Shoulders of Giants – Bruce Greenwald Barron’s Interview

Spend each day trying to be a little wiser than you were when you woke up.

— Charlie Munger

 

Bruce Greenwald is the Robert Heilbrunn Professor of Finance and Asset Management in Columbia Business School, and also Director of Heilbrunn Center for Graham & Dodd Investing. He recently had an interview with Barron’s [link here], which I find very insightful.

 

Below are some wise quotes from the article & my thoughts for self-reminder purpose.

 

Opinion on Discounted Cash Flow

There is a fundamental stupidity about discounted-cash-flow valuations.

Very much agreed. Let’s be honest, we all know that you can pretty much get any value out of a DCF model by tweaking terminal cash flow or discount rate. I personally think a sensitivity analysis for these two parameters is absolutely needed along with the DCF model itself.

In practice, I typically use 10% fixed discount rate for all SMID businesses I analysis, so the sensitivity to discount rate is less of an issue. By the way, the reason for using a fixed discount rate, is that I believe the academic way of getting cost of equity based on beta doesn’t make sense (inherit from Munger’s point of view) and that 10% is no worse than the number I could get out of some WACC formula.

Another problem I had when I do discounted cash flow valuation is that since I do DCF at last, most of time I have formed some opinion about the price-value relationship (from asset based analysis, ratio analysis, etc.). Thus, I tend to revisit and re-examine the model if the first iteration outcome appears to be far off. This is heavily anchor biased, obviously. I think I may be better off to ignore the DCF valuation altogether than going back and tweaking the model to get some “more expected” value if I don’t feel comfortable with the first iteration. After all, I don’t feel “more confident” about my verdict after tempering model anyway.

Bottom line, DCF is a great model for making pitch. So all analysts need to master it to sell your ideas to either PM (for buy side) or buy side clients (for sell side). For investing your own money on ideas, one should focus less on the DCF result, rather should use it with full awareness of its limitation. As Greenwald put it: “You are combining very good information, your estimate of near-term cash flow, with very bad information, your estimate of distant cash flow. When you add bad information to good information, bad dominates.”

 

The “Columbia” Way of Evaluating Business

We start with the balance sheet, which doesn’t project anything… The second-most reliable piece of information is the profit-generating capacity of that business, normalized for accounting distortions and cyclical factors. Forget the growth and the forecasting. Let’s look at what is there today… [The third element] has to do with the Warren Buffett instinct, the strategic assumptions…

Coincidentally, my approach has exactly these three elements, with the exception that I do the third one (strategic assumptions, or I call it qualitative/moat analysis) first, then to assets then to earning power. I guess it’s not surprising since I developed my approach on Graham-Buffett works. The normalization of profit-generating capacity is not what I do well, since it requires more works to go back history (a part time investor sometime doesn’t have that much luxury). A lot of businesses I look also don’t have enough operation history. But the key idea is to evaluate based on normalized earning capability, either historical or estimated.

Greenwald also outlined three scenarios based on the relationship between assets value and earning-backed-out value. Very insightful.

In case one: A company has an asset value of $8 billion, and earnings power of $4 billion [normalized earnings, divided by the cost of capital]. Asset value vastly exceeds earnings-power value. The takeaway is that value is being destroyed by weak management. If they borrow to grow, they’re destroying the capital. That’s where value traps come from. Does a discounted cash-flow calculation tell you that story? Not in a million years.

 Case two: Asset value and earnings power are about equal, which is exactly what would happen in a competitive market. Growth is worth zero, because competitors enter and drive the earnings down.

 Case three: Asset value is $8 billion, and let’s assume earnings-power value is $40 billion. This is the Coca-Cola (ticker: KO) case. For that to be sustainable, there have to be barriers to entry. This is Buffett’s moat stock. Are there economies of scale, barriers to entry, customer captivity? I can look at reproduction value, which is a hell of a lot better than some forecast 10 years into the future.

 

Specialist vs. Generalist

“Suppose I spend my life writing onshore South Texas Gulf Coast oil leases. You fly down from New York and buy one from me. Who do you think made money on that transaction?”

Greenwald is clearly an advocate for specialization. But for myself, I just enjoy exploring different disciplines more. I may lose to more informed investors on certain sector, but you can also argue that specialization on certain mature and fully-consolidated industry is waste of resource. What’s your purpose if you happen to be assigned to rail sector and try to select the winner out of a less than 10 stocks universe? Airlines industry nowadays is another example. I simply won’t enjoy that type of live.

 

Best Value Investors

Warren Buffett, obviously; Seth Klarman [Baupost Group]; Howard Marks [Oaktree Capital Management]; Mitch Julis [Canyon Partners]. They are very disciplined. And you want people who are good judges of business. Glenn Greenberg [Brave Warrior Advisors] is a superb judge of where the moat is, how sustainable it is. Li Lu [Himalaya Capital] is very good at picking management. So is David Swensen [Yale University endowment].

I follow almost all closely, except for two: Mitch Julis & Glenn Greenberg. Noted and will look out for these two investors.

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