Geoff Gannon July 22, 2008

20 Questions for Jeff of Circle of Competence

Jeff, author of Circle of Competence, is a young and learning investor not yet out of college. He derives his investing framework from Superinvestors ranging from Ben Graham and John Maynard Keynes to Joel Greenblatt and Eddie Lampert. Jeff believes the most effective approach to investing is that of a business owner and entrepreneur looking for misunderstood businesses selling very cheaply with little risk of capital impairment.

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1. Are you a value investor?

No doubt. There’s no other approach I’ve ever been comfortable with. The thing is, value investing, as we tend to think of it, is not the only path to investing success. I’ve read about plenty of individuals who have been successful trading, making macro calls, and reading tea leaves for all I know. Value investing, business investing, is the one I hit it off with, so I’m with it for better or worse.

2. What is value investing?

Value investing is this really simple approach that’s not so easy to practice. In my eyes, value investing is a mentality that assets have some value independent of their selling price. They might be the same, they might not be, but if you can find the ones selling for some large amount less than they’re worth, there’s an opportunity to make a ton of money down the road. Buffett, Graham, Klarman, I mean these guys have proved this thesis true over and over with their successes. It takes some hubris, a confidence that you’re right and everyone else is wrong, and the courage to basically not let your humanity interfere with rationality. That’s the toughest part of value investing.

3. What is your approach to investing?

I’m basically just looking to own a small handful of companies that I know pretty well, selling for way less than they are worth. I want to find 5-10 companies where I can be extremely confident that I know what the heck is going on. It’s the only approach to investing that makes sense to me. I approach investing like I was a control investor, a buy-out specialist, or an entrepreneur. To find these opportunities, I’m search for companies that are being subject to some devil: neglect, myopia, or misunderstanding. If I can find a solid business with a solid balance sheet, run by competent management, being subject to one of those devils, and it’s something that I understand, I’m probably researching or buying it. That means spinoffs, small caps, distressed businesses, companies with multiple divisions; all of these are fair game. I want to find situations where the risk I’m being asked to take is out of whack with the potential upside. I’m okay with an investment that doesn’t make me any money. I’m not okay with losing money.

4. How do you evaluate a stock?

I don’t really evaluate stocks. I (try to) evaluate businesses. As I said before, I’m thinking like a control investor. What is the company worth now, and what is it going to be worth 3 or 4 years out? I’m willing to hold something for 5 or 10 years, absolutely, but only if there is a compensatory reward, and little downside. If the business passes my first two filters, I’m reading everything I can on the business. I’m evaluating the strength of the business, the strength of their balance sheet, their performance versus competitors, the words coming from the mouth of management, the price of the shares, everything. I’m either going to value the company based on the salable assets it has today, or the present value of its future cash flows. Something selling for a 20% sustainable free cash flow yield is as cheap as something selling for half of liquidation value. I just want to know all I can know about this business from an outside perspective, given the limited resources at my disposal. It’s necessary if you’re going to have 80% of your portfolio in 5 holdings, or even 4 holdings.

5. Why do you buy a stock?

I’ve figured out that I don’t have the time or intelligence to evaluate every security, so I’m only buying the companies I’ve taken the time to understand. Did Sam Walton care that Bill Gates got rich building Microsoft? I doubt it, because he was too busy getting rich building Wal-Mart. When I’ve strayed from this mentality, I’ve bought into the wrong companies, trust me. I don’t want to see a small price disconnect, either. I’m looking for a price that’s way off considering the value and economics of the business. GARP is a good term, except not the way it’s traditionally used. I like Growth at a Ridiculous Price. My early experiences losing money helped me develop that sort of thinking. Lastly, though I’m thinking like a 100% owner, I don’t have the money to actually do it, so I have to have faith that management won’t kill my company and cause me to lose money. In some cases, management is a key part of the thesis. At minimum, I’m just betting that they’ll maintain the value that is already there. I’m running a very concentrated portfolio, so I can’t afford to be wrong very often. One big mistake could do some serious damage, so I keep that in mind before I buy anything.

6. Why do you sell a stock?

I’ll sell something for a couple of reasons. Number one, I was wrong. Either I didn’t understand the business well enough, or my analysis was off. Unless there is a compelling new reason to hold on, say the business is now selling for less than net cash or something, I’ll sell. Number 2, the business becomes overvalued. I don’t want to risk permanent capital loss at the point. Lastly, if I have a much better opportunity to invest in, I’ll sell. However, the burden of proof is on the new idea, as Eddie Lampert has said.

7. What investment decision are you most proud of?

I’m proud of my decision to hold off on buying Delta Financial last year. I’d already gotten killed on another, similar, company, and I started analyzing DFC in a similar way. I’m looking at this company, saying to myself “OK, here’s a better than average mortgage originator, they’ve done a great job securitizing…” I mean I almost rationalized buying this company after losing my shirt on American Home Mortgage. Somehow, I was able to catch myself and not invest. I knew that it was outside of my circle of competence, even though it looked cheap and somewhat understandable at the time. I’m a huge fan of Mohnish Pabrai, but he made an admitted mistake and I was able to say no ahead of time. A rare good decision for me.

