Pitch the Perfect Investment
Paul D. Sonkin is an analyst and portfolio manager at GAMCO Investors/Gabelli Funds. He is currently a co-Portfolio Manager of the TETON Westwood Mighty Mites Fund, a value fund which primarily invests in micro-cap equity securities. Prior to joining GAMCO in 2013, Sonkin was for 14 years the portfolio manager of The Hummingbird Value Fund and MBA from Columbia Business School and a BA in Economics from Adelphi University. For 16 years, Sonkin was an adjunct professor at Columbia Business School, where he taught courses on security analysis and value investing. For over 10 years, he was a member of the Executive Advisory Board of The Heilbrunn Center for Graham & Dodd Investing at Columbia Business School. Sonkin has extensive corporate governance experience having sat on six public company boards and is the co-author of Value Investing: From Graham to Buffett and Beyond (2001).
Paul Johnson has been an investment professional for more than 35 years and currently runs Nicusa Investment Advisors. Previously, he was a top- ranked sell-side analyst, a hedge-fund manager, and an investment banker. As a portfolio manager, he invested in virtually all sectors of the economy and has participated in more than 50 venture capital investments during his career. Johnson has taught 40 semester-long graduate business school courses on securities analysis and value investing to more than 2,000 students at Columbia Business School and the Gabelli School of Business, Fordham University. He received the Commitment to Excellence award in both 2016 and 2017 from the graduating class of Columbia Business School’s Executive MBA program as well as the 2017 Columbia Business School’s Dean’s Prize for Teaching Excellence. He received the Gabelli School of Business graduate-level Dean’s Award for Faculty Excellence in 2017. Johnson was a contributing annotator to The Most Important Thing Illuminated, by Howard Marks, co-author of the history of value investing in Columbia Business School: A Century of Ideas, and co-author of The Gorilla Game, Picking Winners in High Technology. He has an MBA in Finance from the Executive Program at the Wharton School of the University of Pennsylvania and a BA in Economics from the University of California, Berkeley. Due to increasing frustration from not having a good book to assign to their students, they co- authored Pitch the Perfect Investment. In their book, which was released by John Wiley & Co. in September, they give the reader the tools to decipher a portfolio manager’s schema. These tools will help in selecting a security to pitch that captures the audience’s attention, in determining whether a genuine mispricing exists, and in showing how to generate a true “edge.”
Graham & Doddsville (G&D): How did you two first meet and come up with the idea for a book?
Paul Johnson (PJ): We‘ve known each other for a long time. We met in 1994; Paul was my student, then he was my Teaching Assistant for a while, before he started teaching his own class in 1996. Then in 1997, we co-taught the Value Investing class during Bruce Greenwald‘s sabbatical. We‘ve been personal and professional friends for more than 20 years. We started the collaboration on the book four years ago, at the Heilbrunn Center‘s Graham & Dodd Breakfast in fact. After that breakfast, we were just chatting and catching up, and Paul said he was writing a book. I responded, ―Yeah, I‘ve always wanted to write a book, but I know it will take too much time and energy. I then asked, ―What is the name of your book? And he said, ―The Perfect Pitch. I thought that was funny, because I had always wanted to write a book called, ―The Perfect Investment. Paul suggested that we should work together, which I initially thought was a crazy idea. However, we started emailing back-and-forth that morning, after we returned to our offices, and quickly discovered that our two books were opposite sides of the same coin. Before long, we had agreed to write Pitch the Perfect Investment, which we decided would be a combination of our two books. Although I didn‘t fully understand what Paul meant when he first said that the pitch ―is the architecture of the research process, I learned to appreciate his insight over time while working on the book. Paul argued that if you can‘t pitch the idea successfully, then you haven‘t done the proper research on the idea and if you get the pitch right, everything else falls into place. I believed at the time we started working together that the goal was to find the perfect investment and the ―pitch‖ would take care of itself. I have come to realize that Paul‘s view is correct and my view was incomplete. A lot of people think of pitching as persuasion or selling. But in our view, pitching is making a convincing case why the market is wrong and you are right. We don‘t think of the pitch as selling, rather, the pitch is the opportunity to explain your recommendation in a way that the PM understands the opportunity and wants to adopt the idea. The pitch is the culmination of your research process.
G&D: Most investment books are targeted at seasoned practitioners. Why did you choose younger analysts as your primary demographic?
