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Photographs by N Mahalakshmi

What's On Your Mind, Mr. Buffett ? 2017

"Like most things in life, you generate luck for yourself; it's a true cliche"
Michael van Biema on his investment style, picking fund managers, and his take on India

N Mahalakshmi & Rajesh Padmashali

Michael Van Biema: Founder, van Biema Value Partners

From the Fifth Avenue office building of van Biema Value Partners, Central Park is within walking distance. For Michael van Biema though, his day job is hardly a walk in the park. His firm looks for talented investment managers to deploy client capital. To do that, he travels all around the world. In fact, he has just returned from a trip to Japan. van Biema has been there and seen it all. Starting off as a technology entrepreneur, van Biema had a notable stint as a professor of value investing from 1992 to 2004 at Columbia Business School, the very place where Warren Buffett graduated from, after chasing Ben Graham there. In 2004, he capitalised on his teaching experience and set up his own value investment advisory firm by roping in notable investors. He has also co-authored two books, Value Investing: From Graham to Buffett and Beyond in 2001, and Concentrated Investing just last year. In an interaction with Outlook Business, van Biema talks about why a disciplined approach is imperative in value investing and why only few make that cut.

>>> A profound insight in one of your articles is, “Value investing divides the world into companies that you can value reasonably versus companies that are not possible to value”. Could you articulate further on this?
I think it is important to point out at the beginning that what’s ‘knowable’ and ‘not knowable’ is dependent on the person who’s doing the ‘knowing’. We all have our own distinct circles of competence, which keep evolving and changing over time as one looks at different businesses. But, if you look at the history of successful value investors, they always stuck to simple businesses. There wasn’t a lot of flux in the business model or the competitive dynamics of business. 

So, it’s very interesting… this is sort of Buffett’s year of coming out, in terms of technology. But as he put it, he doesn’t see himself investing in tech companies but investing in consumer companies. There’s some degree of truth to that although one can argue as to whether both IBM and Apple were consumer businesses. Both certainly have a high component of technology. I myself started my career in technology so I might have a slightly different circle of competence here. Nevertheless, there is always a huge risk in consumer tech companies as technology can change overnight. The iPhone has a terrific franchise and presumably a long-lasting one. But there’s nothing to say some new technology won’t come along tomorrow and displace the iPhone. 

What Buffett is saying is that he sees a durable franchise in Apple but doesn’t necessarily see it in IBM, at this point. Ironically, these days IBM is probably more of a tech company than Apple is, which somebody of my generation finds it strange to say because Apple has been always viewed as this cutting-edge tech company. IBM is going to have to do a lot more to come up with new technologies and consumerise them if it has to survive and prosper. When it comes to investing in technology, it’s like having three boxes on your desk. One box is for companies, whose business model you think you can easily figure out. The second box is for companies that are complex and you can probably figure out. The third box is the too-hard-to-even-try box. A lot of the younger money managers are seduced by the second and third boxes as they are intrigued by their complexity. But what one learns over time is that there is nothing wrong with making money by concentrating 90% of one’s efforts on the simple box rather than spending a lot of time figuring out the complicated ones.

>>> Do you view Apple as a tech company or a consumer company? Also, why did Buffett buy Apple now and not in all these years?
Apple is a durable franchise at this point in time. But durable franchise of a tech product company has a shorter time span compared with, say, Coca-Cola. Coke has a very long window of opportunity. People are going to drink Coke unless lifestyles dramatically change in 30 years. Is Apple going to dominate cell phone technology for the next 30 years? It is very hard to say. People may be running around with cell phones embedded in their teeth or something! I think Buffett made the same mistake that I’ve made with companies such as Apple and Google. We were taught that technology companies were very dangerous to invest in as tech could change from under one’s feet quite rapidly. I think that was an unwritten rule for value investors and it took a long time for Buffett to convince himself that he was wrong in that regard because it’s been apparent for far too long that Apple and Google are becoming dominant players in their respective spaces. 

Probably, that’s the one thing that value investors didn’t take sufficient note of. There is a huge network effect today and, as a result of it, some of these companies have a very strong franchise. The reason that value investors stayed away from technology businesses is that they were viewed as companies where you had to speculate on future growth. And as we all know the value of future growth is zero unless you have a really strong franchise. It can even be negative as it was during the dotcom bubble for many companies. The faster you grow, the higher is the money you lose. I think we’ve all realised that these network effects generate a very strong franchise and hence, these companies are going to generate good profitability eventually. Profitability for Amazon has historically been relatively small but one can see that they’ve built up an impenetrable network effect, at least, in the US.

