TheAcquirer’sMultiple:HowtheBillionaireContrariansofDeep

ValueBeattheMarket

TOBIASE.CARLISLE

Copyright©2017TobiasE.CarlisleAllrightsreserved.ISBN:0692928855

ISBN-13:978-0692928851

DEDICATION

ForNick,Stell,andTom.

CONTENTS

Preface

Acknowledgments

AbouttheAuthor

1HowtheBillionaireContrariansZig

2YoungBuffett’sHedgeFund

3TheGreatBerkshireHathawayRaid

4Buffett’sWonderfulCompaniesatFairPrices

5HowtoBeattheLittleBookThatBeatstheMarket

6TheAcquirer’sMultiple

7TheSecrettoBeatingtheMarket

8TheMechanicsofDeepValue

9ThePirateKing

10NewGentlemenofFortune

11TheArtofDeep-ValueInvesting

12TheNineRulesofDeepValue

Appendix:SimulationDetails

Notes

PREFACE

“Itisbettertobelucky.ButIwouldratherbeexact.Thenwhenluckcomes,youareready.”

—ErnestHemingway,TheOldManandTheSea(1952)

This book is a short, simple explanation of one of themost powerful ideas ininvesting:zig.

Zig?

Zig when the crowd zags. Zig with the value investors. Zig with thecontrarians.

Here’swhy: the onlyway to get a good price is to buywhat the crowdwantstosellandsellwhatthecrowdwantstobuy.Itmeansalowprice.Anditmightmeanthestockisundervalued.That’sagoodthing.Itmeansthedownsideissmallerthantheupside.Ifwe’rewrong,wewon’tlosemuch.Ifwe’reright,wecouldmakealot.

When we find undervalued stocks, we often find they are cheap for areason:thebusinesslooksbad.Whybuyanundervaluedstockwithaseeminglybadbusiness?Becausethemarketsareruledbyapowerfulforceknownasmeanreversion:theideathatthingsgobacktowardnormal.

Mean reversion pushes up undervalued stocks. And it pulls downexpensivestocks.Itpullsdownfast-growing,profitablebusinesses,anditpushesup shrinking loss-makers. It works on stock markets, industries, and wholeeconomies.Itisthebusinesscycle:theboomafterthebustandthebustaftertheboom.

Thebest investorsknow this.They expect the turn in a stock’s fortunes.Whilethecrowdimaginesthetrendcontinuesforever,deep-valueinvestorsandcontrarianszigbeforeitturns.

Meanreversionhastwoimportantconsequencesforinvestors:

1.Undervalued,out-of-favorstockstendtobeat themarket.Glamourous,expensivestocksdon’t.

2. Fast-growing businesses tend to slow down. Highly profitablebusinesses tend to become less profitable. The reverse is also true.Flatlining or declining businesses tend to turn around and startgrowing again. Unprofitable businesses tend to become moreprofitable.

Thismightbeasurpriseifyou’refamiliarwiththewaybillionaireWarrenBuffettinvests.Heisavalueinvestorwhobuysundervaluedstocks.Butheonlybuys a special group with sustainable high profits. He calls them “wonderfulcompaniesatfairprices.”Andheprefersthemto“faircompaniesatwonderfulprices”:thosethatareundervaluedbutwithmixedprofitability.

Billion-dollar fund manager Joel Greenblatt tested Buffett’s wonderfulcompaniesatfairpricesidea.Hefounditbeatthemarket,andhewroteaboutitinagreat2006bookcalledTheLittleBookThatBeatstheMarket.Itisoneofthemostsuccessfulbooksoninvestingeverwritten.

We ran our own test onGreenblatt’s book and found that hewas right.Buffett’swonderfulcompaniesatfairpricesdobeat themarket.Buthere’sthetwist:faircompaniesatwonderfulpricesdoevenbetter.

Inthisbook,Ishowhowtofindthosefaircompaniesatwonderfulprices.And I explain in plain and simple terms why they beat Buffett’s wonderfulcompaniesatfairprices.

Wewroteaboutthetestin2012andagaininmy2014book,DeepValue.Itdidwellforanexpensive,quasi-academictextbookonvaluationandcorporategovernance.ButIwantedonethatcouldbereadbynon-professionalinvestors.

This book is intended to be a pocket field-guide to fair companies atwonderful prices. Its mission is to help spread the contrarian message. It’s acollectionofthebestideasfrommybooksDeepValue,QuantitativeValue,andConcentrated Investing. In this book, the ideas in those are simplified,summarized,andexpanded.

ThebookisbasedontalksIhavegivenatHarvard,CalTech,Google,theNew York Society of Security Analysts (NYSSA), the Chartered FinancialAnalystsAssociationofLosAngeles(CFALA),andothers.

MyworkhasbeenfeaturedinForbes,TheHarvardBusinessReview,TheJournal of Applied Corporate Finance, two editions of the Booth ClearyIntroductiontoCorporateFinance,and theManualofIdeas. I’ve talkedabouttheideasin itonBloombergTVandradio,YahooFinance,SkyBusiness,andNPR,amongothers.

Theoverwhelmingresponseisdisbelief.Thereason?Manyfindtheideascounterintuitive—inconflictwithourintuitionaboutthewaytheworldworks.Afew,however,findtheideaswhollyintuitive.

Youdon’tneedtobealawyer,acharteredfinancialanalyst,atechgenius,oraHarvardgraduatetogetthisbook.Buffettwrotein1984,“Itisextraordinaryto me that the idea of buying dollar bills for 40 cents takes immediately topeopleoritdoesn’ttakeatall”:1

Afellow…whohadnoformaleducationinbusiness,understandsimmediatelythevalueapproachtoinvestingandhe’sapplyingitfiveminuteslater.

Inthebook,Isetoutthedataandmyreasoning.We’lllookatthedetailsofactualstockpicksbybillionairedeep-valueinvestors:

•WarrenBuffett•CarlIcahn•DanielLoeb•DavidEinhorn

We’llseethestrategiesofBuffettandhisteacher,BenjaminGraham,andothercontrarians,including:

•billionairetraderPaulTudor-Jones•venturecapitalistbillionairePeterThiele•globalmacroinvestorbillionaireMichaelSteinhardt

•billionairetail-riskhedgerMarkSpitznagel

Iwrotethisbooksoyoucanreaditinacoupleofhours.It’swrittenformykids,family,andfriends,forpeoplewhoaresmartbutnotstock-marketpeople.Thatmeansit’swritteninplainEnglish.WhereIneedtodefineastock-marketterm, I’ve tried to do it as simply as possible. And this book is packed withchartsanddrawingsexplainingwhyit’simportanttozigwhenthecrowdzags.You’lllearnwhyfairstocksatwonderfulpricesbeatthemarketandwonderfulstocksatfairprices.Let’sgetstarted.

ACKNOWLEDGMENTS

Iamgratefultotheearlyreviewersofthisbook,notablyJohnnyHopkins,ColinMacintosh,JacobTaylorand

LonnieRushatFarnamStreetInvestments,andMichaelSecklerandJohnAlbergatEuclideanTechnologies.

ABOUTTHEAUTHOR

Tobias Carlisle is the founder and managing director ofCarbonBeachAssetManagement,LLC.He serves as co-portfolio manager of Carbon Beach’s managed accountsandfunds.

Heis theauthorof thebestsellingbookDeepValue:Why Activists Investors and Other Contrarians Battle forControlofLosingCorporations(2014,WileyFinance).Heis a coauthor ofConcentrated Investing: Strategies of theWorld’s Greatest Concentrated Value Investors (2016,Wiley Finance) andQuantitative Value: A Practitioner’sGuidetoAutomatingIntelligentInvestmentandEliminatingBehavioralErrors (2012,WileyFinance).Hisbookshavebeen translated intofivelanguages.TobiasalsorunsthewebsitesAcquirersMultiple.com—homeofThe Acquirer’s Multiple stock screeners—and Greenbackd.com. His Twitterhandleis@greenbackd.

He has broad experience in investmentmanagement, business valuation,corporate governance, and corporate law. Before founding the precursor toCarbonBeachin2010,Tobiaswasananalystatanactivisthedgefund,generalcounselofacompanylistedontheAustralianStockExchange,andacorporateadvisory lawyer.As a lawyer specializing inmergers and acquisitions, he hasadvised on deals across a range of industries in theUnited States, theUnitedKingdom, China, Australia, Singapore, Bermuda, Papua New Guinea, NewZealand,andGuam.

HeisagraduateoftheUniversityofQueenslandinAustraliawithdegreesinlaw(2001)andbusiness(management)(1999).

1.HOWTHEBILLIONAIRECONTRARIANSZIG

“Tobeatthemarketyouhavetodosomethingdifferentfromthemarket.”—JoelGreenblatt,TalksatGoogle,April4,2017.

Zigzig(verb):Tomakeasharpchangeindirection.Usedincontrasttozag:Whenthecrowdzags,zig!

Thebillionairecontrariansofdeepvaluezigwhenthecrowdzags.

Theybuywhatthecrowdwantstosell.Theysellwhenthecrowdwantstobuy.

Theybuystockswithfallingprices.

…withfallingprofits.

…thatlosemoney.

…thatarefailing.

…thathavefailed.

Buttheyonlydoitwhenthestockisdeeplyundervalued.

Billionaire value-investor Warren Buffett famously says he tries to be“fearfulwhen others are greedy, and greedywhen others are fearful.” Said inotherwords,Buffettzigswhenthecrowdzags.

Like Buffett, billionaire corporate-raider Carl Icahn is also a valueinvestor. He has been called the “the contrarian to end all contrarians.”2 KenMoelis,formerchiefofinvestmentbankingatUBS,saidofIcahn,“He’llbuyattheworstpossiblemoment,whenthere’snoreasontoseeasunnysideandnooneagreeswithhim.”3Icahnexplainswhy:4

Theconsensusthinkingisgenerallywrong.Ifyougowithatrend,the

Theconsensusthinkingisgenerallywrong.Ifyougowithatrend,themomentumalwaysfallsapartonyou.SoIbuycompaniesthatarenotglamorousandusuallyoutoffavor.It’sevenbetterifthewholeindustryisoutoffavor.

Icahnzigswhenthecrowdzags.

BillionairetraderPaulTudorJonesisawell-knowncontrarian.InJackD.Schwager’sMarketWizards(1989),hesaid:

Ilearnedthateventhoughmarketslooktheirverybestwhentheyaresettingnewhighs,thatisoftenthebesttimetosell.Tosomeextent,tobeagoodtrader,youhavetobeacontrarian.

PaulTudorJoneszigswhenthemarketzags.

BillionaireinvestorPeterThieledrawsthisdiagramtodescribethe“sweetspot”forhischosenstocks:

SweetSpot:AGoodIdeaThatSeemsLikeaBadIdeaSource:PaulGraham,“BlackSwanFarming,”September2012,

Availableathttp://www.paulgraham.com/swan.html

Thiele’s “sweet spot” is a good idea that seems like a bad idea to thecrowd. But Thiele thinks it might be a good idea. Thiele’s zigging while thecrowdzags.

Billionaire global macroinvestor Michael Steinhardt made his investorsabout five-hundred times their money over thirty years until 1995. In hisautobiography,Steinhardtdescribedhowhetoldaninternwhathelookedfor:5

Itoldhimthatideallyheshouldbeabletotellme,intwominutes,fourthings:(1)theidea;(2)theconsensusview;(3)hisvariantperception;and(4)atriggerevent.Nomeanfeat.Inthoseinstanceswheretherewasnovariantperception…Igenerallyhadnointerestandwoulddiscourageinvesting.

Steinhardt’s “variant perception” is a view that is different from thecrowd’s.Steinhardttriestozigwhilethecrowdzags.

BillionaireglobalmacroinvestorRayDaliosays:6

Youhavetobeanindependentthinkerinmarketstobesuccessfulbecausetheconsensusisbuiltintotheprice.Youhavetohaveaviewthat’sdifferentfromtheconsensus.

Dalioissayingyouonlybeatthemarketifyouzig.

Billionaire distressed debt investor Howard Marks says, “To achievesuperior investment results, you have to hold nonconsensus views regardingvalue, and they have to be accurate.”7 Venture capitalist Andy Rachleff saysMarksthinksaboutinvestmentsinatwo-by-twogridthatlookslikethis:

OutsizedReturns:RightandNonconsensusSource:AndyRachleff,“DemystifyingVentureCapitalEconomics,Part1,”Availableat

https://blog.wealthfront.com/venture-capital-economics/

Onone side, you can either be “Consensus”—gowith the crowd—orbe“Nonconsensus”—zig.On the other side, you can be right orwrong.Rachleffexplainshisgrid:8

Nowobviouslyifyou’rewrongyoudon’tmakemoney.Theonlywayasaninvestorandasanentrepreneurtomakeoutsizedreturnsisbybeingrightandnonconsensus.

Youdon’tbeatthemarketifyou’rewrongorifyouzagwiththecrowd.

The last one surprisesmanynew investors.Youdon’t beat themarket ifyou’rerightandyouzagalongwiththecrowd?Nope.Youdon’tbeatthemarketwhenyou’rerightifthecrowdhasalreadydecidedthestockisagoodone.Thereason?Aswe’llsee,youpayahighpricethatreflectsthecrowd’shighhopesforthestock.Evenifthestockmeetsthosehighhopes,itwon’tbeatthemarket.

Youcan’tbeat themarketbyzaggingalongwith it.Tobeat it,youmustzigasthecrowdzags.Here’swhy:theonlywaytogetalowpriceistobuywhat

thecrowdwantstosellandsellwhenthecrowdwantstobuy.

Alowpricemeansapricelowerthanthestock’svalue.Itmeansanunfair,lopsidedbet:a smalldownsideandabigupside.Asmalldownsidemeans thepricealreadyincludestheworst-casescenario.Thatgivesusamarginoferror.Ifwe’rewrong,wewon’t losemuch. Ifwe’re right,we’llmake a lot.A biggerupsidemeanswebreak,eventhoughwehavemorelossesthansuccesses.Ifwemanage tosucceedasoftenasormoreoften thanwemakemistakes,we’lldowell.

But it’s not enough to be a mere contrarian. We must also be right.Steinhardtsays,“Tobecontrarianand tobe right inyour judgementwhen theconsensusiswrongiswhereyougetthegoldenring.Anditdoesn’thappenthatmuch.Butwhenitdoeshappenyoumakeextraordinaryamountsofmoney.”9

Billionaire value-investor Seth Klarman says, “Value investing is at itscore themarriageofacontrarianstreakandacalculator.”10Klarman is sayingthatwe should do somework. It’s not enough that the crowd doesn’t want astock. We should figure out if we do. For that, we look at the company’sfundamentals.

Whatareacompany’sfundamentals?Buffett’steacher,BenjaminGraham,taughthimthatashareisanownershipstakeinacompany.It’snotjustatickersymbol.Thinkinglikeanownerimpliesthreeideas:

1.We should knowwhat the company does.What is its business?Howdoesitmakemoney?

2.Weshouldknowwhatitowns.Whatareitsassets?Whatdoesitowe?

3.We should knowwho runs it and who owns it. Is managementdoingagoodjob?Arethebigshareholderspayingattention?

Sometimes investors use company (or corporation) and business assubstitutes.Theyaredifferent.Acompanyisalegalentity.Itownstheassets.Itemploysthestaff.Itentersintothecontracts.Itcansueandbesued.Businessis

the activity of selling goods or services with the aim of making a profit.Shareholdersownshares in thecompany.Thecompanyownsthebusinessandtheassets.

Abusinesscanbeworthalot,worthless,orworthlessthannothingifit’sregularlylosingmoney.Also,acompanycanhavelotsofvalue,oritcanhaveanegativevalue if itowesmore than theassets itowns.Many investorscloselywatchprofits—thefruitsofthebusiness—butignoreassets,includingcash.

Weoften findundervalued stocksare cheap for a reason: thebusiness isbad or poorly managed. Glamorous, fast-growing, or highly profitablebusinessescommandhighprices.Undervaluationresultsfromflatlininggrowth,falling profits, losses, or looming failure.Why buy a company with a failingbusiness,evenifitisundervalued?

Therearethreereasons:

1.Itmighthavevaluableassets.Thecrowdoftensellsastockbasedonitsbusinessalone,ignoringitscashandotherassets.

2.Many seemingly scary, bad, or boring businesses turn out to belessscary,bad,orboringthantheyseem.

3. Poorly managed companies attract outside investors who mightbuythemorturnthemaround.Thisiswhatprivateequityfirmsandactivistsdoforaliving.Butshareholdersdon’thavetowaiton other investors. They have rights as owners, and theyexercisethoserightsbyvotingatmeetings.Withenoughvotes,shareholderscanchangeacompany’sbadpolicies.

These three reasons create opportunities for contrarianswith calculators.Thisiswhyweseekoutstocksthatlosemoneyorseemlikebadideas,andit’swhy we ignore the crowd. Undervalued and out-of-favor companies offer thechance to zig—tobuy somethingvaluable that someone elsewants to sell toocheaply.

Companies become undervalued because businesses hit a bump in theroad.Thecrowdoverreacts.Orelsethebusinessisboringandthecrowdgrows

impatient.Whenanundervaluedcompanyownsascary,bad,orboringbusiness,oftenallitneedsistime.Givenenoughtime,manybusinessesturnouttobelessscary,boring,orbadastheyseematfirst.Aseeminglypoorbusinesswithalotofassetvaluecanbeagoodbet.Ifthebusinessimproves,itcanbeagreatbet.

Howdoweknowifanygivenbadbusinesswillgetbetterwithtime?Wedon’t.Butweknowmanybadbusinesseswill.Thereasonisapowerfulmarketforceknownasmean reversion, a technical name for a simple idea: thingsgobacktonormal.

MeanReversion:ThingsGoBackTowardNormal

Mean reversion pushes up the prices of undervalued stocks, and it pullsdownthepricesofexpensivestocks.

It returns fast-growing and high-profit businesses to earth, and it pointsbusinesswithfallingearningsorgrowinglossesbacktotheheavens.

Itworksonstockmarkets,industries,andwholeeconomies.Weknowitastheboomsandbustsofthebusinesscycleorthepeaksandtroughsofthestockmarket.

Extrapolation:WeFindtheTrendandExtrapolateIt

Mean reversion is the expected outcome. But we don’t expect meanreversion. Instead,our instinct is to finda trendandextrapolate it.Wethink itwill always be winter for some stocks and summer for others. Instead, fallfollowssummer,andspringfollowswinter.Eventually.

Thisisthesecrettocontrarianinvesting:theturnsarehidden.Iftheywereaspredictableaswinterafterfallorsummerafterspring,we’dquicklyfindthepattern.Instead,it’srandom.

Whatcausesmeanreversion?Howdoesthehigh-growth,high-profitstockfallbacktoaverage?Howdoestheundervaluedstockrisetofairvalue?

Benjamin Graham once described this as “one of the mysteries of ourbusiness.”11Hewasbeingalittlemodest.Themicroeconomicanswerissimple-ish.Theansweriscompetition.

Competition:GrowthandProfitsAttractCompetitors

Fast growth and high profits attract competitors—entrepreneurs andbusinessesinrelatedindustries.Competitorseatawayatthegrowthandprofit.

Lossescausecompetitorstofoldorsimplyleavetheindustry,andthelackof competition creates a time of high growth and profit for the survivingbusinesses.

Billionaire value-investor Jeremy Grantham knows profits are meanreverting:12

Profitmarginsareprobablythemostmean-revertingseriesinfinance,andifprofitmarginsdonotmean-revert,thensomethinghasgonebadlywrongwithcapitalism.Ifhighprofitsdonotattractcompetition,thereissomethingwrongwiththesystemanditisnotfunctioningproperly.

Buffett agrees. He wrote in 1999 that you must be wildly optimistic tobelieveprofitscanremainhighforanysustainedperiod.Hesaid:13

Onethingkeepingthepercentage[ofcorporateprofits]downwillbecompetition,whichisaliveandwell.

The ebbing and flowing of competitors cause mean reversion at thebusiness level, butwhat causes it at the company level?Howdo undervaluedand expensive stocks get back to fair value? The answer is other investors.Fundamentalinvestors.Valueinvestors.

Fundamentals:UndervaluationAttractsInvestors

Undervaluedassetsandprofitsattractinvestors.Valueinvestorsandotherfundamentalinvestorsstarttobuystocksandpushupstockprices.

Expensive assets and profits cause those investors to sell. The sellingpushesdownstockprices.

Meanreversionhastwoimportantimplicationsforinvestors:

1. Undervalued, out-of-favor stocks tend to beat the market. Themore undervalued the stock, the greater the return. Valueinvestors call thedifferencebetween themarket price and theunderlyingvaluethemarginofsafety.

MarginofSafety:TheBigger,theBettertheReturn

The bigger themargin of safety, the better the return.This iswhy we ignore advice like the old saying, “Never catch afalling knife.” Undervalued stocks are lower risk thanglamourous,expensivestocks,whichhavenomarginofsafety.

2.Fast-growthorhighlyprofitablebusinesses tendtoslowdownorbecome less profitable. Declining or unprofitable businessestendtodobetter.

Overreaction:PriceOver-/UnderestimatesProfit

Investorsmaketheerrorworsebyoverpayingforunsustainablegrowthorprofit.Theyextrapolateouttheprofittrendandbuy.Ifthestockdeliversonthepromised growth or profit, it only earns amarket return. If it doesn’t, it getscrushed.

Value investors take the other side of this trade.Where the stock pricediscounts even the worst-case scenario, the worst-case scenario can lead tomarket-beatingreturns. If somethingbetter than theworst-casescenariooccurs—ifprofitsorgrowthreturn—thereturnscanbetremendous.

Withoutknowingwhenitwilloccur,valueinvestorsandothercontrariansexpecttheturninastock’sfortunes.

TheWorst-CaseScenario:TimetoBuy

Theybuyatwhatlooksliketheworstpossibletime,suchaswhenprofitsare fallingor lossesarewidening, and it looks like thiswill continueuntil thecrashing stock hits zero. It’s the worst-case scenario. But the stock isundervalued,anditoffersawidemarginofsafety.It’stimetobuy.

