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Course 508
Great Investors: Others in the Hall of Fame

Introduction

Most successful investors take a few ideas from several others and spin those ideas into their own. In the previous lessons, we've highlighted some of the greatest investors of our era, however there are certainly many more. In this lesson, we'll introduce you to a few more money managers we think deserve a spot in the "Investing Hall of Fame." Make sure to look for the common investing themes across these superb stock-pickers.

Charlie Munger

Charlie Munger, vice chairman of Berkshire Hathaway, is often overshadowed by his colleague Warren Buffett. However, much of the investment philosophy employed by Buffett and Berkshire can be attributed to Munger's influence.

Like Buffett, Munger is from Nebraska. He started his career as a lawyer, but through his friendship with Buffett, Munger eventually left his successful law career to join Buffett in running Berkshire HathawayBRK.B. Over the years, the two have developed a great rapport, often highlighted during Berkshire Hathaway's annual meetings. When shareholders pepper the two with queries during question-and-answer sessions, Buffett will give his usual insightful thoughts, while Munger answers with his dry witty remarks, often leaving listeners in stitches.

Here's one gem from the 2005 shareholder meeting, where Buffett and Munger discussed the compensation committees of many boards of directors:

Buffett: I've been on 19 boards, and I've never seen a director to whom fees were important object to an acquisition or a CEO's compensation--members of compensation committees act like Chihuahuas, not Great Danes or Dobermans. [Pause] I hope I'm not insulting any of my friends who are on compensation committees.

Munger: You're insulting the dogs.

Munger helped Buffett develop his knack for not only finding undervalued stocks, but for investing in strong businesses with strong competitive advantages. In other words, business quality truly matters to Munger, not just how cheap a stock is.

Munger also urges investors to gain worldly wisdom to become successful at stock-picking. This means that investors should not just focus on a few narrow topics but expand their horizons to understand many different subjects. For example, an engineer should learn accounting to understand how a business can make a profit. Likewise, a good financial analyst shouldn't just crunch numbers but also learn how the machines in a factory work. This worldly wisdom helps investors gain knowledge about the way things work in a broad sense, which in turn helps them to better understand the economics of a certain business. With worldly wisdom, investors can stay focused on what matters while others are running for the doors due to a short-term blip. In other words, the worldly wisdom Munger preaches can help savvy investors profit from others' shortsightedness.

Bill Miller

Few investors have melded the growth and value schools of investing better than Bill Miller, manager of the Legg Mason Value TrustLMVTX mutual fund. Some value-investing enthusiasts disagree that Miller is one of their own. While his practice of valuing stocks on the underlying businesses is acceptable, Miller has made some questionable "value" plays. Some famous examples include America Online (which later becamepart of Time WarnerTWX), Dell ComputerDELL, and Amazon.comAMZN. Though none were of the traditional "value" mold, all these stocks made substantial price gains after Miller bought them.

Critics characterize Miller as a growth investor in a value investor's clothing, but a look into his thought process reveals Miller's knack for seeing value where others don't. This ability has allowed the Legg Mason Value Fund to beat the S&P 500 forover a dozenconsecutive years--a remarkable feat.

Like any value investor, Miller looks for businesses with strong competitive advantages that are trading below his estimates of the firms' worth. He uses a discounted cash-flow model to determine intrinsic value. Unlike many value managers, however, Miller is willing to make fairly optimistic assumptions about growth, and he doesn't shy away from owning companies in traditional growth sectors. In his fund, pricey Internet stocks rub elbows with bargain-priced financials and turnaround plays. Miller will also let favored names run, allowing top positions to soak up a large percentage of assets. This portfolio concentration may fly in the face of modern portfolio theory, but Miller isn't one to accept the conventional wisdom.

A more recent example of Miller's value/growth mix is his purchase of GoogleGOOG, a rapidly growing Internet search engine. While many investors shied away from this stock due to valuation concerns, Miller scooped up shares during its IPO. The stock doubled quickly after the company went public. While it's still too early to tell where Google will be five or 10 years down the road, this purchase was done in classic Bill Miller fashion--investing in a wildly profitable company that few investors understand or appreciate.

