>>> Do you remember the first time you attended the Berkshire meeting? What makes you come back?

The first time I attended the meeting was in 1993. I attended it again the next year but stopped after that. It is only in recent years that I have become a regular. It’s kind of interesting — Warren Buffett has such a small universe to invest in and if he is still doing it better all these years, then he is really a smart guy. Potentially, if you have a better opportunity set, you should be doing a lot better, but that is not the case here. Also, coming to Omaha means you get to meet and talk to other people. Someone made an analogy by saying, “When you go to a church to attend a religious service, you know what they will say”. It’s the same doctrine, the same principles, the same ideas. But listening to those doctrines, principles and ideas on a regular basis is good because we are human. We know what’s right but we don’t necessarily follow it all the time. We have biases, we make mistakes, so it’s good to revisit the framework once in a while. This is a cathartic place to contemplate what others do, makes you think about what you do, reflect on your mistakes and, hopefully, make fewer mistakes in the future.

>>> Given that the universe of small-caps is really huge, how do you know where to fish?

A little bit of it is in the history of our firm. Originally, I was an accountant auditing Tweedy, Browne. They bought cheap stocks — the cigar butts. Over time, I realised that a lot of those companies didn’t do well — they weren’t good businesses, were not well run and were poor capital allocators. But some did really well and they were mostly cyclical businesses. That’s one of the things you look for and screen for in industries that are beaten down and out of favour. When a cyclical business is in a downturn, the market can overreact and significantly undervalue a company in terms of its recurring long-term earnings. The cyclical process also means that if it is a well-run company with a good manager, it will be the beneficiary of a downturn because competitors go away and you get market share. So, you end up paying a discounted price for a business that has good growth potential. Thus, we always spend time on industries that are doing poorly.  

Today, we have investments in the home building-related business, which we first entered in 2009. After the financial crisis, we went from 1.6 million single-family homes to 450,000 homes. One of the things we do is look at such areas. Having done this for 34 years, there are a lot of companies about whom we have strong institutional knowledge. Then, of course, we also screen for companies in industries that we think have the potential but we don’t necessarily know of. But for most companies in the pool, we are cognisant of their business dynamics. 

Many years ago, we had invested in the health care business related to assisted living. Ten years back, the government changed the reimbursement rates. They split the management companies from the real estate investment trusts (REITs) and the service companies. As a result, everyone was going bankrupt. So, we looked around and invested in few REITs which we found interesting. There was a service company with $5 in cash and was quoting for $5. Our entry point was cheap as they were selling for cash. The business was recurring but, in the short term, was facing some issues. Over time it turned out to be a good business that we got to learn more about.

So, we regularly look for industries and businesses that are out of favour and doing poorly. Some work okay and some do really well. You don’t need a lot of them to work really well. If you hold them through the recovery period, they potentially offer 3-5x return, even 10x.  

>>> How do you know that the distress in not secular and that it is going to come back?

You never know the answer to that question. That is based on business judgement and understanding. I’ll give you an example. We started to invest in the manufactured housing business in 2004-2005. They went from 400,000 new starts in 1998 to 145,000 in 2004. So, the industry was significantly smaller from what it was earlier. Yet, when we compared manufactured housing with home building, the former made a lot of sense because you build a home per square foot for much less money, with them being built in a controlled factory environment. We thought the industry should do really well and recover and, hence, invested in the business. But what happened was, in 2004-2006, nobody was buying an $80,000 manufactured home because you could buy a $220,000 single-family home for no money down, if it was your first mortgage. Hence, financing became such that a $220,000 home cost you less than an $80,000 home. Therefore, though competitively it was a great product, financing made it uncompetitive. As a result, the industry further shrank from 145,000 to 45,000 homes. That made it worse and a lot of companies went away. 

We still have one of such company called Cavco. It is the second largest in the business after Berkshire’s Clayton. We think it is in a good position with a smart ex-Clayton manager running the company. The industry continues to exist — manufactured housing still makes sense, it is still a competitive product. But after 12 years, it hasn’t delivered a good annualised rate of return. So, this can happen sometimes since we focus on cyclical capital-intensive businesses. 