As Klarman says, “High uncertainty is frequently accompanied by lowprices.Bythetimetheuncertaintyisresolved,pricesarelikelytohaverisen.”14

They’llalsosellatwhatlookslikethebestpossibletime:profitsarehighandrisingquickly,anditlookslikethiswillcontinueforever.Thestockpriceissoaring. It’s thebest-casescenario.But thestock isexpensive,anditoffersnomarginofsafety.It’stimetosell.

Zig:ContrariansExpectMeanReversion

While thecrowdimagines theprofitandstockprice trendswillcontinue,valueinvestorsandcontrarianszig.

TheMagicFormula“Youpayaveryhighpriceinthestockmarket

foracheeryconsensus.”—WarrenBuffett,ForbesMagazine(1979)

Buffettbuysundervaluedstocks.Recallthatheonlybuysasmall,specialgroupwithsustainedhighprofits.Hecalls thisgroup“wonderfulcompaniesatfairprices.”Andheprefersthemto“faircompaniesatwonderfulprices”:thosethatareundervaluedbutwithmixedprofitability.(We’llexploretheseconceptsindepthinalaterchapter.)

JoelGreenblatttestedasimpleversionofBuffett’swonderfulcompaniesatfairprices idea.Hefound that itbeat themarket,andhewroteabout it inTheLittle Book That Beats the Market. He called Buffett’s simple wonderfulcompaniesatfairpricesideathe“MagicFormula.”

In thebook,Greenblattdescribedhowhecreatedhis test.Werepeated itforthisbook.(Wealsotalkaboutourtestandtheresultsindetailinchapter7.)WeagreewithGreenblatt.TheMagicFormuladoesbeatthemarket,asthenextchartshows.

$10,000InvestedintheS&P500andtheMagicFormula(1973to2017)

ThirtyStockswithMarketCap$50MillionandAbove

Themagicformulabeatsthemarket,justasGreenblattclaims.Butwhat’sthetruecauseofthemarket-beatingresults?

Here’s the twist. Fair companies at wonderful prices—what I call the

Acquirer’sMultiple—dobetter.

In this test, we buy the most undervalued stocks with no regard forprofitability.(Wetalkaboutourtestandtheresultsindetailinalaterchapter.)

$10,000InvestedintheAcquirer’sMultiple,MagicFormula,andS&P500(1973to2017)

ThirtyStockswithMarketCap$50MillionandAbove

Inourtest,theAcquirer’sMultiple—faircompaniesatwonderfulprices—beatstheMagicFormula—wonderfulcompaniesatfairprices.Itseemsthesizeof the margin of safety—the market price discount from value—is moreimportantthanprofitability.

Highprofitsaremeanreverting,andfallingprofitsdampenthereturns totheMagic Formula. The Acquirer’sMultiple buys stocks with mixed profits;somearehighlyprofitable,othersbreakeven,andotherslosemoney.Itreliesonpricemeanrevertingtothevalueandthebusinessesimproving.

Does thismean thatBuffett iswrong aboutwonderful companies at fairprices being better than fair companies at wonderful prices? Does Buffett’sliking for wonderful companies at fair prices disagree with the idea of meanreversioninprofits?Inshort,no.

Buffettseeksstockswithsustainableprofits,thosethathavewhathecallsa “moat”—inotherwords, acompetitive advantage.Amoat is something thatallowsabusinesstobeatitscompetition.

There aremany sources ofmoats. If a business canmake itswidget forless,sellitformore,orsellmoreofitthananyotherbusiness,ithasamoat.

A patent, for example, is a moat. A patent is the sole right tomake aninvention. If you have one, you can stop everyone else from making yourinvention for twenty years. If no other business can copy the invention, theownerof thepatenthasamonopolyandcanchargewhateverpricemaximizesitsprofit.

Awell-knownbrandisalsoamoat.Coca-Colacanchargemoreforitscolathan store-brand colas. It’s not a monopoly, but it allows Coke to earn moreprofitpercanthanitscompetitors.

Theproblemfor investors is it’shard tofindbusinesses thatcankeepuphighprofits.Wecan’tpredictwhatbusinesseswillmaintainprofits.Evenifwelook for high past profits and the reason why, themoat, most businesses seeprofitsfallovertime.Inalaterchapter,wetrytoidentifymoatsinascientific,repeatableway.Butourchanceoffindingabusiness thatcansustainprofits isstillasgoodasflippingacoin.Therearethreereasonswhy:

1.Onlyafewbusinesseshaveamoat.Mostdon’t.Itcanbehardtotellabusinesswitharealmoatfromonethatisatthepeakofitsbusinesscycle.

2.Amoatisnoguaranteeofhighprofits.Coke’sbrandallowsit tosell its cola formore thanother colas.But if tastes change toothersodas,orwater,Coke’sprofitswillfall.

3.Moatsdon’tlastforever.Newspapersusedtohaveamoat.Ifyou

wantedtoadvertiseinacity,youadvertisedinthelocalpaper.There was no other way. The Internet has changed thatrelationship. Now, you might advertise with Google orFacebook.

Buffett isabrilliantbusinessanalyst—thebestaliveandperhapsthebestwhohaseverlived.Hislongmemory,giftfornumbers,andlifelongdevotiontobusiness analysis set him apart. He has a sixth sense for finding moats withrelentlessprofitability.Buthedidn’tstartoutinvestinginwonderfulcompaniesatfairprices.

Buffettgothisstartasavalue-investingcontrarian.Hewasalreadyrich;hehad$34millionin1972—$200millionin2017dollars—whenhechangedfromfaircompaniestowonderfulones.Inthenextchapter,webeginwithoneofhisearlyinvestments.

2.YOUNGBUFFETT’SHEDGEFUND

“ThehighestratesofreturnI’veeverachievedwereinthe1950s.IkilledtheDow.Yououghttoseethenumbers…IthinkIcouldmakeyou50percentayear

on$1million.No,IknowIcould.Iguaranteethat.”

—WarrenBuffett,BusinessWeek,July5,1999

Thebusinesswasonanuglypath.Itmadehuge,detailedpapermaps.Onemapforasmallcitymightweighasmuchas50pounds.Whencustomers’mapsneededupgrades,thebusinessmailedoutastickertocovertheout-of-datepartof the map. The company had operated for seventy-five years. Twenty yearsearlier,ithadbeenamonopolyaveragingmorethan$7millionayearinprofit.Now it had to competewith a better technology. Its customer base shrank ascustomersmergedandcutexpenses.Profitshadfallenmorethan80percenttoless than $1 million a year. It had cut dividends five times in eight years.Twenty-seven-year-oldWarrenBuffettlikedwhathesaw.

The company, Sanborn Map, also owned $60 million in cash andinvestmentsworth$65pershare.Yetthesharescouldbeboughtfor$45.Buffettsentalettertotheinvestorsinhishedgefund.Hewrotethatthe$45stockpricemeanteitherthemapbusinesswasworth–$20pershare($45–$65=–$20),orthe investment portfoliowasworth 69 cents on the dollar ($45÷ $65= 0.69)withthemapbusinessthrowninforfree.Eitherway,itwasundervalued.ItwasaclassicBenjaminGrahamvalueinvestment.

BenjaminGrahamhadtaughthimasimple,powerfulidea:buydollarsfor50 cents. Buffett spent his days looking for such stocks. It wasn’t easy. Realdollarsdon’tsellfor50cents.(Fakeonesdo.)ButGrahamtaughtBuffetthowtofinddollarshecouldbuyfor50cents.

GrahamshowedBuffett thatsometimesacompanyownsadollar,andhecouldbuy it for50centsbybuying theshares.That’sagooddeal,butBuffett

won’t control the dollar. The company will. He will need to make sure thecompanylooksafterhisdollar.

InthecaseofSanbornMap,Buffettfoundadollartradingfor69cents.Buthowtoprotectthedollar?Buffett’shedgefundboughteverysharehecouldfind.Inshortorder,he’dpickedup46,000sharesoutof the105,000onissue.With43.8percentofthecompany’sshares(46,000÷105,000=43.8percent),Buffettcouldcontrolthecompany.Heaskedtheboardtopayoutthe$65persharetotheshareholders.Theboardrefused.

Buffettactedquickly.Heusedhishedgefund’sshareholdingtogethimselfelectedtotheboard.Athisfirstboardmeeting,hefoundoutwhythestockwasso cheap. The other board members worked for Sanborn Map’s biggestcustomers.Theyownedalmostnostockandjustwantedthemapssoldcheaply.Buffettagainsuggestedthecompanyselltheinvestmentsandpaythemoneytotheshareholders.Theotherdirectorsrejectedtheidea.

Atthenextmeeting,Buffettaskedthemtousetheinvestmentstobuyoutany stockholder whowanted out. The board agreed, if only to avoid a proxyfightwithBuffett.(With43.8percentofthestock,Buffettwassuretowin.)Halfofthe1,600shareholderswhotogetherowned72percentofthestockacceptedthe offer. Instead of cash, shareholders who accepted got $65 worth ofinvestmentsfortheir$45shares,a44.4percentreturnontheirinvestment($65÷$45=44.4percent).

SanbornMapswasatypicallyprofitableinvestmentforBuffett.ItwasalsoagoodexampleofBuffett’sinstincttozigwhenthecrowdzags.Themarketsawthefailingmapbusiness.Profitshadfallensteadilyformorethantwentyyears.ButBuffettlookedpastthe80percentdropinprofittotheassetvalue—its$65pershareincashandinvestments.

TheBuffettHedgeFundStrategy“Mycigar-buttstrategyworkedverywellwhileIwasmanagingsmallsums.Indeed,themanydozensoffreepuffsIobtainedinthe1950smadethedecade

byfarthebestofmylifeforbothrelativeandabsoluteperformance.”—WarrenBuffett,“Chairman’sLetter”(1989)

Buffett has said many times that his best returns came in the 1950s. In1957,hestartedahedgefundcalledtheBuffettPartnership.Howdidheinvestearlyinthisearlypartofhiscareer?HelookedforundervaluedstocksthatmetGraham’sdollars-for-50-centsrule.

Grahamhadanothernameforthese50-centdollars.Hecalledthemcigarbutts.A“cigarbuttfoundonthestreetthathasonlyonepuffleftinitmaynotoffermuchofasmoke,butthe‘bargainpurchase’willmakethatpuffallprofit,”hesaid.15SanbornMapshadbeenaclassicexampleofacigarbuttin1958.In1959,hefoundanotherone,DempsterMillManufacturingCompany.

BuffettstartedbuyingDempsterataboutthesametimehewasfightingforcontrolofSanborn.Dempsterwasamakerofwindmills,pumps,tanks,andotherfarming and fertilizing equipment. It had run into trouble. The business wasbarely profitable. It made its windmills faster than it could sell them and itsinventoryhadgrowntoobigcomparedtoitssmallbusiness.

Investors looked at Dempster’s low profits and sold it down to half thevalue of its working capital, which included its bloated inventory. Buffettestimated its net working capital—cash, accounts receivable, and inventoryminus all liabilities—at around $35 per share. He guessed the tangible bookvalue—the amount of physical assets owned by the company free of anyliabilities—tobemuchhigher,between$50and$75pershare.Hecouldbuythestock for $16 per share. The business would never be very profitable. But itcouldbeaprofitableinvestmentifhecouldparedownitsbloatedinventory.

Buffetthadstartedbuyingstockin1956,payingaslittleas$16pershare.He continued to buy stock over the next five years, buying small blocks ofsharesatanaveragepriceof$28.Inhis1962hedgefundletter,Buffettsaidthestockwasundervaluedbecauseofa“poormanagement situation,alongwithafairlytoughindustrysituation.”16Managementcontinuedtoignoretheinventoryproblem. Dempster’s bankers started getting nervous. The bank threatened topullitsloanandshutdownthecompany.Buffetthadtoactfast.

LikehehadinSanborn,Buffettusedhiscontrollingshareholdingtogetaboardseat.Onceincontrol,hesolddowntheinventoryandotherassetsofthecompany.Theassetshesoldwereturnedintocashandinvestedinstocks.

Buffett was almost done when he attracted some unwanted attention.Before he could finish the job, the townsfolk inBeatrice,Nebraska, got upsetwhenhetriedtosellthetown’sonlyfactory.Thelocalpaperstartedafront-pagecampaign to save it. Under pressure, Buffett sold the factory back to thefounder’sgrandson.Thelocalpaperrangthefiresirentocelebratethesale.

The townsfolkmight havewon the battle, but Buffett won thewar. Hishedge fund made $20 million, triple its original investment. It was anotherprofitableexampleofthereturnstoziggingwhilethecrowdzagged.

In the same letter that he revealed his holding in Dempster, Buffettdescribed his investment strategy. He said he split his investments into threegroups:

1.Generals2.Workouts

3.Controlsituations

Generalsweresimplyundervaluedstocks.Buffettboughtthestockatabigdiscounttoitsvalueandsoldwhenthemarketpushedthepriceuptothevalue.

Theworkouts were stocks on a timetable. They did not wait on marketaction. Some other force put these stocks on a rocket sled. That force was acorporateaction,aboard-leveldecisionthatdeliveredabigreturnofcapitalorstockbuyback,aliquidation,orasaleofthebusiness.

Ifageneral—oneofBuffett’sundervaluedstocks—stayedundervaluedfortoolong,itmightbecomeacontrolsituation.Buffettwouldsimplykeepbuyinguntil he owned enough to control the company. Dempster started out as justanotherundervaluedstock.Whenthepricedidn’tmove,Buffettdid.

Overfiveyears,heboughtenoughtogetcontrolofthecompany.Onceonthe board, he took several steps to improve the company’s value. Thosecorporate actions helped improve the value ofDempster frombetween $50 to$72pershareto$80pershare.Buffett’sreturnwasevenbetterbecausehepaidonly$28pershareonaverage.

Ifageneralmovedupbeforehegotcontrol,hesoldout.Ifitdidn’tmove,orfell,heboughtmore.TheabilitytogetcontrolofthecompanywasimportanttoBuffett because it gavehimcontrolofhis the stock’sdestiny.StockseithermoveduporBuffettmovedinandfixedthemup.Itworked.Anditworkedbestindownorsidewaysmarkets.Eitherway,Buffettbeatthemarketlikearentedmule.

CoattailRidingBuffett was happy to invest behind other investors seeking control. He

called this “coattail riding” in his 1961 letter. He did this with many of hisgenerals:17

Manytimesgeneralsrepresentaformof“coattailriding”wherewefeelthedominatingstockholdergrouphasplansfortheconversionof

unprofitableorunder-utilizedassetstoabetteruse.WehavedonethatourselvesinSanbornandDempster,buteverythingelseequalwewouldratherletothersdothework.Obviously,notonlydothevalueshavetobeampleinacaselikethis,butwealsohavetobecarefulwhosecoatweareholding.

The generals were stocks not needing as much attention as Buffett’scontrolsituations.Adominantstockholderhadcontrol,andheorshewasbusydoingthe thingsBuffettwoulddoifhewas incontrol—sellingunprofitableorunderused assets and buying back stock. Buffett made sure the stock wasundervaluedenoughandthenletthebigstockholdersdothework.Hewasalsohappytoselloutatwhatheregardedas“fairvaluetoaprivateowner.”18

Buffett was always on the lookout for undervalued stocks with a quietshareholderabouttobecomeactive.Thesestockswereatatippingpoint.WhenthebigshareholderstarteddoingthethingsBuffettliked,Buffettknewthestockpricewouldshortlytakeoff.

As long as the stockwas undervaluedwhen Buffett bought it, he couldwaitpatiently.Buthewouldn’twaitforeverforthesleepingshareholdertowakeup. If theundervaluedstock’spricedidnothingfora long time,Buffettwouldslowlybuyabigshareholding.Thenhewouldtakecontrol.

Buffettpreferredtoletothersdothework,buthewouldtakecontrolifthecompanykeptlosingmoney.Heknewtheabilitytotakecontrolputhimintoawin-win position. If the stock went up, he mademoney. If it went down, heboughtmore,fixeditup,andmademoney:19

Ourwillingnessandfinancialabilitytoassumeacontrollingpositiongivesustwo-waystretchonmanypurchasesonourgroupofgenerals.Ifthemarketchangesitsopinionforthebetter,thesecuritywilladvanceinprice.Ifitdoesn’t,wewillcontinuetoacquirestockuntilwecanlooktothebusinessitselfratherthanthemarketforvindicationofourjudgment.

Buffettusedthiswin-winmethodinhishedgefundtogreateffect.Forthetwelveyearsheranthefund,hereturned31percentayear.Thechartandtablebelowshowhishedgefund’sreturns.

BuffettPartnershipversusDow(1957to1968)

BuffettPartnershipPerformance(1957to1968)

Throughhisshareofthehedgefundandhisfees,Buffettturned$100,000whenhewastwenty-sixyearsoldintoapersonalstakeworth$25millionbythetimehewasthirty-eight.

Buffett wound up his hedge fund in 1969. He couldn’t find enoughundervalued stocks to buy. The fund had simply grown too big. Through thefund,hecontrolledmorethan$100millioninassets.Hesaidheneededtoinvestatleast$3millioninanystockforittomakeadifference.Thatmeantthestockneededamarket capitalization,ormarket cap,of at least$100million.And ithadtobeabargain.

In 1969, the market was booming. There simply weren’t enough big,undervaluedstocksaround. If theywereundervaluedenough, theyweren’tbigenough. If they were big, they weren’t undervalued. He told his investors hewouldwindupthefund.They’deachgetcashandsharesinthefund’sbiggestholdings.Onewouldbeanundervaluedgeneralhefoundin1962.Thatgeneralgrewtobecomeacontrolsituation,whichhecontrolstothisday.

3.THEGREATBERKSHIREHATHAWAYRAID

“IntheearlydaysbothWarrenandIwouldsometimesbuycontrolofacompanyinthemarket.Wedon’tdothatanymorebytheway.Wehaven’tdonethatfordecadesbutintheearlydayswedidsomeofthat.Warrenboughtcontrolof

BerkshireHathawayinthemarket.”—CharlieMunger,Interview,ConcentratedInvesting(2016)

Dan Cowin called his thirty-two-year-old buddyWarren Buffett to givehim a stock pick. Cowin was another value investor. He told Buffett he hadfound a textile maker called Berkshire Hathaway in New Bedford,Massachusetts. Berkshire traded at one-third of its liquidation value—theamountofmoneytheycouldgetoutofthecompanyiftheystoppedthebusinessandsoldtheassetsforscrap.

Cowinguessed the liquidationvalue at $22million, or $19.46per share.Berkshire shares traded for $7.50. Buffett said he knew about Berkshire andagreeditwastooundervalued.Buthowwouldheunlockthevalue?

CowinsaidBuffettcouldeasilysellhisstockbacktothecompany.Everytwoyearsorso,itspresident,SeaburyStanton,usedthecompany’scashtobuybackitsstock.BuffettcouldbuybeforeStanton’snextbuybackandsell to thecompanythen.

If Stanton took too long, Buffett could also take the company over andliquidateitbysellingtheassets.CowinknewthathehadrecentlydonejustthatwithSanbornandDempster.WhynotBerkshire?BuffettstartedbuyingstockinthecompanyonDecember12,1962.Hepaid$7.50 for the first two thousandsharesandtoldhisbrokertokeepbuying.

By1963,Buffett’s hedge fundwas the biggest shareholder inBerkshire.ButBuffettwantedhis identity kept secret.He askedCowin to take a seat onBerkshire’sboardandstartsniffingaroundthecompany.CowinquicklyfoundoutthatSeaburyStanton,thepresident,foughtwiththeotherdirectors.

One director, Seabury’s brother, Otis Stanton, was upset Seabury had

picked his own son, Jack, to become the next president of the company.Otisdidn’t think Jack was up to the job, and he didn’t want Jack running thebusiness.Otispreferredanotherworker,KenChace,whoranthefactory.

Seaburywasalsofightingwiththecompany’schairman,whohadrunthecompanyforalmostthirtyyears.Seaburysawhimselfasaherowhohadsavedthecompanyyearsearlier.Hehadinvestedmillionsofdollarsinitwhenothershadbeentooafraidtokeepthebusinessgoing.Hethoughtthecompanyneededanotherroundofinvestment.Thechairmanwasn’tsosure.

Thechairman’snephewhadwrittenhisHarvardbusiness-schoolthesisonthecompany.Afterhandinginhisessay,hewassoworriedaboutthebusinessthathesoldallofhisshares.Thechairmanreadhisnephew’spaperandrefusedtogoalongwithSeabury’splantoinvestevenmore.ButSeaburywonout.Hepoured millions into the company. It didn’t work. The textile industry inMassachusettswas failing.Nothing Seabury did helped.Depressed, he starteddrinking heavily. Cowin found this out, too and reported it to Buffett. Theydecideditwastimetogoforthethroat.Buffettboughtevenmorestock.

Seabury sawBuffett’snew roundofbuyingasa threat.He responded toBuffett’sgrowingshareholdingbymakingseveraloffers tobuybackBuffett’sstock. This was one of the exits Buffett had thought about before he startedbuying.WhenSeabury’s latest buybackpushed the stockprice to$10,BuffettdecidedtotraveltoNewBedford.HewantedtomeetSeaburyandtalkabouthisplansforanotherbuyback.20

When they met, Seabury asked, “We’ll probably have a tender [for ourownstock]oneofthesedays,andwhatpricewouldyousellat,Mr.Buffet?”

Buffettresponded,“I’dsellat$11.50ashareonatender,ifyouhadone.”

Seaburysaid,“Well,willyoupromisemethat ifwehavea tenderyou’llsell?”

Buffett replied, “If it’s in the reasonably near future, but not if it’s intwentyyearsfromnow.”

“Fine,”agreedSeabury.

