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U.S.News & World Report
Bruce Greenwald on Value Investing
Friday November 7, 11:43 am ET
By Kirk Shinkle

Bruce Greenwald, who holds the Robert Heilbrunn Professorship of Finance and Asset Management at Columbia Business School, is coeditor of the forthcoming sixth edition of the value investing classic Graham and Dodd’s Security Analysis (McGraw Hill).

After watching stocks plummet this year, he’s sizing up the opportunities seen through the lens of value greats like Warren Buffett who perceive a rare chance to start buying on the cheap. Excerpts:

What’s the current environment like for a value guy?

I’ll tell you the one really nice reason to be a value investor: When things like this happen, you cannot help but go nuts at the opportunity. What this looks like is the end of 1974, where good stocks are selling at three times sustainable earnings and stocks that normally wouldn’t have sold at less than 20 times earnings are selling at 10 times earnings. These are exciting times. The short-term issue is that in the near term there will be a painful macroeconomic environment and we don’t know how long it will last.

What should investors eyeing cheap stocks watch out for?

The craziest thing to do is take recent earnings and add a multiple to it. There are a lot of stocks, like steel companies, that have very high recent earnings and trade at only four to five times earnings. They look like a 20 percent return stock, but those earnings won’t be sustainable. If you look at steel companies five years ago before this huge capacity run-up, their earnings were about a third to a quarter of what they are now. You have to stay away from those kinds of enthusiasms–things that look cheap on the basis of peak earnings. You’re looking for [stocks] that are protected by assets.

How should you approach earnings predictions?

What you don’t want to do is use unmoderated price-to-earnings. Never look at current or even recent earning, especially in areas like oil companies where we know they are inflated and coming down. Typically, what a value investor will do first is get a sustainable earnings number, an average PE over a business cycle. You really have to go back 10-12 years to get a feel for what average margins typically look like in these businesses. That’s what you use for earnings. The second thing, when you look at a PE, you’re always assuming it’s sustainable. You always want to make sure it’s protected either by assets or the kind of moat that Buffet talks about. Otherwise, even if it’s been making lots of money, it’s a business that will be competitively vulnerable.

Does the weak credit environment change the value investing proposition?

The first thing is that for value investors, you are not going to try to forecast the future. Most value investors would say if it’s anything like credit crunches we’ve seen in the past, it will be gone in a year. That’s what the betting has to be. It’s a short-term problem and not something you focus on. It has, however created opportunities in debt markets. Banks are dumping senior secured debt, selling it on the market for 50-60-70 cents on the dollar. The implied returns are north of 15 percent, and because you’re senior to everybody else in the event of bankruptcy, you’re likely to get paid. That’s where opportunities have been created by the credit crunch. If you listen to Buffet, it’s where he’s been investing up until now. Those opportunities are still there, but my guess is they’re going to go a way.

Any advice for investors who are still nervous?

If you look at any (mutual) fund and you look at the average annual return–a dollar invested every year through the life of the fund–and then you look at the returns weighted by how much money was in the fund . . . , the difference in those two returns is 6 percent a year. That’s true almost across every category of funds. What that means is investors are buying in at exactly the wrong time and dumping things at the exactly wrong time. In this environment, the people who are dumping things are getting out at almost exactly the wrong time. What you want to have is a steady, well-developed policy you stick to.

What do you think of Warren Buffett’s move so far into Goldman Sachs (GS) and General Electric (GE)?

First of all, Goldman and GE are not real Warren Buffett moves. They’re literally what he did at Solomon Brothers. He got paid very handsomely both in terms of a high return and protection on the downside. His preferred carries a significant interest return on it and is protected in event of a catastrophe. He got a very favorable deal. This is not the kind of real investment he’s making. He has talked about accumulating further positions in one of two financial services companies. I don’t know if he’s had to reveal which one yet, but it’s either American Express or Wells Fargo. There you can see what he’s looking at. American Express is easier because it doesn’t have all the complexity of a bank.

