Lee Ainslie — No Holds Investing

Winter 2014

Lee S. Ainslie III is the head of Maverick Capital, which he formed in 1993. Prior to founding Maverick, he worked at Julian Robertson’s Tiger Management. He holds a bachelor’s degree from the University of Virginia and an MBA from the University of North Carolina’s Kenan-Flagler Business School.

Graham & Doddsville (G&D): How did you get interested in investing?

Lee Ainslie (LA): When I was in eighth grade, my father was the headmaster of a boarding school, and the school decided to start an investing club. I thought that sounded fun and interesting, so I asked if I could join that club, which they let me do. I started keeping a paper portfolio, and my interest developed from there.

G&D: It’s well known that you got your start under Julian Robertson at Tiger Management. Was there anything that was markedly different than the public perception about the way things were run at Tiger?

LA: I’m not sure I have a strong understanding of what the public perception is, so it’s hard to say if anything was markedly different. When I was there, it was a smaller firm. When I accepted the offer, they were managing around $500 million. I was only there for three and a half years, but by the time I left, the firm had grown pretty dramatically, both in terms of assets and in terms of people. I certainly learned a great deal from Julian but also from my peers there. What truly made Tiger a special place was that you were surrounded by so many individuals who were not only very talented and dedicated investors, but also just really nice people. I developed many friendships, which have lasted the twenty years since I left. We all had different pockets of knowledge about investing, not only in terms of sectors and industries, but also different ways of looking at and thinking about stocks. We spent a lot of time comparing notes and playing devil’s advocate to each other, and so the collective talent of the team ended up being a great benefit to my investing education.

G&D: Since that time, have there been other investors or books that you’ve read that have really influenced you?

LA: At one point in time, I read every single investing book I could get my hands on. Then Amazon came along, and the number of investment books has grown exponentially! In terms of who influences me now, I would really point to my peers at Maverick. We have worked hard to recreate that part of the culture of Tiger in that I am surrounded by extremely talented investors. If a week goes by that I haven’t learned something new, then that is really a wasted week. Sometimes, I’ll discover another way of evaluating a particular stock or hear about a decision by a management team that could be interesting. Other days, I’ll learn about a development in an industry that changes my perception of the competitive dynamics in that industry or recognize a certain macro development may have a meaningful impact on the environment. Whatever it is, I’m hopefully learning every day. We have tried to develop a culture where we have a group of people who view themselves as peers, who are not afraid to challenge one another, who enjoy working together and who are driven by common goals and values. I believe I’m a much better investor today than I was twenty years ago, and I really have my colleagues to thank for that more than anything else.

G&D: What led you to your decision to leave Tiger and start Maverick Capital?

LA: That was an extremely difficult decision because I had been treated extremely well at Tiger and had so much respect for Julian. I was approached by a family in Texas who were sort of serial entrepreneurs and had decided that they wanted to help launch a hedge fund. I declined their offer to work with them more than once, but they were persistent. I finally recognized that even though I was not sure I was ready to take on such responsibility, that when I would finally be ready, the odds of finding this kind of opportunity would be slim to none given their track record of success in a number of different fields and their willingness to be so supportive of this new venture. I am very thankful to them. While they have not been actively involved in the business for many years, they remain good friends and significant investors.

G&D: What was Julian’s reaction to it? Did he give you any words of advice?

LA: His reaction was understandably mixed. I don’t recall his giving me any particular advice when I told him about my decision. However, by that point I had already had three plus years of hearing from him how critical integrity and reputation are in the investment business, and those are lessons I certainly took to heart.

G&D: What was the toughest part of the transition going from working for Julian as an analyst to running your own fund?

LA: At Tiger you were essentially expected to be the foremost authority on a small number of stocks. For the investments you oversaw, no other public investor should know more about those companies than you did. This objective was possible because most folks were responsible for anywhere from a handful to a couple dozen positions in the portfolio. However, an appropriately diversified portfolio requires more than a handful of stocks, so I needed a different approach when starting Maverick. Likewise, a properly diversified portfolio is not just focused on one sector or on one region, and so there was a period of time when I was more dependent upon sell-side analysts and friends than I was comfortable with. For someone who was very accustomed to being extremely close to each investment I was responsible for that was a bit of a scary feeling. That drove a very early effort to expand the internal resources at Maverick, but initially during the first couple of years, that was the biggest transition.