8. What investment decision do you most regret?

Since I’ve made lots of mistakes, I’ll give you two. First, I bought American Home Mortgage, as I just mentioned, and it went Chapter 11 a week or two later. I was trying to catch the falling knife, and I did shallow, shoddy, analysis. Bad times. Second, I bought 6 month calls on Discover after its spinoff from Morgan Stanley. Lost it all. Those two were awful investments, but I learned a good deal from each of them. One was that I needed to overhaul the quality of my research. The other was a pretty firm rule: no short term options.

9. Why do you blog?

I began blogging for two reasons. One, I am an avid reader of financial blogs myself, and I couldn’t help it. Two, I desired the opportunity to get my words down on paper and in the view of public scrutiny. It would allow me to improve my analysis and my framework, because if I’m wrong or sloppy, someone will hopefully notice and call me on it. Plus, I have to keep writing to keep readers reading. That means I have to spend time researching stocks, reading good articles, and really thinking about what I’m reading so I can write about it on the blog. There’s some obvious positives in there for someone looking to improve as an investor.

10. What’s your best post?

Even though, by far, I focus most of my attention on the business I discussed
above, I very occasionally do little arbitrage situations, I mean like 3 of them ever. I think my best post was one called Jaclyn: Arbitrage for the Little Guys. I like it because I got to go, point by point, through the relevant materials in their filings, with direct information and my own analysis to back it up. The arbitrage worked out perfectly, and my analysis was on point. If only all of my investments, and public analyses, went so well. Also, my readers seemed to really enjoy it, got a lot of positive feedback.

11. What’s your worst post?

I try to put my best foot forward every time I post, so this is a tough question. I’d give it to Of Toads and Princes: The Yahoo! Deal Falls Apart. Not necessarily because it was a bad post, it was fine, but that type of post is not what my blog is really for. I kind of just grabbed a news headline that stuck me and ran with my own criticism. Search technology is not in my circle of competence, so I shouldn’t be commenting on it in the blog. It’s called the Circle of Competence. For all I know, that transaction has the potential to create a search leader out of Microsoft. I won’t be commenting on it in the future, needless to say. I should be sticking to analyzing the handful of companies I understand, writing about mental models and intelligent investing, and commenting on Superinvestors. The Yahoo! post broke that mold.

12. What financial publications do you read?

I enjoy the WSJ every day, Barron’s every week, Fortune, Forbes, SmartMoney. I also read Bloomberg and the Financial Times online, often. I just recently ordered the Economist and I’ll be reading that weekly as well, replacing Forbes and SmartMoney. I’m switching off of Forbes and SmartMoney to get away from reading the same opinions over and over. Forbes is a great magazine, no doubt, but given a limited resource (my time), I think I’m better off reading a broader and better written publication like The Economist. After reading Fortune, Barron’s, the WSJ, the New York Times, you start getting sucked into groupthink, which can be dangerous. The Economist will help broaden my thinking and push it in other directions. For instance, if you stick to those publications, all you’ll currently read about is housing, energy, the election, the falling market. I’d like to stay abreast of all that, but I need more perspective. Buffett has an uncanny ability to filter noise from signal. I’m not nearly as good at doing so, and thus I need to filter out some of that noise out before it even gets to me. Information overload is a real thing if it’s not usable information.

13. What investing blogs do you read?

Besides newspaper run blogs, like DealBook, I read a ton of value investing blogs. In addition to yours, some of my favorites are NoiseFreeInvesting, Valueplays, Controlled Greed, Cheap Stocks, and Reflections on Value Investing, which I also contribute to. My blogroll has the entire list. I find good ideas and enjoyable reading in these blogs. I’m a fan of Going Private as of recent. She is a great writer.

14. What’s the best investment book you’ve read?

If you’re talking about investing how-to’s, it’s The Intelligent Investor. I derive the base of my thinking from that book, no doubt. The Dhando Investor is close as a modern treatise. If we’re talking everything investing related, then it’s easily Buffett: The Making of an American Capitalist. I’ve read that about 6 or 7 times probably, in two years. It goes without saying that Alice Schroeder’s book this fall is going to cause me a few sleepless nights. Regarding The Dhando Investor, that book hit some nerve in my brain. I must’ve read that one 6 or 7 times as well. Buffett and Graham talk a lot about business-like investing, that mantra we’ve all heard. But, it wasn’t until I read Pabrai that I began thinking of investing like an entrepreneur thinks about running a business, which is at the core of my framework now. If Graham is the Old Testament and Buffett is the New Testament, Pabrai is like CCD or Sunday School for me, clarifying some already established concepts. Low risk of capital impairment, uncertain future outcomes; that framework hit me like a ton of bricks. It just made a lot of sense.

