Greenblatt vs. Burry: Even Value Investors Disagree

I didn't intend this to be a series, but it has quickly turned into one. The original idea, from this post, is that holding up company managers as "shareholder friendly" (in that they do a fine job representing shareholder interests) can be like a backhanded compliment. Which shareholders, exactly, are they representing? Because it's a certainty that few of the company owners share the exact same interests or desires for the business. 

The most stark contrast might be between investors with an interest in the business showing short-term gains to impress the market, increase the stock price, and provide an opportunity to exit with a profit. They will want managers to work over their accruals as best as possible to show higher earnings. Or to just stop making investments in the business and let the lowered expenses generate a bigger bottom line. 

Their objectives are not going to mesh with the investors hoping to stick around for the long haul. This group will not be excited by elaborate accounting to increase GAAP earnings. Nor will they want executives to neglect important expenses (like marketing, talent acquisition, research and development, etc.) in order to show a fatter profit next quarter. These expenses are investments in spurring growth and/or maintaining strong barriers to entry, both important in maintaining long-term profitability.

And even reasonable, level-headed investors can disagree with each other and therefore have diverging interests.

Case in point: Joel Greenblatt versus Michael Burry, a disagreement Michael Lewis brought to light in his book, The Big Short.

Joel Greenblatt, of value investing fame for his various books and tremendous track record with Gotham Capital, seeded Michael Burry's hedge fund and benefited from multi-year period of impressive returns. Then Burry made his big bet against sub-prime lending, a complex and hard to understand investment, but one with a high likelihood of success (in Burry's estimation at least). 

Burry's fund was down 18 percent in 2006. It was making his investors very edgy, and most of them - while being perfectly happy with his extraordinary returns in the years leading up to this - pushed him hard to ditch the strategy. As they threatened to pull their capital from him, he locked it up. 

From the book:

In January 2006 Gotham's creator, Joel Greenblatt, had gone on television to promote a book and, when asked to name is favorite "value investors," had extolled the virtues of a rare talent named Mike Burry. Ten months later he traveled three thousand miles with his partner, John Petry, to tell Mike Burry he was a liar and to pressure him into abandoning the bet Burry viewed as the single shrewdest of his career.

Listen...there is a certain fog of war to these things. This stuff is not black and white. What seemed such a low-risk, high-return investment to Burry appeared quite different to Greenblatt. Perhaps Burry did a poor job communicating his ideas to the Gotham Partners. Perhaps the partners did a poor job listening. Regardless of the reasons, here we have two very intelligent investors and reasonable people disagreeing over how the money should be invested. 

What is the shareholder friendly move in this dilemma? Should Burry try to liquidate his bets to give Greenblatt his money back? Not only would that go against a thesis Burry held with deep conviction, but it would ensure a loss as the strategy had not yet matured. 

Or was the the shareholder friendly move the very action that Burry took? In other words, protecting Greenblatt against himself by locking up the money (no redemptions) and handcuffing him to the trade. 

History tells us Burry was right. Greenblatt made off like a bandit by getting stuck with his former mentee. But this is just one example. I have no doubt there is no shortage of counterpoint examples in which hedge fund money is locked up, promptly lost (Philip Falcone anyone?), and investors are left holding the pittance that remains. 

If reasonable, intelligent people (even value investors) can have diverging opinions and interests in a hedge fund example like this, surely the conflict only broadens when you have a wide base of investors in a public company. 

So, what exactly does it mean to be shareholder friendly? Does it mean paying out a fat dividend to keep pension funds happy even when you have an expansion opportunity to plow that cash into growth? Does it mean cutting your marketing staff during a down turn because you know your margins will be pressured and you don't want to disappoint Wall Street with a down earnings period? Does it mean cutting off a research initiative after two years of losses when you have high conviction that it will pay off in a big way if you just suffer another two years of losses to get it going?

*****

I'm a big fan of Joel Greenblatt. His books have helped my thinking tremendously, and he is serving an important role as he spends time educating people about his investing methods. And while I use the story of Michael Burry to illustrate my point, I want to make sure Greenblatt has the chance to make his case.