Soonafterward,SeaburysentalettertoBuffettandtheothershareholdersofferingtobuybackstockat$113/8.Theamountwas12.5centspersharelessthanBuffett and Seabury had agreed.Buffettwas furious.He decided that hewouldn’t sell his position back to Seabury and Berkshire. He’d take it overinstead.Andhewouldpaymorethan$113/8todoit.

Buffettmovedquickly.First,hewenttoOtisStantontomakeanofferforhisstock.OtisagreedtosellouttoBuffettononecondition:BuffetthadtomakethesameoffertoSeabury.Buffettgladlyagreed.Otis’ssharespushedBuffett’sshareholding to 49 percent, bought at an average price of $15 per share. Thatwasenoughtocontroltheboard.

Buffett then called a specialmeeting of Berkshire shareholders andwaselectedadirector inApril1965.Seaburyandhis son Jack resignedat aboardmeeting amonth later. The board elected Buffett chairman, a position he hasheldsince.Thestockclosedthatdayat$18.

The New Bedford Standard-Times ran a story about the takeover.RememberinghisearlierfightwiththetownsfolkofBeatriceanditslocalpaper,Buffettsaidhewouldnotliquidate.Heassuredthepaperheplannedtorunthebusiness.

Buffett did slowly liquidate Berkshire’s textile business. When he gotcontrol,textileswereBerkshire’sonlybusiness.RatherthanreinvestBerkshire’searnings in textiles as Seabury would have, Buffett directed them to newbusinesses. The textile business just wasted away. He finally shut it down in1985.

In his letter to the shareholders of Berkshire that year, Buffett wrote,“Should you find yourself in a chronically leaking boat, energy devoted tochangingvesselsislikelytobemoreproductivethanenergydevotedtopatchingleaks:”21

Unlessyouarealiquidator,thatkindofapproachtobuyingbusinessesisfoolish.First,theoriginal“bargain”priceprobablywillnotturnouttobesuchastealafterall.Inadifficultbusiness,nosoonerisoneproblemsolvedthananothersurfaces—neveristherejustonecockroachinthe

solvedthananothersurfaces—neveristherejustonecockroachinthekitchen.

Second,anyinitialadvantageyousecurewillbequicklyerodedbythelowreturnthatthebusinessearns.Forexample,ifyoubuyabusinessfor$8millionthatcanbesoldorliquidatedfor$10millionandpromptlytakeeithercourse,youcanrealizeahighreturn.Buttheinvestmentwilldisappointifthebusinessissoldfor$10millionintenyearsandintheinterimhasannuallyearnedanddistributedonlyafewpercentoncost.Timeisthefriendofthewonderfulbusiness,theenemyofthemediocre.

AmericanExpressBuffett met Charlie Munger in 1959. Munger had a huge effect on

Buffett’sinvestmentstyleovertheyears.UntilhemetMunger,Buffettthoughtaboutvaluationonlyintermsofhardnumbers.Hesaidhewantedthefigurestohit him over the head with a baseball bat. Munger thought Buffett was toolimited.

Somebusinesseswere“worthpayingupabittogetinwithforalong-termadvantage,” he said.22 When analyzing an investment, Munger thought moreaboutitssofterqualities.HetriedtogetBuffetttothinkaboutmorethanjustthehardnumbers.

The problem asMunger saw itwas that the stocksBuffett liked usuallyowned bad businesses. Munger didn’t like bad businesses. “The trick,”accordingtoMunger,“istogetmorequalitythanyoupayforinprice.”23

Buffett’s first step downMunger’s roadwas an investment inAmericanExpress,orAmEx,asitisknown.In1963,AmExwaspulledintothe“salad-oil”fraud committed by a client, Tino De Angelis. De Angelis bought and soldsoybeanoil,whichhestoredintanksinhisNewJerseywarehouse.

AmExisbestknownforitsTraveler’sChequesandcreditcards.Butitalsohadasmallerbusinessissuingwarehousereceipts.(Thedocumentsareproofaclient owns a commodity like soybean oil stored in awarehouse.)Warehousereceiptsmakeitpossibletotradeacommoditylikesoybeanoil—sellitbackandforth—withoutmovingthephysicaloil.

AmExgaveDeAngeliswarehousereceiptsfortheamountofsoybeanoiltheythoughtwasinhistanks,whichDeAngelisusedtogetmarginloansagainsttheoilandtradeit.

WhattheAmExinspectorsdidn’tknowwasthatDeAngelishadnotfilledthe tankswith soybeanoil.Hehad tricked them into thinkingheownedmoresoybeanoilthanhedidbypartiallyfillingthetankswithseawater.DeAngeliswassogoodatfoolingtheinspectorsthattheythoughtheownedmoresoybeanoilthantherewasinthewholeworld.

De Angelis was caught when the price of soybean oil plunged and hecouldn’tpayhisbroker.ThedropwassodeepitwipedoutDeAngelisandhisbroker,too.FolkswhohadlentmoneyagainstDeAngelis’swarehousereceiptslookedtoAmExtopaythemback.TheycomplainedAmExshouldhavemadesurethetankscontainedsoybeanoilandnotseawater.Itwasagoodargument.Theywanted$175million,whichwasmorethantentimeswhatAmExearnedin1964. It looked likeAmExwouldbewipedout, too.Themarketcut thestockpriceinhalf.

Buffettbecame interestedwhenhesaw thestockprice fall.AmExwasatough stock to value. It was an insolvent lending business tangled in a fraud.Buffett wasn’t worried about the fraud or the $175million payment. He wasworriedabouthowAmEx’sbusinesscustomersvieweditscredit.Iftheybecameapprehensive, they might stop taking traveler’s cheques and AmEx cards.RestaurantsandsmallhotelscouldgooutofbusinessifAmExwaswipedout.Iftheystoppedacceptingthecards,AmExwasfinished.Buffettwasalsoworriedthat De Angelis’s fraud would stain AmEx’s brand in the minds of AmExcardholders.Ifitdid,peoplemightstopusingtheAmExcards.

Buffettaskedhisbroker,HenryBrandt,tofindoutifrestaurantsandothersmallbusinesseswerestillacceptingAmEx.ThiswasanunusualquestionfromBuffett.Hewasusuallyonlyinterestedtheharddata.Brandtstakedoutbanks,restaurants,andhotels.

Brandt delivered toBuffett a foot-high pile of papers.Buffett read themwith relish. He also visited several restaurants in Omaha. He saw they stillacceptedthecard.Thefraudhadn’thurtAmEx’sbrand.BuffettguessedAmExwouldsurvive.

Buffettusedabout40percent,or$13million,ofhishedgefundtocontroljust5percentofAmEx’sstock.Itwasthelargestbetthefundhadevermadeonasinglecompany.Withassetsofjust$32million,BuffettPartnerswastoosmalltogetcontrolofAmEx.Itcouldonlyeverbeageneral. If thestockpricefell,Buffettcouldn’tkeepbuying.Twoyearspassed.

In1965,AmExpaidDeAngelis’s lenders$60million,$115million lessthan first sought. Buffett’s gamble on AmEx paid off. The stock had tradedbelow$35.Nowitquicklypoppedto$49pershare.Buffettwasup40percentintwoyearsonhisbiggestshareholding.

The key toBuffett’s change of heartwaswhat happened next.Over thefollowingfiveyears,AmExtradeduptoaround$185.Itsbusinesscontinuedtogrow,andBuffett’shedgefund’sholdinggrewwithit.Buffettsoldoutwhenheliquidatedthehedgefundin1969.Afterfiveyears,theshareswereupmorethanfivetimes.

TheAmEx investment showedhimMungerwasonto something.Buffettknew itwasworthat least$50per share if it survived thesaladoilcrisis.ButAmEx’svaluewasnotinitsassets;itwasinitsbusiness.Andthatbusinesskeptgrowing.Combiningagrowingbusinesswithabargainpricemeantgreatreturnsthatkeptgoingyearafteryear.

Mungerwasright.Agoodbusinessboughtattherightpricewasthebetterinvestment.Therewouldbenomorehostilecontrol situations forBuffett.Thereturnswerehigher,butthestocksweretoosmallforhisgrowingbankroll.Andthecompaniesdidn’tgrow.

Buffett said, “Charlie shoved me in the direction of not just buyingbargains,asBenGrahamhadtaughtme.Thiswastherealimpacthehadonme.IttookapowerfulforcetomovemeonfromGraham’slimitingview.ItwasthepowerofCharlie’smind.”24

4.BUFFETT’SWONDERFULCOMPANIESATFAIRPRICES

“It’sfarbettertobuyawonderfulcompanyatafairpricethanafaircompanyatawonderfulprice.”

—WarrenBuffett,“Chairman’sLetter”(1989)

WhenBuffettheardSee’sCandieswasforsale,hesaid,“CallCharlie.”25MungerlivedinCalifornia.HeknewallaboutSee’s.HetoldBuffett,“See’shasanamethatnoonecangetnearinCalifornia…It’simpossibletocompetewiththat brand without spending all kinds of money.”26 Buffett looked at thenumbers.Heagreedhe“wouldbewillingtobuySee’sataprice.”27

Theofferingpricewasskyhigh.HarrySee,thesonofthefounder,wanted$30million for a business with just $8million in hard assets. The extra $22millionon topof thehardassetsboughtSee’s intellectualproperty—itsbrand,trademarks,andgoodwill.Anditboughtabusinessthatearned$2millionaftertaxin1971.

Buffett hesitated; $30 million was a lot of money. But Munger arguedSee’swasworthpayingup for, soBuffett counteredwith$25million.At thatprice,BuffettandMungerwouldpay12.5timesSee’sprofitsand4timesSee’shard assets. It was a huge leap for an investor who liked to buy stocks at afractionofhardassetvalue.

HarrySeedidn’twanttolowerhisprice,butBuffettexplainedthatheandMungerwereatthe“exactdollarlimitofwhattheywerewillingtopay.”28Anyhigher and they would walk. See caved. On January 31, 1972, Buffett andMungerboughtSee’sCandiesfor$25million.

Why was Buffett willing to pay so much? He saw the value in See’s

customer franchise. See’s chocolate was especially high quality. Chocolatelovers preferred it to candy that cost two or three times as much. Also, thecustomerserviceinSee’sshopswas“everybitasgoodastheproduct.”29Itwas“asmuchatrademarkofSee’sasisthelogoonthebox.”30

Together, these qualities created See’s customer franchise. See’s tookcheap raw materials—sugar, cocoa beans, and milk—and turned them intopremiumchocolate. It earned thehighmarginbetween the rawmaterial inputsandthebrandedchocolateoutput.

Inthepast,Buffettwouldhavesoughtalowerprice,perhapsadiscounttothehardassets,togiveamarginofsafety.ButSee’sabilitytomakelotsofprofiton little hard assetsmade itworth a lotmore than its hard assets. See’s highprofitsallowedittogrowquicklyandthrowoffcashatthesametime.ButwhatwasSee’sworth?

See’smade just less than$5millionpretax in1971. It earnedahuge60percent profit on its $8 million in hard assets ($5 million ÷ $8 million = 60percent).Let’sassumeadiscountrateofbetween10and12percent.(In1972,wecouldget6percentleavingourcashinthebank.Weaddonalittleextra—4or6percent—becauseSee’s isriskier thanabankaccount.)Inthatcase,See’swas worth between five and six times its hard assets (60 percent ÷ 10 or 12percent=5or6times).With$8millioninhardassets,See’swasworthbetween$40and$48million(5or6×$8million).

The$25millionpricewasonlyaboutone-halftotwo-thirdsSee’svalue.Inthis light, See’swas a bargain.There is a secret toSee’s.Even ifBuffett hadpaid full price, See’s would still have been an incredible investment. Here’swhy.

In2007,twenty-fiveyearsafterBuffettboughtit,See’searned$82millionon$40millioninhardassets.Thatwasanamazing195percentreturnonassets.Thehugegrowthinprofit—from$5millionto$82million—happenedwithoutmuchmoreinvestedinitshardassets.

See’s paidout toBuffett almost all theprofit itmadebetween1972 and2007:$1.4billion.AndSee’sinvestedonly$32milliontogrowitshardassets($40million–$8million=$32million).BuffettgottousemostofSee’s$1.4

billioninprofittobuyotherhigh-profitbusinessesforBerkshire.

This iswhyBuffettdescribedSee’sas“adreambusiness.”HecomparedSee’s to an ordinary business. He guessed an ordinary business needed about$400millioninhardassetstomakethesame$82millionprofitasSee’s.Buffettmeansanordinarybusinessearnsabout20percentonitsassets($82million÷$400million=20percent).That’sveryhigh.And itwould still beworth lessthanSee’s.

In 1989, Buffett summarized the lesson he learned from See’s into asentence:“It’sfarbettertobuyawonderfulcompanyatafairpricethanafaircompanyatawonderfulprice.”Hecontinued,“Charlieunderstoodthisearly;Iwasaslowlearner.”31

TheBuffettBerkshireStrategy“Itisourjobtoselectbusinesseswitheconomiccharacteristicsallowingeachdollarofretainedearningstobetranslatedeventuallyintoatleastadollarof

marketvalue.”—WarrenBuffett,“Chairman’sLetter”(1982)

With See’s, Buffett moved beyond Graham’s idea of value investing.Buffettstilltriedtobuystocksatabigdiscountfromvalue,butheworkedoutthatvaluedifferently.Grahamsawthevalueinthehardassetsandtriedtobuythem at a discount. Buffett saw the hard assets being only as valuable as thebusiness’sability toprofiton them.Thehigher theprofitonassets, thehigherthevalueofthebusiness.

Forexample,let’ssaywehavetwobusinesses,eachearning$1millioninprofit.Onehas$5millioninassets.That’sthegoodbusiness.Theotherhas$20million inassets.That’s thebadbusiness.Wecan invest in thegoodbusiness,wecan invest in thebadbusiness, orwecan leaveourmoney sitting in long-termbonds.

ReturnonCapital:HighProfitabilityIsWorthMore

Thegoodbusinessearns20percentonits$5millionincapital($1million÷$5million=20percent).Thebadbusinessearns5percenton$20million($1million÷$20million=5percent).Thelong-termbondsyield10percent.Whatarethebusinessesworth?

Valuation:LowReturnonCapitalMeansaDiscount

Thegoodbusiness isworth twice(20percent÷10percent=2 times) itsassets, for example, 2 × $5million= $10million.This is becausewe get thesamereturnfromthelongbondbyinvestingtwiceasmuch.

The bad business earning 5 percent on invested capital is worth half itscapital(5percent÷10percent=0.5 times).Wecalculate it’sworth0.5×$20million=$10millionbecausewecangetthesamereturnfromthelongbond—$1million—byinvestinghalfasmuch.

Bothbusinessesareworth$10million.(Andbothhavethesameprice-to-earnings(PE)multiple:10times.)Grahammighthavepreferredthebadbusinessathalfitstangibleassetvalue.ButBuffettprefersthegoodbusinessattwiceitsassetvalue.Why?

HighReturnonCapital:GrowthCreatesValue

Growth.Eachdollarofprofitreinvestedinthegoodbusinessisworth200centsonthedollarinbusinessvalue(20percent÷10percent=2times).Let’ssay thegoodbusiness reinvests all its$1million inprofit andkeepsup its20percent profitability. The next year, itwill earn $1.2million on $6million incapital.Applying the samemultiple, it isworth $12million.Last year, itwasworth$10million.The$1millionreinvestedinthebusinessisworth$2millioninbusinessvalue.Nextyear,itwillbeworth$14.4millionandsoon.

Contrastthiswiththereturntotheownerofthebadbusiness.Eachdollarreinvestedtherebecomesfiftycentsonthedollarinbusinessvalue(5percent÷10percent=0.5times).Thebadbusinesschewsuphalfofanydollarinvestedinit.How?

LowReturnonCapital:GrowthDestroysValue

Let’s say the bad business reinvests all its $1 million in profit andmaintains its profitability. The next year, it will earn $1.05 million on $21millionincapital.Valuedthesameway,thebusinessisworth$10.5million,just$500,000morethanthelastyear.The$1millionreinvestedinthebadbusinessisworthjust$500,000moreinbusinessvalue.Itturned$1inprofitinto50centsinvalue.Itsgrowthdestroyedvalue.

This is the most surprising result of Buffett’s theory of value. Not allgrowthisgood.Onlybusinessesearningprofitsbetterthantheraterequiredbythemarketshouldgrow.Businesseswithprofitsbelowthat rate turndollars inearningsintocentsonthedollarinbusinessvalue.

Theownerof thegoodbusinesswants thebusiness to reinvest andgrowbecause thatgrowth isprofitable.Theownerof thebadbusinesswantsall theearningspaidoutbecausethegrowthdestroysvalue.

Alas,goodbusinesscan’tabsorbmuchextracapitalwithoutprofitsgoing

down. And bad businesses need all earnings reinvested just to keep up withinflation.

Forabusinesstobeworthmorethanitsinvestedcapital,itmustmaintainaprofit greater than the market requires. In our earlier example, the marketrequired10percent.Formostbusinesses,highprofitsaren’tsustainablebecausethey attract competitors. While they may earn more over a short time, mostbusinesseswillonlyearnamarketreturn—say10percent—onaverageoverthefullbusinesscycle.Recallourearlierdrawingofthebusinesscycle:

BusinessCycle:HighReturnsMeanRevertDown

This,saysBuffett,iswhythemoatissoimportanttothebusiness:32

Atrulygreatbusinessmusthaveanenduring“moat”thatprotectsexcellentreturnsoninvestedcapital.Thedynamicsofcapitalismguaranteethatcompetitorswillrepeatedlyassaultanybusiness“castle”thatisearninghighreturns.Thereforeaformidablebarriersuchasacompany’sbeingthelow-costproducer(GEICO,Costco)orpossessingapowerfulworldwidebrand(Coca-Cola,Gillette,AmericanExpress)isessentialforsustainedsuccess.Businesshistoryisfilledwith“RomanCandles,”companieswhosemoatsprovedillusoryandweresooncrossed.

InhisBerkshireletters,Buffetthaswrittenalotaboutmoats.Buffettwantsspecial businesses with a moat that resist mean reversion. He calls these“economicfranchises.”

This is how Buffett separates an economic franchise from an ordinarybusiness:33

Aneconomicfranchisearisesfromaproductorservicethat:(1)isneededordesired;(2)isthoughtbyitscustomerstohavenoclosesubstituteand;(3)isnotsubjecttopriceregulation.Theexistenceofallthreeconditionswillbedemonstratedbyacompany’sabilitytoregularlypriceitsproductorserviceaggressivelyandtherebytoearnhighratesofreturnoncapital.Moreover,franchisescantoleratemismanagement.Ineptmanagersmaydiminishafranchise’sprofitability,buttheycannotinflictmortaldamage.

Incontrast,“abusiness”earnsexceptionalprofitsonlyifitisthelow-costoperatororifsupplyofitsproductorserviceistight.Tightnessinsupplyusuallydoesnotlastlong.Withsuperiormanagement,acompanymaymaintainitsstatusasalow-costoperatorforamuchlongertime,buteventhenunceasinglyfacesthepossibilityofcompetitiveattack.Andabusiness,unlikeafranchise,canbekilledbypoormanagement.

Theeconomicfranchiseisaspecialbusinessthatearnshighprofits.Crucially,itkeepsupprofitsoverthebusinesscycledespitetheeffortsofcompetitors.Competitioncausestheprofitsofanaveragebusiness—onewithnomoat—toreverttothemean.Franchisesresistmeanreversion.

Franchises:HighReturnsResistMeanReversion

Mostbusinessescandonobetterthanearnamarketreturn.Inpeakyears,theylooklikegoodbusinesses.Introughyears,theylooklikebadbusinesses.

Goodmanagersmaximizeabusiness’s returnon investedcapital.Buffettrecognizes,however,thattherearelimitstowhatmanagementcando:34

Goodjockeyswilldowellongoodhorses,butnotonbroken-downnags…I’vesaidmanytimesthatwhenamanagementwithareputationforbrilliancetacklesabusinesswithareputationforbadeconomics,itisthereputationofthebusinessthatremainsintact.

ThisisBuffett’swonderfulcompany,whichearnsdefensiblehighreturnson capital. It has good economics and resists competition. Good managersmaintainthehighreturnsbypayingoutanycapitalnotneededinthebusiness.Theyalwaysworktoshoreupthebusiness’smoat.

Thestandardwonderfulcompany—thinkSee’sCandies—growswithlittleextracapitalandatahighratewhilepayingoutmostofitsprofits.

As long as the business earns high profits, wonderful companies payinvestors to hold them for the long term. As Buffett quips, “When we ownportionsofoutstandingbusinesseswithoutstandingmanagements,our favoriteholding period is forever.”35 This allows the investment to compoundwithout

payingcapitalgainstax.Itisoneofthemainreasonswonderfulcompaniesaregoodinvestmentprospects.

With this leapmade,Buffett leftGrahambehind.Grahamwarned itwastoohardtotellwhetherhighprofitswereduetogoodeconomicsorapeakinthebusiness cycle. “Corrective forces” Graham said, “are usually set in motionwhich tend to restore profits where they have disappeared, or to reduce themwheretheyareexcessiveinrelationtocapital.”36

BuffettheededGraham’swarning,buthebelievedsomebusinessescouldearn high returns due to their unusual economics.They could resistGraham’scorrectiveforces.

In1989,Buffettboileddown the investment lessonshehad learnedoverthirtyyearsaftermeetingMungerintoasinglesentence:37

It’sfarbettertobuyawonderfulcompanyatafairpricethanafaircompanyatawonderfulprice.

A year later, at sixty, hewould be a billionaire. In the next chapter,welookataneasywaytofindBuffett’swonderfulcompaniesatfairprices.

5.HOWTOBEATTHELITTLEBOOKTHATBEATSTHEMARKET

“Themarket,liketheLord,helpsthosewhohelpthemselves.But,unliketheLord,themarketdoesnotforgivethosewhoknownotwhattheydo.Fortheinvestor,atoo-highpurchasepriceforthestockofanexcellentcompanycanundotheeffectsofasubsequentdecadeoffavorablebusinessdevelopments.”