PJ: Early on, Paul said to me,―Since we both teach MBAs, why don‘t we write a book for them? There is no book for the college or MBA student, or recent college or MBA graduate, and it‘s desperately needed. We felt that college and MBA students are similar. Although the MBA student usually has more experience, they have similar challenges in acquiring the necessary skills to be successful in the business. And, we both taught our investing classes at Columbia by piecing together an eclectic collection of articles, chapters from books, journal articles and random newspaper clippings. However, there never was a single source that addressed the topics we wanted to cover in class. Paul and I decided to write a book for that audience because nothing existed to fill the gap.
Paul Sonkin (PS): As Paul said, one of our motivations was that we didn‘t really have a good book to assign to our students. We also tried to avoid targeting the practitioner as our primary audience for the book because practitioners think they already know everything. We didn‘t want to get into a debate with them about how much they already knew, or thought they knew. We still think that every practitioner will learn a lot by reading the book, but they are not our primary target audience. Rather, our target is the college or MBA student that is pitching a stock for a job interview, a stock pitch competition, or a student-run investment fund, or the analyst that just graduated from college or business school who is new to the job. These are our primary audiences. There‘s no training on Wall Street, so most young analysts are just thrown into a situation where they don‘t know which end is up. We wrote our book to be a survival guide. It addresses 80% of what they need to know, in a single, distilled volume. The MBA student looks a lot like the college student with, as Paul said, perhaps a little bit more experience. But I think a large percentage of people that go get their MBAs are career- switchers. Their needs are similar to the college student. And this book gives them everything they need to survive and thrive on Wall Street.
PJ: I‘ve been teaching at Columbia for 25 years. My thought was always, why do my students have to make the same mistakes I made? Why does every one of them need to reinvent the wheel as they start their career? Why not learn from the mistakes I and others have made. Everyone will make your own mistakes — that, I promise you. But why should everyone have to re-learn basic lessons? This is ridiculous. Besides, Wall Street has become more competitive and the stakes are much higher now to develop the necessary skills more quickly. My approach to teaching has always been to bring people up to speed as quickly as possible. Then let them leverage what they learned in school to be successful in business.
PS: During my 16 years teaching at Columbia, my approach was the same. In my class, I tried to simulate the real world — pitching a stock to a portfolio manager—as much as possible. We wrestled with a lot of difficult investing concepts, trying to pin them to the ground in the process of writing this book. We don‘t feel our book is the definitive treatise on the subject, rather, we are just trying to move the ball down the court. We‘re just trying to advance the discussion and contribute to the investment community‘s understanding of these critical issues.
G&D: Both of you focus a lot on small-cap stocks. Is that one reason why you were able to collaborate successfully on a book?
PS: What works about our collaboration is that first off, we both have a lot of working knowledge of the domain. But we‘re very complimentary because I‘m all over the place in the way I think about the issues. With my gift of attention deficit disorder, I came up with all these crazy ideas and examples, and then Paul and I worked together to distill them down.
PJ: Paul will come up with, say, 10 crazy ideas, two of which are like, ―Wow, that‘s the craziest thing I’ve ever heard — we can‘t write that and those would get kicked away pretty quickly. Four or five of them were a creative take on something that‘s conventional, which often changed our view on a specific topic, many of which are embedded into the book‘s core principles. And two or three of the 10 ideas would blow me out of the water. I often said in our discussion, ―Can you repeat that? I am taking notes as fast as possible. I recognized early in our collaboration that Paul has this unique and wonderful ability to see stuff very differently than I do, and differently than most people do. Paul‘s job was to come up with crazy ideas and my job was help filter out the best ones. I urged Paul not to self-edit. Don‘t ever say, ―This idea is too crazy to share with PJ. I told him regularly, ―I want you to tell me everything that comes into your mind on these topics. I want your unique perspective on these issues. Let me filter. That became our partnership. The fact that we‘ve known each other for a long time and were trained in a similar way probably helped, but I think our shared passion fueled our collaboration. Certainly, our mutual respect, natural chemistry and all those things help the relationship, but at the end of the day, it‘s a collaboration focused on trying to figure this stuff out, working to make it clear, and writing it to share with other people. I always thought I was a visual thinker, but Paul is that on steroids. There were countless times he‘d get up in the morning and email me a chart he had created to explain an insight or new perspective he had overnight. I would look at what he sent me and say ―Paul, that idea alone is worth the price of the book. He usually responded, ―Oh you like it? And I would respond, ―It doesn’t matter whether I like it, the visual explanation is awesome. The chart is going into the book. We both gravitated toward small and microcap stocks because that’s where we thought we had an edge. In that way, we are similar. We both grew up in that universe and our approach to the asset class is similar. We agree that it would be fun to be able to figure out what Google is worth, but you would be competing with 500 other analysts and portfolio managers who are each trying to figure it out. We both concluded that all those investors are probably really smart and are formidable competition. As a result, we both tried to find situations to analyze with fewer smart people to compete with. We both got into small caps because that sector of the market was the least efficient. However, other investors figured that out and, unfortunately, even that part of the market has become fiercely competitive.