G&D: That was a concerted effort when you started to have analysts covering a smaller number of names. A lot of analysts we talk to have pretty broad coverage universes, so your goal was to have the depth of knowledge that comes with having a smaller number of names.

LA: There’s a trade-off with having very narrow expertise. If one focuses on just a very small number of names they can develop a deep understanding of certain companies but may lose perspective of how that opportunity set compares to a broader universe. So how do you have your cake and eat it too? We addressed this issue by hiring what we refer to as sector heads who oversee our efforts in each of the six broad industry groups in which we invest. By 1998, we had heads for each sector so there was finally no stock in the portfolio where I was the only individual tracking the investment. The next five years were spent building out the depth and talent of those teams. Now we typically have three to six people on each sector team. Over the last decade, the incremental growth of the investment team has been driven by developing expertise that is beneficial to all the sector teams.

Today, we generally hold about four investment positions per investment professional. At most hedge funds, this ratio seems to average somewhere between 10 and

20. This gives us a significant advantage in terms of the quantity and depth of our due diligence behind each investment decision and how familiar we are with the companies in which we invest.

To ensure that our sector heads have a strong understanding of the relative attractiveness of their investments to a broader

universe and are attuned to developments that may impact different industries we established a stock committee that usually meets several hours each week. This group includes every sector head, our Chief Risk Officer, and myself, and is chaired by Andrew Warford. These meetings are focused on evaluating and reviewing potential and current investments, and under Andrew’s leadership we have done a wonderful job of maintaining a very consistent and very high hurdle for including a stock in the portfolio.

There’s also a weekly portfolio management meeting that I lead in which we consider our portfolio exposures and risks in light of different developments around the world. We have tried to find a balance that allows our sector teams to be quite focused on the industries they cover and yet to be fully informed about factors outside of their universe that could play a role in their decisions.

G&D: As you were building your analyst team, what did you look for in the people that you hired?

LA: The initial group consisted of people whom I had known for a long time and had great confidence in their abilities. However, each of these individuals were being asked to take a risk in that they would almost certainly make less money in the short term in the hope that together, as a team, we would be successful over time. They had to have confidence in our effort. Today, the majority of our investment team joined Maverick as an analyst. Typically, our analysts have worked for two years at a Wall Street firm or a consulting firm before joining us. We make a two- year commitment to them and expect the same in return, and some are asked to stay longer. We usually hire one to three analysts each year, and it’s a highly selective process. We review hundreds of resumes from extraordinarily well- qualified individuals. Our selection process has improved meaningfully over the last few years. First, we changed our interviewing process to make it very targeted on evaluating different skills and attributes that we believe are essential to success at our firm.

Secondly, we introduced a third-party testing component which measures characteristics that the interviewing process may not reveal. Thirdly, we spent time analyzing the success of past recommendations of the folks on our team who conducted our interviews to understand who in the past was adept at predicting good candidates — evaluating people and evaluating securities are two different skills.

The most important components we gauge include competitiveness, mental flexibility and emotional consistency — that last trait is surprisingly important. This is a very stressful business. We are all human, and we all make mistakes. How one responds to those mistakes and whether someone can keep a level head and make thoughtful decisions is critical. Conversely, how does one respond to a few big wins? With some folks, early success leads to inflated confidence that may slow the recognition of a mistake.

At the end of the day, investing is not rocket science. Most of the folks we’re interviewing are certainly bright enough to discount a cash flow stream or calculate a P/E multiple. Productivity and dedication can be much more important differentiators than just raw brain power. Intelligence helps, but whether you’re driving a Porsche or a Ferrari doesn’t matter too much if the speed limit is 65 MPH.

G&D: One thing we read about was that your team is trained in lie detection and interview techniques. Is that an important process when you are interviewing a management team or conducting channel checks?

