On Monday March 13, 2006 Kevin Kelly, Kyle Schanre and I interviewed Whitney Tilson. Mike Price: Hi! To start would you fill us in on your background in investing? Who has influenced you most in your strategy? How has your strategy evolved? and Why value investing?
Whitney Tilson: I was always interested in business and have been a serial entrepreneur since my college days. I’ve started and run a wide range of both for-profit and non-profit businesses since my freshman year at Harvard in 1985.
My parents met and married in the Peace Corps, so the last thing I grew up around was investing. In fact, my parents had never owned a stock in their lives until I started managing their money when they moved the Ethiopia in 1996 or so. So, when I helped start Teach for America coming out of college and then worked at the Boston Consulting Group for two years, I read the Wall St. Journal avidly, but always threw away the C (Money & Investing) section. I always thought I'd start and run my own companies, and never had an interest in investing -- all the way through Harvard Business School (I graduated in 1994).
But a few years out of Business School (I was working with Prof. Michael Porter, as Executive Director of the Initiative for a Competitive Inner City, a nonprofit we founded), my wife and I paid off my B School debts and started to save some money. It was the first money I'd ever had in my life and I had to figure out what to do with it. You know what they say about necessity being the mother of invention. So, fortunately I had a good friend in the money management business who told me to read all of Buffett's annual letters and that's all I'd need to know. He was right, I've been reading nonstop about investing since then.
Mike Price: Who has influenced you most in your strategy?
Whitney Tilson: In addition to Buffett, as major influences on me, I'd certainly cite Munger, Graham, Phil Fisher, Joel Greenblatt (I audited his course at Columbia Business School in March of 2000), Seth Klarman (if you can get a copy of Margin of Safety). Bill Miller, Bill Nygren and I'm sure I'm forgetting quite a few others. One of the reasons I started Value Investor Insight, incidentally, is so I could continue to learn from some of the smartest money managers around.
Mike Price: How has your strategy evolved?
Whitney Tilson: It's always been an eclectic, opportunistic value style, drawing from many different flavors of value investing, but when I first started in the mid-1990s, I was much more of a buy-a-great-company-at-any-price-and-hold-it-for-20-years type of investor.
Mike Price: Like The Motley Fool?
Whitney Tilson: Yes. Fortunately, I saw the perils of such an approach in time to save myself. This strategy worked great in the late 1990s as blue-chip growth stocks like Gap, Dell, Intel, Microsoft, etc. went from moderately priced to wildly overvalued, but you had to sell or you were going to get killed!
Kevin Kelly: They didn't. Were you ever attracted to short term trading which was the "hot thing" during those times?
Whitney Tilson: No, I've never done any short-term trading.
By the way, I don't want to bash the Fool -- they're a fine web site, were very good to me, and there were and are some great writers there, but they weren't sensitive enough to the extreme overvaluation of many of the stocks in the model portfolio and a lot of their followers lost a lot of money. I wrote about this in a number of columns, including Valuation Matters in 2/2000 and Valuation STILL Matters in 2/2001.
Kevin Kelly: That's a problem many value investors face...selling too early. Do you have any rules to determine when you sell?
Whitney Tilson: Sometimes, I've ended up selling something pretty quickly if the investment thesis changes, however (such as Arch Wireless (now USA Mobility) a year or two ago). I don't consider myself to be particularly clever when it comes to selling… nor when I’m buying, come to think of it.
I call it The Lament of the Value Investor: in too early, out too early, but hopefully manage to double my money anyway.
The key to making money, I think, is to know what to do when a stock you buy goes down 20% from when you first bought it. Do you buy, sell or hold? Those are the hardest decisions -- and the ones that can make (or lose) you the most.
Kyle Schnare: What do you do when one of your stocks goes down 20%? Can you walk us through some of the steps you go through. Do you slowly sell your positions when you are ready to sell?
Whitney Tilson: I wish I could give you an easy answer, but the real answer is: It depends. You have to re-do your work and decide if your investment thesis is still intact and the stock is just cheaper -- if so, buy more.
