I haven’t posted in the last couple weeks as I’ve been meeting with different money managers in the Seattle area but I want to make sure I write about my 45 minute call with Gary Furukawa.

A brief background – Gary Furukawa is the co-founder of Freestone Capital Management an investment firm based in Seattle that has $2 billion assets under management (AUM).  Gary founded the firm in 1999 and ran the company as President and Chief Investment Officer until he relinquished (if I recall) the role in 2007.  Prior to Freestone he graduated as Magna Cum Laude from the University of Washington and worked at Solomon Smith Barney for 11 years where he managed $500 million in client assets.

Needless to say, he has a wealth of experience and knowledge.  The primary question I had for him was: What does it take to become successful in the investment industry.   Gary is a no bullshit guy and shoots you straight (something I appreciate and always try to improve).

He distilled it into two criteria:

1. Instinct
2. A nose for opportunity

Instinct – According to him, in the upper echelons of success in money management, either you got it or you don’t.  The “instinct” for investments can’t be taught.  All the schooling and training in the world can’t give you what it takes to be a truly exceptional money manager.

However, in my opinion this begs the question, “How did the instinct originate? Where did it come from?”  Blink: The Power of Thinking Without Thinking by Malcolm Gladwell discusses the art of thin slicing and essentially how instinct trumps the “rational” approach to making decisions.  Instinct is actually acquired – knowingly or unknowingly – by individuals that are experts in a field through time and experience.  For example, a particular tennis coach can call a fault with 95% accuracy when the ball is in the air before the server hits.  First, the ability seems bizarre to say the least.  But second, as bizarre and supernatural as it may seem, this skill was acquired through time.  Perhaps through 10,000+ hours of teaching tennis, and years and years of watching serves.

Personally, I believe instinct plays a huge role, but whether it can be acquired through time is subject to debate.

A nose for opportunity – I believe this follows closely to his first point about instinct.  The idea of buying a dollar bill for pennies appeals to people or it doesn’t.  Some people just “get it” while others are “ho hum”.  Certain individuals have the knack for spotting opportunities and acting on them.  It’s something hard – if not impossible – to teach an individual.

My follow on question for Gary was, “Well, where does the margin of safety and risk management come into play?” After all, the concept of margin of safety is an established tenet for value investors.  From Gary’s perspective, if you have the first two right (the instinct and nose for opportunity) risk management will follow.  At the outset this seems ludicrous especially if you consider the huge market for risk analysis, but then again, crowds don’t define right and wrong.  You’re either right because you’re right, or wrong because you’re wrong – not because people believe otherwise.

If you consider his statement in the context of buying undervalued assets his statement holds.  Good instincts and the ability to recognize opportunity tend to bring the attendant margin of safety.  A good deal should scream at you when you see it.  If you have to debate whether the $100 perfume bottle is a good deal, it’s probably not.

There you have it – the hallmarks of a great money manager according to Gary Furukawa.

Why does value matter?

When it comes to value investing determining value is 80% of the battle.  Knowing the value of a business requires (1) deep knowledge of the industry and (2) a framework to determine value. Just because you know Apple will sell more iPads this year than last is not enough to determine the value of the company which is heavily dependent on income.  While you might reasonably predict that revenues for Apple will increase, and growth will come from certain segments, it is much more difficult to predict what will happen to income.  Income depends on many factors.  How will their bargaining power with suppliers be affect profit? What will competitors do that may influence Apple’s competitive position for better or worse?  Will the company maintain pricing power with respect to inputs (costs)?  Will the company continue to innovate and forever stay ahead of the curve?

Valuing a business, therefore, requires a solid understanding of the company, industry, and factors that may affect it.  That is why it’s imperative to know your boundaries and limitations – and especially when you’re getting close to it.  Knowing what the general population knows isn’t enough.  You must dig deeper and hone your understanding of the business.

In Margin of Safety, Seth Klarman presents four methods for determining value, all of which have their advantages and disadvantages.  In some cases, using more than method might be the best solution.

1. Net Present Value (NPV)

This is probably the most widely used metric to determine value.  This is a concept that everyone in business school and the finance industry learns.  Adding up all the predicted cash flows and discounting back to today’s dollars using the appropriate discount rate - usually the prevailing market rate.  For example, to determine the value of the bond today, you would estimate all the future interest payments and the principal return when the note is due and apply the appropriate discount rate.  The number yielded will give you the net present value (or price) of the bond.