He did so in an October 2011 presentation to the Value Investing Congress (courtesy of Market Folly here). 

In a Q&A Greenblatt was asked about Lewis' account of events. His response was witty (and I suspect true), but more importantly he provided some balance to the whole affair...

Michael Lewis has never let the facts get in a way of a good story. What they got wrong in the book is Burry wanted to side pocket both mortgage and corporate CDS... we did not want him to side pocket the liquid corporate CDSs … only reason we took money from him was we were getting redemptions.

Greenblatt was not the unreasonable ogre Lewis made him out to be. He had his own pressures. This doesn't contradict my point. In fact, I think it strengthens it. Sometimes a manager must be able to ignore the panic of his investors. He just might be protecting them in the long-run by sticking to his strategy despite their immediate needs. We know this happens in publicly traded companies, too. Large investors (hedge funds, pension funds, mutual funds) get calls for redemptions that force them to sell their holdings to generate cash to pay out departing investors. They must sell irrespective of the investment prospects.

The CEO of a publicly traded company can't, of course, stop investors from selling. But in understanding that investors will often have interests that diverge from those of the business itself, one can see that it does make sense - sometimes - to vest enough authority in managers to let them ignore their shareholders and keep plugging away for the long-term benefit of the franchise.

My Contribution to the Facebook Noise

All eyes are on Facebook and CEO Mark Zuckerberg as the stock is scheduled to debut on the NYSE this Friday. They have lips flapping as pundits and gurus are shouting over each other to get their opinions noted on whether this business is worth your investment dollars. Allow me to add to the din by expanding on my previous post, Whom Does Management Serve?

Zuckerberg has garnered plenty of criticism for pocketing the majority of voting rights, ensuring that he will have total and complete control over every aspect of the business, not the least of which is strategic direction. And he's not shy about saying has his own plans for the company which is likely to be at odds frequently with investors looking for financial results. 

Facebook's Registration Statement (filed in February with the SEC) contains a letter from Zuckerberg outlining his priorities. Some excerpts...

Facebook was not originally founded to be a company. We’ve always cared primarily about our social mission, the services we’re building and the people who use them. This is a different approach for a public company to take, so I want to explain why I think it works...

Simply put: we don’t build services to make money; we make money to build better services. And we think this is a good way to build something...

These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits.

By focusing on our mission and building great services, we believe we will create the most value for our shareholders and partners over the long term — and this in turn will enable us to keep attracting the best people and building more great services.

We don’t wake up in the morning with the primary goal of making money, but we understand that the best way to achieve our mission is to build a strong and valuable company. This is how we think about our IPO as well.

Here we have a CEO telling the world, in no uncertain terms, that maximizing profits is not his priority. He has a bigger and different vision for the world. As investors we should be aghast, right?

Before addressing that, let me admit that I have no idea what Facebook is worth as a business. It's probably a fair amount, but my prevailing model used to understand social media companies is MySpace.  It was the pre-Facebook darling, beneficiary of young eyeballs and the power of the network effect. As such, it was scooped up by News Corp for a fat price. And shortly thereafter all the eyeballs left. Quickly and unceremoniously. That fickle bunch decided Facebook was the place to do all the stuff they had previously done on MySpace. And now MySpace is a shadow of its former self.

We're assured that Facebook is superior, having solved all the problems that plagued MySpace and left subscribers willing to entertain an alternative. That would never happen to Facebook, we're assured. Maybe. But I'm not comfortable with the possibility, and so it's a clear pass for me.

That being said, I'll confess the utmost admiration for the move Zuckerberg pulled to consolidate control. And if Facebook is going to live up to its potential, it will come at the hands of the founder. He has a vision for it that extends beyond share price. I think that's essential for a business. They lose their soul when they get too eager to please shareholders.

If I could get pass the MySpace hang up, I would assess the following in determining if Facebook was a good investment...

First, is it participating in a large and/or growing market for the services it offers? I believe it probably is. It has a lot of room to add new users and expand the ways members utilize it today. 