The one industry that we have a lot of experience in is the oil service business, especially offshore drilling. Earlier in my career, I bought a well-run company called Atwood Oceanics. In 1983-84, it had a $20 million market cap, with $40 million in cash. We were paying nothing for the business. What had happened in the ’70s, when this business really came up, was that all this equipment was built but there was huge oversupply as demand dropped dramatically. These are 30-year assets, but the business went through a 15-year cyclical downturn. Today, if you look at the shipping business, bulk shipping runs that risk. They have built so many ships that there is supply to last another 10-15 years. There is oversupply because there is a slowdown in China’s demand for iron ore, coal and copper. But even if that picks up, it’ll take a long time to make good annualised returns. So yes, there are risks in terms of judging the cyclicality. Is it a secular decline? Well, you can make mistakes even if it is cyclical. So, I have had experiences that have not worked out that well. We have to keep making these assessments from time to time. 

>>> How do you know when you are wrong? 

Even if the price of a stock halves and it takes it three years longer to recover, you can still make a good annualised rate of return because the new price offers a good entry point. We have done this over the years. We have been wrong in the short-term but we kept buying more as the stock went down. Then, after a while, we ended up being extremely right and made an awful lot of money. 

The best example of that is a Richmond-based company called NewMarket Corporation, which sells additives to the petroleum industry. When we first bought it, the industry was plagued by oversupply and weak demand, and then we had the Asian financial crisis. The company had a lot of debt, so the problems got compounded. We had bought it at $35 originally but continued to buy it all the way down to $4. There was still some risk because the company had debt, but we thought that the family that owns the stock is committed to the business and, therefore, it was going to be a survivor. Moreover, it was trading at a fraction of what we thought the fair value was. But, even though it was deep in the woods, I didn’t buy all the NewMarket stock when it was at $4, as I didn’t necessarily see when things were going to change. However, when the business started to recover, the stock got back to $15, and went beyond because the industry dynamics changed. The company gained pricing power after the market leader Lubrizol changed its strategy from chasing growth to focus on pricing and cash. We had a tipping point when it was at $15. We made loads of money because we had bought a lot of stock at lower levels as we had the conviction. But my only regret is that we sold too early. 

In a cyclical business, if you are going to hold for the long-term and the business does come back, you still have the opportunity to bounce back. We were foolish enough and persistent enough to say that tomorrow is the future. At some point, there will be a tipping point and it culminates into an opportunity. The price that we paid for NewMarket was a tiny price. The proof that it really is a good business is the fact that a very smart investor paid a much higher price for Lubrizol, the industry leader. Lubrizol probably has some advantages because NewMarket is the smallest guy in the business and Lubrizol is the biggest. But both enjoy the all-important pricing power. NewMarket operated in a niche and did really well. While we sold a lot of stock at $15, we eventually sold the balance stock at the end of 2013 at $275. We got a $25 dividend too. The dividend itself was higher than the stock price we paid. And we sold it for 20x the price we bought it for in 2005. This, even though it is not a growth business. It grows at 1-2% a year. It is engine motor oil. So, not a great business but we could still make money. 

>>> What should be your margin of safety when your call is based on some change that will alter future earnings? Second, how much would you rely on management to understand the future, because managements are often  unable to get past their own biases?

Let me explain my experience with Builders FirstSource. In 2009, I figured that in five years we’ll be back at 1.1 million single family homes. Seven years later, we definitely are not back at that number. I was wrong. Of course, after we made that call, people were saying that recovery is never going to come, so in the middle of 2011, the stock was half of what it was in 2009. We bought more of the stock because we were convinced. The margin of safety is okay if the number ends up being 800,000 homes instead of 1.1 million, because it is still a pretty big number. If I am wrong about the five-year period, and it takes longer, even then I am okay. 

But what really happened was that when the business did turn, a lot of positive things came together — they acquired the largest guy in the business. Home building, meanwhile, has gone up to 750,000 from 450,000. You wouldn’t have known that, but this is what usually happens. Over time, I have actually got more cognition that 1.1 million is not the right number and it’s more like 1.2 million or 1.3 million. There is clearly the likelihood that there is pent-up demand. You are not going to move to a normalised number after six-eight years of being half that number. Things happen eventually on the other side. The longer it takes, the more the opportunity for the company to build its competitive position with acquisitions. If there are good management teams, then there are probably going to be opportunities. That is my experience. And some of that is serendipity. You didn’t know that is going to happen. Just like in the case of NewMarket, you did not know how the industry dynamics would change. Good things happen to survivors in businesses when a recovery does happen. 

