Letter #227: David Abrams and Tano Santos (2019)
Letter #227: David Abrams and Tano Santos (2019)
Founder of Abrams Capital & Investor at Baupost and CBS Professor of Asset Management and Pricing | Applying a Fundamental Value-Oriented Approach to Investing
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David Abrams is the Founder and Managing Partner of Abrams Capital. Prior to founding Abrams Capital, David spent a decade at Seth Klarman’s Baupost Group, where he was the third investment professional. Before Baupost, he worked with legendary investor (and poker player) Mark Dickstein on merger arbitrage and distressed bonds. He started his career at Oxford Arbitrage Associates where he worked on merger and risk arbitrage transactions.
Tano Santos is the Robert Heilbrunn Professor of Asset Management and Finance and the Academic Director of the Heilbrunn Center for Graham & Dodd Investing at Columbia Business School. Before Columbia, Tano was an Associate Professor at UChicago’s Booth School of Business.
Today’s letter is the transcript of a conversation between David and Tano. In this conversation, David shares his journey to Baupost and then founding Abrams Capital on the heels of a stock market crash, why Abrams has a broad mandate, the key factors to examine when analyzing the fundamental economics of a potential investment, the importance of forming judgments and using qualitative analysis rather than solely relying on numbers, how the tolerance for risk has changed from 20-30 years ago, the increasing value of human and intellectual capital, why an increased risk appetite and tolerance for failure is beneficial for markets, and the advantages and disadvantages of being a generalist. He then gets a little more tactical, discussing why you always need to consider the position of the other side of the market, the assessments David sues to determine the fundamental value of a company, the impact of competition on investment decisions, how catalysts affect investment requirements, his approach to developing a successful relationship with a company’s management team, why exiting investments isn’t always a straightforward process, how he develops his investment wish list, how traveling helps him keep a broad perspective and outlook on various industries, the relationship between conviction and position sizing, his approach to industry diversification, currency risk, and hedging, why he doesn’t use leverage, whether the state of the economy at large factors into his investment process, his perspective on the future of value investing and the asset management industry, and much more!
I hope you enjoy this conversation as much as I did!
[Transcript and any errors are mine.]
Related Resources
Baupost Group
Value Investing with Legends
Transcript
Tano Santos: Welcome to a new edition of the Value Investing with Legends podcast. I'm your host, Tano Santos, the David & Elsie Dodd Professor of Finance at Columbia Business School, and the Faculty Director of the Heilbrunn Center for Graham and Dodd investing. In an article in June 2014, the Wall Street Journal described my guest today as the "one man wealth machine," an investor who had returned over 15% since the founding of his investment vehicle in 1999. He is a quiet and understated man, one that is rare to catch. And he's not keen on interviews or appearances, so I'm particularly thankful for his presence here today, and for the many occasions in which he has participated in many Columbia Business School events, whether the SEMA conference or the first time I saw him, which was at the hugely entertaining panel on the financial crisis with Congressman Barney Frank. David Abrams, welcome to the Value Investing with Legends podcast.
David Abrams: Thank you.
Tano Santos: David Abrams is the managing partner of Abrams Capital, and investment firm that currently manages about $9bn dollars across a wide spectrum of investments. Mr. Abrams serves as a director of several private companies. He's a member of the Board of Trustees of Berklee College of Music and an overseer of the College of Arts and Sciences at the University of Pennsylvania. He holds a BA in history from the University of Pennsylvania. And he started his career with another value investing legend, Seth Klarman, at Baupost in 1988. He said of Mr. Abrams--and I love this quote--"He loves a good puzzle and a good treasure hunt." It doesn't get more Ben Graham than that. He's also the author of one of my favorite quotes on value investing, which one that I've stolen many times for my students: "Value investing is the E=MC^2 of investing"--Albert Einstein's famous equation linking maths to energy through the speed of light. So welcome again, David, thank you so much for being here with us today.
David Abrams: Oh, thank you.
Tano Santos: So I want to start, as always, we're doing this podcast, with your intellectual beginnings in the field of asset management, of investing. You, as I said, you graduated in history from the University of Pennsylvania. I'm curious about your intellectual trip from history to asset management.
David Abrams: I got into--unlike a lot of people--I got into investing really by accident. It wasn't something that I had a longtime interest or passion for. I'd simply graduated college and was looking for a job and was fortunate enough to find some people that were starting a firm. And the way I like to put it is that they were looking for cheap labor and I was looking for a job. So I actually didn't start with Seth. I started here in New York with a couple of jobs before I got to Baupost. First was with a firm that at that time was known as Oxford Arbitrage Associates, and I was doing merger arbitrage, risk arbitrage transactions.
Tano Santos: And you have no background whatsoever?
David Abrams: I had no background whatsoever. And as I said, they were mostly looking for cheap labor. And really, when I started, I didn't know--I had never taken a business course, I didn't know what a stock was, I didn't know what a bond was, I didn't know the difference between the two. I knew nothing about accounting. My boss was a little bit horrified when he said you don't know what the basic accounting equation is that assets equals liabilities plus equities? And I didn't know what any of those things were. But fortunately, they stayed with me, and I read a lot and learn a lot in the first two years.
Tano Santos: And what were you doing? Just basic analysis on firms and stuff like that?
