Berkshire Ruminations

Thursday, April 26, 2007

Mario Gabelli and Value Investing

I recently got a chance to meet Mario Gabelli, chat with him briefly and attend a lecture he gave to our business school. It was another exciting opportunity for me that I owe to my status as a student at a school with a very generous benefactor, Mr. Harvey Eisen, who routinely helps bring the classroom to the real world.

Some folks might be more familiar with his company, Gamco Investors (GBL), than with Mario Gabelli himself, so let me review why I think he is one of the most important investors to study.

As far as the hall of value investing fame goes, I would say Warren Buffett and Charlie Munger top the list, but Mario Gabelli is not far behind. Like Warren Buffett, Mr. Gabelli is a graduate of Columbia Business School. So naturally he is a strong proponent of the value investing style formalized by Benjamin Graham and David Dodd in the 1930s. He is still active at the school, lectures occasionally and consults with the current value investing professors.

Mr. Gabelli’s innovation is the concept of Private Market Value (PMV). The underlying idea of PMV is that a public company is worth the amount that a private investor would be willing to pay for the company in its entirety were it not public. This is a somewhat more concrete modification of the concept of intrinsic value, for which Graham and Buffett both had more ambiguous definitions.

For instance, Mr. Buffett defines intrinsic value as the present value of all cash that can be taken out of the business over its remaining life. Of course, calculating this can be frustratingly difficult as it relies on important assumptions of future earnings, capital expenditures and various other unknowns. Conversely, PMV can be estimated a little more accurately by garnering an awareness of the private market for businesses. This strategy worked well for Mr. Gabelli as his firm was getting off the ground in the early 1980s, just as the leveraged buyout phenomenon was peaking and public firms were indeed being taken private with some regularity.

But Mr. Gabelli does not settle for only companies that are likely takeover candidates, as this would severely limit his universe of potential investments, especially in a less LBO-friendly environment. Thus, he also looks for a “catalyst” – something that can cause a public firm’s hidden PMV to be unlocked without the need for a buyout. Such things may include a new management or regulatory change.

While Mr. Gabelli rightfully gets the credit for popularizing this idea, one can see the strategy at play in the investments of many investors, including Warren Buffett. Take for example Berkshire’s investment in Coca-Cola in the mid-80s. Mr. Buffett saw an enormously strong brand that had been muted. But there was also a catalyst in the form of new CEO Roberto Goizueta who took over the company with a new strategy. More recent examples might include Berkshire’s investment in Mid-American Energy and PacificCorp, which came immediately after the repeal of the Public Utility Holding Company Act.

So what is value investing these days anyway? I get asked that from time to time, but it can be difficult to answer. The simple answer is that it is a catch-all term to characterize a variety of investing styles, all of which make the supposition that the market oftentimes gets prices wrong. Perhaps it is best to describe modern value investing by what it is not.

Value investors give no credence to charts, moving averages or any technical indicators. This is because, under the assumption that stock prices might be wrong, then so too can the charts. But it is also because value investors focus on fundamentals, whether those fundamentals include financial ratios, market shares or brand value. Note that such fundamentals are not necessarily easily measured or even identified.

Value investors do not worry about trends, and generally avoid “hot” stocks. Buying a stock on momentum and hoping that momentum is sustained is simply too risky. This does not imply that a value investor cannot buy a hot stock, but only that it being hot is not the reason for the value investor’s purchase.

However, value investors always distinguish between value and price. Far too many investors assume price and value are synonymous. They are not. Price is what you pay, value is what you get.

In the end, value investing boils down to the purchase of stocks for less than they are worth. What they are worth boils down to some estimation of value based on factors unrelated to the market or its pricing of the stock. Thus, the value investor does his best to ignore the market entirely until he decides what he feels is the right value of the stock – just as he would be forced to do were the company private – and then makes a decision by comparing this value to the price.

FD: I own shares of Berkshire Hathaway, but have no position in any other company mentioned in this post.

Sunday, April 22, 2007

Beware the Sell-Side Analysts

I thought I would publish some auxiliary results to an empirical study I have been working on, as they might be of direct interest to investors like me. I was able to get a large amount of data on analyst forecasts and corresponding corporate earnings announcements from a Thompson Financial database called the Institutional Brokers Estimates System.

The database contains data on the earnings announced each quarter by a company and the mean estimate for that quarter’s earnings among all analysts that follow the stock. I got all the data available dating back to 1984 and found the average difference between the forecast and the actual earnings. I call this “forecast error.” The bottom line is that analysts consistently overestimate earnings. This indicates that there are probably more earnings disappointments than there are surprises, or that disappointments are sometimes so large that they skew the results. The average forecast error is consistently positive, after accounting for nearly 250,000 quarterly earnings announcements over this time. In fact, in only two years, 2002 and 2003, was the error negative, indicating that analysts on average underestimated earnings in those years.

So how can we interpret these results? I hesitate to draw too many inferences as doing so might be seen as hasty by my academic colleagues. So I will leave that up to the reader. But it is not particularly surprising to me that stock analysts hired by brokerages or investment banks looking to make stock transactions happen would be overly bullish about a firm’s prospects. Or, alternatively, perhaps these analysts aren’t doing much thinking themselves and are instead merely following the guidance of the company, whose incentives are also obviously biased towards bullishness.

Regardless of the interpretation, this unambiguously suggests taking the pervasive “strong buy” recommendation with a grain of salt. But of course, we already knew that.