Marty Whitman

Marty Whitman is a vulture of a value investor. Whitman, manager of the Third Avenue Value FundTAVFX, can usually be found rummaging through the rubble of distressed stocks--those of beaten-down companies, some on the brink of insolvency. But most of Whitman's depressed stock plays eventually turn around for the better. The key to Whitmanesque stock-picking: Buy companies that are cheap (presumably because of some temporary issue) and safe, and hold on to them.

Whitman is a value investor after Benjamin Graham's own heart. Like Graham, Whitman looks for stocks that are dirt cheap, but the two investors use different measuring sticks. Graham used a company's price/book ratio to determine whether its stock was cheap. He generally wouldn't buy a company unless its stock was trading for less than 1.2 times book value per share.

Whitman takes a different approach. He focuses on a company's takeover value, or how much he thinks a buyer would pay to buy the whole company. Whitman doesn't like to use book value because he says it overlooks too many intangibles. For instance, a money-management firm can use its reputation and relationships to gain additional business. Its reputation and relationships are assets, so to speak, but they don't appear as such on a company's balance sheet. According to Whitman, takeover value accounts for such intangibles.

Whitman combs through a company's financial statements to figure out what he thinks the business is worth. He then checks to see whether the company's balance sheet has remained strong in spite of setbacks in the business. He will generally pay no more than 50% of what he thinks a buyer would pay to acquire the whole firm.

It can take a long time to unlock the value of a beaten-up stock. As long as a company is safe and cheap, Whitman is willing to wait.

Bill Nygren

Bill Nygren is the manager of the Oakmark SelectOAKLXmutual fund. He joined Harris Associates, advisor to the Oakmark funds, in 1983. After a stint as director of research for Harris Associates for most of the 1990s, Nygren began managing the Select fund in early 2000, near the height of the technology bubble. Value investing is always tough, but even tougher when a bubble exists in stock prices. During these times, the undervalued stocks usually stay cheap for a long time, while the expensive "hot stocks" of the moment keep going up. When Nygren took over, Oakmark's investors were jumping ship trying to take advantage of ever-increasing Internet and other technology stocks. By sticking to his guns, however, Nygren eventually proved that his methodology of buying growing, but undervalued firms pays off in the long run.

Nygren buys stocks that are trading at discounts to their estimated private market values. To estimate a company's intrinsic value, Nygren and his colleagues use discounted cash-flow analysis and look at comparable transactions, among many other factors. When picking stocks, Nygren likes to look for companies he believes the market underappreciates, perhaps because of a short-term difficulty. In a speech given in early 2005, Nygren described his investing philosophy using a variation of the 80/20 rule, a strategy made famous by his former portfolio holding, Illinois Tool WorksITW. Nygren said he looks for stocks where 80% of the commentary about a company revolves around a piece of business that contributes only about 20% of the profits. When he finds a situation like this, it is likely the market is undervaluing the firm.

Such is the case with Nygren's largest holding (at the time of this writing), Washington MutualWM. Much of the news about WaMu is about the company's troubled mortgage business, while most of the firm's profits come from the highly profitable and growing retail banking business. Nygren believes that once the market realizes its misplaced focus, WaMu's stock should appreciate. Only time will tell if Nygren is correct, but as a long-term buy-and-hold investor, Nygren can wait.

Ralph Wanger

Ralph Wanger, semi-retired manager of Columbia Acorn FundLACAX, searches for smaller stocks he believes have yet to be uncovered by Wall Street. Before investing in a company, Wanger looks for companies that are financially strong and have significant growth opportunities ahead of them. These are obvious criteria that most investors look for. However, while many small-cap growth investors are willing to overlook valuation for the upside potential of a stock, Wanger believes that growth should only be purchased at a reasonable price.

Markets often overvalue growth stocks, so this is an important point. On the plus side, however, the small companies Wanger looks for have often largely been ignored by the Wall Street analysts, thus many investors are not aware of potential opportunities. Since fewer investors are paying attention to smaller companies, the chance of finding an undervalued stock is more likely.