David Abrams: I was doing analysis on merger and arbitrage deals. So it turned out to be a great training--you see all kinds of different industries, you focus on the transactions, which is a little bit different, and in some ways, that's a mode of thinking that I sometimes use today, not all the time. You see a lot of different types of securities, because sometimes in mergers you get warrants issued or spin offs or whatnot. You see a lot of full spectrum of things. The thing you don't get is that you tend to be involved in these companies for pretty short periods of time, so you don't get to see them over time. That's something I learned later on. But in terms of a training round, it was a great start. I also was benefited because at the firm--the firm was broader than that, and so there were people doing options arbitrage, so that was interesting. There was a guy who traded distressed bonds. There was a merchant banking group--I didn't interact too much with them, but I saw a little bit of what they were doing.
Tano Santos: So it was a relatively large operation, then?
David Abrams: No, it was a pretty small operation that did a lot of different things, actually. I think they started--at the time, it was a decent amount of capital, but today, it seems like a very small amount of capital--I think they had $10mn that they raised. And we went from there.
Tano Santos: I see. So you stayed there for a couple of years?
David Abrams: I stayed there for a couple years and then joined another guy by the name Mark Dickstein to do essentially merger arbitrage and distressed bonds.
Tano Santos: I see. And then you stayed there for another short period of time, and then finally, you went to Baupost.
David Abrams: Right. So I was in New York for about five or six years before I went up to Boston.
Tano Santos: Okay, so when you went up to Boston with Seth, now you have a more solid background, so to speak, on investment and finance--what are your responsibilities when you arrive at Baupost? Why did they make you do? What did Seth make you do?
David Abrams: Well, one of the attractive things--I didn't really want to leave New York, I love New York--
Tano Santos: Are you in New York, by the way--
David Abrams: I grew up in New Jersey. So the attractive things about Baupost at that time, was that Seth--I met Seth and he seemed like an incredible guy. Everybody who knows Seth knows that he is both--not only just a brilliant investor, but an incredible person.
Tano Santos: Yeah, the man leaves an impression.
David Abrams: And he's so involved with the community and all that kind of thing. Part of the attraction was that I was the third investment professional at Baupost. So it was Seth, there was another guy, and then I was the third person. So it seemed like an opportunity to get in on something at a pretty early phase. It wasn't day one, but it was, in hindsight now, it was very early days. But they had, at that time, they had what seemed like a huge amount of money--I think it was $180mn when I joined 1988, beginning of 88.
Tano Santos: So Baupost had been around for five, six years by then.
David Abrams: It'd been about--yeah, it'd been about four, five years.
Tano Santos: And you were doing yet again--
David Abrams: So what I was doing then--the attraction was that they had a very broad mandate. And I could see early on that arbitrage was going to be limiting, even though I came in 1983 not knowing anything, by 1985 I figured a few things out. And I could figure out that arbitrage wasn't exactly what people were billing in. The idea initially behind arbitrage, if you went back before my time to people like Gus Levy at Goldman Sachs, was transaction would be announced at $20 a share and people would sell at 19 because there's only $1 left, and they want to move on to something else, and that dollar, that 5%, was pretty big spread. And that was how arbitrage began. But over time, people figured that out, and it morphed into something really different. And by 1985 or 86, people weren't buying $20 deals at 18.5 or 19, they're buying $20 deals that 20.5 or 21, hoping that Mike Milken would finance somebody else to pay 24 for the same company. So I early on identified the need to broaden myself out, and Seth had a really broad mandate. And so that was--a combination of Seth being a great guy, a lot of money early days, and the broad mandate, was what drew me to Boston.
Tano Santos: That's great. So I mean, this is kind of interesting, and we'll come back to this issue of--this is one of the things that I like very much about, obviously you, but also Seth and many others, is this generalist approach that is not dead. And I want to return to this topic, but I want to keep with your professional career first before we move into more methodological issues. So you stay essentially for a decade at Baupost, moving up, essentially, and you ended up running a significant fraction of the portfolio. Is that correct?
David Abrams: I wouldn't say that I ran a fraction of the portfolio--I was an important person there. I mean, ultimately, Seth was the portfolio manager, so he ran the whole portfolio. It wasn't the kind of place where they say, Okay, Abrams, you take x dollars and good luck to you. So it was a collaborative effort. Ultimately, Seth was the portfolio manager.
Tano Santos: Very good. And by then you're doing--you've extended your area of expertise.
David Abrams: Yeah, in the course of 10 years, we had done stocks, we had done merger deals, we had done bankruptcies, we had done bank bailout deals, we had done real estate, we had done--in the whole course of the 10 years, we had done Japanese warrants, we had done all kinds of things.
Tano Santos: I see. Now, you leave in 1998. You had the idea of Abrams Capital Management right away? Or what is--
David Abrams: When I left Baupost, I really didn't leave to start an investment firm. I left to just take time off. I had been working nonstop for since a week after graduation for 15 years, and just wanted to take some time to gather my thoughts and figure out what the next phase of my life would be. I thought there would be a good chance I would do something different than investing--as I said, I had gotten into investing purely by accident, really. And I liked it very much, but I thought, Well, there are other things in the world one can do with one's life. And so I took some time off--I left in the early 98, and then ultimately the markets crashed in the summer of 98 and I couldn't think of things that I would like to do more on a day to day basis. There are things that interest me--a lot of things that interests me, but not that I want to get up every day and do for 40, 50, 60 hours a week. So in the end, about a year later, I decided to--
Tano Santos: To come back into the asset management business, effectively. And when you start your firm, let's start talking a little bit about investing philosophy and value investing in particular. Again, you're thinking about a generalist asset management company that is opportunistic, that is willing to basically get into a variety of situations. You come in a peculiar moment. I mean, there's a correction in the markets where the markets keep going up quite a bit until they crash. How do you leave those late years of the tech bubble cycle? I mean, what were you thinking at the time? What kind of things were you finding out? Was it a good time to--I'm sure it was a good time to raise perhaps money for a new fund, given the booming stock market--
David Abrams: I mean, a couple of things. First of all, it wasn't a good time to raise money. It was actually one of the worst times in history to raise money, because when it happened, I went out--the market crashed in the summer of 98 based on Long-Term Capital blowing up.
