Tom Brown recently posted a rebuttal to Jason Zweig’s Wall Street Journal column. Geoff Gannon also wrote a great follow-up article with more on Benjamin Graham. I suggest reading all three articles.

In this post, I wanted to comment on a few aspects of Tom Brown’s argument, some of which I have been thinking about lately. The following is a quote from Tom’s post:

True value investors, by contrast, tend not to worry what might happen in the interim. Instead, they come up with their best estimate of a financial company’s intrinsic value by estimating the magnitude of likely losses along with its “normalized” earnings level two or three years out. They then compare that estimate of intrinsic value with the stock’s price today. Zweig says such estimates are impossible. I disagree.

I have always enjoyed Tom’s posts, but I can see a few problems with the above statement. (As a disclaimer, I know relatively little about financial companies, as they are out of my circle of competence. I hold no interest in any financial beside Berkshire Hathaway.)

First observation:
With highly leveraged financial companies, what happens in the “interim” can not only hurt you, it can kill you. Compare a bank to a retailer. Let’s say that you find a cheap retailer, where you estimate normalized earnings a few years out to derive its value. Assuming your estimate is correct, you should be able to ride out any short-term volatility to obtain the long-term value of the company. Like Tom says, that is the foundation of value investing.

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Tariq Ali writes a great post about the follies of our fellow investing clan. I disagree with a few of the specific points he brings up but think the overall message is right on.

It’s wrong to judge the quant and technical analysis firms without knowing exactly how they work. If an investor who was just starting out asked me what style I suggested, value investing would be my answer, hands down. It’s much easier to grasp, and anyone can do it—you don’t need a PhD or any extraordinary skills. But that doesn’t mean that the other forms of investing aren’t valid.

Some traders are just lucky. Some value investors are just lucky. Both styles have practitioners who are phenomenal at what they do, and who have proved it over time. Until you’ve practiced all of these forms of investing, it’s hard to judge which is more valid.

The Headcount

Using the number of employees at a firm to judge success is misleading. Again, I don’t know much about them, but many don’t just run a single fund. Citadel for example has a wide range of investment-related activities (much like investment banks like Goldman Sachs). Also, it’s hard to get an idea of exactly how many of those employees are the actual decision makers for the portfolio (what really matters).

Warren Buffett has 1.5 employees (himself plus half of a Munger) on the investing side, and manages over $100 billion. I’d say he has done just fine over the years. There are three clear advantages to having a limited headcount. One, it avoids group-think when making decisions. Two, there’s no need to worry about “one-employee disasters”, ala Amaranth and Brain Hunter. And three, more obviously, it lowers overhead for small firms.

Eddie Lampert has a few dozen employees. Mohnish Pabrai has 1.7 employees. Neither is the “correct” amount as it all depends on your investing style. From what I’ve heard, Pabrai does little to no scuttlebutt. Lampert sends his analysts out on research and fact gathering missions and is constantly analyzing mountains of data regarding his positions. Both investors have proven they are highly capable and successful.

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Victor Niederhoffer is a well-known hedge fund manager who got his start managing a trading firm in the 1980s. From 1982-1990, he partnered with George Soros and ran the Fixed Income and Forex divisions of Soros’ firm. Niederhoffer has published two books: The Education of a Speculator (1996) and Practical Speculation (2003). Since 2001 he has run Manchester Trading LLC, which manages three small funds with total assets under management of about $350 million at the end of June. Manchester’s main fund had returned 50% annualized through the end of 2006, earning it a prize for best performance by a Commodity Trading Adviser².

Despite the level of respect for him in the trading world, Niederhoffer is most well known for the blow-up of his hedge fund in 1997. After the Asian financial crisis and a 7% one-day drop in the Dow, Niederhoffer Investments lost a majority of its capital and was forced to close down. These losses wiped out virtually all of the gains the fund achieved racking up 35% annualized returns since inception.

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1. Fooled by Randomness, by Nassim Nicholas Taleb [ ^ ]
2. Wikipedia: Victor Niederhoffer [ ^ ]