Second, does it have a profitable economic model? (i.e., Do its revenues exceeds its costs and expenses and can it produce earnings in excess of its costs of reinvested capital?) Most likely, yes. It's profitable now, though throwing tons of cash back into growth. That user base must have some economic value, and the management minds at Facebook will likely discover the right method for tapping into it. 

Third, does it have competitive advantages in place that protect its market share and margins from encroachment? That's the part that I just don't know, and I don't think I could wrap my head around that issue even if I decided to spend a lot of time researching it.

If the answers to these questions were yes, and I believed Mark Zuckerberg had the ability to drive its success by focusing on the long-term value of Facebook as it serves as social connector for the world...but that in continuing to build it in that model, he was likely to face the ire of investors that would prefer profits now rather than wait...

Then I would celebrate Zuckerberg cornering control the way that he did. As a long-term investor, I would celebrate a CEO that openly denigrates profit decisions in favor of investing in the long-term competitive advantages of the business. And I would relish the fact that profit-takers would have no voice in the decisions guiding the business.

I would appreciate that the characteristics that make Facebook a franchise will be stronger five or ten years hence, and that I would therefore own a piece of a much more valuable pie.

But there are a lot of "ifs" to be satisfied first.

Whom Does Management Serve?

This week I've been a bit obsessed with the idea that the manager's job is to represent the interests of shareholders. It brings to mind the Yogi Berra epithet: 

In theory there is no difference between theory and practice. In practice there is.

In theory it makes sense. Companies are vehicles for invested capital to find returns. We entomb that concept in law and in corporate structure where the board of directors is explicitly charged with representing shareholders. Managers run the day-to-day and should have investors' interests on their minds, remaining on constant look out for ways to increase shareholder value. 

But we put the idea in play, how does a manager best represent investor interest? Indeed, which investor?

Investors are far from a like-minded group bound together by common interests in the business' success and united in their opinions on how that success is best achieved. Oh no. To highlight just a few investor archetypes:

There are the hedge fund traders, moving in and out with positions measured in millions of shares and closed out within minutes or hours when the stock moves up or down by a penny or two.

There are the pension funds for (as an example) retired nuns. They hold shares for years but issue measure after measure for shareholder consideration on such social issues as whether you should offer health benefits to your lowest paid employees. 

There are the corporate raiders that accumulate massive positions, gain board representation, and then force management to monetize assets and distribute the cash. This pushes the share price up for a time, during which the raiders sell out and move on to their next target.

All are investors in your public company. Each has very specific objectives. And those objectives are divergent and irreconcilable.

So, how does management effectively represent investors when their interests don't align?

As a frequent visitor of Charleston, South Carolina, I've been required to read the works of native son Pat Conroy. My favorite book is his memoir My Losing Season in which he details his time playing basketball for the Citadel. 

The Citadel, a military prep college in Charleston, is hard on its first year students (called "Knobs"), believing it must break each of them down and build them back up again in its own disciplined model. Conroy was not spared the hazing rituals. In a particularly poignant scene from the book he recalls being surrounded by several upperclassmen who begin demanding he do a variety of conflicting activities. As I recall, one would get in his face and scream that he do push-ups. Another would degrade him for doing push-ups, telling him he's supposed to jump up and down. And yet another would scream at him for jumping; he should be reciting the school's creed. 

The demands came rapid fire. After several minutes of this Conroy was a wreck. He instinctively fell into fetal position on the floor, his mind unable to process another command. The older cadets walked away, satisfied that they had broken this cocky Knob.

The human mind cannot process conflicting orders without freezing up. It's simply not how our wiring works. And so, while the idea that management works for investors sounds good in theory, in practice it's unworkable. Many an executive has driven himself to exhaustion trying to appease these feckless masters. 

What's a manager to do?

Focus on the business itself.  Use the overall health of the business as a proxy for the long-term investor...that investor whose interests are aligned with the company investing in its advantages, foregoing immediate gratification en lieu of higher earnings further down the line. 

