- So welcome all to this event. A conversation with Bruce Greenwald on the occasion of the
publication of the second edition of his value investing
textbook value investing from Graham to Buffet and beyond the second edition finally
came out after a long wait. We're delighted that that is already here. And we're gonna have a
conversation with Bruce about what's new in the
second edition, but also about of course, his views on the state of value and value investing the States of markets and the future of value investing on our financial markets in general. Bruce of course, doesn't
need an introduction. He will get one non the less he's the Robert Heilbrunn
Emeritus Professor of asset management here at
the Columbia Business School where he has been a phenomenal
presence since he joined from HBS many decades ago. Bruce is an academic of
enormous distinction. As we all know an intellectual powerhouse and a phenomenal impossible debater. I was at home yesterday
with Bruce discussing and talking a little bit
about the event today. And, you know, talking
with Bruce is always an intense experience and one that is not for the faint of heart. So when I'm looking forward
to yet another conversation with Bruce, so, welcome Bruce. Thank you for. - Thank you for the kind introduction. But I gotta warn people as usual, my idea of a good conversation is I talk and everybody else listens. - Yeah. So this is why assume
conversation is ideal. So the way we're gonna do this is we're gonna see it on conversation about, as I said the
book and broader topics we're gonna be talking
for about 30, 40 minutes give or take, and then we're
going to allow for questions. Please do ask them in the Q&A tab in your Zoom screen, we'll
read them, we'll process them. And either Meredith Trivedi,
the Administrators Director of the Heilbrunn Center
or myself will read them and we'll have a good
conversation and we'll go for an hour and 50 minutes
depending on how we all feel and how hungry we are at
the end of this event. So, Bruce, I want to start by asking you about the timing of this publication. It was long in coming you,
and I have spoken about the second edition for a long time of the value investing book. So why now? How come it's coming now? - Okay, so why do you
have to understand about Judd and I in these books is that we have a phenomenal ability to release some at exactly the wrong time. So that the first edition
of this book came out in 1999 at absolutely the
peak of the telecom bubble when everybody said was value investing value investing was dead. And I'm pleased to note that
this book was done again in a period of the fangs,
where again now in 2020, 2019, everybody again feels that
value investing is dead. So we have not lost our gift for bringing out books at the wrong
time, but let me say this. I think that at least this time we have addressed probably
partially inadvertently what I think all are at this time, the really big issues
with value investing. - So, very good. So let's talk about these
and let's talk about, a topic that you and
I have discussed often that I think the second edition addresses decisively,
which is this issue of that we've moved obviously well beyond the original ideas of
brilliant I say well, Ben Graham and David Dodd
and that we're thinking more seriously about franchise investing and a little bit of a problem that we have with the terminology here that value investing has moved well beyond kind of the original approach
of David Dodd and Ben Graham, can you talk a little bit about that? Can you talk about these. - Yeah I think it's
important to start really with an understanding of what value investing has always been as conceived by Graham,
Dodd and of course Buffet and the other really
distinguished value investors. And I think it's really
consists of two basic ideas. The first is you look for opportunities where nobody else is looking and you stay away from the crowds that are overpaying for
glamorous opportunity. So there is that idea of just statistically
cheap, ugly out of fashion. And I don't think an important
sense that has gone away. Now, if you look at the
statistical value models simple statistical metrics
of what is poor out of fashion overlook are no
longer as reliable as they were. And I'll talk about reasons
why I think that's the case. I think the second thing
about value investing and it's really where
the value comes in is that the Graham and Dodd tradition is a tradition of approaching valuations with a clarity and a precision that normal investors don't, it's more than just slapping a multiple on things and saying, okay,
this is a growing business. It's worth 40 times earnings. It's more than just
forecasting quarter zonings. And trying to guess
where the price is going. It's really about understanding what it is that you're buying. And there I think that
the really big change in this edition is the traditionally what Ben Graham and David
Dodd bought were assets and they bought competitive businesses or assets in competitive businesses. And for those growth doesn't matter because the force of competition means that if you invest in growth, you're gonna earn the cost of capital. If you get organic growth that's just gonna attract more competition and you're again, unless
you invest money not more, and you're just gonna work a fair return. So I think that in their day, they focused on the
part of the market where and I think this is always important to understand where their assets value earnings power value
approach was much better and a much clearer framework for incorporating externally
or paying information than these stupid DCF models
that's superseded them. The problem is that they
never dealt with growth. And I think that's where because of fundamental, underlying changes in the economy, value
investing has got to adapt. Now, I don't think that means getting away from value because really it's all about understanding how
much growth is worth and when it's worth anything at all. So there is a value approach to growth. And I think in a sense it's the growth investors
who have to adapt. So I think value is
clearly gonna have to go in that direction. The second edition is
really all about how to go in that direction, but at
the same time to be true to those Graham and Dodd
principles of knowing that you're buying and having a really
good valuation framework when you address the issue. - Yeah. So in that sense, I think the
real and there's real value in those chapters, six, seven, and eight. And in particularly on the appendix that is illuminating all
of the second edition of the book where, you
know very good job done on actually describing
the analytics of growth and how does it feed on the valuation? So let's separate let's organize the discussion for our listeners today. So why don't we start with the you know, let's have a discussion about franchise when we start with, what do franchises look like? And then we do go to the issue of some of the mechanics and
the valuation of growth. So when we're talking about franchises, Bruce, what do these franchises look like? - Okay, so let me just say one thing first and absolutely clearly. If you are not in franchise business which is a business
protected from competition by barriers to entry, which typically are the same thing as incumbent competitive advantages growth has no value because it's the any value that's there is
gonna get competed away. So when you talk about value