G&D: What are the theoretical concepts about investing you discuss in the book?
PS: (laughing) What concepts don‘t we discuss in the book?
PJ: One of my favorites is our discussion of risk and uncertainty in Chapter 9. We feel strongly that all investors need a better understanding of the difference between the two concepts. For example, if I gave you a lottery ticket, it is uncertain whether you‘ll win. I think that is clear to most people. However, is there any risk? I gave you the lottery ticket for free, so there is no risk. Now what if you bought the lottery ticket with your own money? Now there is uncertainty and risk: the uncertainty of winning and the risk of potentially losing the money you spent on the ticket. There may be a lot of uncertainty, but there is no risk without committing capital. Although this is a simple example, it demonstrates that risk and uncertainty are not the same thing. Uncertainty is usually what everyone talks about when they discuss the different possible future outcomes or scenarios, although they often mislabel uncertainty as risk. There‘s uncertainty in the future, but risk only exists if someone commits capital and is only the part of uncertainty that could potentially cause harm to the investor. We feel that this distinction is an important subtlety for all investors to appreciate. As we show in the book, uncertainty and price is what determines risk. There are a lot of situations that are highly uncertain, and the uncertainty spectrum may be quite large, but if the price is low, then there may be little to no risk.
PS: One of the cases we discuss in the book involves Herbalife bonds. It was a situation where there was a lot of uncertainty, but not a lot of risk.
PJ: Lehman bonds after their bankruptcy filing is another example. Lehman bonds were trading at eight cents. A couple of really smart investors did the analysis and concluded that although there was a lot of uncertainty as to what would be the final outcome for the bond holders, the worst case in their estimate was 22 cents. They couldn‘t come up with a scenario where they got less than 22 cents. But they had no idea when the bonds would be redeemed, so they didn‘t know their expected return. In the end, the bonds were redeemed for 41 cents. There was a lot of uncertainty, but limited risk, and a terrific return in the end. Those investors were rewarded for understanding the difference between risk and uncertainty.
G&D: Before we discuss the perfect pitch, why do you think the pitch is so central to this industry?
PS: If you want to go into investment management, you‘re going to have to go on a job interview. I don‘t think there‘s any other way you can get the job. And the portfolio manager doesn‘t really know how to conduct an interview, so they‘ll look at your resume and ask some basic questions to break the ice. And then, when they have run out of patience, they‘ll ask what they really want to know, ―What‘s your best idea?
PJ: Every interview is ultimately a stock pitch. We wrote the book with the goal of showing the student or recent graduate how to come to the interview with an investment idea that will get the portfolio manager to say,―I‘m going to end the interview here so that I can start working on this idea now. Perhaps this goal is too ambitious, but that is what we want the student thinking every time they prepare for a job interview. They need to understand that their pitch needs to be so persuasive that the manager wants to end the meeting early to pounce on the idea.
PS: For the book, we felt it was critical to reverse engineer the manager‘s cognitive process. We thought,―Okay, what would be the elements of an idea that would motivate the PM to clear his or her desk?‖ First, you have to think about whom you‘re pitching to. Portfolio managers are busy and there‘s better than a 50/50 chance that they have attention deficit disorder. You need an idea that is going to capture and hold their attention very quickly. We thought, ―What response are you trying to elicit from the portfolio manager? What is the best possible outcome other than he just hires you on the spot?‖ In our research for the book, we spent a lot of time thinking about the entire process — from the first time the portfolio manager lays eyes on you until he decides to put the idea in his portfolio.
PJ: We also think that stock pitch competitions have lost their way, at least the ones we have attended. For many of them, the competition has become an exercise in showing the judges how much work you‘ve done and how many slides you can put in your presentation, rather than finding a compelling investment idea. I think the judges have also been trained to look for the person who did the most work and has the best slides, as opposed to the most interesting investment opportunity.
G&D: What does this book bring to the table that is different from all the other value-investing books out there?
PS: In addition to teaching my own classes at Columbia, I also graded papers for Bruce Greenwald‘s Value Investing class for six years. During those six years, I attended most of the lectures from the super-investors Bruce invited to speak in class. In addition, I’ve read the same books as everyone else. I formulated my investment strategy on the ideas from those investors that resonated with me the most. We wanted to write a book that explains the behavior of these great investors.
