Volatility, they say, is a friend of value investors. But the crisis of 2008 proved to be an exception to the rule. Take the case of Charles Brandes, the 70-year-old founder of Brandes Investment Partners, who saw assets under management wilt from an eye-popping $111 billion at the end of 2007 to around $21 billion in a span of five years. But the turn of events has not shaken the confidence of the dyed-in-the-wool value investor, who believes that so long as human nature doesn’t change, value investing will remain an effective long-term investment strategy. Incidentally, Brandes is among the privileged few to have legendary value investor, Benjamin Graham, as a mentor.
Their relationship began in 1972 when Graham walked into a brokerage where Brandes worked, wanting to buy a stock. Those initial learnings from Graham have since become the foundation of Brandes’ investment philosophy for the past 39 years. Among the very first to have started investing in emerging markets way back in 1982, Brandes believes that while volatility can distort prices in the near term, the value of a business is eventually reflected in stock prices over the long term.
Tell us about how you got to meet value investing doyen Benjamin Graham.
I was very interested in economics and had embarked on an investment career in 1968. The late 1960s was a go-go era with a lot of hot new initial public offers (IPOs). The onset of the bear market in 1970 wiped out all these new concepts and the market was down 40-45%. One couldn’t have had a more stomach churning initiation. I didn’t know what to do as I didn’t have any guidance or an investing philosophy. I was still looking around and one day Benjamin Graham walked into the brokerage office, where I was working, to buy National Presto Industries. And since I was the designated person to greet incoming people, I got to interact with him. Soon after, when I paid a visit to his office, he kept asking me a lot of questions for which he already had the answers. For me, as a rookie, it was unbelievable that I was being asked questions to guide Benjamin Graham! I did have a few opinions even at that time, though.
Had you read any of his books before you met Graham for the first time?
I had read Security Analysis but not The Intelligent Investor. But after meeting Graham, of course I read The Intelligent Investor very carefully and got to know the story about Warren Buffett reading the same book and the pivotal effect it had on him. I think Buffett read it in 1949 and I read it 22 years later in 1971. To be able to interact, talk and then re-read his concepts helped me realise that it was magical, and that’s how I got attracted to value investing. When I started my investing career, value investing was called Graham & Doddism. The term value investing has come about much more recently.
You went ahead and invested in emerging markets (EMs) much ahead of others…
When I started my firm in 1974, I was not just fascinated by the US market but also with the potential investment and knowledge of other markets. But there weren’t a whole lot of public companies in EMs to invest in and hardly any reports or disclosures. The closest EM to San Diego, where my office was located, was Mexico. At that time, Mexico would have been called a frontier market, not an emerging market. In 1982, the Mexican government faced a debt crisis. As value guys, we thought that, perhaps during a crisis like this, we can get an opportunity to invest cheap. Going through the S&P 500 book, I found state-owned Telefonos de Mexico.
The only reports I could get was some old balance sheets and income statement for two years. But just looking at those I said, “Wow, look at the price. It looks like the stock is trading at 10% of the book value.” Of course, you can’t believe the book value and it looked like it was trading at 1X or 2X reported earnings. That was the first EM in which we invested. From then on, over the years we have continued to invest in EMs, depending upon the opportunities that arose.
When you invest in EMs, is there an optimum level of diversification that you seek? And when you diversify, is it more to eliminate risk or volatility?
We do not seek optimal diversification in portfolios but seek optimal long-term investment opportunity, with a satisfactory level of diversification. If you look at recent statistics, EM volatility has been going down compared with some developed markets. I think that is going to be case in the future as well. I don’t think that we will have the events in EMs that we have had in the past. When you are thinking about volatility in EMs, you are thinking more about past considerations than what will happen in the future. I wouldn’t be the least bit surprised if volatility in EMs becomes very much like that in developed markets — the old globalisation thing.
Also, if you look at the Asian financial crisis in 1997 and 1998, the South American debt crisis such as the Argentinean debt crisis in 2001 and 2002, or the Mexican debt crisis in 1982, and now the European debt crisis — all are related to government debt. However, today, the balance sheets of most EM economies are strong and even stronger are balance sheets of companies in the private sector. That’s sufficient vindication that EMs are unlikely to be volatile.