Tano Santos: The Russian Crisis was at the time as well.
David Abrams: Yeah, the Russian and the Asian crisis, yeah. And people hated hedge funds. And when I went out to raise money in the fall of 98, people didn't want to hear about hedge funds. They didn't want to hear about one with a broad mandate. And I didn't have a track record--I had been at Baupost, been successful there, but as I said, Baupost is really Seth's track record, and he was the portfolio manager. So it was not a good time to raise money, but it was a very good time to invest. And I think that's something that's typically true. The best times to invest are the hardest times to raise money and the worst times to invest are when it's easiest to raise money.
Tano Santos: I forgotten exactly about how volatile markets were in 1998, with the Russian situation, LTCM. The Asian crisis of 97 was still lingering, and the resolution of that mess. And what a big effect they had. I guess that's perhaps what I was not aware of what a big effect they had on the hedge fund industry, on raising capital for the hedge fund industry, in relatively benign macroeconomic conditions in the United States.
David Abrams: Right. I mean, it was really--people did not want to hear about my venture. We raised--on day one, we started with $25mn. I was far and away the largest investor. So I raised roughly $10mn outside. So that kind of tells you--after six months of trying and 10 years at Baupost, I raised $10mn. So it's a little bit different than people might have in their mind. I went to Baupost because I liked broad mandate, and that's something that I always believed in and still believe in. So certainly, that was something that I was gonna adopt. And Seth and I think a lot of like, so a lot of the things that I do are things that Baupost does that I had in my mind, and I learned at Baupost. So there's a lot of similarities. I mean, obviously, there's some differences--we're much smaller. But there's a lot of similarities to the approach.
Tano Santos: Right. So let's start talking then a little bit about issues of method and how you construct a portfolio, how you come up with ideas, and so on, and so forth. There are many issues that I want to get into with you. Before we get into the specifics of the valuation analysis, and how you think about that, how you think about price and stuff like that, I want to understand--you've mentioned in a couple of interviews, or a couple of occasions--I don't remember whether interviews or things that I've heard you say before--this thing of the deep analysis of the business operations--you have to understand the economics of the situation at hand--why is it that this is a good business that you want to be invested in or interesting situation that you want to be invested in? What do you mean by that given that I know you've been involved in many different situations? What kind of analysis do you do? Perhaps you can give us an example regarding a specific firm perhaps, or a specific situation that you found particularly enlightening. What do you mean by that understanding of the economics of the situation at hand?
David Abrams: I think that we invest in a wide array of things. So there's sometimes--there's assets, sometimes we buy things in distress, sometimes we buy things that are good and growing. In all cases, we do want to understand the fundamental economics because it's easy to tell what has been, it's easy to tell what is today. We're always trying to deal, as an investor, with what's going to be in two years, or tomorrow, or five years from today. So to understand the dynamics about what's going on--and a lot of it has to do with who has power in relationships, what people's alternatives are, what the value to the customers, what the value of the employees. So you try to understand that as opposed to just take using historical numbers and projecting them forward.
Tano Santos: So what do you mean by this thing of Who has the power in relationship? Are you referring for instance to whether a company say has some pricing power, whether customers have an alternative to--
David Abrams: Yeah, so pricing power is an interesting one. So a lot of people, ourselves included, you like to find businesses, companies with pricing power. So that's good. But to say that something has pricing power and to leave it there, I think, is really an incomplete line of thinking. Because nobody has unlimited pricing power. And then the question is, What can help you? And what can hurt you? I think, in a way, you're trying to ask yourself, Okay, what can help you? What can hurt you? And so to kind of understand those things at a deeper level is really crucial.
Tano Santos: So let me understand that a little bit further. So when you actually approach a company, and you see, well, this company is kind of protected by perhaps some barriers to entry, something that gives them the ability to price above marginal cost--something then that you do is well, which are the substitutes to this particular product or service? Who can come in and contest that market? Is the force of--is it really a barrier to entry? Is it something that a capital is going to be invested in order to circumvent? So you do a lot of analysis around this question? Is that what you're referring to?
David Abrams: We do. And we think about it. A lot of times, the analysis is as much just thinking it through--I mean, there's plenty of times when there's information and data that you can get around this, but in the end, you're trying to form of judgment about something. And I don't think that the judgments are going to be found on an Excel spreadsheet. So it's about thinking those things through as much as anything,
Tano Santos: Right. You have this very nice line, actually, that there's no algorithm for investing. And I guess this is, particularly for many of our students, sometimes, you have to tell them, Look, it's exactly that. There's no algorithm--there's no 1, 2, 3, you do this, you will be a successful investor forever on, essentially. There's a lot of qualitative analysis. And I feel that it this is particularly true when it comes to the business operations of the firm. In many occasions, you won't have the hard data, you won't be able to estimate a demand curve that the firm is exposed to. So you're left a little bit with some qualitative analysis. And you have to live with that. You have to live with the consequences of there's something that is not as precise as you would want it to be, but is equally firm as the basis for investments. Do you agree with that?