The hardest thing in the world is to invest in a stock that's down -- it feels like you're throwing good money after bad.
I'd guess that we buy more, hold, and sell about 1/3 of the time each. In Arch Wireless, we were down a bit, but our investment thesis was blown and we were happy to get out at only a small loss.
When McDonald's went from $16 to $13 in the spring of 2003, we did more work, got more conviction and doubled the position from 5% initially (down to 4% at the bottom) up to an 8% stock position plus a 2% LEAP call option position and made more money on this (it's still our largest position) than any other stock in 7 years of professional money management. More recently, over the past year we've been averaging down on BUD and WMT.
Mike Price: In the past you have written multiple articles and presentations about behavioral finance. What attracts you to study this?
Whitney Tilson: I think Buffett was exactly right when he said: “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ…Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
When I look back at my biggest investing mistakes, they've usually been emotional ones, not analytical ones. I've posted the behavioral finance presentation I gave at the Value Investing Congress on my web site at http://www.tilsonfunds.com/behavioral_finance.php3, along with links to some articles I've written on this topic.
Mike Price: Who do you believe to be the modern "superinvestors"?
Whitney Tilson: First of all, the people I listed above as having influenced me, including Buffett, Munger, Greenblatt, Klarman, etc. Second, many of the people we've interviewed for Value Investor Insight: Pzena, Einhorn, Whitman, Miller, Weitz, Olstein, Robbins, Brown, Ubben and Jacobson. Finally, some of the less well known money managers we've interview may some day become legends as well -- just give them time: Ashton, Sellers, Shubin Stein, Kravetz, Ghazi, etc.
Among other investors whose holdings I follow (via 13Fs or mutual fund filings) are: Steve Mandel (Lone Pine), Mike Burry (Scion), Glenn Greenberg (Chieftain), Warren Lichtenstein (Steel Partners), Leon Cooperman (Omega), Mohnish Pabrai (Pabrai Funds), Barry Rosenstein (Jana), John Griffin (Blue Ridge), Tom Russo (Gardner, Russo & Gardner), Tom Gaynor (Markel), Bill Nygren (Oakmark), Mason Hawkins (Longleaf), Dan Loeb (Third Point), Sequoia, Tweedy Browne, Davis Funds, Fairholme -- as you can see, we think there are a lot of smart investors out there and we get many of our best investment ideas by looking at what other smart people are buying.
Kyle Schnare: What are some of the biggest mistakes you've made?
Whitney Tilson: I'll answer it in two ways: macro mistakes and micro (company-specific) mistakes. On the macro side, while we're bottoms up investors, we got way too bearish way too soon coming out of the bear market in late 2002 and early 2003. We ended up selling a lot of stocks way too soon and ramping up short and put positions, which cost us dearly. We had very good returns in 2003 and 2004 (before a blah, up low single digits 2005), but we could have made a LOT more money if we'd just ridden the rebound more.
We've also been hurt by being too early on the big-cap growth stock theme. We've done very well with MCD, Wendy's and Costco, for example, but BUD was among our biggest losers last year and WMT, BRK and MSFT haven't done much. We think we'll be proven right on all of these, but we were certainly early.
Our biggest losses have been from making bearish bets -- mainly buying puts on the Nasdaq 100 (QQQQ) and Semiconductors (SMH) -- which was a mistake and we've closed out these positions. Of course, MBIA, which we've been short for years, has been persistently painful as well, but we're still confident in our investment thesis.
Kyle Schnare: As you know Wendy's will be spinning off Tim Hortons within the next two weeks. Were you for this approach? What are your thoughts on Tim Hortons?
Whitney Tilson: We own WEN and, though it's had quite a run, still think there's plenty more upside. Nelson Peltz is an extremely smart, driven guy and has a great track record in this space -- look at what he did with Arby's -- and he laid out a plan that we think is achievable that could drive the stock to as high as $89, he estimated (see his 13D filing).