Can you talk about the kind of adjustments one needs to make in valuations? For example, if you look at US companies, their disclosure standards are much better than EMs.
I don’t believe in US accounting either. In the past we would seek a bigger discount in EMs because we felt that some numbers were not totally reliable. Today, in many cases, EM companies are completely reliable. International accounting standards even in EMs are becoming a major factor and that is also reflected in the companies that we have in our portfolio. The financials of EM companies are as true as they are in developed markets, although that is not saying much for either one.
Having said that, we need to be intimately familiar with specific financial information of any individual business, in addition to being reasonably comfortable with the larger economic environment in which it operates, regardless of its geographic location. Markets or regions that have historically demonstrated higher volatility with regard to (but not limited to) factors such as interest rates or inflation generally require a corresponding higher margin of safety prior to purchase, due to the potentially wider range of possible outcomes.
How do you adjust for interest and inflation rates? Because of your long-term focus on cash flows, even in EMs, does it mean that you don’t look at interest rates much?
In the case of inflation, we have to look at each individual company to assess the impact. I think that inflation is not necessarily a negative. Generally, operating margins of companies worldwide during periods of inflation and non-inflation have remained pretty much the same. We will look at interest rate from the standpoint of its cost and impact on balance sheets. But more importantly, it’s the outlook on a particular industry or a company that we will bother more about.
For example, in India, currently interest and inflation rates are relatively higher compared with the rest of the world. In such a context we have Infosys, where the stock has declined by 30% following a big slowdown in earnings. When we analysed Infosys, it was a growth company and not really a value company. Although it wasn’t cheap and was trading extremely high, we looked at Infosys and its long-term potential growth potential. That is much more important than analysing a country’s inflation and interest rates.
Buffett has maintained that his exposure to EMs will be largely through US multinationals. You, on the other hand, believe MNCs are poor substitutes for local EM candidates and that they do not provide the required diversification. But given the heightened currency risks, is this pursuit really a “safe” strategy?
One of the supplemental benefits of international diversification for the long-term investor is portfolio diversification. In order to fully obtain this diversification benefit, it’s necessary to own companies domiciled in markets that are independent of the US market over the long term. Owning US-based multinationals can be good; but owning comparable quality companies at the right price in multiple different markets provides an attractive opportunity and generally better diversification. One example of that is how we managed our dedicated EM portfolio during the period of 2008-2009.
Since 1994, in our dedicated emerging market portfolio our weights have generally been higher in small- and mid-cap companies rather than large-cap companies. After the big declines in 2008 we went overweight up to 85% in the small- and mid-caps. In 2009, our EM portfolio was up 115% for the year against 79% for the Morgan Stanley Emerging Market Index. These very cheap small and mid caps gave us the ability to outperform the EM index.
As you look around, are there any emerging markets where you still see value or do you have to use a more dilutive approach?
There is nothing today worldwide that sticks out as having Graham-like value. I would say the biggest one that really looked like a Graham-type value market was Japan, which is up 40%. By the way, we were severely criticised a year-and-a-half to two years ago for being in Japan. We had many big institutional clients fire us because we insisted on being over-allocated to Japan. They said, “Don’t you know Japan has a huge government debt problem, demographic problem? They have been in a deflationary environment forever. Nothing is ever going to change in Japan.” We found Graham-like value there big time.
We even found in Japan net-nets and they were very hard to find for many years. We had four to five net-nets in our Japan-only portfolio. I would say even though Japan has rallied considerably we are still over-allocated to Japan, though not too much. There are still small caps that are very cheap. So we are finding value there. Obviously, with this big rally in worldwide markets, they are not as good as before. But, if you look at the world from the aspect of normalised long-term history, stock prices are still below normal. For a long-term thinker there is still value today.
Are you saying that despite the cheer, it is easy to find bargains? What about information efficiency, then?