—WarrenBuffett,“Chairman’sLetter”(1982)

In2006,JoelGreenblattpublishedTheLittleBookThatBeatsTheMarket,where he promised an easyway to findBuffett’swonderful companies at fairprices.Greenblatt is awell-known value investor.He had great returns in hisGothamCapitalfundovertwentyyears,andhehasalonghistoryofresearchingandwritingaboutvalueinvestment.Greenblatt isnowaprofessoratColumbiaUniversity. His Little Book described a test he ran on Buffett’s wonderfulcompaniesatfairprices.

Greenblatt read through Buffett’s Berkshire letters. He broke downBuffett’smethodintoitstwoparts:

1.Awonderfulcompany

2.Afairprice

AWonderfulCompany“I’dratherhavea$10millionbusinessmaking15percentthana$100million

businessmaking5percent.IhaveotherplacesIcanputthemoney.”—WarrenBuffetttoKenChace,President,Berkshire38

Buffett says a wonderful company is one with a high return on equity.Whatdoeshemean?Returnonequitymeasureshowmuchmoneyacompanymakes—the profit—for each dollar invested in it—the equity. The higher theprofitoneachdollarinvestedinthecompany,themorewonderfulitis.

Here’sanexample.Let’ssaywehave twobusinessessellingsoftdrinks:theRed SodaCompany and theBlue SodaCompany.Both sell bottled sodasfromvendingmachines.The companies are identical except for the name andthecolorofthebottle.

They have the same number of vending machines and a bottling plantwherethesodaisputinthebottles.Theyalsoeachownadeliverytrucktomovethesodafromthefactorytothemachines.Theyeachspentthesameamountofmoney—$10 million—building the factory, trucks, and machines. They bothraised the$10million inequity selling stock to thepublic,whichwasused tobuythe$10millioninassets.

Sodadrinkerspreferredsodastobluesodas.RedSodasellsmoresodasatahigherprice thanBlueSoda.At theendof theyear,RedSodahasmade$2millioninoperatingearnings.(Operatingearningsestimatetheincomeflowingtotheownersofacompanybeforeanytaxorinterestispaid.Wewilltalkaboutitinsomedetailinthenextchapter.)

BlueSodahasmade just$1million inoperatingearnings.RedSodahasearned a 20 percent return on equity ($2million÷ $10million= 20 percent).BlueSodahasreturnedhalfasmuch,just10percentonequity($1million÷$10million=10percent).RedSoda ismorewonderful thanBlueSodabecause itmadetwicethereturnonequity.Simple.

AFairPriceThesecondpartofBuffett’s rule isa fairprice.For this,Greenblattused

what he called the “earnings yield.”39We call it the Acquirer’sMultiple. Toavoidconfusion,we’llcall it theAcquirer’sMultiplehere. In thenextchapter,we’ll look at it in detail. It is a little like the PEmultiple,which compares acompany’smarketcaptoitsearnings—itsprofit.ThePEmultipleisagreatruleof thumb to figure out how cheap a company is. The lower themultiple, thecheaperthecompany.

TheAcquirer’sMultipleworks the sameway, but it includesmore datathanthePEmultiple.StockswithlowAcquirer’sMultiplestendtodobetterthanstockswith lowPEmultiplesover time.TheAcquirer’sMultipleworksbetterthanthePEmultiplebecauseitisbetteratworkingoutastock’struepriceanditstrueearnings.

We’llexaminetheAcquirer’sMultipleinsomedetailinthenextchapter.Fornow,knowtheAcquirer’sMultiplemeasureshowmuchyouhavetopayforeach dollar a company makes. The less you have to pay for the operatingearnings,thebettertheprice.Let’sgobacktoRedSodaandBlueSoda.

We already know Red Soda made $2 million and Blue Soda made $1million in operating earnings last year. If we pay the same amount for eachcompany,say$10million,theAcquirer’sMultiplewillbe5forRedSoda($10million÷$2million)and10forBlueSoda($10million÷$1million).

RedSodaischeaperthanBlueSodabecauseitsAcquirer’sMultipleat5islowerthanBlueSoda’sAcquirer’sMultipleat10.Thisis trueeventhoughwepaythesameamountforeach,$10million.AlowerAcquirer’sMultiplemeanswegetmoreoperatingearningsperdollarspentonsharesofRedSoda.

TheMagicFormula

TheMagicFormulaLet’s put the return on equity and the Acquirer’s Multiple together.

Greenblatt is looking for a stock that makes a lot of profit for each dollarinvested in it.At the same time, hewants to pay as little as possible for eachdollaritmakes.Hewantsawonderfulcompanyatafairprice.

MagicFormula=WonderfulCompany+FairPrice

Ifwehave the choice of investing inRedSodaorBlueSoda,wepreferRedSoda.Why?Becauseithasahigherreturnonequity(20percentversus10percent forBlueSoda) and a lowerAcquirer’sMultiple (5versus10 forBlueSoda).RedSodaismorewonderfulandatafairerpricethanBlueSoda.

In2005,Greenblattaskedayoungcomputerprogrammergraduateof theWhartonschooltotesthisRobo-Buffett.TheWhartongradtoldthecomputertolookatthebiggestthirty-fivehundredstocksinadatabaseofUSfinancialdatagoingbackto1988.

In each year, the programgave each stock in the database a rank out of3,500basedonitsAcquirer’sMultiple.Italsogaveeachstockanotherrankoutof3,500basedonitsreturnonequity.Itaddedeachstock’sAcquirer’sMultipleranktoitsreturnonequityranktocreateanewcombinedrankforeachstock.

IfwereturntoRedSodaandBlueSodaexamples,RedSodagetsarankof1outof2foritsAcquirer’sMultiplebecauseitislower.BlueSodagetsarankof2outof2becauseithasahigherAcquirer’sMultiple.BlueSodaalsogetsarankof2outof2for its returnonequitybecause it is lower.RedSodagetsarankof1outof2becauseithasahigherreturnonequity.

IfweaddBlueSoda’s2outof2fortheAcquirer’sMultipleand2outof2forthereturnonequity,itscombinedrankis4(2+2).RedSoda’s1outof2forthe Acquirer’s Multiple and 1 out of 2 for the return on equity gives it acombinedrankof2(1+1).RedSoda’scombinedrankof2islowerthanBlueSoda’scombinedrankof4,soRedSodaisthebetterstock.Weagreedthatwastruebefore,sothisisagoodsystem.

Greenblatt’s computer program did the same thing but for all thirty-fivehundred stocks. It put together a portfolio of the thirty stocks with the bestcombinedrank—thelowestAcquirer’sMultipleandhighestreturnonequity.It

thentrackedtheportfolio’sreturnoverthenexttwelvemonths.Itdidthatonceayearforeachoftheseventeenyearsinthedatabase.

Whenthetestingwasfinished,Greenblatt lookedattheresults.Hefoundthem “quite satisfactory.”40 He called the combined wonderful-company-at-a-fair-pricestrategytheMagicFormula.

TestingtheMagicFormulaWe updated Greenblatt’s research for this book. We started our test in

1973andtestedeachoftheforty-fouryearsuntil2017.Greenblatt’sportfoliosofthirtymagicformulastockswouldhavemade16.2percentperyear.Toputthisin context, investing at 16.2 percent per year for forty-four yearswould haveturned$10,000 intoover $7.6million (before costs and taxes).Over the sametime,theS&P500returnedjust7.1percenteachyear.Themarketwouldhaveturned the same$10,000 into just $205,481.There’s no question,Greenblatt’sRobo-Buffettisagreatsuccess.

The smallest company in Greenblatt’s thirty-five-hundred-stock databasehadamarketcapofjust$50millionin2005.Whataboutbiggercompanies?In2005,Greenblattlimitedthedatabasetothelargesttwenty-fivehundredstocks.Thesmallestcompanyhadamarketcapof$200millionin2005.

Theaverageyearly returnwentup to17.2percent,whichwasmore thandouble the market’s return. In a database limited to the largest one thousandstocks, thesmallestcompanyhadamarketcaparound$1billion in2005.Themagic formula returned of 16.2 percent yearly on average. These are greatresults.

$10,000InvestedintheS&P500andMagicFormula(1973to2017)

ThirtyStockswithMarketCap$1BillionandAbove

ThesetestsofGreenblatt’sMagicFormulashowitwouldhavebeatenthemarketbyawidemargin.

Ifmosthighlyprofitablebusinessesmeanrevert to lowerprofits,whydoMagicFormulastocksbeatthemarket?IsitbuyingamixofBuffett’swonderfulbusinessesandsomefairbusinessesatacyclicalpeak?Whatifweremovetheneedforhighprofitsandjustbuyundervaluedcompaniesusing theAcquirer’sMultiple?Whatifwebuyfaircompaniesatwonderfulprices?

6.THEACQUIRER’SMULTIPLE

“Intheoldlegendthewisemenfinallyboileddownthehistoryofmortalaffairsintothesinglephrase,‘Thistooshallpass.’”

—BenjaminGraham,SecurityAnalysis(1934)

The Acquirer’s Multiple is an industrial-strength PE multiple. It’s athrowback to the corporate raiders and buyouts of the 1980s. In dusty, oldfinancejournals, it isdescribeditas theAcquirer’sMultiplebecausecorporateraidersandbuyoutfirms—theacquirers—usedittofindwholecompaniescheapenough to take over.Wheremost investors only look at profits, the corporateraiders looked to see what a company owned. They used it to find treasurehiddeninplainsightoncorporatebalancesheets.

The Acquirer’s Multiple compares the total cost of a business to theoperating income flowing into the company. It assumes the acquirer can sellassets,payoutthecompany’scash,orredirectthebusiness’scashflows.

Itisapowerfultoolbecauseitrevealshiddencashandhiddencashflows.Italsouncovershiddentrapsandcompaniescarryinghugedebtloads.

The Acquirer’s Multiple is the enterprise value divided by operatingearnings.

Thinkof theenterprisevalueas thepriceyoupayandoperatingearningsasthevalueyouget.ThelowertheAcquirer’sMultiple,themorevalueyougetfor thepriceyoupay and thebetter the stock.Let’s look at eachof theparts:

enterprisevalueandtheoperatingearnings.

EnterpriseValue:HowtoBuyaStockforFreeTheenterprisevalue isanx-ray into thecompany. It is the totalpricean

acquirerof acompanymustpay.What’s thedifferencebetween theenterprisevalueandthemarketcap?

Marketcaptellsushowmuchitcoststobuyallofacompany’sshares.Itis thenumberwewouldarriveat ifwecountedallofacompany’ssharesandmultiplieditbythestockprice.

MarketCapandaShare:PizzaandaSlice

Therelationshipofsharepriceandmarketcapiseasytovisualizeaspizza.Marketcapisthewholepizza,andeachshareisaslice.Ifwedon’tknowhowmanyslicesareinthepizza,thepriceofapiecetellsusnothingaboutthepriceofthewholepie.

Piesthesamesizecanbecutintofour,eight,orsixteenpiecesormore.Weneedtoknowthepriceofeachpieceofpizza—eachshare—andthenumberofpiecesinthepie—sharesonissue—toknowthetotalprice—marketcap.

For example, if the share price is $10, and there are 8million shares onissue,themarketcapis$80million($10pershare×8millionshares).Market

capgoesupanddownwiththestockprice.Ifthestockpricegoesupto$20,themarket cap goes up to $160million ($20per share× 8million shares). If thestockpricegoesdownto$5,themarketcapgoesto$40million($5pershare×8millionshares).

MarketCapandSharePrices:UpandDown

Themarket capwill also goup anddownwith the number of shares onissue. If the company issues more stock, the market cap will go up. If thecompany buys back stock, the market cap will go down. Even if we’re onlygoingtobuyafewsharesandnotthewholecompany,weshouldthinkaboutthewholecompany.Doingsomakesusawareofshareissuesandbuybacks.

Somenewinvestorsmakethemistakeofthinkingthepriceofasharetellsus how expensive the company is. They think a $10 share is twice as big orexpensiveasa$5share.Thisisn’tright.Untilweknowhowmanysharesareonissue,wedon’tknowwhichcompanyisbiggerormoreexpensive.

Let’ssaythecompanywith$10shareshas4millionsharesonissue.Theother companywith $5 shares has 8million shares on issue. Both companieshavethesamemarketcapof$40million($10×4millionand$5×8million=

$40million).(Andwestilldon’tknowwhichismoreexpensive.Westillhavetocomparewhatwe’repayingwithwhatwe’regetting.)

MarketCap,Shares,andPrices:HowMany?

Toknowthetotalpriceofacompany’sstock,wemustknowbothitsstockpriceandthenumberofsharesonissue.Thisisthemarketcap.Butit’snotthewholestory.

EnterpriseValue:TheWholeIceberg

Enterprisevaluetellsushowmuchitcoststobuyallofthestockandallofthedebt(andotherthingslikedebt).It’slikelookingataniceberg.Marketcapisthebitpokingabovethewater.It’seasytosee.It’stherestoficebergunderthewaterline—the debt—that sinks big ships. That’s why we look there, too.Sometimeswefindgoodnews;thecompanyhaslotsofcashandnodebt.Thatmakesitcheaperthanitappears.

Let’ssaywehavetwostocksthatarethesameineverywaybutone.Bothhaveamarketcapof$10million.Onehas$5millionindebt,andtheotherhas$5millionofcashinitsbankaccountandnodebt.Whichoneischeaper?Thecompanywith$5millionincashischeaperthantheonewith$5millionindebt.Butwecan’ttellfromthemarketcapalone.Bothhaveanidenticalmarketcapsof $10million.Why is the companywith $5million in cash cheaper than thecompanywith$5millionindebt?Let’slookatwhathappenswhenweacquireallofthesharesofeachcompany.

Ifwespend$10millionbuyingthecompanythatowes$5millionindebt,wenowownacompanywith$5million indebt.Wehave toservice thedebt.Whatwecantakeoutof thecompanywillbecutbythecost tocarrythedebtuntil we pay it off.What about the company with $5 million in cash? If we

spend$10millionbuying thatcompany,wecan immediatelyuse thecashandanyprofits.Thecompanyonlycostus$5millionbecausewegotthecashback.

EnterpriseValue:DebtisBadandCashisGood

Howwouldtheenterprisevaluetreatthesetwocompanies?Theenterprisevaluepenalizesthecompanywithdebtbyaddingthedebtontothemarketcap.Itrewardsthecompanywithcashbytakingawaythecashfrommarketcap.Thecompany that owes $5million in debt has an enterprise value of $15million($10millioninmarketcap+$5millionindebt).Thecompanywith$5millionin cash has an enterprise value of $5 million ($10 million market cap – $5millioncash).

Why is debt important? Let’s use General Motors (GM) as a real-lifeexample.In2005,GMhadamarketcapof$17billionanddebtof$287billion.Ifweonly lookedatGM’smarketcap,wewouldhavemisseditshugepileofdebt.Adding thedebt toGM’smarketcapgaveanenterprisevalueofat least$304 billion.UsingGM’s enterprise valuewould allow us to see itwas a lotbiggerthanitsmarketcapsuggested.WhenGMfiledforbankruptcyin2009,itshugepileofdebtwasamajorreason.

Theenterprisevalueincludestwootherimportantcoststhatarelikedebt:preferred stock and minority interests. Preferred stock is stock that pays itsholderapreferreddividend.(Itispreferredbecauseitispaidbeforethecommonstockdividendandhassomeotherrightsthecommonstockdoesn’thave.Ifthecompanydoesn’thaveenoughmoneytopayboth,itcanonlypaythedividendonthepreferredstock.)

Itislikedebtbecausethedividendisfixedandmustbepaidregularly,justlike interest.Theenterprisevaluepenalizescompanieswithpreferred stockbyaddingthepreferredstockontothemarketcap.Acompanywitha$10millionmarket cap and $10million in preferred stock has an enterprise value of $20million($10million+$10million=$20million).

A minority interest is a small stake in a company’s business owned bysomeoneelse.Ifweownallofacompanyandsomeoneelseowns10percentofthebusiness,weonlyown90percentofthebusiness.Toownallofthebusiness,wehavetonegotiatewiththeotherpartytobuyouthisorherminorityinterest.Enterprisevaluetreats theminority interestasanotherdebt.Itmustbepaidbyanacquirerofthewholecompany,justlikedebtorpreferredstock.

NegativeEnterpriseValue:ExtraCashIsGreat

Companies with enterprise values of $0 (and less) do exist. A low ornegativeenterprisevalueisagoodthingtofind.Itmeansthecompanyhaslittledebtandlotsofcashrelativetothemarketcap.

Themarketistellingstockswithnegativeenterprisevaluesthebusinessisworthlessthannothing.Ifyoubuyastockwithanegativeenterprisevalue,youarebeingpaid—indirectly—tobuythestock.Youcouldusethecompany’sowncashtobuyallof itsshares.Inpractice,stockswithlowornegativeenterprisevaluesoften(butnotalways)ownbadbusinesses.Theyburnlotsofcash.

Forexample,let’ssayacompanyhasa$50millionmarketcapand$100million incash. Ithasanenterprisevalueof–$50million($50million–$100million = –$50 million). Companies with negative enterprise values attractactivistswhocanredirectthecashtootheruses.Theycanliquidatethebusinessandpocketthecashleftoverafterpayingallthecosts.

AswelearnedwithGM,anenterprisevaluemuchbiggerthanthemarketcapmightsuggestthecompanyhasalotofdebt(orpreferredstockorminorityinterests). It ismoreexpensive than itappearsby lookingatmarketcapalone.Thisiswhywesaytheenterprisevalueisthetruepriceofacompany.

OperatingEarningsIn his letters to shareholders,Warren Buffett often writes that he tracks

“operatingearningsbefore interestandtaxes.”AtBerkshire,hesayshis“mainfocusistobuildoperatingearnings.”41Sowhatareoperatingearnings?

Buffett says, “The ‘operating earnings’ of whichwe speak here excludecapital gains, special accounting items and major restructuring charges.”42Operating earnings is the income that flows from a business’s operations. Itleavesoutinterestandtaxes.Italsoleavesoutunusual,one-offthingslikegainsfromsellinganassetorsettlingalawsuit.Theone-offitemsareleftoutbecausetheywon’toccuragaininthefuture.Theydon’tshowtheusualoperationsofthebusiness.

Operating earnings are not reported in a company’s financial statements.Theymustbeworkedoutfromthem.Theyaredefinedfollows:

OperatingEarnings=

Revenue-CostofGoodsSold-Selling,General,andAdministrativeCosts-DepreciationandAmortization

Ifwe compare the earnings number reported by a company—the bottomline—to its operating earnings, thedifferencebetween the twowill be interestand taxes.Whenworkingoutoperatingearnings,weaddback interestand taxbecauseinterestistax-deductible.Theamountofinterestacompanypaysonitsdebtaffectstheamountoftaxitpays.

OperatingearningsareverysimilartoearningsbeforeinterestandtaxesorEBIT.Manytimes, thenumberswillbeidentical.ButoperatingearningsdifferfromEBITbecausetheoperatingearningsfigureisworkedoutfromthetopofthe income statement down, and EBIT is worked out from the bottom up.Calculating operating earnings from the top down standardizes the metric,making a comparison across companies, industries, and sectors possible. Byexcluding special items—income that a company does not expect to recur infutureyears—ensuresthattheseearningsarerelatedonlytooperations.

Investorsuseoperating earnings tomake an apples-to-apples comparisonbetweenstocks.Forexample,let’ssaywehavetwoidenticalcompanies,butonehasalotofdebt,andtheotherhasnone.Thecompanywithalotofdebtwillpayalotofinterest,anditstaxwillbelower.Itwillhavealowernetincome.Thecompanywithnodebtwillpaynointerestandmoretax.Itwillhaveahighernetincome.

Addingbacktheinterestandtaxallowsustocomparetheearningsofthetwo companies. When we do, we will see the businesses made the sameoperatingearnings.Theyareidentical,sotheyshouldbeworththesameamount.Operatingearningsallowsanapples-to-applescomparisonbetweenstockswithdifferentmixesofdebtandequity.

HowToUseTheAcquirer’sMultipleIfwedivideastock’senterprisevaluebyitsoperatingearnings,wegetits

Acquirer’sMultiple.Howdoweuseit?LikethePEmultiple,wecancomparetwo different companies to see which is cheaper. The lower themultiple, the

better.AnAcquirer’sMultipleof5ischeaperthananAcquirer’sMultipleof10.Let’slookatsomeexamples.

Let’s say we have two companies. The first has a market cap of $10million: $5 million in cash and operating earnings of $1 million. It has anenterprisevalueof$5million ($10million–$5million). It has anAcquirer’sMultipleof5($5million÷$1million).

The second has a market cap of $10 million: $5 million in debt andoperatingearningsof$1million.Ithasanenterprisevalueof$15million($10million + $5million). It has an Acquirer’sMultiple of 15 ($15million ÷ $1million).

The firstcompanywith the lowerAcquirer’sMultiple ischeaper.This istrue even though the companies have the same size market cap ($10 millioneach) and operating earnings ($1million each). The debt and cashmakes thedifference.

HowdowedecidebetweenastockonanAcquirer’sMultipleof20andabank account earning 5 percent? Are they comparable? Roughly. Operatingearningsaren’tdirectlycomparabletointerestbecausewecan’tspendthem.Wecan spend interest. Remember,we have to account for any debt the companyhas. The interest payments will affect the tax paid and the net income thecompanymakes.

The Acquirer’s Multiple is best for comparing two or more companies.Andthat’showweuseit.Weworkitoutforeverycompanylistedonthestockmarket.Thenwe lookfor themostdeeplyundervalued—thosewith the lowestAcquirer’sMultiple.

HowdoestheAcquirer’sMultiplestackupagainsttheMagicFormula?