oriented growth investing you are talking about
franchising business. So if, as a value investor you're gonna do this in the
Graham and Dodd tradition. What you've got to first verify is that this company you're gonna buy into has a sustainable
franchise, sustainable moats in Buffet's language to
stainable barriers entry. It turns out that you can
actually measure a moat. And I'm sure Warren
Buffet always knew this but would never tell anybody about it. And it's the key to what
a franchise looks like. And it's got two elements. So the first element is if
you've got an entrance coming in what is the minimum viable market share that that entrance has to get to? And that's all about economies of scale. So it's how big do they have to be to have sufficient scale
economies to be viable? If you look at things like
distributing carbonated caffeinated beverages, you
pretty much have to get to 25% local market share to be able to sustain the distribution
infrastructure you need the marketing infrastructure and the local advertising infrastructure. You're part of a global automobile market. You can be viable at
one to 2% market share and you're not gonna keep
anybody out at that point for things like cell phones,
look at cell phone companies they start to be economically viable at basically 10 to 17% market share. So you start there you're looking for a situation where the economies of scale make it hard for somebody to in. And the second element of this
equation is how hard is it? And how long does it take for an entrant or a competitor
to acquire that market share. And that really is all
about share stability which is driven by customer captivity and whatever proprietary technologies you can bring to the table
to help keep competitors out. And there, the measure is simple. So if you look at carbonated soft drinks caffeinated soft drinks,
about one 10th to two tenths of percent market share changes
hands in any given year. If you're gonna get to 25%
market share at 1% a year, what you're talking
about is a 250 year moat. If you're gonna do it at 2% a year you're talking about 125 moat,
and that's a powerful moat. So the two elements
you're gonna look at there are the economies of scale and the proprietary technology
and a customer captivity that protects those economies of scale. For cell phone companies you get to 15%, typically they're as much as half a percent changes hands here. So you're talking about a 30 year moat. For automobiles you
got to get to one to 2% and 1% changes hands a
year, so you're talking about a one-year moat,
which has no moat at all. So what you're looking for are moats, minimum required, scale for entrance and the difficulty of acquiring that scale that is economies of scale
and customer captivity and proprietary technology. Ultimately of course, to have the economies of scale you need you wanna be the dominant
competitor in your market. So all the first and simplest test here is are you the dominant competitor or the dominant firm in your market? So you start there and then you look at the
required economies of scale, whether they're network effects or whether there are simple,
fixed costs being spread out. And you look at the customer captivity the customer behavior and
the face of competition. Those are the elements
you have to look for. - Can I ask you a question about this about the issue of customer captivity? So it's the I think it's a
brilliant insight in competition. The mystifying fact is the idea that the barrier to entries
this peculiar combination of economies of scale
bundle with some form of customer captivity that
gives potency to the moat. How deep do you go Bruce when you approach a new business in understanding the sources
of customer captivity you try to establish, well,
there's something about habits. People like Coke over Pepsi, or they addicted to
their Marlboro cigarettes or something about our networks venality, or is it something about it's difficult to find a, an alternative? How deep do you go in understanding what is the true source
of customer captivity that is given that a
stickiness to the incumbent? - Well I don't think you start there, I mean, I think that one
of the wonderful things that Ben Graham pioneer
was looking at history. So the first thing you want to look at is the history of share stability. I mean if you take a 10 year period and you look at the average absolute share change, that's
firms have experienced. So you look at shares at the beginning of the period, you look at
shares at the end of the period you see how much share
on average change hands for the average firm plus or
minus, and you divide it by 10. That's going to give
you a share stability. And if you don't see that you don't to worry about (indistinct)
- Exactly. - So you start with the history and then you start to
think about what is it that's gonna keep your customers with you and away from anybody else. And the simplest one for high frequency purchases is habit that it's not worth
during an extensive search to find an alternative to Coca-cola and people just naturally
for certain goods prefer uniformity of
experience over variety. So if people talk about variety that's probably not gonna be
powerful customer captivity. Then there are search costs. If it's a complicated product and it's a high value product finding an alternative
is not going to be cheap and that's gonna keep customers with you. They're only gonna
change slowly over time. And finally there are
direct switching costs. So you've got all those
elements you're looking for in detail. But as I say, in the Graham and Dodd you always want to start with history. - So very good. So can we start talking a little bit about the analytical contribution
of the second edition which I really think is absolutely key and how to think about the problem of growth valuation and
how we incorporate it into the framework that
we've been teaching to the students for many years. So can we. - I think the first again you wanna start with a good qualitative understanding of what's involved in
whenever growth creates value and in franchise businesses,
there are three aspects of growth that create
value that just don't do anything for you in competitive markets. The first obviously is organic growth. That's not a surprise. And you want to look at that. And what the value of that is. The second is earning above
cost of capital research capital costs on reinvested earnings. It's sort of the value creation from reinvestment, which
almost usually means growth. And the third what people
don't normally think about as growth is growth in margins that comes from steadily improving technology. Is if you are a competitive
firm and the technology improves all your competitors, have it. And it just gets good out in the price. Whereas if you benefit
from bearing as the entry, your costs go down and you get to take home
a substantial fraction so you start there. Then again, the crucial
thing about value investors and it really is gonna
be what distinguish is value oriented growth investors from ordinary growth investors is you have to know how much to pay. And that means knowing what
the growing operation is worth. And here is the crucial point of the book. You cannot do that in value terms that when you've got a growth business the value is so far out in the future. And is so sensitive to changes in the growth rate and the cost of capital that it's really very hard or impossible to put an accurate number on what firms are worth. But what you can do is
