goldman Abandoned 'Real' Economy
on seekingalpha.com