>>> What are some of the most common mistakes value investors make?
Value investors are always attracted to cheap businesses or businesses that appear inexpensive. There is a tendency to overlook the fact that if businesses stay cheap for far too long, their value can disappear over time. The compound rate of return goes down significantly. The other shortcoming for value investors is that they are terrified of growth. Take the case of Amazon and Apple, both were great growing companies and continue to be so. So, the trick is to find companies where not all of the growth is embedded in the current valuation. In other words, find companies that are growing, that have a strong enough durable franchise so that the value of the growth is realised. 

The genius that Buffett is, he has a very keen understanding of how to analyse franchises. That’s really what he’s brought to the table in terms of changing the way people think about investing and value investing. That skill of analysing franchises and intuiting which franchises are going to be durable and which are not, is pretty unique. Another example is Nike, which built a durable franchise very early on. When you think about it, how could a sneaker company have a durable franchise? Turns out Phil Knight figured out a way to make a durable franchise by doing something different. 

>>> In one of your interviews you said that you don’t believe in growth at a reasonable price…
To a certain extent, yes. But, I hope I am evolving over time as opposed to devolving. You have to be very careful about growth at a reasonable price because the very definition of reasonable price can be unreasonable, and investors tend to use that as an excuse for paying up too much. The key thing that remains true about value investing is that the companies you’re investing in must have a margin of safety. If you ask me what’s the single most important concept that Ben Graham brought to the table? I’d say it’s definitely margin of safety.

Again, it’s a simple mathematical truism — if you lose money you got to make twice as much to get back to where you started. If you can avoid or attenuate the downside in the long term you’re going to do well. That’s what the results of value investing show over time. Value investors do not do so well in markets like the one we’ve been having in the US, where everything keeps going up. But if you have some regression, a downside to the market periodically, which we really haven’t had for the past seven to eight years now, that’s where we start to charge ahead. So, this has been a difficult period for value managers and it reminds me of the tech bubble where everybody was saying value doesn’t work anymore when in fact since the 1940s, there have been periods where value has underperformed. But it’s always been for relatively shorter periods. Since 1940, if you look at the cumulative outperformance of value, it’s been over 3,000%. But very few patient people would have captured that performance as it’s hard to be patient over a 10-year period.

>>> Do markets like these make value managers vulnerable to style drift?
Definitely, it does. But our managers don’t do that and if they did do that, they wouldn’t remain our managers. We’ve been in the business for 12-odd years and less than a handful of managers have left us because of style drift. But it’s a brutal feeling. If you underperform for three, four or five years in a row, it’s hard on you psychologically and even harder to explain to your clientele that it is going to eventually work. It requires a lot of personal discipline and a lot of belief, which is why there are relatively fewer successful managers. 

>>> How do you ensure diversity or that returns keep coming in during times like these?
Value investing is like a spectrum. On the one end is the traditional Ben Graham-type manager, who is looking for net-net type stocks or stocks with cash-heavy or asset-heavy balance sheets. On the other end of the spectrum are Buffett-like managers who are looking at franchise businesses but are not paying up for growth. Some managers do purely small cap or micro-caps, while some are size agnostic. They’ll buy anything from an Apple to a $100-million market cap. We try and diversify geographically. Unlike last year, which was much better, this year has been an unusual investing environment. With the government manipulating the markets, to a certain degree, it has changed the dynamic for valuations. Many businesses today are either highly overvalued or highly undervalued. 

Our goal is to bring the best small value managers to our clients. We have different ways of doing and structuring that. Historically, we operated as a fund of funds, but now we’re operating as a supplier of small value managers. We also have commingled vehicles and allow investors to invest directly with some of our managers. Most of our clients have diversified portfolios and the reason they work with us is because we’re good at finding these small under-the-radar managers and they want at least part of their portfolio to be managed by them. We’ve even had large pension funds as our clients as they know we’ve been successful in finding managers who have become very successful over a relatively long period of time.