LA: I’d say it’s helpful but not extremely important. There is some training you can do to improve your ability to recognize signals that can help you determine whether someone is not being forthright or honest. This can come in handy when you’re talking to a management team and asking difficult questions. We haven’t found that these techniques provide some magical ability, but they can help you understand whether someone is addressing a topic that gives them discomfort.

G&D: Was this training a result of you having been lied to by a management team in the past?

LA: Not really, I think every business in the world continually becomes more competitive. I’m sure that’s true for the dry cleaner down the block — I bet their business is more challenging than it was a decade ago.

That’s certainly true in our field, and so you constantly have to find ways to improve. If you’re not improving you eventually get left behind. So this training really was a result of trying to find ways to improve our abilities. I heard about this group of ex-CIA officers who conduct this coaching from one of our investors actually, and I think it’s been helpful.

G&D: How have your responsibilities as a portfolio manager evolved over the years? Are you still close to every investment decision you make?

LA: Over the years it’s been a bit cyclical. If you go to the very beginning, we had one investment professional, so I was very close to every decision we made, for better or worse. There have been periods where the business itself has required a larger investment of time as we were going through changes in our process or rough patches in performance so investors want to speak with me more. Other times, I end up investing more time in evaluating and managing our investment team — these responsibilities tend to ebb and flow. Over the past couple of years, the amount of time I have had to invest in running the business has been relatively light.

We typically have about 150 stocks in the portfolio, and I am familiar with all of them, but I am closer to our larger positions and investments that have not worked the way that we had expected. So when I’m doing a deep dive or going to visit a management team, often the P&L of that position has a minus sign in front of it.

With Andrew’s role as chair of the stock committee, both he and the relevant sector head are very close to each investment, and to me it’s reassuring to know that we have at least two senior, proven investment professionals very attuned to the potential return and risks of each stock in the portfolio.

G&D: Can you talk a little bit about the difference in how you think about the timeframe and the sizing between long and short ideas? How you think about the similarities and differences in regards to portfolio construction?

LA: I think compared to many other hedge funds, we may have a longer term timeframe and tend to think very strategically when evaluating different industries and companies. We are typically looking to understand where a business will be in two to three years. However, this is different from our average holding periods, as often others begin to recognize some of the elements of the investment that we have been focusing on and the position becomes incrementally less attractive, and of course other times we recognize that we’re wrong. Nevertheless on the long side, our typical holding period is still over a year, and on the short side it is closer to nine months. Although our investment horizon is similar for longs and shorts, our holding period ends up being longer on the long side because we have often been fortunate to identify great businesses run by talented managers.

When a business is generating a strong return on capital and the cash flow stream can be reinvested effectively, then we may able to own that stock for several years. The short side typically doesn’t work that way because when a company has significant issues, these flaws usually come to light sooner rather than later. So on the short side, you often end up having more of an event orientation.

In terms of sizing, our average long is roughly twice the size of an average short at Maverick, and our long portfolio is more concentrated than our short portfolio. This construction allows us to maintain net long exposure typically between 30% and 60%. The greater level of diversification of our short portfolio reflects the riskier nature of these investments and that these positions turn over more frequently, so having a deeper bench of such investments is helpful.

G&D: We’ve interviewed investors who have said that it’s rare to find people who are adept at both long and short investing. Have you found that to be the case?

LA: I disagree with that thesis. We believe that having responsibility for both longs and shorts sharpens analytical judgment and helps a team build a more complete industry. In my experience, people that are solely focused on shorts tend to become extreme pessimists. They look at any situation and immediately start to find all of the things that may go wrong, while quickly overlooking important potential positives.

Furthermore, shorting is more challenging for several reasons, one of which is that the market tends to appreciate over time. So even talented short-sellers who are generating alpha tend to get rather frustrated over time. These issues may be even more acute at Maverick than many firms because all of our short exposure is achieved by shorting individual stocks, as opposed to using ETFs, S&P puts, or other market- related instruments.