>>> Buying more on a decline may be logical when you are convinced about the business. But how about buying more of a winning idea? How do you convince yourself to buy something more expensive? 

If you have spent enough time and focus on the business to see what the opportunity is, it will somehow help you change the focus. You have to tell yourself, that (the low price) was great but that was the past.

>>> Since your strategy is to take high-conviction contrarian calls, and use averaging actively, how do you construct your portfolio? 

In terms of an aggregate portfolio, we are odd creatures. It is still pretty much stock picking for us. If you have high conviction, you buy. I am not necessarily thinking about high percentage. If I pick up a couple of stocks that really have the potential to be multi-baggers, they are going to be a significant portion of the portfolio. That is probably going to work relatively well for the aggregate performance. Over the 30 years that I have done this, I have never really structured my way towards creating a portfolio. Instead, I just pick up individual stocks. If I win enough of them over time, they will generate a really good combined rate of return. 

>>> Is there a checklist to verify that you don’t fall victim to behavioural biases?

That would be being superhuman. We are not going to be able to do that. We are going to make mistakes. It’s like a confession, you go to the church and say, “Forgive me father for I have sinned”, and he says, “I hope you don’t repeat it.” And you go out knowing, I am only human, I am going to sin again. It is like that. I am going to make mistakes. I am going to have judgement issues. That is how it is. All you have to do is think if the difference between what the business can earn and what the business, therefore, is worth, and the price you pay is big enough to have a margin of safety. So, the things I am wrong about don’t hurt much. 

Of the things that have hurt me in the short-term, there is a good chance that some of the facts are still accurate and, hence, will give me the opportunity for an even better investment. Therefore, buying more of the things we know are doing really bad has been a good strategy for us. I would rather have a behavioural bias and own stocks, own them for a little too long rather than sell. Because, when things start to go the other way, there is a long runway of opportunity. It’s a bad idea to sell too early then. The biggest mistake I ever made was selling NewMarket too soon. Now, if I didn’t sell the stock, and conversely the stock came back down, I could have bought more of it. That is a mistake that I can live through and benefit from, as opposed to selling too soon because I am probably not going to be able buy at that value again. That is going to be a hard behavioural problem to get over.

>>> In an earlier interview, you had said that there are three major areas to look at to gain an investing edge — information, analytical and behavioural. The information part is fairly straight forward. How do you sharpen the analytical and behavioural aspects?

The behavioural aspect is a personality thing. It is also an experience thing. The biggest thing about the behavioral aspect is that the market may continue to think that you are wrong. But if you are confident of the work you have done, you should have the conviction to say that I don’t care what the market is saying, I am right and they are wrong. It is easy to believe that in a certain way because the market definitely focuses on the short-term and doesn’t look at the long-term. The analytical edge is really focusing on the right information and also the right time perspective. 

But take the case of the oil industry in the US. The fact is that, for a long time, oil was going up a million barrels a day and no one focused on that number. It was in plain oversight until it reached a tipping point, when it came down from $90 a barrel to $30 a barrel. Could it get worse than that? Absolutely it could. Production has already gone down from 9.6 million barrels in the US to 9 million barrels. The rig drilling numbers were almost half a year ago. Now, they are half of that, so they are a quarter of where they were. Everywhere production is declining, and it might accelerate. But there will come a tipping point, we don’t know exactly when. So you look for the right companies, with the right balance sheets and the right management. In the long-term, there is a good chance it will make a lot of money. And if it stays bad longer, more competitors would get out of the way. Thus, more opportunities would come up, and the guy who has got the balance sheet and knows what he is doing will grow the earnings power of the business in the downturn. 

But while pursuing this long-term strategy, the capital you manage can’t have a different time horizon than you do in managing money. Berkshire is in a wonderful position as it has permanent capital. We have really made money for people over a long period of time. But the long-term capital and the attitude of our investors have been fundamental for me to be able to do what I do.