David Abrams: I think you absolutely have to live with qualitative analysis. There's uncertainty, there's competition. I think that one of the things that is obvious to everybody, probably forever, but particularly in the last 10 or 15 years, is that capitalism is very competitive. And there's a lot of change. And that there's change going on every day all around us. And maybe because of technology it's a little bit easier to see, I think it's always been the case. At some times, it moves more quickly and other times it moves more slowly. Today, it certainly feels like it's moving more quickly, but maybe that's just what people always say in their moment.
Tano Santos: I think you're absolutely right. And one of the things that is distinctive about the world we live in today is this enormous amount of capital willing to essentially finance entry into a propriety of industries, essentially. And I think yields are relatively low in many domains, so capital is willing to take on bets, essentially, that perhaps 20, 30 years ago, it was more unwilling to take.
David Abrams: That's certainly true. I mean, they're also willing to take bets with--if you look at it as the capital investment themselves, but they're also willing to take bets with intellectual capital that they weren't willing to take thirty years ago. So people will back 22 year olds and 20 year olds and 25 year olds in a way that they probably wouldn't before. I think overall, it's a good thing, but it makes it more intensive. The other thing, too, is that a lot of the businesses that have arisen in the last few years--one of the things that's absolutely fascinating about them is that if you look at some of the super profitable ones, they didn't require much capital to get going. They would require the intellectual capital, and that's why there's a lot of capital, say, I'll take a shot on a team, on a person, on a young person, or a young team, because the potential payoffs--everybody can see what the potential payoffs are. Whereas in the past, if you're building--whatever, if you went back into the 70s and 80s, and oil prices were really high, and people wanted to maybe get into the oil game--well back then, that was like a big ticket to get into, and the only way you could get into that game was spending a lot of money, because otherwise you're not gonna get anywhere. Today, with what's going on with technology and whatnot, there's much broader opportunities.
Tano Santos: Yeah, this is a very good point in a way, that is interesting about the business environment today is that a lot of it already comes financed because it's the human capital, which helps these kids to consume loans themselves in order to put themselves through college or through a master's program. So in a way, the capital that is needed to actually invest in the physical needs of that new firm is relatively limited, in a way, which is going to put a lot of pressure on valuations, almost by construction.
David Abrams: It does. And so much also, even more and more, even with the cloud--even people that were wanting to get into technology used to have to buy their own servers and whatnot, and now you can plug into AWS or Azure or whatever. So it's a very fertile environment for innovation, and people try to--and the other thing, too, is that the world's changed. It used to be if you worked for a company that went bankrupt, people would hold it against you, maybe for a very long time. And I think it's one of the more positive changes is that people don't necessarily hold that against you. It's like, okay, you tried something, it didn't work out. Let's go on to the next. Let's move on. It's in that sense, very positive.
Tano Santos: Well, I always thought that this is one of the great things about the American capital markets, which is this second and third chance that you get here relative to say, Europe, where their chances are much more limited. And I agree with you that, again, there's a connection between that and taking chances and people who've tried several things before. And the amount of capital. Let me bring you back just one second to one thing that I don't want to leave unaddressed, which is this issue of the generalist, and in relation to how competitive things are these days. You said that you see eye to eye with Seth Klarman on this issue of being a generalist, being able to find value across a range of situations, of industries, of countries, and so on and so forth. Is that how you see it? The generalist is still alive and well? Or you think, going forward, we're going to need aspiring investors to specialize in order to find value?
David Abrams: I think that both models can work. I don't think it's one or the other. I think it's a little bit depends on your temperament, it depends on your organization. And I think there's trade offs. So benefits of being a generalist is that you're comparing this beat up stock to that growth stock to this asset to this bond. And maybe you get a broader perspective. And that can be helpful. The obvious negative to being a generalist is that when you get into new areas, you're going to be in information disadvantage. A lot of people are going to know a lot more about the specific XYZ of various industries or various companies than you are. So you need to--you always need to approach markets and business with a lot humility. But I think as a generalist, even more so.
Tano Santos: Right. I agree with that. And this brings me to this issue that Bruce and I always tell the students of the program, which is, you have to ask yourself, always, when you enter into a particular position or stock, or you take a particular position in a distressed situation--what is it the other side of the market knows that you don't that is making it sell that position to you rather than buying with you? What is your differing view relative to the market and why is it that you find value where others do not?
David Abrams: Yeah, so I think you have to really be, as you said very well, you have to be cognizant of what's the other side of the story. Every stock, I like to say, is at least two stories--a bull story and a bear story. And you need to understand both very well. You need to understand what the true risks you are assuming, and how they can play out, and so the fare well. So yeah, I think that is really true. You can carry this a little too far, in the end, if there's 100mn shares of stock of some company outstanding--somebody owns them. They may be good or bad, but--and it may be good or bad at the current price, but somebody owns them. And we don't go too crazy with worrying about what other people think. We're trying to determine what people think not by reading reports or anything like that, but really by understanding the economics of the business and comparing it to the security's prices. And that will really tell you what people are really thinking.
Tano Santos: Okay, so let's talk a little bit about that. Let's talk a little bit about this issue of the valuation. So you find--and we'll come back to the issue of search and how you find ideas in a moment, but you've decided that you like this company, you find it attractive, something interesting to think about. You cannot make quite sense of the price that the market is quoting for you for this particular company. Walk us a little bit into the type of analysis and how you do in order to assess what should be the fundamental value of that company, how much are you willing to pay for that company?