7.THESECRETTOBEATINGTHEMARKET

“Afact,oncelogicallyarrivedat,shouldnotbeextendedbeyonditsnaturalsignificance.”—JohnLeCarré,AMurderofQuality(1962)

In2017,IaskedEuclideanTechnologies,Inc.torunanindependenttestofthe Acquirer’s Multiple and the Magic Formula. Euclidean is a quantitativevalue-investmentfirmbasedinSeattle,Washington,runbyMichaelSecklerandJohnAlberg,whoarepioneersintheapplicationofmachinelearningtoequityanalysis.EuclideanhasdevelopedoneofthebestdatabasesoffinancialdataforresearchintheUnitedStates.

Euclidean simulated portfolios of thirty stocks from 1972 to 2017.PortfoliosofAcquirer’sMultiple stockswerecompared toportfoliosofMagicFormula and the market. Euclidean ran the test in each of Greenblatt’s threeuniverses:stockswithamarketcapsbiggerthan$50million,$200million,and$1 billion. The results are stunning. (For details on the simulation, see theappendix.)

MarketCap$50MillionAndAbove

$10,000InvestedinAcquirer’sMultiple,MagicFormula,andS&P500(1973to2017)

Inour$50millionmarket-captest,theAcquirer’sMultiplebeattheMagicFormula.BothbeattheS&P500.TheAcquirer’sMultiplecompoundedat18.6percentyearly.TheMagicFormulamanagedarespectable16.2percentyearly.

That small advantage to the Acquirer’s Multiple made a big differenceover the full forty-four years. A theoretical $10,000 invested in each strategybecame$18.7millionfortheAcquirer’sMultipleand$7.6millionfortheMagicFormula.

MarketCap$200MillionAndAbove

$10,000InvestedinAcquirer’sMultiple,MagicFormula,andS&P500(1973to2017)

Inour$200millionmarket-captest,theAcquirer’sMultiplealsobeattheMagicFormulabutbyasmallermargin.Again,bothbeat theS&P500.Inthelargeruniverse,theAcquirer’sMultiplecompoundedat17.5percentyearly.TheMagicFormulaaveraged17.2percentannually.

ThattinyadvantagetotheAcquirer’sMultiplemadealittledifferenceoverthefullforty-fouryears.Atheoretical$10,000investedineachstrategybecame$12.6 million for the Acquirer’s Multiple and $11.2 million for the MagicFormula.

MarketCap$1BillionAndAbove

$10,000InvestedinAcquirer’sMultiple,MagicFormula,andS&P500(1973to2017)

Finally, inourbiggest$1billionmarketcap test, theAcquirer’sMultiplebeattheMagicFormulabyawidemargin.BothbeattheS&P500.Inthebiggestuniverse, the Acquirer’s Multiple compounded at 17.9 percent yearly. TheMagicFormulaaveraged16.2percentannually.

That small advantage to the Acquirer’s Multiple made a big differenceover the full forty-four years. A theoretical $10,000 invested in each strategybecame$14.9millionfortheAcquirer’sMultipleand$7.6millionfortheMagicFormula.

In each universe chosen byGreenblatt, the Acquirer’sMultiple beat theMagicFormula.(Formoredetailonthesimulatedreturns,refertotheappendix.)

What caused theAcquirer’sMultiple to beat theMagic Formula?Meanreversion.Choosingstocksonhistoricalprofitabilityreducesreturns.Toshowit,we created a new strategy that only buys stocks with the highest profits. Itdoesn’tlookatvalue.WecallitPureCharlieinhonorofCharlieMunger’sPoorCharliefromPoorCharlie’sAlmanac.

PureCharlie is theoppositeof theAcquirer’sMultiple.He ispureprofitand is all about return on invested capital. He buys the thirty stockswith thehighest profits. He doesn’t care about value at all. Here’s how Pure CharliestacksuptotheAcquirer’sMultipleandtheMagicFormulainthesametest.

MarketCap$50MillionAndAbove

$10,000InvestedinAcquirer’sMultiple,MagicFormula,andPureCharlie(1973to2017)

In our $50millionmarket-cap test, both theAcquirer’sMultiple and theMagic Formula beat out Pure Charlie. Notably, Pure Charlie still beat themarket.(It’snotabadstrategy.)PureCharliemanagedareasonable15.1percentyearly. Over the full forty-four years, a theoretical $10,000 invested in PureCharliebecame$5.1million.

MarketCap$200MillionAndAbove

$10,000InvestedinAcquirer’sMultiple,MagicFormula,andPureCharlie(1973to2017)

Inour$200millionmarket-captest,boththeAcquirer’sMultipleandtheMagicFormulaagainbeatoutPureCharlie,who returned14.8percentyearly.PureCharliebeat themarketagain.Overthefullforty-fouryears,a theoretical$10,000investedinPureCharliebecame$4.5million.

MarketCap$1BillionAndAbove

$10,000InvestedinAcquirer’sMultiple,MagicFormula,andPureCharlie(1973to2017)

Inourbiggest$1billionmarket-captest,boththeAcquirer’sMultipleandtheMagicFormulabeatoutPureCharlie.PureCharliereturneda13.7percentyearly. Pure Charlie still beats the market. Over the full forty-four years, atheoretical$10,000investedinPureCharliebecame$2.9million.

PureCharlie is not a bad strategy.Buyingportfoliosof highlyprofitablecompaniesworks.Butitdoesn’tbeattheMagicFormula,whichlooksatvalue,too.Ofcourse, lookingpurelyforvalueworksbest.That’swhytheAcquirer’sMultiplebeatsboth.(Formoredetailonthesimulatedreturns,pleaserefertotheappendix.)

These results aren’t unusual. Dresdner Kleinwort, an investment bank,foundthesamethingintheUnitedKingdomandEuropeinatestfrom1993to2005.43TheAcquirer’sMultiplebeattheMagicFormulaineachofthoseplacesover the same time.Only in Japandid theMagicFormulagive theAcquirer’sMultiplearunforitsmoney.

DresdnerKleinwort found chasingwonderful companies shrinks returns.ThegainsfromusingtheAcquirer’sMultiplebyitselfare“sizeable.”Thebesttheysaid for theMagicFormulawas that itwouldhavehelped theAcquirer’sMultiplekeepupwiththemarketinthedot-combubble.Undervaluedstocksfellbehind in the frothy boom from1997 to 1999.TheDresdnerKleinwort paperconcluded,“Ingeneralwefindthatthevaluestrategyisverypowerful.”

There is also a 2009 paper by Loughran andWellman on the enterprisemultiple,acloserelativeoftheAcquirer’sMultiple.Itconcludedtheenterprisemultiplewas a “highly significantmeasure of relative value…for virtually theentireuniverseofUSstocks”:44

Inotherwords,ourresultsmayactuallyberelevanttobothWallStreetandacademics.

WhydoestheAcquirer’sMultiple’sbeattheMagicFormula?Whydofaircompanies at wonderful prices beat wonderful companies at fair prices? AnolderstudybyGreenblattholdsaclue.

Greenblatt’sCigarButts“Ourstatisticalscreensaremerelyexploitingagroupofundervaluedstocksthatareeasilyidentifiedandarefurtherprotectedbystrongbalancesheetsandlargeassetvalues.Additionally,becauseofthedepressednatureandliquidmake-upofthecompaniesthatmeetourtestcriteria,theyareoftentheobjectoftakeover

initiatives.”—JoelGreenblatt,“HowTheSmallInvestorBeatsTheMarket”(1981)

In 1976, nineteen-year-old JoelGreenblatt read about BenjaminGrahamforthefirsttime.HereadaForbesMagazinearticlecalled“BenGraham’sLastWill andTestament.” It described an interviewGrahamgave to theFinancialAnalystsJournaljustmonthsbeforehisdeathin1976.

Inthearticle,Grahamsaidhewasnolongerinfavorofcomplicatedwaysofvaluingstocks.Allthatheneededwereafewsimpletools.

The important idea was to buy a group of stocks meeting some simpleyardstick for undervaluation. Graham said he would pay little mind to each

stock.

Graham suggested investors use his cigar-buttmethod, the samemethodBuffettusedinhishedgefundtofindSanbornMapsandDempsterMills.Thismethodlooksforstockswithmorecashandotherliquidassetsthandebt.Thenitbuys only those stocks at a big discount to the net value.Graham said itwas“foolproof”and“unfailinglydependable.”45

Greenblattwasastudentat theWhartonSchoolwhenhereadthearticle.He was intrigued. He decided to test Graham’s method. With his classmatesRichPzenaandBruceNewberg,GreenblattreadthroughapileofoldStandardandPoor’sstockguides.ThethreewantedtofigureoutthereturnstoGraham’scigar-buttstocks.

Theydecidedtotestthereturnsthroughatimeofbigmarketmoves.TheychosethevolatilesixyearsfromApril1972throughApril1978,whichincludedthe1974stockmarketcrashwhenthemarketalmosthalved.Italsoincludedthestrongrecoverythatsawthemarketdouble.

Theyhadtovalueeachstockandtrackitsreturnsbyhand.Itwasabigjob.TheylimitedthestudytostocksstartingwiththelettersAorBthatwerebiggerthan$3million.

Thissampleincludedabout750stocks.Thatwasabout15percentof thestocks listed in the Standard and Poor’s stock guides. After months ofpainstaking testing, Greenblatt, Pzena, and Newberg had some results. TheyfoundGraham’scigarbuttsbeatthemarketbyalot,morethan10percenteachyear.

Greenblatt wrote up the results. The article appeared in the Journal ofPortfolio Management in 1981 and was called “How the Small Investor CanBeattheMarket.”

Inthearticle,Greenblatt,Pzena,andNewbergasked,“Whydoesitwork?”They answered, “Wewere unable to discover any ‘magic’ qualities associatedwithstockssellingbelowliquidationvalue”:46

Simplystated,bylimitingourinvestmentstostocksthataccordingto

Simplystated,bylimitingourinvestmentstostocksthataccordingtofundamentalnotionsofstockvaluationappearseverelydepressed,wewereabletolocatemorethanourshareoftheseinefficientlypriced,undervaluedsecurities.Inotherwords,thereareprobablymanymoreundervaluedstocksthatarenotsellingbelowliquidationvalue.

Grahamwas right. Buying a group of stocks using his simple cigar-buttruleworked.OtherstudiesconfirmGreenblatt’sresults.

In 1983, Henry Oppenheimer tested Graham’s cigar-butt rule again.OppenheimerwasthenanassociateprofessoroffinanceattheStateUniversityofNewYork.He lookedat the returnsover thirteenyears from1970 to1983.Oppenheimerfoundtherulebeatthemarket.

With Jeffrey Oxman and SunilMohanty, we tested Graham’s cigar-buttruleovertwenty-fiveyearsfrom1983to2008.Wefounditbeatthemarket,too.Whydoesitwork?

First,thestocksareundervalued.Andthemoreundervaluedtheyare,thebigger the return. Graham’s instinct about the margin of safety is right. Thegreaterthediscount,thebiggerthegain.

For each stock, Oppenheimer worked out the discount to its cigar-buttvalue.Heputthestocksintofivegroups,fromthemostundervaluedtothemostexpensive.Themostundervaluedgroupbeatthenextgroupandsoon.Themostexpensive group had the lowest returns.Themost undervalued group beat themostexpensivegroupbymorethan10percentayear.

Oppenheimer’s second finding is his most interesting one. He split thestocksintotwogroups.Onehadonlyprofitablestocks,andtheother,onlylossmakers.Oppenheimerfoundthelossmakersbeattheprofitablegroup.

Histhirdfindingisalsointeresting.Hesplittheprofitablegroupagain.Thefirstgroupwascomprisedofdividend-payingstocks.Thesecondgrouppaidnodividend.Oppenheimerfoundthestocksthatdidn’tpayadividendbeattheonesthatdid.

We agreedwithOppenheimer.Cigar butts beat themarket.Loss-making

cigarbuttsbeatprofitableones.Cigarbuttsthatdidn’tpayadividendbeatthosethatdid.Why?

Inshort,meanreversion.

Weexpecttofindthewiderthediscounttovalue,thebetterthereturn.Theotherfindingsareunexpected.Butbothfitourtheoryofmeanreversion.

Meanreversionpushesupthebeaten-downpricesofundervaluedstocks.Itpushesupbeaten-downbusinesses,too.

The key to maximizing returns is to maximize our chance at meanreversion. That means maximizing the margin of safety. We want the mostundervaluedstocks.Andwewanttomakesuretheysurvivetomeanrevert.

Awidemarginofsafetyisimportantbecauseitgivesmeanreversiontimetoworkitsmagic.HerearesomesimpleruleswecantakefromtheAcquirer’sMultipleandGraham’scigar-buttstudiestomaximizethemarginofsafety.

TheSecret:MarginofSafetyInSecurity Analysis,Grahamwrote that if asked to “distill the secret of

soundinvestmentintothreewords,”hewouldsay“marginofsafety.”

Wefindthemarginofsafetychieflyinthediscounttovalue.Butitisalsoa test of the balance sheet and the business.Here are three rules covering themarginofsafety:

1. The greater the company’s discount to its value, the bigger themarginofsafety.Thebiggerthemarginofsafety,thebetterthereturn and the lower the risk.Awide discount allows for theordinary errors in calculations of value, and it allows for anydropinvalue.Thisbreaks the receivedwisdomof themarket.And financialacademicsignoredit.Boththinkhigherreturnsmeanmorerisk.

2.Findamarginofsafetyinacompany’sbalancesheet.Many,many

stockshavesunkduetotoomuchdebt.Weneedtomakesurethe stocks havemore cash than debt or that the debt is smallrelativetothebusiness.TheAcquirer’sMultiplefavorsexactlythesestocks.

3. Find amargin of safety in a company’s business. The companyshould own a real business, which should have historicallystrong operating earnings with matching cash flow, whichconfirmstheaccountingearningsarereal.Itmeanstheyarenotthecreationofacleverembezzler’smind.Weshouldalsolookfor signs of earningsmanipulation. This can be the first stepdowntheroadtofraud.

Companies that own science experiments or toys in search of a businessmodelareforspeculators.Butweakcurrentprofits inastockwithagoodpastrecordcreatesagoodchancefordeep-valuecontrarianstozig.

8.THEMECHANICSOFDEEPVALUE

“Aboveall,helikeditthateverythingwasone’sownfault.Therewasonlyoneselftopraiseorblame.Luckwasaservantandnotamaster.Luckhadtobeaccepted with a shrug or taken advantage of up to the hilt. But it had to beunderstood and recognized for what it was and not confused with a faultyappreciationoftheodds,for,atgambling,thedeadlysinistomistakebadplayforbadluck.Andluckinallitsmoodshadtobelovedandnotfeared.”

—IanFleming’sJamesBond,CasinoRoyale(1953)

MichaelJ.Mauboussinhasstudiedwhatmakeswonderfulbusinessesstaywonderful.HeistheheadofglobalfinancialstrategiesatinvestmentbankCreditSuisse.LikeGreenblatt, he’s also an adjunctprofessorof finance atColumbiaBusiness School. He’s written four books on value investing and behavioralfinance. In 2012, he published a fantastic book called The Success Equation,wherehelooksatwhathappenstogreatbusinessesovertime.

Whydo fair companiesatwonderfulpricesbeatwonderful companiesatfair prices?Becausegreatbusinessesdon’t staygreat.Theyonly lookgreat atthe top of their business cycle.Mean reversion pushes great business back toaverage.

Rememberthatagreatbusinessisonethatisunusuallyprofitable.Itmakesmoremoney for each dollar invested in it than other businesses.Mauboussinfindsthatastimegoeson,mosthighlyprofitablebusinessesseeprofitsfalluntilthe businesses become average. A tiny handful keep profits up, but we don’tknowhowtheydoit.Wecan’ttellthefewthatcanmaintainhighprofitsfromthemanythatbecomeaverage.It’srandomchance.

Mauboussin showed how unusually high or low profits trend toward theaveragebytrackingonethousandcompaniesfrom2000to2010.Herankedthebusinessesoneconomicprofit—howwonderfuleachwas—intheyear2000.1Heputthemintofivegroups.Thetopgroupwasthemostprofitable.Thesewerethegreat businesses. He put the bad businesses in the bottom group. These, onaverage,lostmoney.

Thechartbelowshowstheresults.Foreachofthefivegroups, thereisacleartrendtowardaverageprofits.Thehighlyprofitablecompaniesbecomelessprofitable. The loss makers lose less money. All trend toward averageprofitability.

MeanReversion:ProfitTrendsTowardAverageSource:MichaelJ.Mauboussin,TheSuccessEquation:UntanglingSkillandLuckinBusiness,Sports,and

Investing.(Boston:HarvardBusinessReviewPress),2012.

Thereasongreatbusinessesbecomeaveragebusinessesismeanreversion.Thingsgobacktonormal.Itmeansprofitsmovebacktowardtheaverageovertime.Agreatbusinessisanoutlier.Itismoreprofitablethanaverage.Overtime,competitorseatawaytheunusuallyhighprofitsuntilthebusinessearnsaverageprofits.

This also happens to bad businesses, which are less profitable thanaverage.Overtime,competitorsleavetheindustryuntilthebusinessesthatstayearnaverageprofits.Thisisthemachineryofmeanreversion.

Somebusinessesdokeepupoddlyhighprofits.Mauboussinfoundatinyhandfulofstockskepthighprofitsfromstarttofinish.Buthecouldnotfindthe

reasonswhy.Andhecouldn’tfindthethingsthatpredictwhichbusinesseswillkeep up high profits. All he could say for sure is that some businesses stayhighlyprofitable,whilemostgobacktoaverage.

WarrenBuffettcanpicktheneedlesfromthehaystack.Hecanfindthesecompanieswith“moats”thatprotectthemfromcompetitors.Withoutthemoat,competitorsstormthegatesandpushthehighreturnsbacktowardtheaverage.Fewcompanieshaveamoat.Evenmostseeminglygreatcompaniesdon’thaveone.Forthisreason,mosthighlyprofitablecompaniesseeprofitsfallovertime.

Hereisthesimpletruth:profitsmovetowardtheaverageovertime.Onlysome stocks avoid it, and we don’t know why. Without Buffett’s genius forbusinessanalysis,wecan’trelyonahigh-profitbusinessstayingthatway.Thisis why fair companies at wonderful prices beat wonderful companies at fairprices.

Straight-LineErrors“Ourstatisticalscreensaremerelyexploitingagroupofundervaluedstocksthatareeasilyidentifiedandarefurtherprotectedbystrongbalancesheetsandlargeassetvalues.Additionally,becauseofthedepressednatureandliquidmake-upofthecompaniesthatmeetourtestcriteria,theyareoftentheobjectoftakeover

initiatives.”—JoelGreenblatt,“HowTheSmallInvestorBeatsTheMarket”(1981)

WernerDeBondtandRichardThalerareeconomistswhostudy investorbehaviorandstockprices.Theyareknownasbehavioraleconomists. In1987,DeBondtandThalerhadanidea.Stocksgetundervaluedorexpensivebecauseweoverreact.Meanreversionislikely.Butwe“extrapolate”theprofittrendtoofar. We draw a straight line through the recent profits and assume the trendkeepsgoing.

Overreaction:TheProfitTrendExtrapolatedTooFar

Investorsexpect stockswithprofits thathavegoneup for a fewyears tokeepgoingup.Andtheythinkstockswithafewyearsoffallingprofitswillkeepgoingdown.

Stocks with rising profits get expensive because investors expect theprofits to keep going up.And stockswith falling profits become undervaluedbecauseinvestorsexpecttheearningswillkeepfalling.Inotherwords,investorsdon’t expect profits tomean revert.But they’rewrong.Mean reversion is thelikelyoutcome.

DeBondtandThalertestedtheideabyfindingundervaluedandexpensivestocksand then tracking theprofits.Theyrankedgroupsofstocksbyprice-to-bookvalue.

Book value is the value of a company’s assets (what it owns) less its

liabilities(whatitowes).Itisonemeasureofacompany’svalue.Price-to-bookvaluemeasures howmuch you pay for that value. If you pay less than bookvalue,youmaybegettingabargain.Ifyoupaymorethanbookvalue,youmaybeoverpaying.

De Bondt and Thaler put the stocks into five groups. We’ll call thecheapest group the undervalued stocks. They called the expensive group theexpensivestocks.

Thechartshowsthechangeinearningspersharefortheundervaluedandexpensivestocksinthethreeyearsleadinguptothedatethey’repicked.

Overreaction:ProfitTrendbeforeBuying(1966–1983)Data Source: Werner F. M. De Bondt and Richard Thaler. “Further Evidence on Investor

Overreaction and Stock Market Seasonality,” The Journal of Finance 42, no. 3 (1987), 557–581,doi:10.2307/2328371.

It’seasytoseewhytheundervaluedstockswereundervalued.Profitsfell

30 percent in three years before they were picked. Investors expected thoseprofitstokeepfalling.

Expensive stockswere expensivebecauseprofits had risen43percent inthe same three years. Investors expected the earnings to keep rising.Let’s seewhathappenednext.

MeanReversion:ProfitTrendafterBuying(1966–1983)Data Source: Werner F. M. De Bondt and Richard Thaler. “Further Evidence on Investor

Overreaction and Stock Market Seasonality,” The Journal of Finance 42, no. 3 (1987), 557–581,doi:10.2307/2328371.

Stunning. After they were picked, the profits of the undervalued stockswentupmorethanexpensivestocks.Theundervaluedstocks’earningsrose24percent in the next four years. (The chart is incredible evidence of meanreversioninearnings.)

Theexpensivestocks’earningsgrowthslowedto8percentoverthesametime. The expensive stocks couldn’t maintain the earlier profit growth. Theundervalued stocks delivered better profit growth. This is mean reversion inaction.

Theundervaluedstocksalsodeliveredbetterstockpricereturns.Theybeatthemarketby41percentoverfouryears.Meanwhile,thestocksintheexpensiveportfoliolaggedthemarketby1percent.Thesearestrikingresults.

DeBondt andThaler’s findings are good evidence ofmean reversion inprofits.Bigincreasesanddecreasesinprofitsdon’tcontinueforlong.Stocksgetundervalued because we expect the profit trend to continue. Instead, meanreversionkicksin.