We have always held our sector teams responsible for both long and short investments, and our investment process is pretty similar for each. To dramatically oversimplify, we are trying to identify the winners and losers in each industry in which we invest and then evaluate the discrepancies between our conclusions and consensus views, and I believe that is an effective approach for both longs and shorts.

While many firms seem to be markedly better on either long or short investments, at Maverick we have added 6% of alpha per year on both longs and shorts, so I believe this balance supports our approach.

G&D: You said in an interview a few years ago that classic value investors often invest purely on valuation and that was something that you just weren’t comfortable with. How much weight do you place on valuation?

LA: To be clear, I think that valuation is a critical component of understanding where investment opportunities may lie. But I think many “value investors” purely focus on that metric and may ignore other important considerations. It’s one thing if you have a very cheap stock and reasons to believe that the cheap valuation will not persist: there’s a new management team, there’s an activist shareholder, they’re restructuring, they just made a decision to buy back stock, and so forth. I believe it is important to identify a catalyst that should benefit the valuation. The approach of simply identifying a very cheap stock that often has been cheap for a while and then just crossing your fingers and hoping the world will wake up and be willing to assign a higher valuation one day soon is not a very effective approach in my judgment. So while we place great emphasis on valuation in our investment decisions, valuation alone should never be the driver of either a long or a short investment.

G&D: Can you talk about your idea generation process? Are you finding yourself looking more at new ideas or at ideas that you’ve been tracking for many years?

LA: We have always considered our universe to be every stock in the world that trades more than $10 million a day and has a $1 billion market cap. As we speak, there are almost 3,000 such stocks — this excludes A shares in China as US investors only have a limited capacity to invest in these stocks today. If we did, it would add several hundred stocks to our universe. At Maverick, our investment process is driven by our six industry sector teams, which have global responsibility. Each sector team has between three and five people.

Idea generation almost always takes place in these sector teams. There are times I have an idea that merits further evaluation, but most of our sector heads have spent their entire careers focusing on one industry, and they have each proven that they are very talented investors — so we would never move forward on an idea without their input. Our sector heads are probably responsible for the majority of new ideas, but even our junior analysts are expected to develop actionable investment theses. From that spark of an idea, if it’s a company we know well, one little data point can be enough for us to move quickly. However, if it’s a company we have not analyzed before, it typically takes months before a stock can make its way into the portfolio because we will do a deep dive not only on the company in which we’re considering investing, but also on the competitors, customers and suppliers of that company. For better or worse, this process can take a very long time.

G&D: What do you look for in these deep dives? What qualities make for a good investment?

LA: By deep dive, I mean we typically have extensive meetings with as many different members of management as possible as well as managers of different regions or product lines if possible. The most critical factor that we’re trying to evaluate is the quality of management — their intelligence, competiveness and, most importantly, their desire to create shareholder value. At the end of the day, businesses are run by people, and different management teams have different motivations and different abilities. As investors, it is critical that we have a strong understanding of the quality and the objectives of every management team in which we invest.

Of course, we also want to have a very deep understanding of the businesses in which we invest: the sustainability of the business, of the growth and of the cash flow. The primary point of our extensive conversations with customers, suppliers and competitors is the evaluation a company’s strategic position and the strength of a company’s moat or competitive advantages. As we discussed a few minutes ago, valuation is also an important consideration for us. I believe that a successful investor must be very comfortable with a number of different valuation methodologies and have the wisdom to recognize which valuation approach is going to be the most relevant in different situations. The most commonly used valuation metric at Maverick is sustainable free cash flow in comparison to enterprise value. But we may also consider metrics such as enterprise value to revenues, book value, free cash flow yield, P/E ratio, dividend yield, and so forth. Different metrics will be more or less important in different situations.

Finally, as I mentioned earlier, we consider how differentiated our view is; not to say that we will only invest in things where we have a contrarian perspective. For example, Microsoft in the early 1990s and Wal-Mart in the early 1980s were consensus buys among virtually all Wall Street firms, and yet they were among the most successful stocks of their day. So it’s not impossible, but the odds are against you if your view is the same as everyone else’s because that view is probably already reflected in a stock’s valuation. Our most successful investments tend to be those where our research process has led us to a conclusion that is different than the perspective commonly held by most investors, and these deep dives allow us to develop significant confidence in these differentiated views.