David Abrams: The first question that we always ask in any analysis is what's the risk? So is it a kind of asset, a kind of business where you could lose all your money if things go badly? Is it the kind of asset where you could lose a little bit of money? Is it the the kind of asset where you know you're going to make money? And then once you do that, then the question is, Okay, this is what the upside is, and is the return commensurate with that? We look at, really, such a wide array of things, like I said before. So we look at credit, and we look at equities, and we look at companies that are growing, and we look at companies that are stable, or sometimes the companies that are shrinking. And for each one, you need to kind of--there's a bit of a different mental model. If I have a company that's growing, I think the question is, How fast is it going to grow? What could make it not grow? What are some of those business dynamics we were discussing before. If it's a pretty stable thing, obviously, what could make it not stable, what could make it do better than when you're assuming?
Tano Santos: So you're thinking about a specific--can I ask you a little bit about this--you're thinking about specific things that can happen to this company--in a way, it's kind of exercise on continuing forecasting, for lack of a better word, of thinking--
David Abrams: Yeah. What you're trying to think about is the multiple paths that could happen. So there's not one path that can happen in the future. When you look back, there's one path that happened, but that doesn't mean that going forward there's only one path. In the future, there's multiple paths. So you need to have, in your own mind, the range about what that could be.
Tano Santos: Right. I guess that--if you're thinking--I like very much this way you're thinking about--almost like, you start with a risk, What can go wrong with this company? What can make you lose a bit of money or all your capital? What can go right with this company? And then kind of interacting it with a mental model. If the company is shrinking, well, shrinking industries are not likely to attract capital, so you need to worry about that a little bit less than a growing industry, which is likely to attract capital. So now we kind of shift and bring the tools that we have, or the lessons that we've learned, from situations in growing industries where capital came in, contested the market, made life difficult for our company, and so on and so forth.
David Abrams: That's really well said. Exactly. If you have a shrinking industry and it's dying, it's like, people are not dying to get into that. So if you own Alphabet and Google, people are dying to get into that. So those are like really different things.
Tano Santos: Right. And then you have really to think carefully--thinking about that company, of course, what is going to protect this company from all these entrants that are really going to throw a lot of capital at this situation?
David Abrams: One of the things I like to say is, if you look back at the history of network broadcasting, there was--initially there were three networks. And everybody looked at that and said, Oh, boy, they have it made in the shade, and like, How do I get into it? Nobody could figure out how to do it till some guy named Rupert Murdoch figured out how to do it. And what he did was really brilliant. And then he created the fourth network. And then he did really well. And that went really well for a while until cable television came along, and now there's 500 possibilities. And then the internet came along, kind of blew up everything. And now he's dismantling his empire. And that sort of goes to the point of change as well.
Tano Santos: Yeah. I mean, that is an interesting point, that in a way, the forces of competition are relentless. You always have to take them into account, because people will figure out a way--I was telling my students recently about coffee consumption in Asia. And I challenged them to think about tea consumption in Europe in the 17th and 18th century. And the monopoly the Chinese had for a long time of tea production and how the English were able to circumvent that monopoly by essentially developing the Indian industry. And it took a long time actually to actually do this, but eventually, the benefits, the surplus to be made, was so enormous that a lot of capital was spent in developing an alternative industry in a completely different country that became the pearl of the English empire--just almost on account of this--it was just driven, to some extent, by the need to break up this monopoly. So very good. So now you have a sense through--I guess you think about the business on a sustainable basis and see, well, if this business doesn't grow, how much will I be willing to pay for it given the pretty margins that it's posting currently, the type of revenues that they have, operational expenses, blah, blah, blah, those--with their proper corrections. Is that how you think about it first? Or you you go and do a full-fledged discounted cash flow model? How do you go about this?
David Abrams: Well, here's, here's what I would say about this. So if we buy things--with what we call a hard catalyst, so some kind of event that's going to close the gap between what you bought it out and what it's worth. We also buy things where there's no catalyst, so we're just owning businesses. In the first category, if there's a catalyst, we don't need that much growth. We need to buy it cheap and get out. In the second category, where there's no catalyst, we absolutely need growth. And now the growth can come in all kinds of ways. It doesn't have to come through increased revenues, although a lot of times it does, but i can come from running operations more efficiently, it can come from acquisitions, it can come from buying back shares really cheap. But if there's no catalyst, we absolutely need growth.
Tano Santos: So let's talk a little bit about this issue of growth. So I understand this issue of the catalyst, and the perhaps there are situations where you can identify what is the event that is going to trigger value for yourself and your investors. When thinking about growth, management plays an important role, somehow, in capital allocation. How do you think about that? How do you approach the issue of management? Do you talk with them? Do you try to assess the quality, probably the... valuation--
David Abrams: We--not everything fits this bill, but we have a bias towards liking companies where the management owns a lot of stock, and has created value. The idea is fairly simple. And there's a lot of people that understand this, is that having people that have created value have a way of figuring out what will do it more in the future that they're focused on that. So not everything falls into that bucket, but we certainly have--a lot of our companies do. And that's something that we think is really important, because, again, this points been noted many times, if you have a management team where their primary economics are coming through salary and bonus, you can be at odds versus being a shareholder. So that's the first point. The second point was about how we interact with companies. I'm thinking about actually writing something and maybe doing a talk sometime on what I call the G in ESG, the governance side of ESG, because I think there's a space that we occupy somewhere between, say, index funds and Fidelity on the one hand, and Fidelity doesn't want to make anybody upset because everybody has to come and go to their headquarters, and if you start ruffling feathers, people aren't going to do that. So that's the one end of the spectrum. And on the other end of the spectrum, you have people like Carl Icahn that are very abrasive--and Carl's done a great job making money for himself and his investors, so there's nothing--I'm not saying in any disparaging way, that's just not my personal style. I think there's a middle ground of being constructive with people, and then if you have a different point of view, finding a way to express that respectfully and try to move forward. And that's what we try to do. So we don't shy away from things. We try to get involved in situations where they don't need our advice or anything like that. We try to get involved in things that are well run, and people have lots of stock so they're trying to do the right thing. But we are willing to have conversations with you.