Thebigdeclinesturnintogrowth.Andbiggrowthslowsdown.Asaresult,undervaluedstocks’profitsgoupfasterthanexpensivestocks’profits.

Undervalued stocks’ prices goupmore than themarket, too. Ifwewanthigh profit growth and a stock price that goes up faster than the market, weshouldlookatundervaluedstocks.

InSearchofUnexcellence“Inmyopinion,youhavetobewildlyoptimistictobelievethatcorporateprofitsasapercentofGDPcan,foranysustainedperiod,holdmuchabove6percent.Onethingkeepingthepercentagedownwillbecompetition,whichisaliveand

well.”—WarrenBuffett,“Mr.Buffettonthe

StockMarket”(November1999)

TomPeters’s1982bestseller,InSearchofExcellence,isdescribedas“thegreatestbusinessbookofalltime.”Inthebook,Peterslookedat43ofAmerica’sbest-runcompaniestofindoutwhatmadethem“excellent.”Thecompanieshadhighprofitabilityandgrowth.PetershasadoctoratefromStanford.Hedescribedhimself as an “ex-engineer” with a vague idea that “numbers and statisticsweren’tenough.”

Wesuspectedthattheydidn’ttellthewholestoryabouthowcompaniesreallyworked.

reallyworked.

Thebookpromisedthe“eightbasicprinciplesofmanagement…thatmadethese[companies]successful.”Itwasahugehit.

Fiveyearslater,analystMichelleClaymantookanotherlookatthestocksPetersbrandedexcellent.Shefoundmostof thebusinesseshadweakened.Thehigh growth and profits had disappeared. In fact, most of the stocks were nolonger excellent by Peters’s own rules. The reason? Mean reversion.Competitionhadpushed thehighprofitsandgrowthratesback to theaverage.Shesaid:47

Intheworldoffinance,researchershaveshownthatreturnsonequitytendtoreverttothemean.Economictheorysuggeststhatmarketsthatofferhighreturnswillattractnewentrants,whowillgraduallydrivereturnsdowntogeneralmarketlevels.

Peters’sexcellentcompaniesdisappointedasinvestments,too.Asagroup,they lagged the stock market. Individually, two-thirds lagged the market andonly one-third beat it. Clayman said the excellent stocks lagged because themarketthoughtfuturegrowthandprofitwouldbehigherstill.Asaresult,theygottooexpensive.

UsingthesamerulesasPeters,Claymanwent“insearchofdisaster.”Shecreated a portfolio of unexcellent stocks. The table below shows Clayman’sunexcellent stocks beside a newgroupof excellent onespickedusingPeters’srules.

Peters’s“Excellent”StocksversusClayman’s“Unexcellent”Stocks(1976to1980)

Theexcellentstocksweremuchbetterthantheunexcellentstocksoneverymeasure but one: valuation.Growthwas higher for the excellent stocks at 22percentperyear.Theunexcellentstocksgrewatjust6percentperyear.

The excellent stocks also had a better return on equity: 19 percent. Theunexcellentstocksreturnedjust7percent.(Remember,highreturnonequityiswhatmakesbusinesses“wonderful.”)

Ifyouonlylookedatassetgrowthandreturnonequity,youmightexpectexcellentstockstobeatunexcellentstocks.ButClayman’sexcellentstockswereundervalued,andtheexcellentstockswereexpensive.

Clayman’s unexcellent stocks traded at 0.6 times book value. Peters’sexcellentstockstradedat2.5timesbookvalue.Inotherwords,theunexcellentstockswere fair companies atwonderful prices, and the excellent stockswerewonderfulcompaniesatfairprices.Whichstockswerethebetterinvestment?

In2013,BarryB.BannistertestedClayman’sunexcellentstocksfromJune1972 to June 2013. Bannister found the unexcellent stocks beat the excellentstocks and themarket by awidemargin. The unexcellent stocks averaged 14percent per year,while the excellent stocks returnedonly10percent per year.Overthesametime,themarketaveraged11percent.

The unexcellent stocks beat the market by 3 percent per year, and theexcellentstocksdidnot.Theexcellentstockslaggedthemarketby1percentperyear.

UnexcellentStocksBeatExcellentStocksandS&P500DataSource:BarryB.BannisterandJesseCantor.“InSearchof“UnExcellence”—AnEndorsementof

Value-styleInvesting”StifelFinancialCorp.July16,2013..

Thechart shows thevalueof$10,000 invested in theunexcellent stocks.Thesameamountwasalsoinvestedintheexcellentstocksandthestockmarket.ThereturnsweretrackedfromJune1972toJune30,2013.

Thereasontheunexcellentstocksbeattheexcellentstocksandthemarket?Meanreversion.AccordingtoBannister:48

Intheory,highreturnsinvitenewentrantsthatdrivedownprofitability,whilepoorreturnscausecompetitorstoexit,aswellasleadtopotentialnewmanagementoracquisitionbyacompetitororfinancialbuyer.

The excellent stocks lagged because their businesses worsened. Theprofitability and asset growth trended to the average. The businesses of theunexcellent stocks also worsened but not as much as the excellent stocks.

Clayman’s unexcellent stocks beat the market because the discount betweenpriceandvalueclosed.Inotherwords,theprice-to-bookvalueswentup.

Theunexcellentstocks’price-to-bookvaluetrendedtotheaverage,andthestock prices went up. The excellent stocks stayed better businesses than theunexcellentstocks.Buttheexcellentstocks’valuationwentdown,sothestockpriceoftheexcellentstockslagged.Thisismeanreversion.

Meanreversionmeansthestockpricesofundervaluedstocksarelikelytoriseovertime,andthestockpricesofexpensivestocksfall.

Profitable industries attract competition. The same forces push outcompetitors in loss-making industries. For this reason, wonderful businessestendtobefairinvestments,andfairbusinessestendtobegoodinvestments.

Wonderful stocks lag because investors overestimate future growth andprofits. Fair businesses beat the market because investors underestimate thechangein thestocks’price-to-valueratio.Undervaluedstocks trendtowardtheaverage value, and the price rises. Expensive stocks trend toward the averagevalue,andthepricedrops.

Expecting mean reversion is good investing. It works on growth rates,returnsonequity,andstockprices.Thisleadstotworulescentraltogoodvalueinvesting:

1. Over time, undervalued stocks beat expensive stocks and themarket. The reason? Stock prices mean revert to value.Expensivestocksgodown.Undervaluedstocksgoup.This iswhyvalueinvestorslikeIcahnandBuffettbeatthemarket.

2.Returnsonequityandearningsgrowthratemeanrevert,too.Highreturns on equity go down. High rates of earnings growthslows. Low returns on equity rise. Low or negative earningsgrowthrises.

ThisiswhyfaircompaniesatwonderfulpricesbeatwonderfulcompaniesatfairpricesandwhytheAcquirer’sMultipletendstobeattheMagicFormula.

Contrarian investors take advantage of mean reversion. They knowundervaluedstockswithlowreturnsonequityorfallingprofitsbeatthemarket.Theyknowglamorstockswithhighreturnsandgrowthlagthemarket.

Buffett knows this, too.That’swhyhe is careful to buy companieswithmoats.TheMagicFormuladoesnotknowthis.TheAcquirer’sMultipledoesn’t,either. But it paysmuch less for operating earnings than theMagic Formula,whichcauseittobeatMagicFormula.

The Acquirer’s Multiple is the best of both worlds. It looks for deeplyundervaluedstocks.Andsomeofthemwillbecompoundersgiventime.

Are there investorswho seek out fair companies atwonderful prices? Inthenextchapters,we’llmeetthem.We’llseewhattheylookforandhowtheyfindthosetargets.

1EconomicprofitiscalculatedasROIC–WACC.“ROIC”standsfor“ReturnOnInvestedCapital.”It’sanothernameforreturnonequityorreturnoncapital.ROICmeasureshowmuchmoneyabusinessmakesforeachdollarinvestedinit.Themoreitmakes,thebetteritis.“WACC”standsfor“WeightedAverageCostofCapital.”Itmeasurestheratethemarketchargesabusinessforitscapital.Ondebtcapitalitistheinterestrate.Onequitycapitalitistheexpectedreturnsetbythemarket.Themarketchargesriskierfirmsmore,andsaferfirmsless.Inpractice,thismeansriskierfirmsshouldexpectalowerPE,andsaferfirmsahigherPE.ThedifferencebetweenROICandWACCiseconomicprofit.Thisanalysisrecognizesthatcapitalisn’tfree.Abusinessisonlywonderfulifitmakesaprofitbeyonditscostofcapital,or,inotherwords,aneconomicprofit.

9.THEPIRATEKING

“Ihaveheardthatonneutralgroundhewasincrediblyfierce,andaffrontedpeoplebysayingthemostbluntorevensavagethings.Certainlythosewhodid

notknowhimwellapproachedhimwithcautionorheavilyarmed.”—WinstonChurchill,MyEarlyLife:1874-1904(1930)

Itis1:00a.m.onDecember15,1989.ItisnearthecoldestpartofthenightononeofthecoldestdaysoftheyearinthecoldestDecemberonrecordinNewYork.Thirtymenstruggle to lift a seventy-one-hundred-poundstatue from theback of a flatbed truck. It is hard to move because it is heavy and smooth,eighteenfeetlongandelevenfeethigh.Themenhavetoworkfast.Itisfreezingcold,andtheyarecommittinganactofvandalism.

Theyhave less thaneightminutes. In that time, thepatrollingNewYorkpolice officerswill be back to this place.With the help of a rented crane, themenliftthestatuefromthebackofthetruck.Theydropitintoplaceunderthesixty-footChristmastreeinthemiddleofBroadStreet.ItsitsrightinfrontoftheNewYorkStockExchange.Infiveminutes,thetruckandallbutoneofthemendriveaway.

The last man is a forty-nine-year-old Sicilian immigrant, Arturo DiModica.Thesculptureishis.Hehasspent$346,000ofhisownmoneyandtwoyears of his life to build it. It is a huge, muscular bronze bull, horned andscowlingwithitsheaddown.Itleanstoitsleft,nostrilsflaredandtailwhippedupoveritsback.DiModicacallsitTheChargingBull.Craftedinthewakeofthe1987 stock-market crash,he says it is a reminder: a symbolof aggression,optimism, and wealth. It stands for the strength and power of the Americanpeople.ItishisgifttothecityofManhattan.

Di Modica waits in the freezing cold for the sun to come up. Early-morningcommutersarethefirsttodiscoverit.Heisdelightedaspeoplestoptostare at the hugebronzebull.A crowdbuilds.Hundreds of the city’sworkersandtouristsstandaroundit,staring,touchingit.Alineformstorubitshornsforgoodluck.Asecond,longerlineformstoburnishitsballs.DiModicawillwatchuntilnoonwhenhewillbreakforlunch.

That afternoon, officials at the NewYork Stock Exchange will demandthatitberemoved.DiModicadoesn’thaveapermit.(Hehasn’teventriedtogetone.Thisisguerillaart.Youdon’taskforpermission.Thisforthepeople.)ThepolicerefusetheStockExchange’srequest.Theyareeitherunwillingorunabletomove the three-and-a-half-tonbull.Thenextnight, aprivate contractorwilldragitawaytoanimpoundlotinQueens.

AphotographerfromTheNewYorkPostcapturesthemomentthebull ishauledawayonthebackofanotherflatbed.Thenextday,theshotwillappearundertheheadline,“Bah,Humbug!N.Y.StockExchangeGrinchesCan’tBearChristmas-GiftBull.LeveragedPryOut.”NewYorkersarefurious.ThepublicoutcryforcestheNewYorkCityDepartmentofParksandRecreationtoreturnthebull.Lessthanaweeklater,onDecember21,1989,thebullwillbefixedatBowlingGreen.Itstandstheretoday,anicon.DiModicahaspulledoffthelasttakeoverofthe1980s,thetakeoverdecade.

Thetakeoverdecadekickedoffin1976whenCarlIcahnsentashortdocumenttowould-beinvestorsforhisnewhedgefund.DubbedTheIcahnManifesto, itsetoutIcahn’splantofindundervaluedstocksandtakethemover.

Icahnsaiditwas“auniquewaytocreatelargeprofit-makingopportunitieswithrelativelylittlerisk:”49

Mostdomesticcompaniesandalmostallforeigncompaniesareloathtolaunchan“unfriendly”takeoverattemptagainstatargetcompany.However,wheneverafightforcontrolisinitiated,itgenerallyleadstowindfallprofitsforshareholders.Oftenthetargetcompany,ifseriouslythreatened,willseekanother,morefriendlyenterprise,generallyknownasa“whiteknight”tomakeahigherbid,therebystartingabiddingwar.Anothergambitoccasionallyusedbythetargetcompanyistoattempttopurchasetheacquirers’stockor,ifallelsefails,thetargetmayoffertoliquidate.

Itisourcontentionthatsizeableprofitscanbeearnedbytakinglargepositionsin“undervalued”stocksandthenattemptingtocontrolthedestiniesofthecompaniesinquestionby:

a)tryingtoconvincemanagementtoliquidateorsellthecompanytoa“whiteknight”;

“whiteknight”;

b)wagingaproxycontest;

c)makingatenderofferand/or;

d)sellingbackourpositiontothecompany.

Icahn said the main problemwas the managers of the target companies“generally own very little stock themselves and, therefore, usually have nointerestinbeingacquired.”Hesaiditlikeagardenerwhostoppedahomeownerfromsellingahousebecausethegardenermightlosehisjob.

Icahn’splanwassimple:first,acquireastakeinaundervaluedcompany.The stake should be big enough to getmanagement’s attention. Second, pushmanagement to sell the company. At the same time, let themarket know thestock is undervalued by starting a proxy fight to get control. If managementwon’tsell,putthecompany“inplay”bymakingahostiletakeoverbid.

ThetakeoverbidputIcahninawin-winposition.Ononehand,itcreatedapricefloorinthestock.Icahncouldwaittoseeifanotherbuyerwouldmakeahigher bid and sell to them. If no other bidder emerged, Icahn could buy thecompanyhimself.He’dgetitundervaluedbecausenooneelsewantedit.

Bytryingtocontrolthecompany,Icahncouldcontrolhisowndestiny.Hecould buy an undervalued stock and single-handedly force its price up to itsvalue. Icahnwouldn’twait onmean reversion and themarket tomove up thestockprice.He’duseBuffett’soldcontrolsituationtrick.Andhe’ddotheheavyliftinghimself.

Icahn’s first target was Tappan Stove Company, an old range and ovenmaker founded in1881. Icahn’sanalyst,AlfredKingsley,brought the stock tohisattention.Lookingatthevaluation,Kingsleylatersaid:50

AtthetimewetookourpositioninTappan,everyoneelsewashotonMagicChef,butIsaid,“ThemultipleonMagicChefistoohigh.Whereisitgoingtogofromhere?”MagicChefwasatthetopofitscycleandTappanwasatthebottom.That’swhereIpreferredtostakeourclaim.

Tappan was a small player in a market ruled by General Electric andWestinghouse.IcahnthoughttheymightbuyTappanifhecouldputitinplay.

Icahnstartedbuyingstockat$7.50.HepeggedTappan’svalueataround$20 per share. Thatmade his upside around $12.50 per share ($20 – $7.50 =$12.50)orclosetothreetimeshisinvestment($20÷$7.50=2.7times).ThebigdiscountlimitedhisdownsideandcreatedahugeupsideifhecouldgetTappantakenover.Itwastheperfectwin-wintarget.

AfterIcahnboughthisstartingstake,hecalledTappan’spresident,DonaldBlasius. Icahn told Blasius he had acquired fifteen thousand shares and wasthinkingaboutbuyingmore.Blasiusdidn’tget themessage.He thought IcahnwaspleasedhehadtakenthetimetotalktohimaboutTappan.

Icahnwas not pleased.He bought another fifty-five thousand shares andcalledBlasiusagain.Thistime,therewouldbenomistake.IcahntoldBlasiusheliked Tappan as a takeover candidate. He said he had made a lot of moneybuyingundervaluedstocks.Manytimes,abuyouthaddoubled thestockprice.He thought Tappan was a good target for a takeover. Still, Blasius didn’tunderstandwhatIcahnwastellinghim.Takeoverswererarein1977.

IcahnuppedhisholdingtoseveralhundredthousandsharesandsteppeduphiseffortstofindabuyerforTappan.HealsocontinuedbuyingTappanstock.Bylate1978,hispositionwasbigenoughtofilea13DnoticewiththeSecuritiesandExchangeCommission(SEC),asashareholderwithmorethan5percentofa company’s sharesmust file a 13D if they plan to take over or liquidate thecompany.

Withthefiling,WallStreetfinallygotthenewsthatTappanwasinplay.Thestockpricejumped.IcahncalledBlasiustotellhimanacquirerhadcalledhimwantingtobuyhisstockfor$17.Itwaslessthanthe$20Icahnwanted,buthewasthinkingaboutselling.Healsoaskedforaseatontheboard.Blasiussaidno.Finally,hesawIcahnwasarealthreat.

The company moved to issue stock to block a hostile takeover. ThiscreatedaproblemforIcahn.Thenewstockwouldstophimfrombeingabletousehisshareholdingtopushforasaleofthecompany.Hehadtoputastoptothenewstockissue.

Icahnrespondedbyspeakingtothepress.HewantedtoembarrassTappanintowithdrawing the stock issue and selling the company. Itworked.Thebadpressmade the board fold almost at once. They agreed towithdraw the stockissue.

Icahn pressed on. In April, he sent a letter to Tappan shareholders andwrotethathewantedaseatontheboard.Healsowantedtosellthecompanyathis $20-per-share estimate of its value. It was a huge premium to its marketprice.He said themanagers didn’t care that the stockwasdownbecause theywerepaidtoomuch.Icahnthoughtlikeanownerofthebusiness.Hewrote:51

IfIpersonallyownedabusinesswiththeseoperatingresultsandwhichhadasubstantialnetworth,Iwouldcertainlyseektosellthatbusiness.IbelievethesamelogicshouldapplyinthecaseofTappan.

Heremindedtheshareholders that thewithdrawnstockissuehadbeentoblock a takeover. Icahn pledged that if hewas elected to the board, hewouldquickly push to sell the companynear its $20value.The letterworked. IcahnwonhisseatonTappan’sboard.

As a director, Icahnwas as good as hisword.Hemoved quickly to sellTappan’sassets.Atthefirstboardmeeting,hepushedfortheliquidationofthecompany’smoney-losingCanadianarm.Itownedvaluablerealestatethatcouldbesold.HealsosoldthefactoryinAnaheim,California.

At the same time, Icahn pressed for the sale of the entire company. HeshoppedTappantobuyoutfirmsandotherpotentialacquirers.

BlasiussawIcahnhadwonandwouldshortlyfindabuyerforTappan.Hemovedtofindhisownwhiteknight,sohemetwiththegiantSwedishappliance-maker AB Electrolux and offered to sell. Electrolux agreed and bid $18 pershare.

It was a great result for Icahn. Electrolux’s bid delivered him a $2.7millionprofitonhis321,500shares,almost100percentonhis$9.60-per-shareaverageprice.

At the final board meeting to approve the sale to Electrolux, Tappan’schairman,DickTappan,said,“Icahnhasdoneusafavor.Wegota50percentpremium over the company’s market value, and Electrolux is going to makecapitalinvestmentsinTappan.”52

Tappan turned to Icahnandsaid,“Ifyouhaveanydealsyouwant tocutmeinon—”

Icahnsaid,“Yes,Ihaveonegoingonnow.”

ItwasIcahn’shedgefund.Andso,DickTappaninvested$100,000intheIcahnPartnersfund.Asthetableshows,itwasagreatinvestment.

Source:MarkStevens,KingIcahn(NewYork:PenguinGroup,1993).

From a humble start, Icahn grew into a “formidable raider and financialtactician,”ashisbiographerMarkStevenspaintedhim.

Atthepeakofhispowerinthe1980s,Icahncontrolledbillionsincapital.Heattacked thegiantsof thepublicmarkets,which includedTexaco, the“BigRed Star of theAmericanHighway,” forwhich he bid $12.4 billion.He alsoattacked U.S. Steel, the world’s first billion-dollar corporation, then with amarketcapof$6billion.

Other investors took notice. A cottage industry of so-called corporateraiders sprang up. They disappearedwith the 1987 stockmarket crash.But a

newbreedofactivist investorsemergedinthewakeofthedot-combustintheearly2000s.We’lllearnabouttwointhenextchapter.

10.NEWGENTLEMENOFFORTUNE

“Itseemedaverygreatworldinwhichthesemenlived;aworldwherehighrulesreignedandeverytrifleinpublicconductcounted:aduelling-groundwherealthoughthebusinessmightberuthless,andtheweaponsloadedwith

ball,therewasceremoniouspersonalcourtesyandmutualrespect.”—WinstonChurchill,MyEarlyLife:1874-1904,(1930)

ItisearlySeptember2000,morethanadecadesinceDiModicaslippedhisbullintoManhattan.Thedot-combuststartedinMarch,butfewfeelityet.Afterfalling just over 10 percent inApril, themarket has almost rallied back to itspeak.Butitwon’tregainthehighs.Asickening50percentplungewindsitswaydown the pike. The bear market won’t be official—down 20 percent—foranothersixmonths.Fornow, thewatersappearcalm.Butayounghedgefundmanager,DanLoeb,hasabigproblem.

Loeb manages a hedge fund called Third Point Partners from an officetwenty-seven floors above ParkAvenue inManhattan. He named Third Pointafter a surf break in LosAngeles, where Loeb grew up. Thirty-three-year-oldLoeblaunchedThirdPointinJune1995withjust$3.3millionfromfamilyandfriends.Only$340,000ofitwasLoeb’s.

Hehasgrownthatsmallgrubstakeat35percenteveryyearsince,turningevery dollar investedwith him into almost $5. Now, five years later, he runs$200million.