Greenwald on the best value bets in the market now:

American Express (AXP):
If you ask yourself what the average yearly earnings should be even in a fairly distressed economic environment, it’s probably about $3.50 a share. Typically, they commit to pay out at least half of those earnings to you in cash, so you’re getting a 7 percent cash return either in buybacks or the dividend. Then they reinvest 7 percent of your money. In the short run, where that money is going is cash to protect themselves financially against any catastrophic drop in credit card repayments, but in the long run it’s going to credit card loans, and the economics of those are fairly transparent: They lend at 15 percent, borrow at 4 or 5 percent, have a 10 percent margin, and the default rate is around 5 percent. So they make 5 percent on every dollar of loans, and they leverage up because you can because it’s fairly safe. Even if they do 7 to 1, which is a fairly conservative ratio, you’re making 5 percent times seven on your unemployed equity capital which is 35 percent, or 20-percent-plus post-tax. And billings by American Express just grow over time. It’s probably faster than GDP because they have high-income customers, and spending is skewed towards services, which are growing faster than (spending) on goods. You probably get another 5 percent even making conservative growth (projections). You’re looking at returns, without any improvement in the multiple, of well over 20 percent. That’s the sort of investment (Buffett) sees. It gives you an enormous margin of safety for long-lived bad economic conditions.

WellPoint (WLP):
You’ve got an annual earnings return of 14 to 15 percent, and mostly its going into cash. You know they’re just a toll on medical expenditures in certain parts of the country, and those will be growing at 5 percent no matter how you look at that. That’s a 20 percent return. Buffett’s not greedy. He’ll live with that all day long. These are safe companies with dominant market positions and trustworthy managements. They may go down in value before they go up, but the long-run prospects are so stable and attractive that I think he’s right to be investing in these things.

Magna (MGA):
It recently traded at a market capitalization of $3.6 billion, and it’s got $1.7 billion in net cash. They’re not going to run out of money, so you’re paying $1.8 billion or $1.9 billion for the business. That business this year, if you look at average margins–and this year it’s a little lower because they’re at the trough of the cycle–is going to earn about 5 percent on sales of about $26 billion, so you’re talking about $1.3 billion of pretax earnings you can buy for $1.9 billion. Then, if you look at the assets and the cost of reproducing those, you have about $8 billion of assets in the business to protect you. If you just take that earnings power, after tax, of about $1 billion, and you say in a risky industry like autos you want a 12 percent return, that’s an 8 multiple. That’s a case where you’re being very conservative about earnings, you’re backed by assets, there’s a lot of cash, and, even though autos are a fraught place to be, you’re buying those $8 billion in assets less than $2 billion. That’s got to be the kind of bargain you’re looking for.

Comcast (CMCSA)

Comcast, when you take out excess depreciation, is trading at an earning return of about 10 percent. Even if everything goes to hell in a basket, the one thing we’ll do is transact over the Internet. They and the phone companies have an incredibly valuable monopoly unless they screw it up. The one encouraging thing that hasn’t appeared in cable company [share] prices is price wars among some companies seem to be moderating.

Microsoft (MSFT)

Microsoft, if you take out $20-30 billion in cash, is trading at about a 10 percent earnings return or so. It’s a business that doesn’t require any incremental capital and will grow at least as fast as global GDP.

Disclosure (“none” means no position): Long GE, GS, none
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So, I got the following comment from a reader.

“the blog was not about politics before and now after the election you take shots at the new admin, so you starting to dilute your blog focus, which I thought was about undervalued companies and business.

As a reader i am not really interested in your political views, actually I am not interested in politics at all. so you can choose to continue to obsess about obama and whatever and I choose to stop visiting and reading.”

Where to start? How about a quiz.

– Can anyone name the largest investor in US financial companies?
– Can anyone name the entity that forced shareholder dilution on US banks?
– Can anyone name the entity that has control of the US mortgage market?
– Can anyone name the entity that arbitrarily changed the basic rules of investing when it banned short selling, first in financials them a gamut of US businesses?
– Can anyone name the institution, that had it’s “bailout fund” been classified as a “Sovereign Wealth Fund” would be the world largest?

The answer to all of the above is the US government.

At no time in my adult life has the day to day action of the US Government had so much effect on investors. Perhaps one could argue the election of Ronald Reagan in 1980, but since I was 12 then, we’ll omit that. The reason politics rarely entered the conversation here before was that politics before had very little effect on it content.