Tano Santos: If I can summarize it then, is you prefer a passive attitude, but if need be, you're happy to engage constructively with management. You will never cross the line into kind of a fully fledged activist investor like Icahn or Ackman.
David Abrams: We don't have that general approach, but we've been known to exercise our rights. And we have done things and we have agitated for change, so it's not that we would never do anything because we have done things. And I think that if you don't, you're perhaps--at least we're not--let me put it this way: we're not comfortable with that. We think it's legal, ethical, economic responsibility to do good job for our investors, and if management is doing something that you really don't like, then you find a way to hopefully alter that course.
Tano Santos: Let me understand little bit about the issue of exit. How do you exit a position? So I understand that if you have a position that to some extent is catalyst-driven--well, the actual realization drives the exit decision--potentially can drive it. What about a growth business? Are you guys--
David Abrams: I think, in the end, you're reliant, in part, on the market. But if the value is growing, and you hold long enough, it's very rare that it's not going to be reflected in the marketplace. And if you throw on top of that--if you have a management team and board of directors that owns a lot of stock, and the stocks really cheap, and they've created--say you've been in it for a while and they've doubled the value of the company in a way that everybody could agree on, but the stock hasn't moved, usually they're going to come and start to buy back stock, and that's going to hypercharged the growth even more. So it'll work out in that way.
Tano Santos: Yeah. It's funny that whenever I ask this question about exiting investments to many of the value investors that have come across this podcast, but also that come to class, this is the one that--I always find that the responses aren't--less clear, if you allow me to put it this way. It's difficult to sometimes--what is the right moment to exit an investment? Is it when the market is telling you the valuation is really expensive relative to fundamentals? Is it because you believe risks are materializing to the fundamental thesis of the company? It's kind of tricky--absent those things--
David Abrams: Well, I think--first of all, I think your point is well taken. I think exiting good companies is really tricky, because they're good. And when do you get off? Now, we do--ourselves put in place a discipline that says, Okay, at some price, holding it, even as good as it will be, won't give us enough of return, so we will sell it. The other thing--obviously, if a thesis changes, it's different. But I think your point that the answers about exits are more squishy is because, I would say, at least for us, I think a lot less about exits than I think about all the other stuff. I feel like if you have a good, growing, profitable business, you'll have all kinds of alternatives to exit. And that's sort of the easy part.
Tano Santos: You're right. I mean, you're absolutely right about this, that whenever I read value investing books, and of course the classics, but also the new stuff that comes out almost every day, it's a topic that goes largely unaddressed. Students ask a lot about this, and rightly so, but it's a difficult one to even think about--sometimes conceptually beyond the obvious one of the catalysts.
David Abrams: Well, I think it's harder--and stuff that's what I call the hard catalyst, the so-called event driven space--betting on an event, the event happens, you get out, whatever. If you have other ones that you mentioned before, like my friend Tom Russo--Tom invests in very good companies, he holds them for a really long period of time--he's got a much harder time figuring out when to exit. Now we do some of that, and that is--it is harder to figure out, and you grapple with that, and there aren't clear answers. If you go--take a step back. Say you're trading in bonds, whether distressed or investment grade--bonds, because it's all contractual payments, it's very easy to figure entries and exits. Like you can be extremely mathematical and extremely quantitative about it. And any good bond investor is extremely quantitative.
Tano Santos: There's almost like the math is driving the decision.
David Abrams: The math drives it 100%. The hard thing about stocks and better companies is that the future is unknowable. So you don't know, like, is a five year track record the beginning? Or is it the end? And you won't know that till you're in year 10. And that makes it harder.
Tano Santos: So let's move on a little bit. And I want to ask you a little bit about this complicated issue as well. So where do ideas come from? For David Abrams?
David Abrams: For us, there's maybe three or four different buckets of things. So there's one bucket, which is we like to look at stuff in distress. And you don't know in advance what's going to be in distress. But if you like to look at distressed, it's not hard to figure out in any given moment what's in that bucket. And then it's fairly easy to sort through that bucket.
Tano Santos: Things that are approaching distress or that are currently in distress?
David Abrams: That are currently in distressed. I think trying to predict where distress will happen is a very difficult business. That's not something we really do. I think that you could waste a lot of time doing that. Alternatively, we like to buy better things--and it's easier to identify those things ahead. Usually everybody knows they're better, so they're not necessarily trading attractively priced at any given moment, but prices bounce around a lot and you can you can keep an eye on those things and try to figure out when they come into your price range.
Tano Santos: So can I ask you about this--do you have a wish list of things you want to--
David Abrams: We do. We have a list of things that we're always updating it and adding and subtracting to the list about businesses that we'd like to buy, or people that we'd like to invest in.