PJ: That’s why writing the book took so long.
PS: If you look at some of these super-investors, like Michael Price, Warren Buffett, Seth Klarman, Mario Gabelli or Walter Schloss, all these guys have different, yet successful approaches to investing. Nonetheless, our framework explains exactly what they are doing. We think our model provides a lens to show how they gain an investment edge.
PJ: It is important to emphasize that the world has changed a lot in the past 40 years. For instance, investing has gotten significantly more competitive, which we talk a lot about in the book. And we argue that unless you have a good roadmap, you‘re going to have problems.
PS: The other challenge with these investors is that while they have so much expertise, most of their knowledge has become tacit and they have trouble communicating it effectively.
PJ: Would you want to take a basketball lesson from Michael Jordan? You‘d might want to play basketball with Michael Jordan, but you probably don‘t want a lesson from him. And you probably don‘t want a tennis lesson from Roger Federer. These individuals are great performers, but they are probably lousy teachers. They‘re fantastic at what they do, but we have found that they cannot explain their craft very well. The legendary investors who speak in the Value Investing class are the same way. What we tried to do was distill their knowledge and processes into a generic framework that one can understand and learn from. And we think we achieved that goal.
G&D: What are the big mistakes that young people make when they pitch stocks?
PJ: A couple of things. Number one is overconfidence, which is a little tricky because you need to be confident in this business.
PS: We have heard countless students say, ―I know the value of the company. In fact, I know the company better than the analysts following it because I‘ve worked on it nonstop for an entire two weeks! We were both judges at a stock pitch competition earlier this year. We were sitting next to each other during the presentations and whispering back and forth about how awful the pitches were. We were shocked at how bad they were. The biggest mistake we see is that students spend 90% of their time figuring out what they believe is the intrinsic value of the company. Maybe 95% of the time. And they say, ―Okay, I think the stock is worth $50, it‘s trading at $42, therefore it’s a buy. They spend 95% of their time explaining why it‘s worth $50, but don‘t address why it‘s trading at $42. They do not explain what the market is missing. They don‘t explain why the mispricing exists.
PJ: One of the key messages in our book is that if you inverted the time allocation and spend 90% of your time explaining what the market is missing and why the stock is mispriced, rather than 90% of your time trying to justify your valuation, we believe that the portfolio manager will listen intently and, might, in fact, clear his desk to eagerly research your stock. If you start your pitch by saying,―The stock‘s trading at $42 because investors believe X, Y, and Z are true. I‘ve done a bunch a work to know why X, Y, and Z are not true and here is why consensus expectations are wrong, the portfolio manager is going to give you his full attention. You then need to walk through why X, Y and Z are not true. If you take that approach, the portfolio manager is going to get highly interested in your recommendation and they‘re going to say to themselves, ―If he‘s right, this stock’s going to $50. Now the focus is figuring out why you‘re right and why the market is wrong. In the book, we explain how every pitch must answer four questions, two of which I highlighted in the example above.
PS: The first question the portfolio manager subconsciously asks himself is, ―How much can I make?
PJ: If it‘s trading at $42, explain to the portfolio manager why you think it‘s $50. That gets him excited. That gets his greed going.
PS: Then the second question is, ―How much can I lose?
PJ: And you better address that because that is the investment‘s risk.
PS: Then the third question is,―Why is it trading at $42?
PJ: You need to explain to the portfolio manager what the market has interpreted incorrectly — what the market is missing. You‘re a young kid, you‘re brand new to the business. You‘ve figured out the stock is worth $50 but the rest of the market thinks it‘s worth $42? Why? How have you been able to figure this out, but the market hasn‘t? You need to answer this question fully or the portfolio manager will assume your estimate of intrinsic value is wrong and the market is probably right. If that‘s the case, he will quickly lose interest in the name — and in you.
PS: Then the fourth question is, ―How’s the market going to figure it out so the stock reprices? We use Michael Steinhart‘s framework of variant perception to address these four questions. A variant perspective means you have a view that is different from the consensus and you are right. The farther away your view is from the consensus, the bigger the price difference is going to be and the greater the opportunity, but the harder it is to prove that you are right. To emphasize the point: to have a variant perspective means that you have a view that is different from the consensus and you are right. You need both to be true.