Rather than employ a top-down approach to investing, where investors first analyze macroeconomic trends such as GDP growth in a certain country, Wanger employs the ideas of investing according to themes. For example, if Wanger believes the population in China is becoming increasingly wealthy, he may look for consumer-goods makers that sell high-end items in the country.

Wanger isn't afraid to go against the trend either. In the late 1990s, many of his small-growth peers posted huge returns by betting that already high stock prices would be carried higher still by a wave of investor enthusiasm for technology stocks. (This is the so-called "greater fool" strategy.) That tactic, of course, was laden with risk, and many funds paid a huge price.

Amid it all, Wanger did what he always has: He sought out sound businesses with strong earnings and cash flows that appeared cheap. That tactic held Wanger's fund back in 1999, but he was eventually proved correct. From March 2000 through April 30, 2001, the fund gained 16.8% on a cumulative basis, while his typical small-growth peer lost a cumulative 31%. However, Wanger isn't in our Hall of Fame just for a few years of performance. A $10,000 investment in the fund in June 1970 would have grown to just less than $1.3 million if held through May 2003, around the time he stepped down from day-to-day duties. In contrast, the same money invested in the S&P 500 Index would have grown to just more than $400,000.

Bill Ruane

The late Bill Ruane, who passed away in October 2005, kept his head when most others lost theirs. Ruane had been managing the Sequoia FundSEQUX since 1970, and with great success. A $10,000 investment in the fund back in 1970 would have been worth $1.7 million at the end of 2004. At many times, Ruane's investing strategy mirrored Warren Buffett's, and not by coincidence. Both of these great investors studied under Ben Graham at Columbia University, and even worked for him for a while. That's why such terms as "intrinsic value" and "margin of safety" often showed up in Ruane's vocabulary. Given this, it's clear to see why, at the time of this writing, Berkshire Hathawaywas the largest holding in the Sequoia Fund.

Ruane looked for companies with sound finances and strong franchises, buying only the few whose stocks traded below their intrinsic values. Further, Ruane wasn't afraid to buck traditional money management trends when necessary. For example, while many managers were scrambling to chase hot stocks to fend off underperformance, Ruane's fund would often sit on a pile of cash when he believed stock prices were too high. This strategy certainly served shareholders well over time.

Ruane may have sat on the sidelines when stockswere overheated, but when he believed strongly in a stock, he was willing to bet big. For example, Berkshire Hathaway at times made up around 30% of the fund's assets. Other companies also often made up a big piece of the Sequoia pie. Ruane was usually comfortable with these large positions because of the wide margin of safety he required before investing. Even if things turned bad temporarily, the margin usually acted as a cushion, preventing any significant losses--this is value investing at its best.

The Bottom Line

There are certainly other investors who deserve a spot in the Investor's Hall of Fame; however, the common threads remain the same. Each of the investors we've mentioned, and several others, are not afraid to challenge the conventional wisdoms of investing. Each looks for solid companies that have strong competitive advantages and looks to invest in these companies for a long period of time. And of course, the price they pay for their investments matters. In our opinion, these stock-pickers are on to something.

Quiz 508
There is only one correct answer to each question.

1 Which one of these investors studied under Ben Graham?
a. Bill Ruane.
b. Bill Nygren.
c. Ralph Wanger.
2 Which investor is known for mixing fast-growing Internet stocks with slower-growing industrials?
a. Marty Whitman.
b. Charlie Munger.
c. Bill Miller.
3 Which investor looks for small-cap growth stocks but won't pay too high a valuation?
a. Ralph Wanger.
b. Warren Buffett.
c. Marty Whitman.
4 If the media is constantly harping on a business that is responsible for only 5% of the sales and profits of a given company, who is most likely to have his interest piqued in that company?
a. Bill Ruane.
b. Bill Nygren.
c. Charlie Munger.
5 Which of the following is the common thread among all the great investors highlighted in this chapter?
a. They all hold Ph.D. degrees.
b. They all buy beaten-down companies that are on the ropes.
c. They all are focused on the price they are paying for their investments.
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