Tano Santos: Let me ask you something very practical about this, because sometimes I get asked this question and I don't know how to answer. How deep do you go--I have a wish list of companies that I would like to own because I think they're wonderful businesses. But of course, there are many wonderful companies out there in the world. How did you go and doing that analysis? Do you know exactly Look, here's my wish list. And I know exactly what is the price in which I would be willing to enter into each of these companies?
David Abrams: Not exactly. We ballpark it. And then to the extent you're interested in companies, to the extent you hear people talk about them, you pay closer attention, you read the article more thoroughly, you listen to the conversation more deeply than if it's something that you know you'd never buy. And then you catalog that away. And a lot of our research takes many years, sometimes more than a decade before we've--from when we first look at something to when we actually buy it.
Tano Santos: Right. And in terms of reading, what is--you wake up in the morning and you read from the financial press, obviously, but what is driving a little bit the broader outlook, the themes that are driving your thinking these days? Do you have any systematic way of going about it?
David Abrams: I think a little bit of a mix between the two. So I try to keep a lot of things coming in in the intellectual funnel, and then I try to have a pretty good screen so I can sort through. So I do things like I invest in, personally, in a wide range of things. And most of my money is invested in the fund, but about 20 years ago, I started putting small amounts of money into some venture capital funds. And that got me a little bit more in the flow of what was going on in Silicon Valley. And then other people come along and they do things and I find them interesting, so sometimes I put some money in there. And then I travel and I try to expose myself to people thinking really differently. So sometimes it's something like a Grant's Interest Rate Conference where they tend to have a more negative view of the world, sometimes its growth equity guys that have a very positive view of the world, sometimes getting out around the world gives you a different perspective. Even within the United States, traveling to different places gives you a different perspective. And just seeing that and talking to people and hearing what they're doing. But then also, once we find something we like, then we drop everything and we focus in on that right.
Tano Santos: Right. Let me ask you, then, a little bit about portfolio construction, position sizing, how do you think about the overall portfolio? Issues of diversification, issues of portfolio turnover? Let's start with position sizing. How do you think about that? Is that you're willing to bias your portfolio dramatically relative to the strength of your conviction on the idea, you follow a disciplined approach and say, No, I cannot judge how strong my conviction is, so let me--
David Abrams: We try to put more money into the things that we have more conviction about. We do stocks, and we do debt. When you're doing debt, you're at the top of the capital structure, so that tends to be less risky, so sometimes those positions get larger than the stock positions do. We'll tend to top out the stock positions at cost around 6 or 7%. We can hold them if they go up, but we'll tend to top them out around their cost.
Tano Santos: In terms of industry diversification, how do you think about--I know that you have a very broad... you have infrastructure, you have bookstores, you have everything--
David Abrams: We look at it, at industry concentration, and sometimes those industry concentration levels can get higher than I mentioned before. So it's something we loosely keep an eye on to make sure that we want to be fairly concentrated, but maybe not as much by today's standards. I see people have 60% of their money in three stocks or something like that, which is just not my cup of tea.
Tano Santos: But it's not something you target. It's not that you want to have industry-diversified portfolio at all.
David Abrams: I want it to be somewhat diversified, but if we had 10 or 12% in an industry--and sometimes we've had, like in 08, in the debt, we probably had closer to 30% in one industry--through one industry, I guess, but it was mostly bonds. But I don't target industry diversification. I just keep an eye on it to make sure we're not getting too concentrated.
Tano Santos: How do you think about the issue of risk management for your portfolio? So if you have investments, say, in different currencies, how do you deal with that? Are you happy to take the currency exposure? Are you happy to hedge it?
David Abrams: We don't tend to have that much outside of the US--we do have some. What we'll tend to do is, if we're owning a business without any catalyst, we'll tend to not hedge the currency risk. In the same way that if you own a big US company like Microsoft or something like that, you have a lot of currency risk because they're making money around the world. If we have a situation where the catalysts or the upside's more capped, and it's in foreign currencies, we then will tend to hedge a currency.
Tano Santos: I see. So it's really kind of situation specific, depending on whether you think--
David Abrams: I think if there's a catalyst, you tend to have capped upside, so I don't want to give it back, or a lot of it back, with a big move in the currency. If I don't have a catalyst, there's more upside, I'm probably holding it for a longer period of time, so I figure it'll all wash out over time.
Tano Santos: And in terms of other risk exposures, say, you take a position on a farm equipment company that you think is great, and you want to hedge out kind of the farm price risk or something along those lines.
David Abrams: I'm not a huge fan of that kind of thing. I think that sometimes the strategies can make--people enter into them with the idea that they're reducing risk, but they actually might be increasing risk, if you have these various hedges. Some people, a lot of people will do that. It's not my cup of tea. I mean, what I always say, If we're not comfortable with the risk, the best and easiest way is to not take that risk.
Tano Santos: Now, you're on record as having said that you don't take any leverage whatsoever. You don't like it--in fact, you probably have negative leverage right now. Is the fund holding cash? And how's the cash position--is it a byproduct of the valuation? Or is that something that you're targeting, depending on how you see opportunities lining up your way.
David Abrams: We don't use leverage in the portfolio. And that's just a basic philosophical decision on my part. I don't want to have to meet a margin call at the wrong time.