>>> What are the qualities that you look for?
We have on our board a bunch of well-known value investors such as Chuck Royce, Mario Gabelli and Jean-Marie Eveillard. They recommend managers to us. So, we have a pre-sorted mechanism whereby the people who come to us are certified for high quality. We have a defined process of picking up smart managers who, too, believe that we’re good long-term partners. The other thing we do is to continuously go through our managers’ portfolios and hear about the stocks they’re investing in, follow the stocks they’re investing in and do our own models of the stocks. That gives us the ability to ask them intelligent questions. Doing that not only earns us respect from them but also gives us an insight into the way they think and whether they’re drifting in terms of style. 

>>> Are there any specific traits that you look for because value investing, as you say, is a lot about behaviour and a little less about approach?
The thing that we look for is whether the guys are really passionate about what they’re doing. I like managers who leave the office on a Friday afternoon carrying two sacks full of annual reports and trade journals. The guys on my board have been doing just this for 30-plus years. On weekends, they don’t play golf, they don’t play tennis and some don’t even play with their children. I’m not advocating that though. But, they would much rather spend the afternoon at home on Sundays, drinking a glass of wine and reading a 10-K. This is a brutally competitive field. Look at all the guys who’ve been successful over longer periods of time, they’re  obsessed with doing this and it’s a passion. It also requires a lot of personal discipline as value investing is a pretty solitary profession. 

>>> Besides passion, what else do you look for?
Long-term focus is another trait we look for. One of the questions we ask our managers is: how do you define success for your career and business? What we want to hear the manager say is, “I’d like to look back in 20 or more years and say that I developed a great long-term track record.” We don’t want managers saying that I want to be the best performing manager in India this year or the biggest value manager in India at any point of time. What we want people to say is that over a very long period of time I want to show that I excelled at doing this. I earlier used to say five years is a long horizon but now I really believe it’s more a 10-year time period to analyse performance really well. 

>>> What is your view on concentrated investing? Isn’t there a selection bias when we talk about concentrated bets?
There certainly is. The guys who are successful are sort of innately applying the Kelly formula, that William Poundstone wrote about in Fortune’s Formula. What the formula does is to mathematically ensure that no single bet will put you out of business. You’ll make very large bets, but not such a large bet that it will put you out of business. All the investors mentioned in the book made bets that didn’t work but they ended up having enough capital to build their business back up.

It’s definitely very volatile and is also one of the reasons that makes it so hard to be a real concentrated investor. Investors are not going to be happy when you’re down 30-50% in your portfolio, based on one stock pick. It has happened with some of our managers and it’s very painful. They lose quite a lot of investors and their assets, but, hopefully, not every investor. Jean-Marie Eveillard, who is not a concentrated investor, always says that he would rather lose some of his investors than sacrifice his principles. And that is the sort of mentality one should have. Concentrated investing can potentially be very hazardous to your investment and health. The interesting thing though is that people who do it, seem to tolerate the volatility. It’s not for everybody. There are plenty of successful investors who have been pretty diversified. 

>>> What is the bedrock of portfolio construction because you say a lot of managers are stock pickers but don’t do a good job of portfolio construction?
There are different ways of doing portfolio construction. We know a very good manager, who has a very simple approach that I like. He has 30 stocks in his portfolio at all times and they are all equally weighted. So, that’s an example of a modern concentrated manager who doesn’t waste time trying to size his positions and he’s been very successful doing that. Typically, concentrated investors have one to three positions where they have unusual confidence. That’s another thing I learnt from participating in the book. In life there are only three-four investments that come along when one should go “all in”. All in doesn’t mean 100%, but a chunk of your portfolio. That’s what many of the guys in the book practised. 

As long as you get more rights than wrongs, you are doing well. And, obviously, there are going to be some people who are not right more than they’re wrong and that’s not a good scenario. However, if they practised diversified investing, it wouldn’t be a good practice either. Though not necessarily harmful but they don’t have the personality and skill set to do well in money management. But really keeping dry powder so to speak, and waiting for those exceptional opportunities is something most people don’t do enough. When you do a lot of work on a particular company and find that it’s not a “great” investment, but it’s a pretty “good” one, you usually convince yourself to put some money into it. The guys who we studied in the book don’t do that. They say if it’s not a “great” investment, I’m going to save the money for something that’s exceptional. So, they’re looking for exceptional risk-reward trade-offs. 