I can understand and enjoy hearing differing views, but to ignore Washington now as a investor is to do so at your own risk. Shareholders of Fannie, (FNM), Freddie (FRE), and AIG (AIG) held by some of the greatest investor of all time and at the time called “undervalued” were wiped out by the actions of the US gov’t.

I’m not sure I have been anything but vicious in my criticism of Bush appointee SEC Commissioner Chris Cox and have begged Treasury Secretary Paulson to take a “time out” and have criticized the current bank injection plan. I have even come off my earlier in the year support of Ben Bernake and said he is trying too many things right now. All these folks are product of the current administration. In that respect, my criticism easily crosses political party lines.

The reader says I “take shots the new administration”. Not really. I have repeatedly trashed the media’s lap dog mentality to it. As a rule if the media in mass love something, I immediately become skeptical about it. For proof one need only go back the first press conference as President Elect. We were subject to hard hitting questions like “what kind of dog will you get”, “what book are you reading”, “where will your kids go to school”. Really? That is the best you got?

The world stands on the edge of global recession and we are wondering if Obama will get a beagle or a lab? Really?

My fear of the current administration is that we know nothing about what they will do. Why? The media did a pathetic job getting answers. Even Tom Brokaw admitted post election “I don’t know” in response to a question about what Obama will do now elected. Isn’t that their job in its most basic element, to find out?

If anyone read the Sunday papers this week they were full of articles guessing about what Obama will do. Guessing…Again, at no time in my adult life have these questions been asked AFTER and election. We knew where Clinton was going and we certainly knew what GW was going to do.

The reader then says I “obsess about Obama”. We’ll, he is the new President. He will be for the next 4 years. I think by default that requires he be top of the list? I will give Obama credit for one thing, he managed to be elected President without anyone really knowing what his plans are. Kudos..

What we do know is based on Barack’s record and his words. From that we know he has never voted for a tax cuts, has had a floating “tax increase” income target and wants to spend $1 trillion more . Other than that, nada. We have some grand plans but, thank to the media, we have scant, if any details.

At least in the 1980 election Reagan had been Governor of California so people had a good idea of his plans based on how he had previously governed. That and the media then at least asked him for specifics. The media was right about one thing in this election though. This is perhaps the most important election in a generation. I just wish they had attempted to give us the information necessary to make an informed decision.

For any investor to ignore politics today is to do so at their own peril. Does anyone think shareholders of Ford (F) or GM (GM) are not wondering if the gov’t will step in, and if they do if their shares will become worthless? Does anyone really think that based on the AIG, Freddie, Fannie episode anyone thinking about buying shares is not standing by waiting to see what the gov’t is going to do first?

Need value investors look any further that Friday’s press conference to see Berkshire’s (BRK.A) Warren Buffett standing onstage for proof that the political climate has the interest in and is of primary importance to investors of all types?

One could easily argue and be correct in saying that Bush 1, Clinton and Bush 2 (until 2008) only had an effect on the fringes of the economics of the country as none faced anything like what is in front of us today.

Today we are embarking on re-writing the basics of our economic and regulatory framework that has been in place for almost 80 years. We are also doing so with an incoming administration we know very little about at a time when things will have to be done rapidly. Does anyone think the rules the banking system follows are going to be the same at this time next year? Me either. If you don’t know what the rules will be next year, how can you value and entire sector of the economy?

Do I want Obama to succeed? Of course. His failure will be all investors and America’s failure. A Carter-like Presidency from Obama is bad for all of us and no one wants that (at least not here). That being said I am not going to sit back and say that a “new day has dawned” or the “world is better today” because we have a new leader who can give a hell of a speech. For the record, had McCain won I would be saying the same thing. Changing the driver does not mean the car works better right away.

I have not commented on Obama’s foreign policy or social programs, their effect on investing in general is negligible. I do get nervous when his people use words like “rule” to describe his readiness though..

Has anyone seen or heard a politician talk recently without them using the words “Wall St.”? Why should we as investors ignore Washington when clearly they are focused on us?

I can’t think of how it would be anything but irresponsible to ignore it and the effect it will have on investing going forward in the blog. If you disagree, feel free to talk about it in the comments section but to ignore the political landscape today I think may be costly..

Disclosure (“none” means no position):None
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