PJ: Howard Marks states this well in his book, The Most Important Thing, when he says,―A forecast only has value if it‘s different than consensus. But it has to be right. The key to making money in the stock market is to be both different from the consensus and to be right. Both are hard. Being different than consensus is never easy, but being right is more important.
G&D: How do you think about a catalyst closing the gap between the analyst‘s variant perception and the market‘s view?
PJ: People throw the word―catalyst around all the time, but we struggled with the definition for four or five months. We kept asking,―What exactly is a catalyst? I think we finally figured it out: a catalyst is any event that starts to get the consensus to realize that the current set of expectations is wrong and begins to move expectations toward your non-consensus point of view. The fourth question can be rephrased as,―what‘s the catalyst? We think there are different types of catalysts. Time can be a catalyst, which we call a ―soft catalyst. Or there could be a specific event or announcement, which we call a―hard catalyst. Most pitches don‘t spend much time on questions three and four. I like to use a retailer, such as The Gap, as an example. Let‘s say that the big issue for the company is that as they get near the end of the season, they write everything down because they can‘t get the merchandise right and their profitability always disappoints investors as a result. That‘s been the issue for years and is what everyone is worried about this year. But, I was walking through one of their stores and thought the merchandise actually looked pretty good. I started calling store managers around the country, and, sure enough, they said, ―No, this is the best season we‘ve ever had. You can highlight this information in an interview or a stock pitch. You lead with ―I talked to 23 store managers across the country and they said this is the best season they‘ve had in years and the markdowns are going to be dramatically lower than they've ever been before. I have a variant perspective and I have information other people don't have. It takes two minutes to tell that story.
PS: Between the two of us, we‘ve listened to thousands and thousands of stock pitches over our careers. We've heard stock pitches from students in class, during stock pitch competitions, from sell-side analysts, CEOs, and corporate Investor Relations. We‘ve gone to conferences where we‘ll listen to 10 pitches a day from companies. Gabelli is having their aircraft supplier conference tomorrow. There will be 12 companies there. That's 12 stock pitches. Most won‘t resonate with me, but one or two may. I always ask myself, ―Okay, what gives me the warm fuzzies? And then I try to reverse engineer what led to that feeling I had. That is what we‘ve done in the book: reverse engineered the portfolio manager‘s cognitive process.
G&D: What part does market efficiency play in your process of repricing?
PS: In our book, we start with the work of Eugene Fama and conclude that for a stock to be efficiently priced information needs to be adequately disseminated, processed absent any systematic bias, and then incorporated into the stock price. An error in any of those three areas can produce a mispricing. You can have an edge or advantage only if it addresses one of the three steps in the process. You either have an informational advantage, an analytical advantage, or a cost or trading advantage. There‘s no fourth advantage.
PJ: We discuss market efficiency at length in the book because it explains the three reasons the stock could be mispriced.
PS: You could have a piece of information that no one else has, and you‘ve obtained it in a legal way so it‘s OK to trade on it. That‘s a pure information advantage — you know something the market does not know. Then there‘s a cost or trading advantage, which means that you can transact in a security where others can‘t or won‘t. When Warren Buffett bought Goldman Sachs preferred shares during the 2008 financial crisis, he was the only one offered that deal. He had a structural cost advantage and generated alpha from it. For him, the security was mispriced. How do you get an analytical advantage? An analytical advantage is where you look at the exact same data set available to everyone else but you see something that other people don‘t see. That‘s your variant perception. And that‘s where behavioral finance comes into it. If everybody‘s fixating on one piece of information and ignoring other information in the public domain that you find important, there could be a mispricing. We devote a significant section of the book to these principles: market efficiency, behavioral finance, and gaining an edge.
G&D: Do you think the markets for large-cap U.S. stocks today are much more efficient than it used to be 10 years ago? If so, what would your book have been like if you had written it then?
PJ: I think the market has become much more efficient. As an example, think about the World Series of Poker. The problem you have in poker these days is that just about all the rules have been worked out. The pros have simulated the game on computers and determined the optimal strategy. The great poker players have written books and given you all the tricks. If I decide I want to become a great poker player, I can read the important books on strategy and then play 1,000 hands a day online. The process of becoming an expert has become simpler and faster. As a result, the game has become a paradox of skill: anybody who‘s not highly proficient has been chased away. Only the greats are left playing the game. There are no more fish for the sharks to feed on — they are gone. As a result, it is sharks feeding on sharks. It‘s the same in investing. I am shocked at how much more efficient the markets have become in the last 10 years. Everybody talks about the fact that it has become very hard to generate alpha. You‘ve seen some great investors leave the business. They are closing shop because they don‘t want to compete against other sharks. That‘s the biggest change in 10 years. I think the second biggest change is alternative data sets. Now there are sophisticated programs that scrape the web, monitor social media, and generate alternative information like credit card ―exhaust, which is secondary or meta data, and satellite imagery. Alternative data has come a long way in the last 10 years and smart investors are using these unstructured data sets to get an edge. Also, information is now released on the web to everyone at the same time. You even have services like Capital IQ and others that will build your financial models for you. When I was a young analyst, there was an advantage to building better models. That skill no longer gives you an edge.
