an interview with charles brandes

11988 El Camino Real ❘ Suite 500 ❘ P.O. Box 919048 ❘ , CA 92191-9048 ❘ 858.755.0239 ❘ 800.237.7119 ❘ Fax 858.755.0916 ❘ [email protected] ❘ www.brandes.com

Charles Brandes, Chairman and founder of Brandes Investment Partners, L.P., has been investing in stock markets since 1968. In this interview, he dis- cusses the merits of and what has – and hasn’t – changed about the stock market over the past 40 years.

Value investing has been a successful strategy over long time periods, yet only a handful of market participants are able to adhere to its tenets. Why do you think value investing remains so difficult for investors to stick with?

I get this question a lot from people who aren’t quite familiar with value invest- ing and the stock market in general. While the techniques and thinking behind value investing are simple, there are two basic things that make it a difficult investment discipline to follow. Both of them have to do with behavioral economics.

Ben Graham didn’t call it behavioral economics, but that’s really what he was talking about in when he talked about “Mr. Market.” Mr. Market really represented the behavioral biases investors are subject to. That’s the first thing that I think makes value investing so difficult. It’s unnatural for humans to think totally different from the crowd. I don’t know why that’s true, but it’s true. It’s difficult to act completely independent. It’s difficult to disregard conventional thinking.

But that’s also what’s good about value investing. It’s totally different from conventional wisdom, and it has worked over the long term. Sometimes it’s difficult to see that, and for human beings, it’s tough to act different from other investors – even if we believe the process will work.

The second reason value investing is so difficult is that everybody has a tendency to think about what has just hap- pened in the immediate past and extrapolate that into the immediate future. We all have the tendency to be influ- enced by short-term events – and that tendency makes people stock market speculators.

It’s difficult for a lot of us to think the way we need to to be value investors. We should be thinking over much longer time periods – a minimum of three to five years. But how many of us sit around in the morning, eat breakfast and think about the next five years? We don’t. We think about what we’re going to do that day. And when you don’t keep that long-term perspective in mind, it makes adhering to value investing a difficult thing to do.

Performance for select portfolios over the most recent 3- and 5-year periods has trailed respective indices. How do you maintain conviction that value investing is still working even during periods when it seems like it’s not?

There are a couple of reasons. There is a famous article by Warren Buffett, “The Super Investors of Graham and Doddsville,” and the people he profiled in that article had extraordinary long-term performance numbers. Yet these same investors had periods of long-term underperformance. Unfortunately, underperformance goes hand in hand with outperformance. Nobody can always outperform.

I can remember investors saying things like, “I’m going to hire this money manager because every single year he or she has outperformed over the last so many years.” I’d argue that is a dangerous criterion to have in mind when it an interview with charles brandes

comes to manager selection. Good investors who outperformed over the long term haven’t outperformed every single year. And there are long stretches of time when those good investors have experienced substantial underper- formance. That’s been the history of any good investor’s results.

I am not concerned with our recent underperformance, especially when we have what we believe to be large margins of safety in our portfolios. We believe that our portfolios are currently well-positioned for long-term appreciation.

Many investors view volatility as risk, but that’s not how you define it. How do you assess risk in the portfolio?

You’re right; our firm doesn’t define volatility as risk. However, volatility certainly can be viewed as risk if you are a short-term player in the stock market. Then of course, volatility is risk. But that’s not what we do at all.

We define risk as the long-term fluctuations in the economic value of the companies themselves, not the overall stock market. Whether a company’s economic value will deteriorate on the downside, and whether that will be a permanent deterioration, is what we consider risk. Unfortunately, we don’t have the ability to always accurately forecast that kind of risk, and consequently, that’s why we build diversified portfolios.

If you look historically over long periods of time, buying stocks with large margins of safety and maintaining a diver- sified portfolio has been a successful strategy. The probabilities of how companies operate, how the economies operate, and how industries operate offer you a good chance of outperforming by taking that fundamental economic risk of how a company will do in the future. So we don’t believe we need to forecast, as long as we have well-diversified portfolios.

You talked earlier about how straightforward value investing is, yet it’s hard to stay the course. What do you consider the quintessential traits of a successful value investor?

I think the fundamental traits of a successful value investor would be to have enough knowledge of the companies and the industries in which you’re investing, know the probabilities of the potential outcomes, know the normalized trends well enough that you can comfortably take a position in that company, and not be emotionally disturbed by short-term stock price movements.

Warren Buffett made an interesting statement, and some people thought that this was the craziest thing in the world. If it is, you can take a look at his results and wonder why he said he “wouldn’t care if the stock market closed for five years” and he never got a quote on any of his companies. Because it’s not the stock market quotes that are important, it’s how the companies are doing that is important. Buffett thinks long term, and he wouldn’t care whether anybody wants to price a company that he owns, even within a five-year period. He wouldn’t care. That’s not what he’s looking for. He’s not looking to get in and out depending on stock market fluctuations. He’s thinking about being an owner of that company, and how well that company does for its owners has nothing to do with stock price. People always ask, “What do you mean? You’re investing in the stock market and you don’t want any quotes for five years?!” I tell them, “Yeah, exactly.” The misperception is you are investing in the stock market, not companies.

Turning it around from a value investor to a value investing firm, what do you think distinguishes Brandes Investment Partners? What distinguishes a successful value investing firm?