G&D: You’ve met a lot of management teams over your career. Have you found more often than not that they are thinking the right things in regards to creating shareholder value, or is it kind of the alternative where you’re generally disappointed?

LA: One of the things we really try to make sure our team understands is that if someone is able to become the CEO of a Fortune 500 company, the odds are that individual is going to be pretty impressive across the conference table for 45 minutes. These executives are not dumb; they know exactly what you’re trying to get at, what you want to hear, what Wall Street thinks the right answers are, and like all good politicians they will do their best to highlight the strengths of their business. When you delve into the potentially weaker aspects of their company, they will typically try to gloss over your concerns or even obfuscate the issues. So when we evaluate a management team, we’re much more focused on analyzing past decisions and actions than simply reviewing their responses to our questions. We also invest a lot of time in trying to interview people they’ve worked with before or people they’ve competed

against and have found insights gleaned through those conversations very helpful over the years.

G&D: You have been quoted as saying there are no “holds.” You either “buy” or “sell”. How do you implement that practically in your portfolio?

LA: I think I have read almost everything that Warren Buffett has written, and I agree with more than 95% of his thinking, but this is one area where I disagree. I understand the tax impact of turnover, but nevertheless, I would argue that an investor should be able to overcome the negative tax consequences of shorter-term holdings through more efficient use of capital. For example, if I am starting a new fund, and my portfolio is a blank sheet of paper then I will evaluate the potential return of every potential investment from the prices the market is offering that day. I can decide how much risk I am willing to take to achieve expected returns, and I can evaluate how each opportunity compares to every other opportunity to develop a portfolio which I believe represents the optimal use of capital. In my view, tomorrow, I should go through the exact same process taking into account any new information including changes in the price of securities. If I conclude that a different portfolio would be preferable then I should buy or sell securities to get to the portfolio that I believe represents the optimal use of capital once again.

This is exactly why we primarily invest in liquid, public equities — so we have the ability to improve our portfolio every day. If we conclude that a 3% position in stock X would be the ideal position size, then we should try to get to that position size that day. Whether stock X is new to the portfolio or it’s a position we’ve held for years is not horribly relevant. Likewise, whether we entered that day with a 2% position or a 4% position in stock X should not play a role in our determination of the most appropriate position size. I think too often investors get wed to certain investments that have worked well or perhaps because they’ve developed a nice relationship with management that they don’t want to disrupt, and so investors often get complacent and comfortable with their current portfolio. In my judgment, it is critical to attempt to identify the best possible use of capital continuously. The “no holds” concept simply reflects the approach that every investment should represent a very compelling risk/reward opportunity from current prices, and if that’s not the case then that capital should be redeployed into positions compelling at current prices. In the perfect world, every member of our investment team is pounding the table to increase the size their positions every day until they are at a maximum size in terms liquidity or risk contribution. When somebody tells me that they don’t think we should sell a stock, but that they wouldn’t buy more at the current price either, then that investment probably does not represent one of our very best uses of capital — unless the size of the position is already at a maximum from a risk perspective. We want our portfolio invested in the most attractive use of capital today at current price points, and if a certain position no longer represents that then we should sell. Sometimes, people have a hard time with this because this philosophy often means we are reducing or exiting a position before it’s reached our expected price. For example, if a stock is 10% away from our original target price, we are likely to sell because we think there are many other opportunities with greater upside. Conceptually, our team has to accept this concept of “no holds.”

G&D: Are there industries or countries that you have a different view on versus the market?

LA: In our core hedge fund, we try to maintain a balance of longs and shorts in every industry and in every region in which we invest. We try to avoid market timing or sector rotation calls. Our returns are driven by our ability to generate alpha within industries and regions.

G&D: Can you talk about a mistake that you’ve made on an investment that has changed the way you think about things?