answer the question, if I buy this firm at today's price, what kind of return am I afterward? And it is that approach
that I think is essential for value investors looking at growth. And you start with just
sustainable earnings divided by the price you're paying,
which is earnings return. And again, you do that in
a standard earnings power Graham and Dodd framework. But then you have to worry about how much do you get today in cash and how much is going to be reinvested on the value of which
is going to be deferred. So the next thing you have to look at and he left reincorporate in
this calculation return is how does the management of that company divide those profits? What fraction do you get and
what fraction gets reinvested? So say you're earning
a 10% earnings return. It's trading at 10 times
sustainable earnings. If they're distributing half of it, you've got a 5% cash
return and you've got a 5% of your money being reinvested the quality of management
capital allocation determines what you're going to get for that 5% reinvestment. Basically what you've got
to look at the history of is how much value in acquisitions in cost reduction projects and so on, has this management generated historically for every dollar they've reinvested, you can think of that as
a value creation path, did they make stupid acquisitions? And there were cases of this in the book where they basically get 20 cents in value for every dollar they invest in this is actually a pretty good term except for the (indistinct) and which case that 5%
reinvestment is worth 1%. If they create $2 of value, because they're doing good acquisitions or they're expanding, or their
competitive advantages apply or they're focused on cost reduction you could get as much as $2
for every dollar reinvested. In that case, the 5%
reinvested is worth 10%. So the second thing you have to calculate is this value creation factor which is the quality
of capital allocation. So you take the retained
earnings percentage and multiply it by that
value creation factor. Then you've got organic growth and it's organic growth, both in sales and in margins that we talked
about from cost production. And you're going to look
at the history of that because you've got a lot of history trying to forecast dramatic changes in the future is almost impossible to do. And Graham and Dodd never tried to do it. It's all about sort of looking at history and betting on continuity. So look at historical growth rates. Now, if those historical
growth rates are 12%, they're not gonna happen in the future. I mean the best you're
going to do in the long run because franchise investments
are long running investments are three to 4% above GDP growth and then maybe a little
bit in margin growth. So the organic growth might be 7%. What you can do then and again, this is an important
Graham and Dodd principle. You have the cash return
the re-investment return and the organic growth return, reinvestment return should translate into a growth rate. And you can look at sort of
whether the overall growth in earnings has been close
to or equal to the sum of the reinvestment return
and the organic growth rate. Once you have that number, you'll know what you're looking at. This has going to be an eight six, 10, 12 with four locks,
sometimes a 15% return. And you know what your buying. Ultimately, you're going to compare that to what alternative investments pay. And if the market like it is today is earning
somewhere around 6%. Then that's a margin
of safety and returns. That's really pretty good. Now there is only one thing that you have to be really careful about here. You will notice that
what we're talking about here is really a detail careful expanded dividend discount moat which is just the cash
return dividends divided by the price plus the growth rate. That model is wrong. Growth rates and growth
returns are not the same thing. A growth rate applies, typically when you calculate it based on the history we've talked
about two intrinsic value. So at the intrinsic value is 2 billion and that organic growth rate is 3%. You're going to be getting 3% of 2 billion, which is 60 million. Doesn't matter what the market price is that 60 million is gonna get
divided by the market price and market price is 4 billion. It's not a 3% return, it's a one and a half percent return. So that growth rate has to be multiplied by the ratio of the intrinsic value to the market value to get a gross return. The problem of course
is you can't calculate the intrinsic value but here is the thing. When a company is fairly valued,
you're paying a fair price. The intrinsic value in the
market value are the same. So an estimate making that assumption is gonna be an
accurate estimate of returns. So if there's no margin
of safety and returns you calculate the return
and yield six or 7%. That's what you're going to
earn for that growth rate. On the other hand, if you are careful so that you've got a 12%
return against the seven or 8% cost of capital that means that intrinsic value is
above the market price. And that means that actually
this is a better bargain than it looks like, but here's
the thing to be careful. If you think you're getting a 6% or 5% or 4% return, and
you're just optimistic about the future or you
pay a very high price. So the cash return is very well. So if you are getting a return, that's below the cost of capital,
that means the market value is above the intrinsic value
and the value of that growth maybe as little as a half
to a third of the growth. So in this kind of careful Graham and Dodd based growth
investing, the critical thing is and I think of this as the
third element of value investing you have to be really disciplined. You cannot be optimistic
about growth rates because you're gonna be fooling yourself because you're leaving
off necessarily this ratio of intrinsic value to market
value from the growth term. And that can kill you if
you're too optimistic. So your benchmark return ought
to be significantly below the cost of capital. And then there is one other
crucial thing that you have to if you're gonna invest intelligently in both worry about
franchises, don't last forever. If you think a franchise
is likely to last. So it's got a half-life of 50 years, rule of 72 says that is on average 'cause you don't
know when it's gonna die. But the average arrival
rate of the death of then for that franchise is about 1.4% a year, which is 72 divided by 50. If you think that's a 30 year franchise that fade rate or that death rate is 72 divided by 30, which is 2.4%. And you gotta have a margin of safety to cover that fade rate. So you cannot ignore the fact that these franchise sizes go away. If you're gonna invest in railroads you're gonna invest in old technology metallurgical companies you better have a margin of safety and returns that covers
a half-life of 20 years or conceivably less which is a fade rate of three and a half percent. But if you do all that in returns you're gonna start to be making intelligent growth investing decisions which are Graham and Dodd classic
value investing decisions. And the only I'll leave it there. Let me stop there. - Yeah so can I get, I
mean, there's so much there that I would like to unpack
a couple of things also in line of what people are
asking the attendees are asking. So I'll come back to this