Foremost, I think it’s a core focus on adhering to the tenets of value investing. It’s also the knowledge and belief in the nature of value investing. At Brandes Investment Partners, we are steeped in the Graham and an interview with charles brandes

Dodd philosophy. We don’t change our direction or thought, and that’s one of the things that has made the company successful.

The people who work here are the big key to how successful the company is. People want to work here because they believe in the philosophy that we follow. They come here and fit in immediately. That makes for solid teamwork. That’s one of the important factors of how we operate.

Has there ever been a period when you’ve needed to update the value investing formula or updated your invest- ment approach?

The basic principles of how companies in a free enterprise economy earn money for their owners haven’t changed, so we haven’t needed to change our approach. Those basic principles don’t change, whether you’re applying them to a technological company, a utility, or a bank. So the answer to that is no, we haven’t changed because the world of free enterprise economy and the basic nature of investors haven’t changed.

However, there have been changes in technology, changes in efficiency, and a lot of changes in knowledge – for instance the Internet is amazing. If you have a question, the Internet allows you to find out the answer right away. It’s unbelievable. That has been a major change in terms of information, and a positive change.

Changes that we’ve decided on, or looked at, are implementation changes and changes of how to look at the basic nature of an industry or a company. As time goes by, the basic nature of an industry or a company may change. So we change with that, but the principles we use to invest haven’t changed.

You just mentioned the Internet, and there’s been a proliferation of technology in terms of investment tools. Do you think it’s made it easier or more difficult to find opportunity?

In some ways, the market price inefficiencies attributed purely to a lack of knowledge and a lack of information sources – those particular market inefficiencies – are going away somewhat. But that’s only one source of market inef- ficiencies. The other basic source of inefficiencies is driven by behavioral economics, and that hasn’t changed. Homo sapiens have been thinking the same way since they emerged, that isn’t going to change overnight. So that element is still there and still strong.

I can remember Ben Graham saying that he would investigate railroads, and some specific things were going on, and he had to travel to the company’s office for some fairly obscure explanation of a railroad bond. Or an equity secu- rity for example, where there appeared to be a lot of value, but it wasn’t obvious, so he had to really dig it out. Today, if you’re really diligent, you can get that information a lot easier than he could.

Because it has been fairly accepted that value investing has worked well, there are a lot more value investors out there. Supposedly, with all that extra competition, the discounts wouldn’t get as big, but I’m not sure if that’s true. Right now for instance, I see many margins of safety at 40%-50%, and that’s as big a discount as I’ve seen before. One thing that we don’t see as much of however, and this is probably because of increased market efficiency, increased knowledge, and an easier ability to get information, is Graham’s famous net/nets. These are securities that are sell- ing at a discount below net/net, or current assets. Those have typically resided in the small-cap universe, but even among small caps it’s fairly rare to find net/nets today.

Some of that net/net stuff, and really cheap stuff, happens because of illiquidity, rather than stock market behavior. Graham saw that in the ‘30s. At that time, nobody had any money, so some companies were trading an interview with charles brandes

below their net cash value. That was really just a matter of illiquidity. A similar thing happened in Brazil about 20 years ago. The government shut down the liquidity and shut down the banks. Some of the Brazilian compa- nies, I can remember, were trading at about one times earnings! And that was because there was nobody there to buy them, and foreigners weren’t allowed to purchase Brazilian stocks at that time, so there just weren’t any buyers.

You’ve mentioned that you’ve been in the market for 40 years now. What has been the common denominator in the stock market over that time?

There are still basic “over shoots” and “under shoots.” That hasn’t changed.

What amazes me is that three or four years ago, I could see things going on in the housing market and the mort- gage market that were getting crazy. And I was totally wrong – because it lasted for years. This has to do with fore- casting – which I’m not very good at – but I could see stuff wasn’t making sense. Housing prices just kept going up, and up, and up. But, being able to forecast when that was going to come to an end is impossible, at least for me.

Thankfully, we didn’t get into any subprime or housing stocks back then. Not that we couldn’t forecast that there was going to be a break somewhere in the irrationality that was going on, but it was because there were no valuations that were in our range. In my estimation, it took a long time for the mortgage problem to build up, so the adjustment period has to be longer, and more drastic. We’re in a pretty drastic adjustment period right now.

But it’s not that much different than the U.S. savings and loan crisis back in 1989 and 1990. Some of the housing price declines during that period were similar to what we’re seeing today. If you go back and look at that history, there was a lot of bad stuff going on in the savings and loan industry, and as a group, they all got knocked down. I was looking at some savings and loans, small cap mostly, that had a tremendous amount of capital. They had some bad loans, but their stock prices would get down to around 20% of book. The market put them all in a bad category price-wise, and there were big discounts. That’s happening now, and that’s one reason why we see value today.

The information in this material should not be considered a recommendation to purchase or sell any particular security outside of a managed account. It should not be assumed that any security transactions, holdings, or sectors discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance discussed herein. Strategies discussed herein are subject to change at any time by the investment manager in its discretion due to market conditions or opportunities. Investing outside of the United States is subject to certain risks such as currency fluctuation and social and political changes; such risks may result in greater share price volatility. No investment strategy can assure a profit or protect against loss.

The foregoing reflects the thoughts and opinions of Brandes Investment Partners® exclusively and is subject to change without notice.

Brandes Investment Partners® is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada. 0608