LA: Unfortunately, I can go through many examples of mistakes that we’ve learned from. In terms of risk/ return management, we develop a risk case that we think has a 10% chance of taking place — so a case that is not highly likely, yet certainly in the realm of possibility — and we vigorously debate the assumptions behind these risk cases. In measuring potential downside, we have often used historical dynamics, such as trough book value or revenue multiples. One of the lessons of 2008, and even more so in 2011, was that, in certain environments those historical patterns can collapse. We took too much comfort in the thought that many stocks were sitting at levels where the downside risks appeared very limited given they were so close to the historical lows on such metrics, and we were proven wrong. In terms of a specific company, we invested in a company called NeoStar, which was a result of a merger between Software Etc. and Babbage’s in late 1994. The companies were the two largest sellers of computer software and operated in malls around the US. On paper, NeoStar was very attractively positioned. By merging, these two competitors would enjoy economies of scale and could improve pricing. As this merger was taking place both Sega and Nintendo had roll-outs of their new game platforms, both of which ended up being bigger than people expected. At the same time, Windows 95 was coming out, so you had huge drivers to both PC and gaming software sales as well as very significant synergy opportunities.

These businesses should enjoy meaningful operating leverage, so just improving comp store sales a few percent should have had a nice impact on operating margins. Putting all these factors together, we concluded that the company would earn significantly more than investors were expecting. And we were wrong. We were wrong because management just blew it. When you asked me about characteristics I look for in stocks, I mentioned quality of management is the most important. While our investment case for NeoStar was extremely compelling, we were doomed by horrific execution. In doing a postmortem, it became clear the merger was a disaster. The companies continued to be run as separate entities and continued to compete viciously. There was huge in-fighting about who was going to get what responsibility. Instead of taking advantage of the obvious synergies, they had duplicate efforts on many different fronts. One large vendor told us that two different people each thought they were ordering for all the stores and as a result, important orders were placed twice, and they literally ended up with twice the expected inventory. It was just an unmitigated disaster. We bought the stock right after the merger in early 1995, and by 1996 it was all falling apart. Our strategic analysis proved correct — both the gaming platforms were huge and Windows 95 became the best-selling operating system of all time. Realizing the potential synergies seemed straightforward as well. But the important lesson was that such considerations are not relevant if the management team is subpar.

G&D: What advice would you give to the students who are interested in a career in investing?

LA: Two things: first, read a lot. Read as many investment books as you can get your hands on. I’ve been able to learn something from almost every book I have ever read.

Secondly, the path to an investment career is not necessarily to work at a hedge fund or at a large mutual fund complex. You can start your career by simply improving your understanding of how different industries or companies work or how Wall Street works. Any brokerage firm or Wall Street firm can be a path to an investment career. A lot of people move from the sell-side to the buy-side over time. We probably have as many former McKinsey consultants as we do former Morgan Stanley investment bankers.

G&D: A lot of our students are also interested in starting their own funds. Assuming they can raise capital, would you recommend that they spend the first few years trying to get training somewhere first, or do you think it is okay to start right after business school without any formal training?

LA: The capital is important, but the know- how is even more important. The fear with starting right away without a great deal of experience is you don’t get many mulligans in this field. If you launch a fund that has disappointing performance, then go to work for another firm for a few years and eventually try to launch another fund — potential investors are still going to want to delve into the returns of your initial effort.

Not that a poor record can’t be overcome, but it’s certainly going to make raising capital harder. You can’t just tell people not to count your past record because you didn’t know what you were doing. So the first couple of years become a make or break period. If it were me, I would want to stack the deck in my favor as much as possible. When I decided to launch Maverick, I had been with Tiger for three years, and I was still scared to death. I was young, naive and probably a touch arrogant in hindsight. If I had a better understanding of the challenges of successfully starting a fund, I’m not sure I would have departed Tiger. Also, today’s world is far more competitive. The odds of a small group of people launching a small fund and growing that fund into a large entity are just much smaller today. When I started, there were probably about 100 hedge funds in the world. Today, there are over 7,000.

G&D: Lee, thank you for your time.