issue of that fade rate, which I really think is important but you know, I want to investigate
a little bit more Bruce. I mean, one thing that
I've always been struck by is that once you start
thinking about growth you really have to start
thinking about capital location the quality of the management
and so on and so forth. And you mentioned acquisitions
as giving you a window on the quality of capital
allocation in that firm. But what if you actually
don't have many acquisitions for whatever reason in that company how do you assess the margin
return invested capital of a company, is it, you look carefully at the segment information
and try to assess to the best possible, how much
are they deploying of that of those retained earnings
across different segments? What kind of analysis do you do? - I would start with gross history. So suppose they are re-investing
half of the earnings. And you think that at fair value, the earnings return ought to be about 8% So that means they're
reinvesting 4% of your money. That's their value. Does it look like earnings
or any other measure of intrinsic value are
growing at 4% a year? And there are lots of
companies that retain a lot of earnings and you don't
see any earnings growth beyond the organic growth at all. And that means that the return they're getting on that is close to zero. So that's where I would start. I would start by asking is
the historical growth rate same to identify or be associated with positive returns on those weekend earnings commensurate with the amount of retainers. Second thing is I would look qualitatively the highest return investments
in franchise businesses by far are operational
improvement investments. They're investing in reducing costs. We know when we look across companies that the most efficient
company in an industry, typically with the same technology, the same kind of labor force the same capital intensity
has a cost structure a half to a third of the industry average. So there are these enormous unexploited cost savings that you're
only gonna take advantage of slowly over time but you want to see a budget
that's devoted to that. If the budget is devoted to expansion, you want to say that they're expanding where their competitive
advantages carry over. And in China, there are
no competitive advantages because it's very dense so anybody can enter the market at slow scale and it's
changing really rapidly. So there's no customer captivity. So if they're going to China and they think they're
going to create a lot of value there, because you know it's a fast growing market,
they're just kidding themselves. So you want to look at the
quality of expansion strategy first within their existing market. Like when Walmart goes from basic Walmart's to
super centers and adds food because they are you're
protected fully by the barriers. Next adjacent markets where
barriers can't carry over third. If you have to go over a go after other markets where there is no existing dominant competitor and you think you can
dominate those markets but do at one market at a time. And if they're not doing that,
they're destroying value. - Very good. So let me then think a
slightly differently then about, let's go to this issue
of the fade rate a little bit you were mentioning you know, kind of rules
that we can follow. I assume that industry specific. It's something about
that particular industry that informs your estimate of the fade rate to do
the appropriate correction in the written calculation. So you have enough of my, you know safety. Do I understand this correctly? - Yeah that's exactly right. And I think there's a
way to think of that. Which has start with 20 years from now and simply ask the question do we think, and I'll use a specific example. Do we think railroads are
gonna be a critical part of the transportation
infrastructure 20 years from now? And if the answer to that is yes then the half life is
certainly longer than 20 years. If you think 40 years out
and you think basically by 40 years out, we're
gonna have smart trucks and smart trucks are gonna be organized into basically truck
trains that are driven you know, four feet away from the truck in front
of them and drafted with nobody in the cab,
because they're all run off GPS systems, then
it's not clear, especially if coal goes away, what the
advantage of trains are. And basically you know, for roads, you've got to
share these right away which is extremely efficient, for trains you don't have that. And so I think if you look at 40 years and you say okay, I think that there's a reasonable chance 40 years from now, these
are going to be dinosaurs. I think then you would say okay, that fade rate is 72 divided by 40, which is if I'm right at 1.8%. Whereas if you think it's gonna be gone in 20 years, it's 3.6%. - Yeah no, I actually I think it is quite
useful to think that way in terms of different scenarios
and how you see about that. Can I bring you back one second Bruce, to this issue
of, so there are a lot of questions in the, in the
Q&A tab about technology and how do we think about
technology in this context? You know, this vaguely
association in many minds tech and growth go together hand-in-hand and I wanted to ask you something that has always presented
some difficulties for me, which is the idea of
expensing, growth CapEx. You know that many of these companies are in the early stages perhaps because they're developing a new industry say the cloud or a new technology. And as I was told, you
want to make an assessment of whether you want to buy
a share of that company. You may have a low earnings on account of the enormous amount of
investment that is being made in you know, in the early
years of that company and your call to make
an assessment of that. How do we approach that problem? - Okay I think there are two ways to deal with that question. The first is, is this a nascent company in an emerging market? And the ones that I would talk about there are, is this a
self-driving car company? Or is this even a Tesla? Well, the question with those companies is that those are emerging technologies and emerging technology markets usually have not stabilized yet so that you don't have
a customer captivity because most of the customers
aren't in the market yet. And you don't have customer captivity because the technology isn't that stable and buyers are always looking
around for new technology and nobody yet really has scale compared to the full size of the market. And if you see that happening I don't care how fast this
company is growing at the moment. You're not going to be able to predict what that company is worth because you're making two bets. One is that when the market stabilizes this is gonna be the dominant company and two is that you have an idea of what this company is going to be worth and what this industry is gonna look like in the fairly distant future
when the industry settles down and you have a dominant competitor. And I think, remember there
is a to top to call pile and I think nascent
technologies all fall into two. - So let me ask. Sure, go ahead. - Then you've got the case
of the Google's of the world the Microsofts of the world,
where the market is stabilized. And there I think you can certainly say you can do a long run view. So Google for example, is a form of information advertising. It's what you go to when
you've made a decision to buy like the yellow pages
or the classified ads. And you want to find out what the price is or