PS: Let‘s say you‘re an analyst following Best Buy, Home Depot or some other big retailer. Ten years ago, RS Metrics didn‘t exist — but they do now. RS Metrics flies satellites over retailer parking lots on a daily basis and takes pictures. Then they have computer programs that count the number of cars in the parking lot and compare the results against other satellite photos that they‘ve taken a week before, a month before, a quarter before, a year before. They can tell traffic patterns from that analysis. If you are analyzing Home Depot‘s stock and you don‘t have that information, you‘re at a huge disadvantage. It‘s the same thing with expert networks. When expert networks came out, the investors who could afford to spend $100,000 per industry vertical on these services had an advantage. Then, when all the big guys had it, you needed it as the ante to stay in the game. Now, if you don’t have it, you’re at a disadvantage.
PJ: We believe that information gathering has become very sophisticated. As for an analytical advantage, you‘re competing against very smart, well-trained and highly motivated investors and analysts. And, it is now very inexpensive to trade. Everything has advanced in the last 10 years and the three ways an investor can get an edge have weakened substantially.
PS: Another issue is the US―listings gap. In 1996, there were about 8,000 companies trading on organized exchanges in the U.S. Based on GDP, that number should be 10,000 today. The actual number of listed companies is only 4,000. One of the reasons the market has become more efficient is that you have a lot of smart investors, with access to the latest technology, chasing fewer and fewer names with more and more money.
G&D: Given this, where should practitioners and students focus?
PJ: If you‘re young and starting out in the business, you should focus on trying to develop an informational advantage. Since you have the time and energy, dig, dig, dig. Call as many potential sources of information that you can find and keep thinking of new sources to contact. Be creative about what kind of information is important to uncover. For instance, young analysts understand the power of social media. See if you can use it to gain an edge. Then, as you get more experience, work to expand your analytical skills so you can develop a more accurate variant perspective. I think that‘s the natural evolution in the business.When you‘re young, be very creative on your information sources and then as you get older, develop a more insightful analytical process. For the practitioner, you need to be able to take raw information and couple it with sophisticated analytics. Only then will you have developed a powerful skill set. You also need to understand what is your variant perspective for any investment that interests you, which changes the questions you need to ask and the type of information you need to gather in order to get an edge. I think that‘s the key to investing.
G&D: How do you apply these theories to private equity and international markets?
PJ: Let‘s separate the two questions because I think the answers are different. In non- public markets, I think there‘s enormous alpha to be generated at the management level. Not the management of money, but the management of companies and people. If you look at corporate governance and how companies are managed you will find that there‘s an enormous amount of inefficiency. Governance in the U.S. is a joke and many CEOs do not have the necessary experience to manage their companies effectively. I think that private ownership is growing because of the ability to control that piece of the governance problem. Fixing the agency problem is truly one of the last vestiges of alpha generation. It‘s very possible that in the future we will see only two types of public companies: the mega companies and the ―living dead‖ companies. Every other company will have been bought by private equity. I worry about the gutting of U.S. public markets; the listings gap that Paul referred to may only get worse. International investing is tricky. Many countries have proper disclosure rules, but the financial numbers the companies disclose are fake. Therefore, there can be a huge opportunity to obtain an informational advantage in trying to verify a company‘s actual economic performance against the financial results they report. I think gaining an informational advantage can potentially be a very big advantage outside the U.S. That said, you had better be on the ground, speak the language, understand the political environment and read the local newspapers—you need to be a native to compete effectively. There‘s a lot in our book that‘s relevant for both private equity and venture capital. Certainly, pitching in private equity or venture capital is very similar to the public markets. Stock prices are given in the public markets; therefore, you need to figure out if the crowd is wrong. In the private market, it‘s the price you‘re willing to pay and how you are going to create shareholder value over time. That‘s the only real difference between the two markets.