Tano Santos: I think the lesson there--I always thought about it this way: that leverage introduces time in the equation, just something very difficult to think about. That your position has to work out in a particular timeframe--certainly before that margin call, to some extent,
David Abrams: A couple of things. First of all, when we tried to study disasters and financial disasters, and you studied all people who had huge financial issues. And then you said what was the reason why they had those huge issues? And leverage which was one reason that would probably capture about 90% of all the disasters. So, in that sense, it seems fairly easy and straightforward to stay away from the one thing that causes most of the distressed. And then I think--maybe it was Buffett who said something about--If you're smart, you don't need it, if you're dumb, you don't want to use it. And I think that also captures up the idea too.
Tano Santos: So let's just take the last minutes of this wonderful conversation to kind of close a little bit with how you see the future of value investing, of asset management in general, of course. And I want to start with connecting it with our previous segment on risk management. How much do you think--particularly given what we lived through in 2008--we started this conversation talking about 1998 and when you started your own firm, and that it was a peculiar moment in terms of world markets with the Russian crisis, the 97 Asian crisis, LTCM, and so on, and so forth. How much do you think about the economy at large? And how much does it feature in your investment process?
David Abrams: Only moderately. I think that we mostly invest in the US, and the thing that we think about--the US has been a very good place to do business for a long period of time. So we do think what could change that, and there are things that could change, there are things that could make it a lot worse. And if those things were to happen, then one would have to, I think, reevaluate investing in the US. So I think about that--
Tano Santos: What are those things? Now you leave me with great curiosity.
David Abrams: Well, there's recent tax proposals. For example, if people thought that they wanted to drive tax rates up to 70% or 90% or something like that, I think you would see a big impact on that. And I think, similarly, there's a proposal that I think's really misguided to... the corporation should be responsible to everybody in a legal way. What that misses, by the way, is that they are--companies are responsible to all their constituents. So if you don't have a good product or a good service, you won't have any customers. And if you don't treat your employees well, they're going to leave. And if you don't do all of that, you won't make any money, and you won't attract any capital, you won't have any investors. So it's not perfect--there's a lot of issues. But it works pretty well, and it works pretty well for that reason. And it's better to let people, companies, individuals, figure that out, than mandating, like they do in Germany, works councils. And there's not a lot of new business formation and innovation in Europe, and there's a big reason for it. So our country has been a home for risk taking and innovation. And if anything, it's picked up speed. But there are proposals out there that could really dent that.
Tano Santos: I think that's exactly right. That anything that compromises that culture of risk taking behavior--we talked at some point during this conversation about this thing of having a second or third, fourth chance to try it out, which is so important in the American economy, that anything that messes up with that, I think is really misguided. It's not only the US economy, I actually think the world economy benefits enormously from this risk taking behavior by the US economy, US entrepreneurs.
David Abrams: Hugely. It's one reason why US companies have been at the forefront of spreading global--of capitalism and raising people's standards of living throughout the world.
Tano Santos: Yeah, absolutely. Can I focus you on these last minutes about the future of value investing, of the asset management industry in general? What are your thoughts on this? And specifically, about this issue that has come up repeatedly on the growth of quant, of smart beta, all those things that are--to what extent they're changing the nature of markets? To what extent are making life difficult for you or for value investors in general? How do you think about that going forward? Will there be a role for traditional value investors going forward?
David Abrams: I would say that markets ebb and flow, competition ebbs and flows, markets go up and down. And so sometimes people confuse bull markets or bear markets with other phenomenon. I think as we've seen advances in technology, everybody has to look--and we are all aware of things that people were doing that machines could do much better. And it would be arrogant and a mistake to not think that it couldn't happen to oneself and one's own industry. So we do think about it. At the same time, we also do a lot of private ventures and even in publicly traded companies we do get more and more closer to our companies and to the people. And I think it's certain that the human relations, the human factor, is not something that the computer is ever going to disintermediate. So I think things will ebb and flow. I'm not overly concerned about quants. I think some of this is making markets less liquid. That's not necessarily a bad thing from my standpoint. Some days it can be frustrating, other days it can be great. So I think you do have to take an honest look at what you're doing and are you adding value to your customer? So am I adding value to my customers? Am I adding value to the companies that I'm invested in? I know it's not true in every case that we're doing that, but we're doing a lot of cases. So again, you don't want to be Pollyannish about it, you don't want to be arrogant, you don't want to be in denial about these changes--they're really important. But people have been looking for black boxes for investing since the day I got on Wall Street, and well before. They'll always look for it. And the reason why it's very unlikely to really happen is that behind every pool of money there's people. And so whether they're endowments or foundations or pension plans or individual accounts, quants are interesting, and they absolutely shouldn't be ignored, but they can only grow in popularity when they're working in the moment. And so--
Tano Santos: What do you mean by that?
David Abrams: So in other words, if they haven't produced good results in the short term, people are going to throw them out. And I think, to this whole point about mental models, what I would say is that markets are neither perfectly efficient or wildly inefficient, but they kind of fluctuate back and forth. And values can be growing and stocks may not reflect that. And stocks can be too high as well as too low. And you see all the pressures that people have. I mean, look at all the--Columbia is part of this group. The Ivy League institutions, every year, they have these indefinite pools of capital, and every year people are ranking them one to eight. And if you're number one, you're feeling great, and your people are feeling great. And if you're number eight, you're feeling terrible. But there's a lot of money that can get lost by doing that.
Tano Santos: I see. This is a wonderful note to end the conversation in. David Abrams, thank you so much.
David Abrams: Thank you.
Tano Santos: Thank you.
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