The same method can be applied to an enterprise.  If future cash flows can be precisely determined, NPV would be the best method of valuation.  While it makes sense in theory, in practice businesses never have earnings as consistent as that of a bond.  Nonetheless, for businesses with consistent earnings and which you believe will continue to maintain their earnings power you can assume the earnings will roughly be the same.  To protect against the unpredictability of the future such as earnings volatility, exogenous events, industry deterioration, you should build in a margin of safety to protect against this. No matter how good you are at analyzing a company you can never be precise about values nor predict the future.  The only guard you have against events out of your control is to require a margin of safety.  The more uncertainty you deem an investment, the larger the margin of safety you must require.

2. Liquidation value

Liquidation value is the rock-bottom value of a company.  Generally, companies in liquidation rarely obtain top dollar for their assets.  Rather, they tend to sell out at clearance prices to buyers that get a bargain.  For example, Circuit City liquidating 10,000 laptops in two days is going to receive much less than Best Buy would if Best Buy were selling the same 10,000 laptops during their regular course of business.  In addition to the extenuating circumstances of liquidation values, it does not take into account going concern value – i.e., value of the company if it were operating.

A quick hand method that can serve as a proxy for liquidation value is the net current asset value.  This takes the company’s current assets (assets turned into cash in less than a year) such as accounts receivable, inventory, marketable securities and nets current liabilities (monies due in less than a year) such as accounts payable and short term notes.

Another more conservative method is the net net current asset value.   This approach takes current assets and deducts all liabilities both current and long term.  This will yield a bare minimum value of the business since the long term assets such as property, plant, and equipment are not taken into consideration.  Generally, if you can purchase a company for less than the net net current asset value you will receive a good margin of safety.

3. Private party transactions

This method values a business based on what a private party would be willing to pay for the whole company.  For example, Company X makes IT components and current earns $50,000 per year.  The market is very optimistic about its prospects and is generally willing to pay a premium in the stock market for this property at forty times earnings.  This will give Company X a market cap of $2,000,000.

Now, would a private party be willing to pay as lofty a price as general market?  Generally the idea is, no.  People purchasing whole business tend to be more realistic than those who purchase pieces of paper (stock certificates) on the internet.

Clearly, there are flaws in this method.  Private parties have and do overpay for business which is why this is a metric that should be used in conjunction with other methods.  

In any event, this serves as another method to measure value.

4. Stock market value

Probably one of the least reliable methods subject to supply and demand in the market.  General price movements in the market are usually caused by investor sentiment as opposed to the fundamentals of the business.

However, when valuing some assets such as closed-end mutual funds or trust companies that have assets consisting almost completely of marketable securities, the stock market valuation is likely the best and only method of valuation.

There you have it.  Four methods to valuation that Seth Klarman and many other value investors use to buy or sell securities.  While, descriptions for the methods above are not meant to make you an “analyst”, it gives you an idea of what value investors are looking for.

I recently read a book called Margin of Safety by Seth Klarman.  It was referred to me by a director of Blackrock when we met at Blackrock Alternative Advisors’ (BAA) downtown offices in Seattle.  Prior to meeting with Jeff I had never heard of Seth Klarman.  Not surprisingly, it is one of the suggesting readings at Columbia’s Value Investing course.

For the record, when I looked at this book on Amazon a few weeks ago it was selling for $1500!  It has since dropped to $500 for those of you who wish to buy it.

I finished the book while in New York and really enjoyed it.  The book is broken down into three parts:

I. Where Most Investors Stumble
II. A Value-Investment Philosophy
II The Value-Investment Process

In many ways, the book is akin to The Intelligent Investor and uses many of Ben Graham’s principals such as “Mr. Market” and the margin of safety.  Like many successful investors, Seth Klarman is clearly part of the Graham and Dodd circle.

In the ensuing posts, I will write about nuggets of value I got from the book.

Performance Derby

Klarman writes extensively about the “performance derby”, essentially, the goal of mutual funds and institutional investors focusing on relative performance instead of absolute performance.  Whenever you hear how an investment class or fund is performing relative to the S&P 500, that’s an example of relative performance.  It’s how an investment compares to the broader market.

Benchmarking is common practice and is frequent used as a yardstick for quick comparisons.  However, it is not without its drawbacks.  Investment managers that try to beat the market quarterly or annually are short term focused.  Of course they want to beat the market, but more importantly, they don’t want to under perform the market.  After all, to stand out of the pack and under perform the market in just one year is a terrible thing – even if their average return is higher than that over the market for 10 years.