These are the businesses I want to invest in. The opposite are those that pledge allegiance to blind total shareholder return, returning cash to investors that could be reinvested in the business to fortify its barriers to entry, improve its offerings, or make itself invaluable to its customers. 

Dun & Bradstreet (DNB): Contemplations on Wasting a Moat

I've been thinking about the role of competitive advantage in evaluating investment opportunities after watching this interview with Clayton Homes CEO, Kevin Clayton (here is the YouTube video). As a subsidiary of Berkshire Hathaway, Clayton benefits from such horse's-mouth management wisdom from Warren Buffett as..."Deepen and widen your moat - that competitive advantage that keeps your opponents at bay - everyday." 

It occurs to me that "generate loads of profits" is neither an inspiring rally cry for the troops nor an enduring moat. Herein lies a flaw with so much focus on concepts like Economic Value Add (EVA) or Total Shareholder Return (TSR). While noble - and I believe accurate - in principle, these ideas are often bastardized by management in their execution at the business level. Oftentimes managers become enamored of sending so much cash back to shareholders that they stop protecting their moats, opening themselves to attacks by capable foes.

Dun & Bradstreet (DNB) comes to mind. I spent some time looking at the business last November when it was trading around 61 per share, its 52-week low, while sporting a respectable ROIC, nice dividend payment, low capital requirements and demonstrating a willingness to throw plenty of cash (even in the form of new debt) at buying back its shares. 

On face value alone, it was a compelling investment candidate...The DUNS Right number is supposedly the ubiquitous mechanism for businesses to evaluate the credit worthiness of trading partners. DNB has honed its process for a century, and - according to them - created a proprietary database of such size and sophistication as to be impossible for a competitor to replicate. In a previous life, I remember my CFO turning to DNB immediately if he had questions about a partner, competitor, or new customer.

That sounds like a good moat, right? 

Well, I believe it really was at one time. But over the years DNB has allowed this resource to wither. They have starved the golden goose in the name of total shareholder returns.

Assuming that the DUNS Right process was the dominant way to evaluate your potential trading partners at one time, what should DNB have done to deepen and widen that moat everyday?

1. DNB should have continued investing behind the data and its uses, employing the best engineers and marketing minds available to make it better and expand its uses. 

2. DNB should have priced it out reasonably and looked for opportunities to reduce its price to make it impossible for new entrants to even attempt a competitive offering.

What did DNB do instead?

They handed all the golden eggs back to investors (and management) and stopped feeding the goose. They turned a powerful tool with long-term earnings prospects into a dwindling asset. They sought to return cash to shareholders first - reducing capital investment, cutting expenses to the bone, and increasing prices on customers - and ignored their competitive advantage.

In the process they alienated customers with an arrogance that suggested a belief in "where else will they go?" They chopped away research and development, choosing to squeeze existing assets instead. (Not coincidentally for a company no longer investing in itself, a quick dig through the scuttlebutt demonstrates that DNB is not considered a good place to work.) They preyed upon their sources of data, calling small business and extorting them for $500 to monitor and update their Paydex scores so other companies saw them as credit worthy. (This makes the input for DUNS Right data suspect, destroying the air of impartial data needed for customers to really trust DNB as trustworthy source of credit info.) 

DNB has returned a lot of cash to shareholders, no question. Not investing sufficiently to protect the competitive advantages of the business can feel really good to short-term investors. Since I considered the investment, the stock price has soared over 30 percent! But for those holding on for the long haul, they must consider the damage done by management. They have taken what should have been an impenetrable fortress surrounding their competitive advantage, neglected it in the name of TSR, and weakened the defenses to a point where competition is entering the market. (Equifax is treating business credit as an adjacent expansion of its consumer credit offerings, Cortera is a start-up exploiting the distrust of DNB and its high cost to crowd-source an alternative at a much cheaper price, and trade associations are pooling information on creditworthiness for their members.)

I passed on DNB despite its apparently cheap price tag. It started with such a strong position in the market, but in neglecting its moat has lost its advantage. While I can't say the competition will prevail, I can say that DNB's neglect has increased their odds considerably.