PS: I recently had lunch with the chairman of a public company. He had just bought a private business at 6x EBITDA. There was a strategic buyer that was willing to pay 10x. So, why did the owners of the company sell to him for 6x when they could have sold to the strategic buyer for 10x? It was because the two founders were in their 90s and had 180 families who were dependent on their company, since they were the biggest employer in the town. The purchaser had to sign something as part of the deal saying that he would keep the employees on for a certain number of years. That part of the deal wasn't disclosed, but that‘s an example where the buyer who paid 6x had a structural cost advantage over the strategic buyer in a private market.
PJ: A friend of mine in the venture capital world, who read an early draft of our book, said young analysts in venture capital have the same problem with pitching that public stock analysts have. It‘s a slightly different pitch as there is usually an auction price instead of a market price. He said if you substitute those pieces however, it‘s the same challenge. In the end, whether it is a VC investment or a stock, the goal is to understand what the portfolio manager wants, what they look for in an investment, and how they determine value. Whether it‘s venture capital or private equity, the pitching parts matched perfectly.
G&D: Often, when listening to a pitch, it can be hard to separate a person‘s charisma and confidence from the quality of their idea. If I am an analyst, how do I compete with someone who has that charisma? Do you address that in the book?
PS: As we discuss in Chapter 12 of the book, there are the factors of credibility, capability, and likeability that the portfolio manager is subconsciously assessing when sizing up an analyst and their idea.
PJ: Someone who is very charismatic is very likable, as we humans tend to gravitate towards people like that. Someone who‘s very confident comes across as very capable. We tend to like that as well. So, if you‘re competing against someone who has more charm than you, I would say just focus on the four questions and you‘ll blow everybody away.
PS: Proper stock selection and a true variant perspective beats charisma every time. In fact, as we all know, many of the most successful portfolio managers lack even basic social skills.
G&D: Except for your book, what are your favorite investment books?
PJ: Howard Marks‘ book, The Most Important Thing Illuminated is very good.
G&D: Are you saying that because you annotated it?
PJ: As I‘ve said many times, I wish I had written that book. That is, until this book. Marks is great when he talks about market efficiency, second-level thinking and risk. I think our risk discussion is better, but we got to write it after he did. I think Joel Greenblatt‘s books are a great way to think about value creation and buying compounders cheap. Ben Graham‘s Intelligent Investor, or at least some of the chapters, are worth reading.
PS: Especially chapters 8 and 20. Well, chapter 1 also.
PS: Michael Shearn‘s book, The Investment Checklist, is also very good. But as we mentioned, the reason we wrote this book is that there was no single book to recommend. When asked the same question in the past, we would have to recommend a chapter here, a chapter there, or perhaps some journal articles, but we could not recommend a single book, or frankly, a whole book. Another book I think would be good for students to read is Peak, by Anders Ericsson. It‘s about how to build expertise. The way to survive in this business is to build up domain- specific knowledge. And the only way to really become an expert is to live, breathe, and eat the stuff for a long time.
PJ: Deliberate practice, like―Jiro Dreams of Sushi.
G&D: The Netflix documentary about the sushi chef in Tokyo?
PJ: Yes, I was watching it this week and love how Jiro talks about his strategy for success. He‘s been making sushi for 65 years and is considered the best sushi chef in the world, yet says he tries to get a little bit better every day. That‘s pretty impressive.
PS: The concept of deliberate practice is critical to understand. Watching soccer games for 20 years will not make you a good soccer player. And not even playing soccer for 20 years will make you a good soccer player. Deliberate practice, which Ericsson talks about, is how you become good. Really focusing on what you‘re doing and constantly pushing yourself just beyond your capabilities and then getting direct feedback from an expert coach is the way that you build up expertise and improve over time.
PJ: I’ll teach my 40th and 41st semester-long course at Columbia Business School this academic year. I‘ve been teaching for 25 years, but I spent 50 hours this summer re-doing most of the material in the course. And that‘s crazy because this class has been ranked as one of the top courses in the Executive MBA Program for the past few years. But I wasn't happy with it. That's why I watch Jiro. He's been doing it for 65 years; I've only been doing it for 25.
PS: Bruce Greenwald is starting to talk about the importance of specialization, and it‘s a shame that he‘s going to be retiring because I think that if this were 20 years ago, he could explore and develop the concept of specialization even more. In a market which is extremely efficient and getting even more efficient every day, I think that specialization is going to be very, very important. And the only way to get specialization is by living, breathing, and eating whatever domain you‘re in.
G&D: When you think about people our age specializing in investing, what ways would you push them to specialize? Is it in a market cap, is it in a style of investing?