We think Tim Horton's is a fantastic business and that the stock post-IPO will likely do very well (as MCD's spin of Chipote did, for example), so the big decision for us will be when to short out the Tim Horton's (thereby just owning the remaining Wendy's business).
Kevin Kelly: While we are talking about specific companies, what do you think of Lear (LEA). I know many value investors (including you) believe this one is a value here. Why's the market wrong in valuing this thus far?
Whitney Tilson: Lear is a classic case today of the dilemma about whether to buy, hold or sell. The stock was the worst performer in the NYSE last year, down 51% (even worse than GM, which was down 48%!) and has been the worst stock this year already, down ANOTHER 44%. OUCH!!!!
Our investment thesis was identical to Rich Pzena's, who laid it out at the Value Investing Congress in November: a classic case of a good company in a terrible sector, and investors mindlessly selling everything, failing to differentiate between companies like Dana (which went bankrupt recently) and GM (which might in the next couple of years) and Lear, which we think is suffering from mostly temporary problems. However there have been all sorts of unpleasant surprises -- the CFO leaving, being drawn into the SEC's investigation of GM, etc., etc. -- so the stock has gone down every day we've owned it, it seems.
We were averaging down for a while, but now aren't sure what we're going to do. It's already quite a big position (though 10% smaller after today's train wreck!), so we may just wait a little while and see what happens here.
Kevin Kelly: Which method did you use to arrive at a valuation? Where do you place a fair value?
Whitney Tilson: The company has earned $5-$6 per share many years in the past and we think that earnings power remains intact, so the upside here is $50-$70 (the stock was above $60 at the beginning of last year). However, the company has to survive the current tough environment and has over $2 billion in debt and a payment due in early 2007. They have a $1.3 billion revolver that they can draw down at any time -- we think they should do so right now, but instead the rumor (likely true we fear) is that the company is instead going to do a highly dilutive convert, which will have the upside of making financial distress less likely, but also truncate the upside somewhat due to the higher share count. All in all, a good lesson about the perils of investing in awful industries.
Kevin Kelly: Interesting. That brings us to another point - the use of LEAPS for value investments. In a stock like LEA how come you chose common [stock] instead of LEAPS and what are common things you consider in choosing LEAPS vs. common [stock]?
Whitney Tilson: LEA already has quite a bit of leverage, so we didn't want to magnify this with the built-in leverage of options. Also, the options are very expensive. For example, today a Jan '08 $15 strike option (the stock closed at $16.01) is $5.30 (ask), which means your breakeven is $20.30, up 27%.
We tend to buy LEAPS on very stable businesses where we think the underlying intrinsic value is growing around 10% annually, the multiple on the stock is likely to expand rather than contract and the options are cheap. Options on low-volatility stocks like WMT, MCD, BRK, MSFT and BUD are cheap and we own LEAPS on all of them.
Kevin Kelly: What has drawn you to some of the mega-caps such as BUD, WMT and MSFT? Where do you think you have an "edge" in playing such widely followed stocks?
Whitney Tilson: Good question -- in fact, one of our investors asked this and we replied in our 2005 annual letter. Here's what he asked:
"I found myself scratching my head over the focus on mega-caps such as Wal-Mart, Microsoft, Anheuser-Busch and even that most sacred of investment archetypes, Berkshire. Though I have no doubt these are all fine companies possessing enormous value, they are more "market-like" and less contrarian (in my opinion) than I was expecting. These companies appear to me to be widely known, owned and, if not loved, they are certainly respected. I wonder if anyone can get a true edge in these names."
Here is what we wrote in our letter:
"He could have also added, "One of your biggest advantages is that you manage a much smaller pool of capital than most other professional money managers, which gives you the flexibility to invest in the nooks and crannies of the market where the greatest inefficiencies - and best bargains - often lie. So why are you giving up this advantage by investing in so many stocks that every other investor can also buy?"