where you can go get this. Well, we have a long
history of information advertising typically grows
about 1% faster than GDP and you can go ahead and
say, okay, in the long run this has gotta to be the growth rate and don't try and guess
the interim growth rate or I think, you know try and guess the ultimate market size of this company because actually be very hard. So just apply that long run growth rate. And if it's a bargain at
that long run growth rate as it was for Google in 2011, then that's gonna be a good investment but inherently you're
gonna be very conservative because you're in an
environment that's very very tough to predict. And again, value investing is about knowing what your buying. - Right right. But can I, can I ask you something, Bruce? I mean, hey, I'm a glutton for punishment. So let me, let me push
back a little bit on this. Okay, let me see if I can get you, like if I think about Google, you brought up the
example of Google right? I mean, one of the interesting
things about Google from the very beginning is that, you know, to some extent the shoulders of customer captivity were quite clear and this kind of (indistinct) in by which your search becomes
better, the more you search. So you're uncomfortable to do that type of qualitative analysis early on in the history of the company. You're not comfortable. I mean, you are you, I feel like the economy
is better than you are. - No let's talk about
the history of search. So, you know, Google goes
public in 2004, but it's that becomes Google around 2001 before that who are the
dominant search engines. I mean, it's incoming as a real vote and everybody decides that's
gonna dominate things. And then AltaVista comes along
and wipes out (indistinct) And then Google comes along. I think it's very hard to tell unless you are a real expert in that industry that finally Google
has solved the search problem and that there are not gonna be big improvements over Google. And this is once you think,
once you start to see that of course you do see
that Google is very good at protecting it's dominant market share It's very good at improving
the search experience improving the advertising
experience over time. That makes it very hard for
inference to catch up to them. But I think until that point occurs, you're going to be speculating and think how much money
could have been lost and income they're out to Vista. - Got it. Okay, so I don't want to run out of time for all the questions that I
want to bring to our attention as well as some of the
questions of the attendees. So let me switch gears
a little bit, Bruce, you and I spoke in sometime
during all this time, a little bit once about this issue of the performance of value versus growth. And given that we're talking quite a bit about that topic today, I think
we should bring it up again and have a good discussion about
kind of the secular aspects of traditional (indistinct)
Value strategies. I would call them that way and why have they performed so poorly? So do you have a view on that? Do you have a view on why a value? I'm sure you have a view because you have. - I thought our timing was not so bad with this book as it was in the 2000 book. If you look at the broad
sweep of industrial history and I'm going to talk about the United States here,
but it's clearly also a class and to the developed countries in Asia there are two basic
transformations that take place. The first is you go from
agriculture to manufacturing. And the second, which
you're in the process of doing is you go from
manufacturing to services. When you go from agriculture, which is dis-aggregated where people in this small institution, small farms people work individually
to manufacturing plants where people work collectively
in the big institutions all of a sudden productivity
growth really accelerate because you can put engineers to work. You've got lots of workers interacting
and improving the process. And so post-World War II, when this transformation is achieved what you see is very rapid growth in economies in Europe, but
also in the United States. After the war, it's under precedent. At the same time, what you have for manufactured outputs early on is you have national markets and the national markets are ones that national companies can dominate. So you look at the industrial
companies in those days it's a general electric the general motors, the IBM's, the DuPonts the Merck's a dominate U.S.
markets and make a ton of money. They are in fact franchise businesses. And that is a golden age for returns on capital general
motors returns on capital at that time from sort of after the war through the 1960s are
well above 40% a year, but over time what's happened to those markets is they globalized. And as they've globalize that required minimum scale that you need to operate has gone down. And competition has intensified
and entry is intensify. And the long run trends sort of post 1960 has been one of declining profitability of declining barriers to entry. And therefore over that whole period growth returns have been disappointed that the Nifty 50 didn't just fall out of favor because they were over priced. They fell out of favor
because they were overpriced and the returns were
uniformly disappointing. That trend meant that if
you were a value investor who didn't buy growth,
by almost that judgment you are going to be
performing relatively better than the market on you. Since roughly the late 1980s, early 1990s when we moved to services,
the opposite has happened on the one hand there's bad
news service organization. Service productivity takes place in relatively small organizations people even in universities and
hospitals work individually. So what you see is slowing
productivity growth and by the way, a much
more uneven distribution of income, but here's the thing. Service markets are local markets they're goods that are
locally produced and consumed. And those are small markets that people like Walmart can dominate. And that meant that over time barriers to entry were increasing. Monopoly profits were increasing and the value of growth was increasing and then in technology
of trend is taking place that actually intensifies those problems. So what happens with technology
is you go from a case like IBM, where IBM does everything, that you don't do piece parts that the consumers of the
technology put together to our post PC era where value changed or just added changed, or dis-aggregated. Everybody has a small
piece of the technology. Google dominates search,
Microsoft soft dominates only operating systems and that operates at the edge of that. Adobe does fonts and video processing. Oracle does only databases and
sort of related applications. Salesforce does only
Salesforce management. And as that happens, technology
has balkanized those markets and remember small
markets are your friend. They dominate those markets. And the trend is that they
make above average returns and because they're barriers and true growth is more valuable. So I think what you've seen
and you can see it by the way in the U.S. profit data in the late 1980s early 1990s profits
were about eighty eight and a half percent of national income. Today it's between 13 and 14%. And that's all this sort of these moats these markets that can be
dominated coming into focus. And that means growth
has been more valuable. And if you're not on the growth train buying growth intelligently,