>>> You’re of the opinion that size is the enemy of performance. Also, can a fund manager’s style evolve with size?
You can’t manage a big portfolio because you will sizeably cut down on the opportunity set. On the other hand, if you’re investing across capital sizes in the US, you will manage a big portfolio but again not a huge one because you don’t want to limit all the smaller companies out of your universe as generally that’s where the best opportunity lies. 

However, a fund manager’s style is equally important. If a guy is micro-cap focused, he’ll be able to invest less money than the guy who invests across the spectrum. For example, we had an investment with a micro-cap manager in the US. We didn’t want him to increase his assets over $100 million as we thought he did real nano cap — $50 million m-cap companies. He ended up successfully increasing his assets but the fund did very poorly. Luckily, we had departed by then. So, in this case it was the manager’s style that determined the amount of capital he could support. We have one manager with whom we invested very early. Earlier he had $10 million in assets, but now he has a billion. We’re now starting to get concerned because a billion even in the US across all size companies is a lot of money to bet on. It gets progressively more and more difficult. We try and stay at the lower end of the spectrum. We believe the value-add for our clients is in finding small managers who have the full spectrum of opportunity and stick with them. Because the bigger you get, the more you limit your opportunities. I would rather stick to the easier task of picking great smaller managers than believe that I’m so great at it that I will be able to pick the Klarmans and Einhorns of the world correctly.

>>> Would the aversion to growth at a reasonable price also apply to India?
India, traditionally, has never been a cheap market. I am willing to pay up more for a high-quality company whether it is in India, the US or Europe. But the tricky question is: will I get the growth and stock appreciation in a reasonable period of time? What a lot of people don’t think about carefully enough is what a company’s compound rate of growth will be if they’re investing at a certain price. Investing in a company at a multiple of 20x is very different from investing in a company at 38x. Some people are willing to pay 38x, thinking the company is growing at 30%. But one should not only think about the company’s growth and P/E but also about how the stock price is likely to perform over a reasonable period of time. To contradict myself, there are some companies who have really strong franchises. Rather than buying a company at 38x, I’d rather buy a company at 22x and forget about it for a decade because my rate of return will be clearly much higher. 

 >>> What is your learning as a value investor?
There are quite a few things I’ve learnt over the course of my career and, I hope, there will be a lot more to learn as my career progresses. The issue of longer time spans is certainly something I’ve learnt. Being a technology guy, originally, my time spans were much shorter because technology changes over a much shorter cycle than investing does. It’s interesting how tech folks such as Bill Gates have embraced value investing as a way to invest his money once he made a lot of it in technology. The other thing is to try and embrace the exceptional things about investing and spend time on them. There are easy ways to distract oneself from an unusually great investment. Life is short, the older you get the shorter it gets and the shorter you realise it is, you want to spend your time on some great and not mediocre opportunities.

The other learning for me is that, as an engineer, I always had this desire to fix things. So, I would find things that were broken and then try to figure a way out to fix them. I still do it, but a lot lesser now, and particularly with people. It’s arrogant to think that you’re capable of fixing things or people, that’s generally untrue. You want to start with things that are pretty much already close to being unbroken because when you try to fix them you frequently waste a lot of effort and time and the outcome is not so great. A lot of value investors find companies that are badly broken, and they think that they can fix them. But, I think, they’re frequently disappointed in their efforts. People who are good at fixing businesses are few and far between. So, if you find somebody who is good at doing that then follow him, it will be profitable from an investment perspective.

>>> How much of investing is about luck and how much of it is skill?
Like most things in life you generate luck for yourself; it’s a true cliché… we’re all going to make mistakes. If you take that in your stride and apply the learning to the next potential mistake, that’s a positive trait and, over time, such people get better and better at what they’re doing. I had a tendency of looking back and kicking myself for making mistakes. But over the years, I’ve worked hard on not doing that because it is a negative spiral that you can fall into. You think you’re a smart guy and don’t want to feel that you’re making mistakes all the time. It takes a lot of personal discipline not to do that. My wife is far healthier in that regard. She will make a mistake and say, “Oh, well” and move on. That’s something I’ve learnt from her. It not only makes you a happier person but also a more able person, who can then create better luck for himself.

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