15. What’s the last investment book you’ve read?

I just finished reading a book called Extreme Value Hedging by Ron Orol. It’s about the tactics and strategies of activist hedge funds in this day and age, and where they came from. It’s a very detailed book that takes this subject from many different angles. Some of it I already knew, but I learned a ton, from activist strategies to required disclosures.

An interesting thing about EVH is that it connects value investors genetically to activist investors. To me, that makes a whole bunch of sense. If you owned a private business, wouldn’t you try to protect it if the managers were screwing up? I believe that activism is necessary at times. You own the business, after all, and one of the privileges of ownership is (partial) control. Even the 1950’s Buffett and Graham would go in and shake things up when they weren’t happy. So while I would never wish to run an “activist fund,” I think it’s wise to speak up when your managers are misbehaving with your capital. Good book.

16. When did you start investing?

I didn’t start investing, really, until a bit over a year ago. I’d been learning about it, reading about it, dreaming about it, for a couple of years. Last year I decided that even though I’d probably lose some money, which I did, it was worth to it to start experiencing investing rather than reading about it. Incidentally, I began investing right near the top of the market. That was a nice, quick proof that market timing isn’t a good approach for me. I’m getting better, slowly.

17. How have you improved as an investor?

The major thing was recognizing my fallibility and inexperience. It’s easy to read up on things and think you’re a real smart guy who’ll do 30% a year for the next 30 years. Then you get in there and lose a whole bunch of money and say, what happened to the smart guy I thought I was? I’ve progressed in learning where my circle of competence lies, how I can expand it, and being patient until that happens. Concentrated value investing involves some serious price swings for your portfolio. I’ve seen some huge volatility in what I own. From that, I’ve learned that I won’t be able to hang in there and buy more unless I’m really comfortable with my holdings. Writing publicly about them helps more than I anticipated, another reason I enjoy blogging.

18. How do you need to improve as an investor?

More of the same I spoke about above. I still need to work on patience and understanding. They are interrelated in more ways than most people realize. Without understanding, you’ll have serious trouble being patient. If I founded and owned some private business, I sure wouldn’t let some idiot tell me what it was worth every day. I really need to take that mantra and apply it 100% to investing in public securities. I can gain understanding through reading about companies and talking to knowledgeable people. I can only gain patience through introspection. It helps to have read Munger, Zweig, and all these guys who point out our psychological flaws. I’d also love to learn more about bankruptcy and real estate investing some day, as I believe that, periodically, there will opportunities in both areas to make a ton of money.

19. Where are the bargains in today’s market?

At first, I was thinking to myself “If you don’t have much capital, there are bargains everywhere.” To heck with that. Even if you do have five or six billion, there are bargains everywhere. Financial stocks, restaurants, retailers, healthcare… pick a sector you think you can understand and get working. There are companies being left for dead that won’t die. Sears is a $50B retailer selling for less than $10B. The market is saying, “This isn’t gonna work, Eddie.” Well, it might, and we don’t have to pay up to see it through; in fact we’re probably being paid to see it through. I’m finding stuff like that everywhere. That’s very true with financial stocks, as well, except that 99% of them are outstanding my realm of understanding. This is not the time to be clutching gold and treasury bonds, sucking your thumb until it’s all better. Just know that the recovery won’t be immediate, and you won’t know when it’s going to happen. At some point, though, people will return to the retail stores and restaurants, return to the credit markets, and need some serious help staying healthy as they get older. I’d structure my portfolio knowing these things will eventually happen.

20. What’s the most interesting company we haven’t heard of?

Primus Guaranty (PRS). They sell CDS on corporate single names and tranches. Basically, 95% of their revenue is just receiving quarterly premiums for insuring default on investment-grade corporate bonds and tranches. The GAAP numbers look awful due to marks, but the business is as good as ever. The company will never have to post collateral for falling CDS values, and they hold 98% of the contracts to maturity. The stock has cratered from over 12 to under 3, for no rational economic reason. It’s simply fear and misunderstanding. They’ve been thrown out with MBIA and Ambac, but unlike the bond insurers, they don’t owe people all kinds of money, and none of their counterparties can demand collateral. There’s no exposure to structured finance insurance. The only situation where Primus is murdered is if investment grade corporate bonds start defaulting at unbelievable rates. Meanwhile, the stock sells about 2x economic earnings and less than a third of solid book value. I know, here I am talking about all the mistakes I’ve made owning financial companies and now I’m recommending one. But I understand Primus the way I didn’t understand a bunch of those other companies I lost my marbles trying to make money on. Primus is a very simple company, one I’m comfortable owning. In any case, I’ll either have a big smile or lots of mud on my face in a couple years.

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