With this short term performance derby orientation, investment managers are likely to sell investments that are in fact good buys and buy stocks that are performing well and in favor to not miss the ride.

This provides value investors with great opportunity to buy undervalued stocks at even a cheaper basis.  This is exactly why you have the excesses on the sell and buy side.

How to Define Risk

Many finance professors and investment professionals define risk as volatility. Volatility (also known as “beta” at universities) is the tendency for the stock to fluctuate more or less in relation to the market. The more a stock fluctuates in relation to the market, the higher risk and vice versa.

Klarman in very simple terms defines risk by two components:

1. The probability of loss
2. The potential amount of loss

It’s amazing how sometimes you can over complicate the simplest things in life (and investments).  Essentially, when thinking about risk you can reduce it to those two components.  Of course this assumes that you don’t have unique liquidity needs.

To all my readers, I sincerely apologize for not keeping up with my blog. It’s been nearly seven months since I’ve blogged. Much of it was motivated by financial and time constraints: blogs usually don’t pay the mortgage and there are only 24 hours in a day.

So, I’m going to make a commitment and try to blog a couple times per week. Since it’s been a while, after receiving my first update you can unsubscribe if you wish – there will be no hard feelings. These updates will keep coming so if you wish to jump ship, do it now.

For writers, this goes without saying, but writing really does take a lot from you. You must plan for it, you must do it, and you must deal with the consequences of it – through feedback that is good or bad.

My goal for resurrecting this blog is twofold:

1. To organize my thoughts on investments and flesh out investment topics and ideas more formally.
2. To hopefully educate and add value to those interested in the topic of investing, personal development, and personal finance. However, I think for at least the near term, it will be “investment” heavy.

I’ve recently come back from my visit to Columbia University and purchased nearly all the books they had on Value Investing. For those of you who don’t already know, Benjamin Graham, widely known as the Father of Security Analysis graduated from Columbia and subsequently taught classes on Security Analysis there. Graham also later came to be known as Warren Buffett’s mentor.

In the ensuing months I will start writing about my readings and interviews, if any, from knowledgeable professionals in the industry. This Friday, I am tentatively scheduled for a call with Joshua Siegal, adjunct professor of Columbia University, who is the co-founder and Managing Principal of StoneCastle Partners which manages more than $2.6 B in assets predominately concentrated in the financial sector.  I’ve asked his permission to post our call on the blog and I’m waiting to hear back.

In Tom Peters’ most famous book, In Search of Excellence, he mentions a great principle: Stick to the knitting. In other words, stick to the business you know.

Warren Buffett often talks about things he’s does not know.  When he doesn’t know something he is apt to point it out.  That seems simple enough, but there is tremendous wisdom in that.  In life, as in business, it’s important to know what you know and know what you don’t know.  As Warren often says, know where your parameter is and when you’re getting close to it.

In the heyday of real estate many general contractors (GC’s) left working for other builders and started developing themselves.  Instead of just making their GC fee (a percentage above cost) why not develop for themselves and get the upside.  That was easy in a bull market – a rising tide lifts all boats.

Low and behold, when the tide goes out you see who’s swimming naked. When the market fell, many builders instantly went bankrupt, even before they filed notice to creditors.  GC’s were faced with lines of credit that were up for renewal, warranty and construction issues, mismanagement of costs, over-leverage, you name it.  Everything can go wrong when you least expect it. And for many people it did in 2007 and 2008.

That happens when you move beyond your competence.

The tendency to resemble lemmings and follow the crowd is a human flaw that will never disappear.  Psychologists call this social proof.  Essentially, you do something for the sole reason that others do it.  If people make money in penny stocks, why shouldn’t you buy 10,000 shares?  Your neighbor just bought ten homes and saw the value of them go up by 15% in one year.  Why shouldn’t you get just a few?

In Search of Excellence, Peters talks about businesses that get an itch to enter new industries and expand for expansion’s sake, a cardinal sin of business management.   Not that businesses shouldn’t be creative and innovate.  Or that companies shouldn’t be nimble and open-minded.  But that businesses should stick to their core competence and expand those competitive moats in which they already have.

Whether you plan to invest in stocks, bonds, ETF’s, private equity, real estate or anything else make really make sure you understand what you’re getting yourself into.  If not, you might as well hire a money manager or financial advisor to protect you against yourself.

When it comes to money and finance, better safe than sorry, know what you’re doing.