Hissecond-largestholdingisanimal-feedmakerAgribrands.Loebhasput$22million—morethan11percent—ofhisfundintothestock.Hepaidaround$40 per share for the stake. Now the company’s chief executive, Bill Stiritz,planstosellitfor$39pershare,adollarlessthanLoebpaid.

Sixty-five-year-old Stiritz is a wheeler-dealer. He was made chiefexecutiveofAgribrands’sformerparent,RalstonPurina,in1981.Atthetime,itwas a messy conglomerate. It owned an animal-feed business, a pet-foodbusiness,afast-foodchain,mushroomandsoybeanfarms,askiresort,andaproicehockeyteam.

Stiritz sold theSaintLouisBlues, theKeystone ski resort, the farms, theJack in the Box restaurants, and the Purina Mills animal feed business. Heboughtsomebetterbusinesses,foldinginthemakersofTwinkiesandEvereadybatteries.

All the deal-making paid off. Operating profit shot up 50 times underStiritz’swatch.Atthesametime,thecompanyboughtbacksomuchstockthatits shares shrunk 60 percent. The stock price,which traded at $1.25when hetook over in 1981, had vaulted into the $80s by the time he stepped down in1997.

HisfinalactatRalstonPurinawastospinoff twobusinesses.Thecerealand grocery business went into a company called Ralcorp. The internationalanimal-feedbusinesswasspunoffasAgribrands.Stiritz thensteppeddown tobecomebothchiefexecutiveandchairmanofAgribrandsandalsochairmanofRalcorp.Includingthespin-offs,Stiritzcreatedmorethanonehundredtimesthevalueheinherited.

Now,aschiefexecutiveandchairmanofAgribrands,Stiritzplans tosellthe business to Ralcorp, where he also serves as chairman. Itmakes sense tohim.Ralcorphasbetterbusinesses.Agribrandshaspilesofcash.Stiritzyearnstorepeat with Ralcorp his experience at Ralston Purina. Key is gettingAgribrands’scashpileforcheap.Thesalesprice is toolow,whichisgreatforStiritzandgreat forRalcorp,butbad for theshareholdersofAgribrandsandabigproblemforDanLoeb.

ThirdPointownsabout4percentofAgribrands’sstock.Thatdoesn’tgiveLoeb much pull. Stiritz won’t take a call from such a small shareholder andcertainly not from a guy with a fund named after a surf break in California.Stiritz is the hundred-bagger legend. Loeb is some punk kid. Stiritz is in thewrong,andLoebisright.Butrightandwrongdoesn’tcountforanythinghere.Influenceisallthatcounts.

Loeb can’t bendStiritz to hiswillwith anything less than 50 percent ofAgribrands’s shares. To buy that much stock, he would need another $190million—$10millionmorethanhehasinhisfund.Andhedoesn’twanttoputallhischipsonthisonestock,anyway.StiritzisintentonmergingAgribrands’scashboxintoRalcorp’sbusinessesatabigdiscounttoitstruevalue.AndLoeb’s

littlefundhasabigproblem.

Loeb remembers a stunt pulled by a hedge-fund-manager buddy of his,RobertL.ChapmanJr.ChapmanandLoebhavebeenfriendsforadecade.LoebevensleptonChapman’scouchforawhilewhenhewasyoungerandbetweenapartments. Chapman runs a hedge fund called Chapman Capital out of LosAngeles.

The13DEarlier in the year, Chapman got into a fight with another company,

AmericanCommunityPropertiesTrust.HewasupsetwhenashakeupoverseenbyJ.MichaelWilson,thethirty-two-year-oldchairmanandchief-executivesonofthefounder,ledtoa40percentslideintheshareprice.

With5percentofAmericanCommunity’s shares,Chapmanhad to fileaSchedule 13D notice with the SEC, the stock market police. In the 13D,Chapman had to tell the market what he planned to do with his AmericanPropertiesstake.WouldhetrytotakeoverAmericanProperties?Wouldhetrytoliquidateit?Wouldhetrytosellit tosomeoneelse?ItemNo.7onthe13Dasks for any “Material to be Filed as Exhibits.” In a flash of inspiration,ChapmandecidedtoattachanopenlettertoWilson.

Intheletter,ChapmanwroteheinvestedinAmericanCommunitybecausehethoughtitwasa“highlyundervaluedmicrocapcompany.”53(Amicrocapisatiny company when measured by market cap.) The shakeup was supposed toboostthepriceoftheshares.Instead,thestockhadalmosthalved.

OnlytheWilsonfamilyhaddonewell.Theyhadboughtsomeassetsfromthecompany for less than theywereworth.Theyhadbeenpaidhugesalaries.Wilsonseniorhadalsobeenpaidhundredsofthousandsofdollarsinconsultingfeesandpayouts.Chapmandescribedtheshakeupaspiling“strategicblunderonWilson-familyplunder.”

Hewasalsoupsetthecompanywouldn’treturnhisphonecalls.Chapmancalledthecompanythreetimesaday,buttheexecutivesofAmericanPropertiesignoredmostofhiscalls.Theraretimestheyreturnedcalls,theydidsomuch,muchlater—weeks,months,orinonecase,ayear.ChapmanwrotethatWilson

was trying topush thesharepricedownso the familycouldbuy thecompanycheaply.

Chapman’splanwasfor thecompanyto liquidate.HefiguredthatwouldstoptheWilson-family“gravytrain.”Anditreturnedmoneyworthalmostseventimes more than the share price. He signed off in a flourish. The board wasletting a thirty-two-year-old “graduate ofManhattanCollege in theBronx andformerbankloanadministrator”playa“real-lifeversionofMonopoly.”54

Verytrulyyours,RobertL.ChapmanJr.

Chapman’s letter worked. He publicly shamed Wilson and AmericanCommunity into selling assets and paying down debt. American Communityalsostartedpayingadividend.Later,whenassetsalesslowed,ChapmanstartedphoningWilsonagain.Hisfirstsevenphonecallswereignored.

Whenhefinallygotthrough,WilsontoldChapman,“You’rea[expletive]painintheass,andwedon’twanttotalktoyou.”55ChapmanputthephonecallinanotherSECfiling,whichattractedalotmoreattentionfromthemedia.Theresult? Wilson and American Community again sped up its sales. The stocksoared.

Chapman’s letter-writingcampaignwasablunt instrument,but itgot thejob done. It attracted attention from themedia and themarket, and the stockjumped. Loeb figures it’s just what he needs. He buys enough stock inAgribrandstopushhimoverthe5percentlevel.Nowhecanfilea13DwiththeSEC.

Hestillhasnorealpower.Butthe13Dgiveshimavoice,andLoebhasamouth.Heused topayabiggerkidaquarteraday toprotecthimwhen itgothimintotroubleintheschoolyard.NowheplanstouseittostirupsometroubleforStiritz.HewillputStiritz’splanunderaspotlight.

Chapman had written his letter in high English like he’d swallowed adictionary. He filled it with phrases like “tacitly dissuade,” “egregiousinefficiencies,” “proffering,” “efficacious means,” “nepotistic practices,” and“cognitivedissonance.”A shareholderneeded adegree inEnglish literature toknowwhathemeant.

Thatwon’tbeaproblemforLoeb.He’spartofthenewbreedofinvestorstrolling Internet message boards, posting rumors and flaming (insulting) oneanother. Loeb’s screen name is “Mr. Pink,” who is also one of the maincharactersinQuentinTarantino’sbloodyheist-gone-wrongfilmReservoirDogs.Mr.Pinkgetsawaywiththediamondsintheend.

InhislettertoStiritz,Loebisopenaboutwhathe’sdoing.Hewritesthathe bought more stock only so that he could file the letter with the SEC. Hebelieves it’s the only way to get his “strong opposition…taken seriously andheardwidely.”HeisangrythepriceofferedforAgribrandsistoolow.Asproofthatthesaleistoocheap,hepointstoAgribrands’sAcquirer’sMultipleandPEmultiple.Thesearehistoolsintrade.

ToolsofTitans“Ourexperiencehasbeenthatpro-rataportionsoftrulyoutstandingbusinessessometimessellinthesecuritiesmarketsatverylargediscountsfromthepricestheywouldcommandinnegotiatedtransactionsinvolvingentirecompanies.”

—WarrenBuffett,“Chairman’sLetter”(1977)

FewinvestorshadheardoftheAcquirer’sMultipleintheearly2000s.Thisis the age of venture capital, dot coms, and IPOs. Loeb uses the Acquirer’sMultiplethewaythecorporateraidersusedit:torevealhiddencash,hiddencashflows,hiddentraps,andcompaniescarryinghugedebtloads.Hehasusedit todigupAgribrands’shiddencashhoardthesamepileofcashStiritzistryingtoquietlyslipintoRalcorp.

Ralcorp has offered $39 per share in cash or $420 million for all ofAgribrands’sshares.ButAgribrandshas$160millionincashsittinginthebank,whichStiritzcanuse ifhegetscontrol.Stiritz isonlypaying$260million forAgribrands($420millionlessAgribrands’s$160millionincash).RalcorpwillalsohavetopayoutAgribrands’s$10milliondebt.Itmustbeaddedtothe$260millionfora totalenterprisevalueof$270million.Loebsees thatRalcorphasoffered only $270 million for Agribrands’s business. What was Agribrandsgivingupfor$270million?

Ninetymilliondollarsinoperatingearnings.Stiritzwasofferingjust$270

millionforAgribrands’s$90million.Dividingthe$270millionenterprisevalueby the $90 million in operating earnings put Ralcorp’s bid on an Acquirer’sMultiple of 2.9 times, which was less than three years of cash flow fromAgribrands’s business. Too cheap by half. He works out the PE multiple bydividing the $420 million by $53 million in reported earnings, or 7.9 times.Again,waytoocheap.

InhislettertoAgribrands,LoebwritesthatRalcorp’s$39pershareoffermeansanAcquirer’sMultipleof2.9timesandaPEmultipleof7.9times.Itisfar toocheap.He’sabuyerat thatprice,notaseller.Hewields thepen likeaflamethrower.Thesalespriceistoolow,andthesaleprocessis“unfair.”56

AschairmanofRalcorpandchiefexecutiveandchairmanofAgribrands,Stiritz is on both sides of the sale. He’s “put[ting his] own personal interestsaheadoftheshareholders”and“strip[pingthe]assetsatanunfairprice.”57LoebsaysthatAgribrands’scashandcashflowsbelongtoAgribrands’sshareholders.They should not to be used to “serve the empire-building desire of Ralcorp’smanagement team.” Loeb wants Agribrands put up for sale “to maximizeshareholdervalue.”58

Verytrulyyours,DanielS.Loeb

OnDecember4,2000,threemonthsafterLoebsendshisletter,Agribrandsannounces that it will not sell to Ralcorp. Instead, Cargill, a privately ownedprocessoroffeedandagriculturalproducts,willbethebidder.Theprice?$54.50pershare,$15.50and36percentmorethanRalcorpoffered.ItisahugegainforLoeb’ssecond-biggestholding.AnditmakesLoebinfamous.

Loebwillusetheinfamytohammeroutanicheforhimself.He’stheself-appointedsheriffonafrontier ignoredbythemediaandtheSEC.Hewillbuysmall shareholdings, just enough to file a 13D, and fire off a letter tomanagement.Though themethodsare seeminglymad, there’samethod to themadness.Thelettersareflaresshotintothedarkness.Andtheywork.

Loeb has captured the mood of the time. Investors ache for rebellionagainst remote boards of directors who believe they have the divine right ofkingstositoncorporateboardsagainstthosewhodonotanswertotheearthlyauthorityofshareholdersandagainst thosewhodonotheedtheconsentof the

people.Almostbyaccident,Loebhasstumbledontothestrategythatwillmakehimabillionaireinjustfiveshortyears.

Einhorn’sIcahnMomentBillionaire value-investor David Einhorn founded the hedge fund

GreenlightCapitalin1996withjust$900,000.Hisparentsinvestedtwo-thirdsoftheassets:$600,000.Hehasreturned25percentperyearsince.Nowheruns$9billionandisworth$1.5billion.

Inearly2013,EinhornpushedApple,Inc.,thentradingat$60,topayoutsomeofitshugepileofcash.EinhornsaidthatApple’s$150billionincashwastoomuchforastockwithonly$60billioninfixedassets.Applecoulduseittobuy“allbut17companiesintheS&P500.”59Itearnednexttonointerest.Itwasbetterinthehandsofshareholders.

HesaidApple’sstockpricewasdiscountedtothevalueofthecash,about$20pershare.Applecould“unlocksignificantshareholdervalue”bycuttingthecashonits“bloatedbalancesheet.”60

Einhornwasn’ttheonlyactivisttocomplainaboutApple’scashpile.CarlIcahnwroteanopenlettertoApple’schiefexecutive,TimCook.IcahnaskedforAppletoreturncashthrougha$150billionbuyback.Icahnwroteintheletter:61

Whenwemet,youagreedwithusthatthesharesareundervalued.Inourview,irrationalundervaluationasdramaticasthisisoftenashort-termanomaly.Thetimingforalargerbuybackisstillripe,buttheopportunitywillnotlastforever.Whiletheboard’sactionstodate($60billionsharerepurchaseoverthreeyears)mayseemlikealargebuyback,itissimplynotlargeenoughgiventhatApplecurrentlyholds$147billionofcashonitsbalancesheet,andthatitwillgenerate$51billionof[operatingearnings]nextyear(WallStreetconsensusforecast…Withsuchanenormousvaluationgapandsuchamassiveamountofcashonthebalancesheet,wefinditdifficulttoimaginewhytheboardwouldnotmovemoreaggressivelytobuybackstockbyimmediatelyannouncinga$150billiontenderoffer(financedwithdebtoramixofdebtandcashonthebalancesheet).

IcahnalsosentthistweettohisTwitterfollowers:62

Icahn said a $150billionbuybackwouldboost earnings per share by33percent.Itwouldalsolifttheshareprice150percentto$150.WhydidEinhornandIcahnfixonApplegettingvalueforitscash?

Activists focus on excess cash because too much can hurt a company’svalue.Let’stakealookatApplein2013.Ithadamarketcapof$500billion.Itearned$37billioninnetincomeovertheprecedingyearandmade$50billioninoperating earnings. It also carried $150billion in cash.Let’s also say the ten-yeartreasurybondoffersa3percentyield.ThetablebelowsummarizesApple’sfinancialdata.

Apple,Inc.’sSummaryFinancialDataSummaryBalanceSheetNetCashandEquivalents $150billionOtherAssets $60billionTotalAssets $210billionSummaryIncomeStatementOperatingEarnings $50billion

OperatingEarnings $50billionNetIncome $37billionOtherStatisticsandRatiosMarketCap $500billionEnterpriseValue $350billionPEMultiple 14×Acquirer’sMultiple 7×ReturnonEquity 67%10-YearT-BondYield 3%

ThePEmultipleforApplewas14($500billion÷$37billion=14times).Thisis lowforagoodbusiness.ThePEmultipleoftheten-yeartreasurybondwas33times(1÷0.03).Theten-yeartreasurybondisanalternativeinvestmenttoApple.Wecaninvestintheten-yeartreasuryat33timesorAppleat14times.Apple is less thanhalf thePEmultipleof the ten-year treasury. It is thebetterbet.

Apple is even more interesting when we look at it with the Acquirer’sMultiple. It tradesonanAcquirer’sMultipleof7 ($350billion÷$50billion).Apple can return all of its hugepile of cash to its shareholders because it hasstrongoperatingearnings.

Einhorn noted that towork out the value this unlocks,we have to guesshowmuchvaluethemarketalreadyplacesonApple’scash.Ifthemarketgivesitnocreditanditreturnsallitscash,thenthecashreturnedisfoundvalue.Thismeansthedividendunlocksthewhole$150billionor$20pershare.

Thismightoccurifthereturnonassetsisboostedtomorethan83percent($50 billion ÷ $60 billion). Profitability like that justifies a PEmultiple of 14times or higher. In that event, themarket cap would stay unchanged at $500billion.Shareholdersget$150billionandkeepstockwiththesamemarketcap,$500 billion. If the market already gives Apple some credit for the cash, theamountunlockedwouldbecut.Einhornwrote:63

Thereisnowaytoknowforsurehowmuchcreditthemarketgives,sothereisnowaytoknowhowmuchvaluewillbeunlocked.Buttherangeisnolessthanzeroandnomorethan[thevalueofthecashdistributed].

ThecaveatisthattotheextentthatthiswouldreflectAppleadoptinga

ThecaveatisthattotheextentthatthiswouldreflectAppleadoptingabettercapital-allocationpolicysuchthatcashandfuturecasharen’ttrappedindefinitely,themarketmightrewardApplewithahigherP/Eratio.

Late in 2013, Einhorn and Icahn succeeded in getting Apple to pay outmostofitscash.Itstartedabuyback.ByFebruary2014,ithadboughtback$40billionofstock,arecordamountforanycompanyoveratwelve-monthspan.Itthenannounced in2014 that itwould return$130billion throughan increasedbuybackanddividend.

Thestockpriceleapt.Aftertradingaslowas$56inMay2013,the2014announcementpushedthestockto$100.Icahnlettheworldknowinaseriesoftweets:64

Bytheendoftheyear,itwasat$120.Icahnscoredadoubleinoneofthelargestcompaniesonthestockmarketinalittleoverayear.In2017,ittradesat$145andwillpayout$2.28pershareindividends.

Apple isagoodexampleof thepowerof theAcquirer’sMultiple,whichidentifies this typeof stock, undervaluedwith adepressedvalue. It offers twoways to win. An activist emerges to improve the value and rapidly close thediscount, or mean reversion acts on the price to push it up gradually in themeantime.

We wrote about Apple in April 2013 (four months before Icahn startedtweetingaboutit):65

Appletradedintothetopthirtyataround$90inlateApril2016.Wewroteaboutitasecondtimethen.Here’sthetweet:66

Eighteenmonthslater,itwasupmorethan80percenttoalmost$165.

11.THEARTOFDEEP-VALUEINVESTING

“I am sometimes attacked for imposing ‘rules.’Nothing couldbe furtherfromthetruth.Ihaterules.AllIdoisreportonhow[people]reacttodifferentstimuli.…Ahintperhapsbutscarcelyarule.”

—DavidOgilvy,OgilvyonAdvertising(1983)

If you want the market return, buy the market. If you want to beat themarket,youmustdosomethingdifferent.Thatmeansbuyingonlyundervaluedstocks,orconcentrating.

Thetrade-offforconcentrationistwofold:

1.Concentratedportfolios tend tobemorevolatile than thebroaderstockmarket.Thismeanstheymovearoundmore,bothupanddown. Good days for the market can be great days for theportfolio.Baddays for themarketcanbe terribledays for theportfolio.

2.Concentratedportfoliosdon’t track themarket.This isknownastracking error. Itmeans concentrated portfolios can go downwhenthemarketgoesupandupwhenthemarketgoesdown.Thesecondkindof trackingerror—portfolioup,marketdown—isthegoodkind.Butyouwon’tnotice.

In practice, you’ll only noticewhen your concentrated portfolio is downwhilethemarketisup.Academicshavefoundhightrackingerrorisassociatedwith good long-term performance. But the market can beat portfolios ofundervaluedstocksforalongtime.Trackingerrorwon’tfeelgoodthen.Noonesaiditwouldbeeasy.

Ziggingishard.Ourgutsscreamatustozagwiththecrowd.Weknowweshouldzig.Butundervaluedstocksarehard tobuy.Theyownbadbusinesses.The growth has slowed, and the profits are falling; they’re losing money, orthey’reheadedtoliquidation.That’swhythey’reundervalued.

Grahamknewit.HewroteinSecurityAnalysis:67

Iftheprofitshadbeenincreasingsteadilyitisobviousthattheshareswouldnotsellatsolowaprice.Theobjectiontobuyingtheseissuesliesintheprobability,oratleastthepossibility,thatearningswilldeclineorlossescontinue,andthattheresourceswillbedissipatedandtheintrinsicvalueultimatelybecomelessthanthepricepaid.

Weworrythestockpricewillkeepdroppingandthatthegrowthwillkeepslowing,theprofitswillkeepfalling,andthebusinesswillkeeplosingmoney.Weexpectthetrendtocontinue.That’samistake,butaneasyonetomake.Thewrongdecision—zaggingwiththecrowd—feelsright,whilethecorrectdecision—zigging—feels wrong. Following the trend is instinctive.Mean reversion isnot. But the data show mean reversion is more likely. This has severalconsequencesforinvestors.

1.Value ismore important than the trend inearnings.Undervaluedlow-orno-growthstocksbeatexpensivehigh-growthstocksandby a wide margin. Mean reversion pushes up undervaluedstocksandpushesdownexpensiveones.

2. Undervalued low-or no-growth stocks beat undervalued high-growth stocks.We expect undervalued high-growth stocks tobeat undervalued low-growth stocks.We assume high-growthvalue stocks are good stocks at bargain prices. But the datashowmean reversion acts on growth, too. It pushes down onhigh-growthstocksanduponlow-orno-growthstocks.

3.Undervaluedlow-profitstocksbeatundervaluedhigh-profitstocks.Meanreversionpushesdownonhighprofitsanduponlowornoprofits.

HighlyprofitablestocksonlybeatthemarketifBuffett’smoatprotectstheprofits. Without the moat, highly profitable stocks will get beaten up by thecompetition.Meanreversionactsonprofits todragdownwinnersandpushuplosers. Investors shoulduse some common sense andnatural skepticismaboutprofitchartsthatmarchallthewaytoheaven.

It is a rare business that can resist competition.And suchbusinesses arehard to identify. Buffett’s great skill has been to find those with defensiblemoats, which are his wonderful businesses. For those of us without Buffett’stalent, themoreundervalued the stock, thebetter.This is contrarian investing.Thisisvalueinvesting.

