Bruce Greenwald on Positioning First Eagle?s Funds

Bruce Greenwald

Bruce Greenwald is a recognized expert on value investing.  A professor of finance at Columbia University and Director of Research at First Eagle Funds, he is the author of the books “Value Investing: from Graham to Buffett and Beyond,” “Competition Demystified: A Radically Simplified Approach to Business Strategy,” and “Globalization: The Irrational Fear that Someone in China will Take Your Job.”  His latest book, “The Curse of the Mogul: What's Wrong with the World's Leading Media Companies,” is available via the link below.

We spoke with Greenwald on November 4.  This is part two of that interview.  In part one, which we published last week, we spoke with Greenwald about his views on the structural problems in the economy and his forecast for higher unemployment rates.

Has the way you practice value investing changed as a result of the financial crisis?

We changed our focus on risk management.  Many other value managers did as well, because they were blindsided. 

There are three principles that I believe good risk managers and value managers should pursue to protect themselves from permanent impairment of capital and variance. 

The first principle is that the quickest way to permanently impair your capital is to overpay for something.  So you always want to have a margin of safety. 

The second issue is that, you go wrong with your margin of safety because your intrinsic value is wrong.  Something happens that surprises you.  That is almost always – if it’s a permanent impairment of capital – a company problem, where a product doesn’t work or a competitor comes in, or an industry problem, like newspapers, where they get destroyed. Sometimes it’s a particular national problem, like in Venezuela.  But those risks tend to be diversifiable.  So the value investors who had always been very concentrated, like Glen Greenberg, who is a wonderful investor, got burned.  He had five to seven positions. 

For the sake of risk management, you’ve got to have at least 20 to 30 globally diversified positions.  This second lesson of diversification applies because the risk of permanent impairment of capital tends to be unsystematic and specific to impairment of capital management and to variance management.  We were very diversified.

The third rule is that, even within a diversified portfolio, if you have if you have a total loss that affects 3% to 4% of your portfolio, you are asking for trouble.  The thing that will convert temporary impairments, which are the macro fluctuations, to permanent impairments is leverage.  We’ve always been extremely careful when it comes to leverage. 

I think the value community has learned this lesson.  The guys like Marty Whitman who got burned were in financial services, where there were enormous amounts of leverage.  We’ve learned that if you want to do a stub, which is a highly leveraged position, you want a five- to six-times upside, because the downside is zero.  You’ve got to start thinking in those terms.  People have learned to think about leverage differently and to be warier of leverage, and only be willing to do it in a restricted part of a diversified portfolio. 

The fourth thing we’ve learned is that when you build your portfolio you have to think about macro risks in terms of scenarios.  Basically it comes down to two scenarios: You can have stagnation and deflation and a recession for extended periods with inadequate demand, or you can have inflation.  You have to know, holding by holding, what your vulnerability is.  For example, real assets – real estate, natural resources, and things like that – are going to do very well in an inflationary environment but are going to get killed in a deflationary environment.  Fixed income is going to do very well in a deflationary environment and is going to get killed in an inflationary environment.