These are very good questions, we've thought about them extensively and can only offer this simple explanation: our job is to scour the entire investment universe and find a handful of cheap stocks to buy (and the occasional overvalued stock to short), regardless of the size of the company, how many analysts follow it or what industry it's in (as long as we can understand it well - see circle of competence discussion below). While it is certainly true that bargains are more likely to be found in the obscure corners of the market, on rare occasions (such as right now, we believe) many of the best bargains are lying in plain sight.
As Warren Buffett noted in his 1985 Berkshire Hathaway annual letter, "You might think that institutions, with their large staff of highly-paid and experienced investment professionals, would be a force for stability and reason in financial markets. They are not: stocks heavily owned and constantly monitored by institutions have often been among the most inappropriately valued."
We also reject the assumption that our ownership of large-cap growth stocks means that we are investing alongside the investment herd, as opposed to being our usual contrarian selves. (Even if we were doing so, that's OK with us as Ben Graham once said, "The fact that other people agree or disagree with you makes you neither right nor wrong. You will be right if your facts and your reasoning are correct.") We would argue that today, investing in the large-cap growth sector is a contrarian investment, and we show evidence for this below.
Finally, while it might appear that owning well-known stocks like Wal-Mart and Microsoft is the easy course of action for us, in fact precisely the opposite is true. We have no doubt that that many current and prospective investors share the sentiments of the investor we quoted above - and nothing we say here will change this - so from a marketing standpoint it would be very much in our self-interest to only invest in unusual, obscure and/or distressed companies. (We do, in fact, own many such companies - our last five new stock purchases fall into this category - but they happen to be smaller positions at this time.)
In summary, we manage our fund as if we had no outside investors, seeking to construct the best portfolio we can, and don't concern ourselves with appearances. We wrote that two months ago -- and nothing has changed...
Schnare: What are the challenges you have in starting up a mutual fund? Do you find it hard with the influx of cash right now? What are the challenges with a mutual fund in compared to a hedge fund?
Whitney Tilson: We have a great firm that takes care of all of the back office, accounting, blue sky filings, etc., but it was still quite a bit of work, reviewing documents, etc. to set up the funds. Now that it's set up, it runs quite smoothly and is only a bit of incremental work for us. (We also had to become a Registered Investment Advisor to run a fund, but with the new SEC regulations, we would have had to do this anyway).
The main issue with any new mutual fund is distribution (e.g., attracting assets) and getting the funds to a size where they at least break even. Our two funds, as they approach their 1-year anniversaries, have only $13 million combined, but that's OK -- our plan is to build a great long-term track record and then we figure that the fundraising will take care of itself. More info on the funds is here by the way.
Kevin Kelly: Why did you choose to establish a mutual fund when the fee structure is more beneficial [to the manager(s)] when running a hedge fund?
Whitney Tilson: It's true that very few hedge fund managers also set up mutual funds, and the less generous fee structure is certainly a major reason (by law, mutual funds can't charge a percentage of the profits). My answer is that we think the mutual fund business, while perhaps not as fantastic as the hedge fund business, can still be a very good business and we like the optionality of it. If we can put up some great numbers (a big if, of course!), it's possible to raise a lot of money quickly in a mutual fund.
Mike Price: What magazines, newsletters, and books would you recommend to value investors?.
Whitney Tilson: To your book question, I've posted my recommend reading list on my site here
As for day-to-day reading, I do a ton of it, starting with the major business publications: Wall St. Journal, New York Times, Fortune, Forbes and Business Week. I only subscribe to three newsletters: Fred Hickey's The High-Tech Strategist, Outstanding Investor Digest (I only recommend it after you subscribe to Value Investor Insight, of course! Sign up for a Free Trial), and Schiff's Insurance Observer.
Kevin Kelly: I know Mike and I are both subscribers to VII. It's one of our favorites.
Whitney Tilson: Thank you! I also make it a point to read everything written by Herb Greenberg (MarketWatch) and Bethany McLean and Carol Loomis at Fortune. As for web sites, I check out wsj.com, nytimes.com, news.google.com and realmoney.com every day.
Kevin Kelly: Whitney, thanks a lot for your time!