you're really gonna suffer. And I think that's why I say for this book, I hope we've done something that actually gets the timing right. To help value investors
adapt to an environment where they're gonna have to start thinking about paying for growth. - Yeah exactly. So, but you know, Louis CS who is an attendee is asking
almost as his own cue, whether the fangs are the new Nifty 50 but clearly your answer
to that is no precisely because they're specialized
in the services sector. - Yes absolutely and when I try and throw outside specializations just look at the non
Google part of alphabet. It's not worth squat. They don't make any money. So as long as they're
disciplined and they stick to those market segments,
they're gonna continue to benefit also manufacturing
companies like Deere that have very well
articulated local service and software support operations so they dominate local markets are gonna also do very well with, so I think this is a different world. I don't think this is 2000. - Bruce I mean one of the questions that is coming quite often in the Q&A tab, and that I would like to spend some time you know, many different ways in which people are asking this question is whether you feel the
method is applicable across all industries, whether energy tech you see, you know, whether
particular industries. So one someone asked the question about, can we apply this framework to banks on account of how highly
labor they are for instance? - Okay, the answer is, it depends whether
they're franchises or not. If these are big global banks competing in global markets forget get it it's gonna be asset value,
earnings power value 'cause they're not gonna
dominate those markets. And these are banks like M and T that started out dominating Buffalo and Buffalo is an unattractive
enough part of the world. So if you're willing to hold
your nose, you can dominate it. And that expanded adjacently
going down IED seven, those companies you're
going to have to evaluate in terms of returns. But let me say this inherently
these return calculations I hope it's clear are
much more complicated than the asset value calculations because you're looking
into the future to do. That means that you're going
to have to have a higher degree of industry expertise
than you have in the past. And I think that means in turn that value investors are going to have to become specialists. And I think they're gonna have to become specialized by industry. And I think they're gonna have to become specialized by country because that's where the
service operations occur. So I think the answer is yes,
there are banks that look like this, but you better
be a banking expert. If you're gonna do a good job of applying this framework
to get what these bearings. Now, let me say one last thing about this. You'll notice that this
helps you at the entry point. You have a price that's
given to you by the market. You can calculate a return. It's not gonna pick
the exit point for you. When you pick an exit point you basically got a pick a price and these returns are not
particularly sensitive to the prices over fairly wide ranges. So and I think this is the experience of good growth investors that the buy decision was
one that's manageable. The sell decision was brutally hard. And typically people like Warren Buffet just
have arbitrary rules. He never sells, Seth
Klarman would never pay more than 20 times on
executives up to 25 times. But you know there's gonna have to
be an arbitrary transit. So I think there are industries
where it's hard to apply and you gotta be an industry expert but yes, I think this applies to all franchise business
and ask yourself this how are you going to
value those businesses? - Right, right. So I, you know, a very
interesting question which is and it is something you and I have discussed in the past. And I want to explore this topic with you which is how do you retain the, kind of the value investing mindset when thinking about growth? I mean, you and I have
talked often, right? That growth lends itself to
all these behavioral biases because you start projecting,
you start getting enamored about the kind of convexity of growth and the extra kick that you
can get out of the valuation. If growth happens to
surprise on the up side it's very easy to fall prey to
all these behavioral biases. So have you thought a little bit Bruce about kind of these organizational rules that we can have
to protect ourselves against these type of biases
that are inherent to growth? - Okay so let me say the first thing about this growth return it's linear in the various elements. So when you do a sensitivity analysis it's not doing a complicated series of XL runs with different values. You have a you know, if the cost of capital is 1% higher, your
margin of safety is 1% lower. If the organic growth rate is 1% higher your margin of safety is 1% higher. The earnings, the current earnings return instead of the reinvestment return you can calculate based
on history, but you know you know the effect of a value
creation factor of one half versus one, it adds linear
weight to this return. The advantage of that is that if you're a good value
investor, you want to start with a conservative estimate
where you're pretty sure that this is gonna be what
organic growth is gonna be. And the most conservative
estimate for these things unless it's a dying in
trust, which is brutal is gonna be just GDP
growth for the growth. But you start with that
conservative estimate and then you can tell immediately what the impact is gonna
be of things being better or worse than you thought,
because it is linear in the organic growth
rate the cost of capital, and it's linear in the favor. So I think that's the other
thing that's crucial about this. And again, it really is part
of the Graham and Dodd genius. What they do is they develop a very simple transparent framework for
incorporating the information about the world that
you collect so much more you know, asset value, earnings dollar value is a much
more transparent framework than a DCF framework. So when you do the sensitivity analysis in your head, you can do them that way. You're not giving free
reign in the context of a complicated calculation
to your hopes and dreams. - Yeah. So yes, I'll go back
to the point of the DCF because in a moment, but I, you know because I know how to press your buttons and yes, to get you overly excited. Bruce, there's a question by James McNay on Amazon and kind of the
value created by Amazon. And he emphasizes these
two sides of Amazon right? The retail part that
you and I have discussed at length with the
students over many years. And of course, AWS, Amazon web services where there may be
potentially more sources of customer captivity. And you know, is one of the obviously most successful companies
in the U.S. universe over the last few years
and so on and so forth. How do we explain that success
in a particular business? I think AWS is a different
thing, but it's a surprise. So to speak. - It is very rare. And I, then let's go back to Google which is a bunch of really smart people. Companies do well in multiple businesses. If you go back to Microsoft, X-Box which is a different business,
they just don't make money. And they, they finally
profitable marketing but it was a very bad investment. It is very rare in this context when we're passed away
from general, we're away from general motors and these
great big industrial companies that companies are good