PS: No, I think it needs to be industry specialization. We will discuss how one becomes an expert in the next book we will write, which will probably come out in four years.
PJ: They might not be able to wait that long for the answer.
PS: I think in order to perceive mispricing cues you have to really understand what‘s going on in a specific industry—you have to be an expert in that industry. The caveat is that you need to pick the right industry—one that‘s going to be around in 40 years.
PJ: Then there‘s the argument to be made that you should go into the industry that no one else wants to go into. Think about the sector usually classified as Technology, Media & Telecom. Everybody wants to do TMT. I convinced my son to do something else because TMT is so crowded. He did and he‘s delighted because he‘s one of the few people in the industry he‘s currently specializing in. It‘s a tricky balance between what everybody else is doing and your natural interest. I‘ve always been interested in basic industrial companies and health care services, but I‘m really a tech guy. I have been following that industry for 30 years. I like reading about it, it's fun, it‘s interesting. I argue with people in the industry, I have an opinion. As the market becomes more efficient, you have to specialize. There are probably not going to be any generalists left. Specialization is the rule in most industries. No pilot is an expert at flying every kind of airplane and no doctor is an expert in every kind of surgery. There‘s always some specialization.
PS: You want to go where no one else is because that‘s where you‘re going to find inefficiencies. If you go into a career fair and there‘s one table that everyone‘s at and another table that‘s empty, you want to head towards the empty table—it might be empty for a very good reason but that should be your search strategy.
PJ: A former student of mine is a senior specialist in the maritime industry and he wanted to go do something else. I said to him, ―You‘re nuts. You have a pole position. You‘re the highest-ranking person of your generation in the industry. Stay where you are. We spent four or five months talking about his options and he decided that he wants to remain the senior person in that industry. And I think he‘ll be able to pull that off.
G&D: When you talk about specialization, does pattern recognition help in other industries? If you‘ve seen something play out in one industry as a specialist are you more likely to spot it in another?
PS: ―Pattern recognition is a term that gets thrown around a lot, but we think about it very differently.
PJ: Paul and I believe that there is value in developing a skill in recognizing patterns across industries. What we are working on as part of the next book is the notion of ―story scripts. It‘s the idea that we've seen these events before in another industry or at a different company, and we noticed a pattern but the real concept is much more nuanced than simple pattern matching. There are some hedge funds here in New York that go through the mental exercise of looking back at industries and scenarios in the 1970s and ‘80s. They ask how one industry in the 1970s unfolded and why it unfolded that way. Next, they look at another industry in the ‘80s and ask the same questions. Then they ask,―How do they compare? They‘re trying to find meta patterns or what we call ―story lines that repeat and then apply those insights to the present day.
G&D: What other advice would you share with students?
PJ: I would specialize early, just so I have a differentiation. Then I‘d start to build the skill set around that specialization. I would then start to read outside the domain and try to expand my knowledge base. For instance, if you study healthcare, you‘re going to end up either going into healthcare technology, because that‘s a piece of it, or into healthcare services. After that you might venture into biotech. However, if you do financial services, you‘re not going to do biotech and financial services. That would be a weird skill set, it‘s too far apart. You do one area and then broaden out your expertise to an adjacent area. I think energy is going to be a fascinating industry in the future. If you have a good understanding of the energy industry that‘s fine, but renewables are ultimately going to have to be a larger part of that industry ecosystem.
PS: I told my son when he went to college that, ―If I were a freshman in college, there are two domains that I would become an expert in. Dermatology and chemistry. I would figure out a way to remove tattoos painlessly. Because I think if you can figure that out and patent it, you could be looking at a multibillion-dollar industry.
G&D: Ha. You are predicting that tattoos will soon go out of favor?
PJ: We have never seen anything like the ―inked fad today. More seriously, people ask,―What skill set should I learn if I want to become successful? I say, ―Learn how to manage people. My friends from business school that have had really interesting careers are the ones that learned to be great managers. People want to work for them. There is a real shortage of people who know how to effectively manage people. I told my son,―Learn how to manage people and you will have won the world, particularly with your generation, because people just don’t want to manage others. You can take this expertise, possibly get equity in the business, and help drive value. If you really want to get rich, to me, that’s where the inefficiency is today: managing people.
PS: The other thing is that you have to be creative. Creativity is defined as coming up with a product or idea that is novel and has value. If you just create novel stuff or come up with novel ideas that don‘t have value, it doesn’t go anywhere. Creativity on Wall Street is variant perception — having a novel view that is different from the consensus and then being right.
G&D: Thank you both for your time, it‘s been a pleasure.