Yes and no. I don’t believe that availability of information has made it more difficult to find bargains for those who follow the Graham Dodd style. The reason is that people get too much information and drift away from the fundamental thinking they need to do as a conservative long-term investor. Data doesn’t really help you in judgements over a long period of time. In our estimation, information inefficiencies alone have historically provided a small opportunity set for global value investors. A larger and better opportunity has been provided by focusing on companies that were inefficiently priced owing to investors’ short-term orientation and frequent over-reaction to usually widely disseminated, very publicly available information.
Considering that Modern Portfolio Theory statistics are only a measure of volatility and not actually risk, how do you factor in the risk of loss into your valuations?
We consider true risk to be the potential for permanent impairment of investment capital; consequently, we place a premium on the relative financial strength of a company and the price to be paid for its acquisition. While it’s unrealistic to entirely avoid the possibility of loss in a stock portfolio, our experience has shown us that the likelihood of permanent loss can be substantially decreased by focusing on a combination of the balance sheet and financial strength of a prospective company, its intrinsic value, and its price. Often times, stock quotes in the short term will indicate that these opportunities are very different (either much better or worse) than what our independent analysis and long-term view would otherwise suggest.
Would it be fair to assume that as a Graham and Dodd value investor you wouldn’t be looking much at financially leveraged companies?
We absolutely have leveraged companies in our portfolio if a lot of the factors, such as how long they would have to refinance their debt, the nature of debt and debt costs, among others, are favourable. We will look at all those factors, the nature of the business itself, how cyclical it is and the kind of advantages they have. You can’t automatically dismiss leveraged companies just because they have debt. But we will be a lot more careful in doing balance sheet financial analysis. We don’t know how a crisis in the future will play out. Things just don’t repeat that quickly with the same mistakes. We will be looking at leveraged companies because, sometimes, they throw up great opportunities. We have banks in our portfolio. But we have been very careful about European banks, though we own a few high quality names. But many others are being avoided from the standpoint of what we learnt
in 2007-2008.
What were your learnings from the 2008 credit crisis?
There were quite a few lessons that we learned during the crisis in actually thinking about companies and industries and how, in a cyclical phase or during a credit crisis, these companies are going to be affected. We have learnt to take a more conservative view with companies with high financial or operational leverage. For example, banks, industrial manufacturing companies and those generally with high level of debt. But the time when you really need to be aware of leverage issues as a Graham & Dodd investor would be at the end of a long bull market. Because we are always trying, as value investors, to maximise what we call our margin of safety or the discount from the actual value of the company over a long period of time.
When you get into very high priced markets or markets that have seen an extended bull run, most of the big discounts disappear. We will also be a little bit slower with very high quality companies after a major bull phase. These would be companies with very strong balance sheets and strong established brands with fairly steady growth. We won’t be as quick to sell those companies in a bull market. Our clients seek out our expertise as a specialty manager and expect us to be fully invested. So we can’t hold a lot of cash and make market timing movements. So, during a bull run we have to be even more careful.
If you look back at the four decades that you have spent in the markets, what would be the most important learnings?
The market has taught me to continually stay the course even though I do believe that prices of businesses in public markets and, maybe, even in private equity, fluctuate and that volatility is much higher than the actual long term value of a business. The market has umpteen times demonstrated the same over the years. Secondly, the market has taught me that long-term can be quite long. Thirdly, the market has taught me to ignore the market most of the time. Just stick to fundamental investing as there are only a couple of times when you should be concerned about the market. One, when prices are so low for businesses that you have a margin of safety in buying stocks or when prices are so high that you no longer have a margin of safety.
In terms of personality, how have you evolved as an investor over the years?
There has been very little change. I still remember in 1987, when the US market had crashed 22% in a single day, I was interviewed and one of the questions asked was, “Aren’t you really worried and wondering what the heck to do?” I had replied, “No, I am very calm, actually.” The reason for that was the stock market falling 22% was not a reflection of the value of my portfolio dropping by 22% in a day. In fact, a fall in the market is actually an opportunity to buy things a lot cheaper and that is exactly the way I still think today. So long as human nature doesn’t change (and we see absolutely no signs of that happening), value investing will likely prove to be a very effective long-term investment strategy.