at many, many things. So I think that when
you see Amazon be good at multiple things, you have
to say, okay, that's luck. I mean, General Electric was an exception like doing money, money
different thing until it wasn't. And I think Amazon is going to be as good an exception on this. It's done exceptionally well in web services and it's
done sort of well in retail, but I think there is some
good news about Amazon. My guess is, and I, again,
think 40 years from now the trend in technology is
that it's interchangeable. If 40 years from now or
even 20 years from now, you know, the way, you
know, God what's it called cloud computing is not
a commodity product. I will be amazed and people will come in and they'll just switch you at no cost. And it's going to be a competitive because it's a huge market. - They're already technology solutions to. - I don't think it's gonna dominate. On the other hand, if you look
at Amazon's retail business there are two parts to it. One is there's the web retail front which is transaction processing. And two is there's the
distribution network behind. We can, net retail fronts
are a dime, a dozen. Nobody's going to dominate that. It's too easy to use Google to find things on the other hand,
distribution as a series of local monopolies and Amazon has gotten
much smarter about that. So if you look at Amazon globally they were going to do everything. And now they've decided
to concentrate on India. If you look at the way they are building out the distribution
networks in the United States they are sequentially trying
to dominate localities before people with dominant
local distribution networks like Walmart get into the business. So at least in that dimension
they seem to have gotten. - Bruce. Bruce I don't know if I've got this connected. Mary's I don't know if you
can come in one second. Sorry. - I thought I got frozen up. (muffled speaking) Okay, can you hear me? - I can hear you. Can you hear me? - Yeah I can hear you're you're fine. - Okay. Great you froze there for a little moment. Were you done with the Amazon answer? Sorry, twice at the end. Yeah, very good. So before I went to people tend to the last topic of today's conversation. There are several questions about kind of the general economic environment and what is that we can hope
for markets going forward. There are a lot of questions
Bruce, about, you know the very low interest rate environment. What does it mean for valuations? What does it mean for looking for good investment opportunities? Are that whether the
investment environment is strange or peculiar on account of the incredibly low interest rates that we have all over the place and the very low yields
across asset classes. And what does it tell you about
current economic conditions and where we're going from here? So why don't we start
with financial markets? And then we go over the economy at large on account of these very
peculiar environment that we experiencing. - Okay, I think actually the
fixed income returns are crazy. And I think that from zero to negative, expecting them to go down lower so that you make capital gains on your fixed income securities is just not gonna happen from here. - Not gonna happen. - So I think the fixed returns that people are gonna get,
which are gonna be some 1% on safe assets are
gonna be wholly inadequate compared to historical experience. On the other hand, the striking part of history is if you
had invested, you know in 2008, right before the
crisis, out of the middle of 2008 from 2008 to today, you would
have made a six to 7% return which is very close in a
low inflation environment to what equity returns are. And those are pretty good returns. And I think that the weird thing is and it's been sustained now
for at least seven years is while these fixed income
returns are crazy low the equity returns have
not been crazy high. I mean the fines they've been crazy high in some sense, but again that's because people are willing to pay for growth rates that
are very hard to judge. And I think that sensible value
investors are who stay away from that, but still there are
extraordinary opportunities for companies, and again, I don't want to sound like a broken record but companies that
understand local service local market domination in services and Deere is a classic example. I mean, there was this huge disagreement between me and Jim Grant when Deere was at 75 and he thought it was going to 25 because in traditional
terms, demand was gonna fall and it had, and they
were gonna be lost making for an indeterminate number of years. Well, life had changed. They were no longer a
competitive equipment. They were a monopoly service provider. And I don't know where
the stock price is today but I think it's well over
200, I think it's like 225. So I think there are
extraordinary opportunities here and an overall level of equity markets that
is not all that crazy. I mean, there are obviously areas of valuation that are out
of hand, but, you know that's what value
investors typically avoid. - Right. Very good. And so I completely agree but can I ask you something
a little bit about this? I mean so I want to explore one thing a little bit more deeply which is one thing that worries me. I was talking, I don't know if it was in the postcards or
elsewhere with Lee Cooperman. And he had a very
interesting insight, you know he was saying, look in a
world where yields are so low. The problem is you're going
to have a lot of investors that are outside their prefer risk habitat and that's distorting
prices kind of everywhere. Do you agree with that
view that to some extent, what we're seeing is the search for yield distorting
prices left and right. And as a result. - Okay, I have to say that I
don't know about most places but in terms of equity prices, the multiples of current earnings. And I think current earnings
look not only sustainable but for many of these unrecognized franchise businesses that are well-run there is a growth element to the return that doesn't get figured
directly into the PE. I don't think that the
equity prices have responded. I mean, they just have
not gone up that much. And remember profits from,
let's just say the profits from 1990 to 20 have gone up by 60%. That's about the profit share of GDP. So at 60% above the growth rate of GDP, whereas historically it had been at, or below the growth rate of GDP. Well, you know 60% over 20 years is like two and a half percent a year. So that's an additional two
and a half percent return. That's being driven by these economic forces
that we've talked about. And if you add that two and
a half return per cent return to current earnings, what
you're starting to see is multiples that are not that crazy. So I think that in stock
markets, you haven't seen this. I don't know, you know, what's happened in real asset markets,
although certainly oil oil Wells are not
trading that expensively. And I don't think
commodity prices certainly haven't gone through the roof. So I think fixed income is crazy. I think it's insane. I thought it's an insane for a long time, but you know there are these other pockets where you can actually look at based on a reasonable judgment about the continuity's of history, what kind of returns are anymore. And the equity prices don't look crazy. - So, you know, there's a lot of questions about whether you would be
willing to talk about things that you like in the market specifically that you've looked at
recently that you like. I know that you're always reluctant to share your views on this,
but I will be a faithful host and convey the questions from
the public on this school. - Well, I got it, so let me talk about an
opportunity that is exists in the market and one company actually in Sweden, but really as a
much greater opportunity. And you want to think about companies that take advantage of
opportunities like this. When you look at electrical
or plumbing contractors who do jobs for big construction projects that's an incredibly
both in a nice market. There are a lot of little
companies in any city. And if you look across
cities in the country there are a lot for literally
hundreds of companies like this with 40 to 60 employees, there was a company in
Sweden called Install co, that I think started off and got above with a 30 million Euro investment and decided that as these old guys who ran these smaller contractors retired, A, they could buy them out
at a relatively cheap price, four to five times earnings and B, by putting them together, there would be economies of scale and forced appointment in
bidding for opportunities in purchasing and in other
just overhead functions and Install Co as I say, which started out as a $30 million Euro investment, I think, I mean it was, it's
been up and down lately, but the market price
which we bought into it, I think about 45 is over 200. I mean, it's something
that's done really well. And you can see how opportunities in small balkanized,
local markets like that, would exists if you're
intelligent, the way Install Co. was where they did (indistinct) first. Then the rest of Sweden,
then very carefully Norway and parts of Finland where they
thought they could dominate. And you can see countries
like Switzerland and Austria in Europe, where probably
somebody could do the same thing because they're isolated smaller local markets, conceivably you know, in the United
Kingdom, it might be the same or parts of France, but
there'll be opportunities like that locally in the United States. So I think that those
are looking at industries with opportunities like that and looking for companies that have the ability to take advantage of that
because they understand structuring local economies of scale on a disciplined expansion strategy is where you're gonna make money. - So I want to finish a little bit then several questions about the future of investing Bruce, and a little bit how we think about value investing going forward. I think the second edition of the book to end where we started
answers the question of growth, which is the way forward. And I want to ask you
two things about this. You know, one is, you know, value investors do the hard work of actually reading the annual report, thinking through the
economics qualitatively and so on and so forth. Technology has, you know made a difference in many
industries, in many types of jobs. Do you see the job of a value
investor being substituted at some point by a piece of software artificial intelligence that can do what we do
you think that, you know We have several students
asking a young Ryan O'Neil from Ireland who is asking about this whether he should consider
learning value investing given that he's worried about the future of technology taking away
his dream job as an investor in of the big fund investing shops. So what are your thoughts of that? - Okay I think that in a
sense, this necessary movement to doing valuations of growth is a godsend on the dimension because judging future growth is something
that's very complicated and very specialized to do. It's like historically
looking at reproduction values of assets to
validate earnings power was something that took a lot of detailed industry knowledge that change relatively rapidly as industry technologies change. So I think the first thing
that's gonna happen is that value investors are
gonna have to be specialists because they're not gonna be able to do these complicated tasks. Well, if they're not specialized not only by the way, probably by industry, but also in many cases by geography, I think because that's where you're gonna get to know managements. And again, when you talk about the future managements have a much bigger impact than just sort of the
asset driven histories that value investors have
dealt with in the past. I think it's gonna be very hard to do general models of that sort. I don't think you can. So then the question is are people gonna do it
industry by industry? And we haven't seen that in the artificial intelligence
business, not even close. I mean, the models are all cross industry cross market market models with big necessarily therefore simple on ambiguous measures of value. So I think the answer is no but you're gonna have to be a specialist in one, two or three,
maybe four industries at most, which is what off
seems to be able to handle. So that, I think as the
answer to that question and if you're disciplined about doing that you're not gonna have a,
you're not going to be replaced by a machine within the next 30 years. Having said that though,
there is a problem out there that I don't think we solve
in the second edition. And we've talked about this Tano we count on yourself. - Yes. - Specialist, analysts
still have to contribute to people who are gonna
build diversified portfolios how you manage risk in this environment is a brutally difficult problem. And I don't think
anybody has a good answer to that for the moment by the value investments
have a better definition of risk, but how you
position size properly how you combine things across different countries,
different asset classes. I think there, aren't going
to be models that do it. And I think Tano is going
to train what's his name? Riley in Ireland. To do that really well it's gonna involve a serious intellectual effort on his part for the next 20 years. - Yes I think this is exactly right. That the definition of risk for value investors have a permanent loss of capital requires a different way of thinking about risk management relative to how traditional business
schools teach this. And that, that remains an open question. So let me just finish with one question that people are asking which is when is the third
edition coming out Bruce? - Never (laughing) Let me say, let me say why. Business Judd and I have written two books one, which is "Competition Demystified" was actually a good book and we're never gonna have
to produce a second edition. The first value investing book
is actually not a good book. I mean, there's this huge area that if you look at the examples we did so the way we tried to
value intel in WB 40, it was incredibly feeble. If you look at the second edition we've really actually done a good job. And since we've got a good job on the second edition and
Tano is gonna be responsible for the risk management
and position sizing problem there is never gonna be a third edition. - But we'll hear much more from
Bruce in a future occasions. So Bruce thank you so much for again, doing this wonderful event and for all the insights that
it was a wonderful lecture to all of you out there, thank you so much for participating and stay tuned for more events from a Help Room in the next few months. And again Bruce, thank you so much for such a wonderful lecture. - Thank you for being a great interviewer. - Thank you everyone. We'll see, we'll see you guys soon and stay safe. Bye everyone.