TheBroken-LegProblem“Most decisions should probably be made with somewhere around 70

percentoftheinformationyouwishyouhad.Ifyouwaitfor90percent,inmostcases, you’re probably being slow. Plus, either way, you need to be good atquickly recognizing and correcting bad decisions. If you’re good at coursecorrecting,beingwrongmaybelesscostlythanyouthink,whereasbeingslowisgoingtobeexpensiveforsure.”

—JeffBezos,“ShareholderLetter”(2017)

Howdowelookpastthefallingstockprices,thelosses,andthecrisis?Weknowundervaluedstocksbeatthemarket.Butwegetstuckonthebadheadlines.Wewanttofollowthecrowdfarawayfromthesestocks.Ourgutfailsushere.

Theissueiswestrugglewithuncertainty.Problemsrequiringustoguessatodds and choose between unknown future outcomes are amystery.Weprefertrends.Thisistrueforeventhebestinvestorsandcognitiveexperts.Ifknowingthatwemakethesemistakesisn’tenoughtostopmakingthem,howdowestop?

Sincethe1950s,socialscientistshavebeentestingtheforecastsofexpertsagainstsimplerules.Studyafterstudyhasfoundsimplerulesbeat theexperts.PaulMeehl,afoundingfatherinthefield,saidin1986:68

Thereisnocontroversyinsocialsciencewhichshowssuchalargebodyofqualitativelydiversestudiescomingoutsouniformlyinthesamedirectionasthisone…predictingeverythingfromtheoutcomesoffootballgamestothediagnosisofliverdiseaseandwhenyoucanhardlycomeupwithahalfadozenstudiesshowingevenaweaktendencyinfavouroftheclinician,itistimetodrawapracticalconclusion.

Meehlmeansthis:forlotsofproblems,simplerulesmakebetterforecaststhanexperts.ThisistheGoldenRuleofPredictiveModeling.69

Valueinvestorsfollowasimplerulelikethis:

•Buyifthepriceismuchlessthanthevalue.Otherwisepass.

•Sellifthepriceismorethanthevalue.Holdotherwise.

Aslongasvalueisalwaysworkedout thesameway,forexample,usingtheAcquirer’sMultiple,MagicFormula,orsomeothermethod,thisisasimpleruleforvalueinvesting.

Many investors hate strict rules. They think it’s better to use the outputfromthesimpleruleandthendecidewhethertofollowit.Thisisn’tabadwaytogo.Expertsmakebetterdecisionswhentheyusesimplerules.Buttheydon’tdoaswellasthesimplerulealone.

This is the broken-leg problem. Suppose we have a rule for predictingwhetherJohnandJanegotothemoviestogether.IfweknowJohnhasabrokenleg,canweignorethesimpleruleandmakeourowndecision?

The argument is the simple rule will get the question wrong because itdoesn’t know John’s leg is broken. Surely,we can include this data to decidethat John and Jane will stay home. Won’t that make our prediction moreaccurate?Thestudies find that itdoesnot.Thereason iswefindmorebrokenlegs than thereare.Wemakeourowndecisions toooften, including toomuchirrelevantdata.

This is true for companies with bad businesses, slowing growth, fallingprofits, or losses. As a portfolio, fair businesses at wonderful prices beat themarket.Butthesecompanieslookliketheyhavebrokenlegs.Theyhavelotsofreasonstooverridethesimpleruleandmaketheirowndecisions.Wearebetteroffifwejustfollowthesimplerule.

DoItYourself“Marine Salvage—A science of vague assumptions based on debatable

figurestakenfrominconclusiveexperimentsandperformedwithinstrumentsofproblematic accuracy by persons of doubtful reliability and questionablementality”

—C.A.Bartholomew,Mud,Muscle,andMiracles:MarineSalvageintheUnitedStatesNavy,DepartmentofNavy,2010.

Onesimpleruleforbeatingthemarketistobuyaportfolioofundervaluedstocks. The acquirersmulitple.com website is good source of ideas. The mostundervaluednamesinthebiggestonethousandstocksareavailableintheLargeCapScreenerforfreeforever.TherearetwootherpaidscreenerscoveringeverystocklistedintheUnitedStates:theAllInvestableScreener,whichisthebiggesthalfofallstocks,andtheSmallandMicroCapScreener,thesmallesthalfofallstocks.

The larger companies found in theLargeCap Screener have historicallygenerated lower volatility and lower returns. Volatility is a fancy name forstocks going up and down.Higher volatilitymeans the portfolio goes up anddownmore.Lowervolatilitymeanstheportfoliogoesupanddownless.

Thesmallercompanies found in theSmallandMicroCapScreenerhavehistorically generated higher absolute returns but had much greater portfoliovolatility. The broadest screener, the All Investable Screener, gives the bestbalanceofreturnandvolatility.

HowtoUsetheScreenersTherearetwobasicapproachestousingthescreenersthatwecallbusiness

ownerandquantinvestor.

Thequantinvestorusesthescreenerstocreateaportfolio.Itreliesontheperformanceoftheportfolioasawhole.Thequantinvestorbuysstocksfromthescreener without fear or favor and ignores the particular problems facing anygiven stock. And the investors ruthlessly play the odds, taking a long-termportfolioapproachtobeatingthemarket.

The business owner uses the screeners as the launching pad for furtherresearch.Itstudieseachstockthewayaclassic,fundamentalinvestorwould:asabusiness.Thebusinessownerbuysastockinthescreeneronlyifittradesatabig-enoughdiscounttovaluetoprovideamarginofsafety,andheorshepassesotherwise.

Both are equally valid approaches, but the business owner is by far andaway the more difficult of the two. Most investors will be better off asquantitative investors.Consider this:mostprofessional investorscan’tbeat themarket.(Andwhenwesaymost,wemean80percentofprofessionalinvestors.)

The reasonsmost people lag themarket: cognitivebiases andbehavioralerrors.

JoelGreenblatthas found that investors struggle to implementhisMagicFormula in practice. In a great piece published in 2012, “Adding Your TwoCentsMayCostYouALotOverTheLongTerm,”Greenblattexaminedthefirsttwoyearsofreturnstohisfirm’sUSseparatelymanagedaccounts.

Hegavehisclients twochoices to invest inUSstocks.Oneaccountwaslikethebusinessowner.Theotherwaslikethequantinvestor.

Thebusiness-owneraccountpickedwhat top-rankedstockstobuyorselland when to make these trades. The quant investor account followed asystematicprocessthatboughtandsoldtop-rankedstocksautomatically.

Greenblatt conducted a great real-time behavioral investing experiment.Business-owner accounts had discretion over buy and sell decisions, whilequant-investor accounts were automated. Both choose from the same list ofstocks.So,whathappened?

The business-owner accounts didn’t do badly. Those accounts averaged59.4percentafterallexpensesover the twoyears,agoodreturn.But theS&P500rose62.7percentoverthesametwoyears.

Thequantinvestorsaccountaveraged84.1percentafterallexpensesoverthe same twoyears,beating thebusinessownerbyalmost25percent (and theS&P500bywellover20percent).That’sahugedifference,particularlysincebothaccountschosestocksfromthesamelistandweresupposedtofollowthesameplan.

Greenblatt says, “The people who ‘self-managed’ their accounts took awinning system and used their judgment to unintentionally eliminate all theoutperformanceandthensome!”

Theytookasimplerulethatbeatthemarketandusedtheirowndiscretionto get beaten. Extraordinary! Greenblatt found the best-performing business-owner account didn’t do anything. After the clients opened the account, theyboughtstocksfromthelistanddidn’t touchthemfortheentiretwoyears.Thestrategyofdoingnothingbeatthebusinessowneraccounts.

Greenblatt concluded, “I don’t know if that’s good news, but I like themessage it appears to send—simply, when it comes to long-term investing,doing‘less’isoften‘more.’Well,goodworkifyoucangetit,anyway.”

The quant investor is by far and away the more boring of the two.Economist JohnMaynardKeyneswrote, “investment is intolerablyboringandoverexacting to anyone who is entirely exempt from the gambling instinct;whilsthewhohas itmustpay to thispropensity theappropriate toll.” Inotherwords,investingisboringifyoudon’tlikegambling.Butifyoulikegambling,youpayaprice.

RulesforQuantInvestorsUse the screeners to select the top-ranked stocks from the Acquirer’s

Multiple database. Each screener finds the thirty best stocks at any time.Youdon’tneedtoholdthirtypositions.Butyoushouldn’tholdfewerthantwenty.

In general, holding more stocks leads to better diversification, whichmeasureshowmanystocksyoubuyandhowmuchmoneyyouputineach.

Morestocksmeanslessmoneyineachstock.Ifastockgoestozero,you’llloseless.Ifastockgoesupalot,you’llmakeless.It’shardertomanagebecauseitmeansmorebuyingandselling.

Fewer stocksmeansmoremoney in each stock. If a stock goes to zero,you’lllosemore.Ifastockgoesupalot,you’llmakemore.Fewerstocksmeanslessbuyingandselling.Thisisasimplemethodforinvestingsystematically:

1.Research:Ignoreanystocksyoudonotwanttoownforanyreason.Holdatleasttwentystocksfordiversification.

2.Buy:It’sbesttobuyallyourstocksatonce.Butit’sfinetoscalein—makeregularportfoliopurchasesovertwelvemonths.Onewaytodoitistobuy

twoorthreestockseachmonth.3.Sell:Fortaxableaccounts,holdwinnersforoneyearplusoneday.Thensell.

Thatmaximizesafter-taxreturns.Ifastockisupandstillinthescreenerafteroneyearandoneday,holduntilitleavesthescreener.Ifastockisdownandinthescreener,hold.Ifastockisdownandleavesthescreener,sell.Youshouldcheckyourstocksatleastquarterlytoseeifyouneedtobuyorsell.

4.Rebalance:Onceyousellastock,buythenextbeststockinthescreeneryoudon’talreadyhold.

The website acquirersmultiple.com has a screener for deep-value stockslistedintheUnitedStatesandCanada.Signupwiththecoupon“ZIG”totrialallscreensforamonthfor9.99(80percentofftheregularprice).

If you’re intent on cherry-picking the best ideas in the screen, I’vesummarizedtheninerulesofdeepvalueinthenextchapter.

12.THENINERULESOFDEEPVALUE

“Survivalisaninfinitecapacityforsuspicion.”—JohnLeCarré,Tinker,Tailor,Soldier,Spy(1974)

“Verybravething,inspying,toputyourfaithinsomeone.Anyfoolcangobacktohisdeskandsay,‘Idon’taltogethertrustthischap.Ontheonehand,ontheotherhand.’Ittakesalotofgutstotakeaflyerandsay,‘Ibelieveinhim.’”

—JohnLeCarré,ThePigeonTunnel:StoriesfromMyLife(2016)

1.Zigwhenthecrowdzags.For any investment, we compare the crowd’s view—the consensus—with ourown.Howdowefindtheconsensus?It’srevealedinthedifferencebetweenthepriceofastockanditsvalue.Wedoourownresearchtoworkoutthevalue.Welook for stockswhereourestimatediverges from thecrowd’s. Inotherwords,wetrytozigwhenthecrowdzags.

Here’swhy: the onlyway to get a good price is to buywhat the crowdwantstosellandsellwhatthecrowdwantstobuy.

Agood price implies a lopsidedbet: a smalldownsideandabigupside.The downside is small because the price already assumes the worst-casescenario.Thatcreatesamarginforerror.Ifwe’rewrong,wewon’tlosemuch.Ifwe’re right, we’llmake a lot. An upside bigger than the downsidemeanswebreak,eventhoughweerrmoreoftenthanwesucceed.Ifwemanagetosucceedasoftenas,ormoreoftenthanweerr,we’lldowell.

Undervalued and out-of-favor companies offer lots of chances to zig—makecontrarianbets.Whenacompanyownsascary,bad,orboringbusiness,thecrowdoverreactsorgrowsimpatientandsells.That’showthestockbecomesundervalued. Given time, many businesses turn out to be less scary, bad, orboringthantheyseematfirst.Thereasonismeanreversion.

2.Buyundervaluedcompanies.

2.Buyundervaluedcompanies.Thebigger thediscount tovalue thebetter the return.This is true in the

United States, United Kingdom, Europe, Africa, Asia, Australia, and NewZealand.It’s true indevelopingandemergingmarkets. It’s trueglobally.Deepdiscountsandgoodreturnsgotogether.

Formost industrial companies, theAcquirer’sMultiple is the best singlemeasure of undervaluation.TheAcquirer’sMultiple is a company’s enterprisevaluecomparedtoitsoperatingearnings.Itisthemetricprivateequityfirmsusewhenbuyingcompanieswholeandactivist investorsusewhenseekinghiddenvalue.

The enterprise value is the true price we must pay for a company. Itincludes themarket cap,which is the share pricemultipliedby the number ofsharesonissue.Themarketcapalonecanmisleadbecauseitignoresothercostsborneby theowner.The enterprisevalue also examines thebalance-sheet andoff-balance-sheet items. It rewards companies for cash, and it penalizescompanies for debt, preferred stock, minority interests, and off-balance-sheetdebts.Theseareallrealcostspaidbytheowner.

Operatingearningsaretheincomeflowingfromabusiness’soperations.Itexcludes one-off items like sales of assets and legal settlements. We adjustoperatingearningsforinterestandtaxpaymentsbecausetheyareaffectedbythecapital structure: themixofdebtor equity.The adjustmentmakespossible anapples-to-apples comparison between two companies with different mixes ofdebtandequity.

For nonindustrial businesses like financials, such as banks and insurers,book value is the better singlemeasure.Whatever the proxy, the goal is deepundervaluation.

3.Seekamarginofsafety.Thisisathreefoldtestofthediscounttothevaluation,thebalancesheet,

andthebusiness.

First, the greater the company’s discount to its value, the safer thepurchase.Awidediscountallowsforerrorsandanydecayinvalue.Thisisthecorollarytothelastrulethatthebiggestreturnsflowfromthebiggestdiscounts.

It breaks the receivedwisdomof themarket and academia that higher returnsmeanmorerisk.Here,thegreaterthemarginofsafety,thehigherthereturnsandthelowertherisk.

Second,onthebalancesheet,wefavorcashandotherliquidsecuritiesoverdebt.Wewatchforoff-balancedebtslikeleasesandunderfundedpensions.Welookforcreditissuesandsignsoffinancialdistress.Nocompanyeverwonwithtoomuchcash,butmanyhavesunkwithtoomuchdebt.

Finally, the company should own a real business. The business shouldhave strongoperating earningswithmatching cash flow.Matching cash flowsensurestheaccountingearningsarerealandnotmerelythefigmentofacleverembezzler’smind.Welookforsignsofearningsmanipulation.Companiesthatown science experiments or toys in search of a business model are forspeculators.Butweakcurrentprofitsinastockwithagoodpastrecordofferagoodchanceformeanreversioninthoseprofits.

4.Treatashareasanownershipinterest,notameretickersymbol.

Ashareisanownershipinterestinacompany.Thishastwoimplications:

First, a shareholder has rights as an owner of a company. Shareholdersexercisethoserightsbyvotingatmeetings.

Second,shareholdersshouldpayattentiontoeverythingacompanyowns.Thatincludesitsbusinessanditsassets,chieflyitscash.

We look at both the business and the balance sheet to find financialrobustness.Abusinesscanbeworthagreatdeal,worthless,orworthless thannothing(ifit’saregularmoneyloser).

Inthesameway,abalancesheetcanholdgreatvalueorhaveanegativenetworthifthedebtoutweighstheassets.

Many investors follow profits—the fruits of the business—but ignoreassetsonthebalancesheet.Theyignorecash.Aseeminglypoorbusinesswitha

strongbalancesheetcouldrepresenthiddenvalue.Theassetvalueoffersafreecalloptiononanyrecoveryinthebusiness.

5.Bewaryofhighearningsgrowthandprofits.Mean reversion is a powerful force. It pushesdownon fast growth rates

andhighprofits,anditpushesuponlowgrowthandlosses.

Fast growth andgoodprofits attract competition,which eats away at thegrowth and profit. Investors followingWarren Buffett’s example seek highlyprofitable businesses with a moat—a competitive advantage. But moats arehardertofindandeasiertocrossthanmostinvestorsrealize.

Research shows most highly profitable companies’ profits mean revertdownover time.A small subset of businesses do earn persistent, high profits.Butwehavenotyetbeenabletoidentifythecausalfactorsexante—beforethefact. In other words, we don’t know beyond broad observations what factorspredictsteadygrowthandprofits.

The evidence shows the odds of finding the next high-growth or high-profitstockareabout thesameasflippingacoin.Buffett’sgeniushasbeen toidentify these businesses. Mere mortals are better served buying at a steepdiscounttovalue.

Thebest place to find futuregrowth andprofit is inbusinesses enduringhardtimes.Thesebusinessesarealsolikelytotradeatawidediscounttovalue.Buyersofthesebusinessescanenjoybothanimprovementinthebusinessandanarrowingofthemarket-pricediscount.

6.Usesimple,concreterulestoavoidmakingerrors.

Cognitive errors happen when we make odds-based decisions aboutuncertain future outcomes. Investing in the stockmarket presents exactly thistypeofproblem.

Thesecrettoavoidingtheseerrorsistouseasetofsimple,concreterules.

Ideally,weshouldwritethemdownandstrictlyfollowthem.

Simple,concreterulesare testable.Theyshouldbebacktestedandbattletested.Thebacktestmakessuretherulesworkoverhistoricaldatasets,ideallyin different countries and stock markets. The battle test makes sure the rulesworkinpractice.Nostrategyhaseverfailedintheory.Almostallhavefailedinreality.

7.Concentrate,butnottoomuch.Ifyouwant tomatchthemarket,buythemarket. Ifyouwant tobeat the

market,youmustdosomethingdifferent.Thatmeansbuyingonlythebestideas,orfocusing.

Thetrade-offforfocusistwofold:

1.Concentratedportfolios tend tobemorevolatile than thebroaderstockmarket.Thismeanstheymovearoundmore,bothupanddown. Good years for the market can be great years for theportfolio.Badyearsforthemarketcanbeterribleyearsfortheportfolio.

2.Concentratedportfoliosdon’t closely follow themarket.Wecallthis “tracking error.” It means concentrated portfolios can godownwhen themarketgoesupandupwhen themarketgoesdown.Thesecondkindoftrackingerror—portfolioup,marketdown—is great to have. But youwon’t notice it.You’ll onlynotice when your concentrated portfolio is down while themarket isup.Academicshave foundhigh trackingerror tobeassociated with good long-term performance. But the marketcan beat portfolios of undervalued stocks for a long time.Trackingerrorwon’tfeelgoodthen.

Don’tbecometooconcentrated.Assumeyourcalculationsandthinkingarewrong.Remember,it’smorelikelyyouarewrongandtherestofthemarketisright.

9.Aimtomaximizeafter-taxgainsoverthelong

9.Aimtomaximizeafter-taxgainsoverthelongterm.

Ouraimis tomaximizethereal,after-taxreturnoverthelongterm.Thishasthreeimportantimplications:

1. Thinking long term—beyond the next few quarters or years—offersahugeadvantagetoinvestors.Companiesoftenbecomemispricedbecausethenextyearorsolookstough.Thiscreatesagoodspotforinvestorswillingtolagovertheshortterm.Wecallthistimearbitrage.Itoffersanenduringedgeavailabletopatientinvestors,nomatterthesizeoftheirportfolio.

2. The effects of compounding take a long time to becomeobservable. But interest on interest or gains on gains becomesignificantoverthelongterm.

3. Taxes and fees are hidden enemies of long-term compounding.High-fee mutual funds and other flow-through vehicles willstruggletobeatpassiveindexes.Butlow-fee,activeexchange-tradedfundsaremoretaxefficientandcandosooverthelongterm.

Valueinvestingisalogical,time-testedinvestmentmethod.Thebestvalueinvestors zig while others zag. They maximize their margin of safety andminimize their costs and taxes.They treat highgrowth andprofits skeptically.And they assume their calculations and thinking are wrong. Skepticism,humility,andlowcostsmaximizeourchancesofsurviving.Withluckandtime,wecanbeatthemarket.

If you enjoyed this book, I’d appreciate a review on Amazon orGoodreads.Goodreviewshelpspreadtheword.

APPENDIX:SIMULATIONDETAILS

“Ascrutinysominuteastobringanobjectunderanuntrueangleofvision,isapoorerguidetoaman’sjudgmentthanasweepingglancewhichseesthingsin

theirtrueproportion.”—AlexanderKinglake,TheInvasionoftheCrimea(1863)Thisappendixcontainsthedetailsofthesimulations.Youcanlivealongandfruitfullifewithoutreadingthispart.ButIknowtherearesomewhowon’tbesatisfied

withoutit.Sohereitis.

Assumptions1.Thehistoricalsimulationresultsdonotrepresenttheresultsofactualtradingandmaynot reflect the impact thatmaterialeconomicandmarket factorsmayhavehadonaninvestor’sdecisioniftheinvestorwasactuallymanagingmoney.The simulated results were achieved through the retroactive application of amodel designedwith the benefit of hindsight. No investment strategy or risk-management technique can guarantee return or eliminate risk in any marketenvironment.

2. In the simulation, Standard & Poor’s Compustat database was used as asource for all information about companies and securities for the entiresimulated time period. From 1987 to 2017, Compustat’s Snapshot (point-in-time) database was used such that the simulation processed financial dataconcurrentwith the timethat thefinancialdatabecameavailable to thepublic.Priorto1987,theperiodwhenthetimingofcompanyfinancialdatareleaseshasbeenlesscomprehensivelycataloged,thesimulationsassumethatfinancialdatawas not available to investors until ninety days following the end of theapplicablefiscalquarter.

3. The simulations were restricted to nonfinancial companies listed on theNYSE,NASDAQ,andAMEXstockexchanges.

4. Companies in the investable universe were ranked by earnings yield andreturnoninvestedcapital(ROIC).Ineachof thesimulations, theserankswerecombinedbyaspecificweightingofearningsyieldandROIC.

5.Tominimizethepotentialimpact,positiveornegative,ofmarkettimingandtoshowhowanequallyweightedthirty-positionportfoliomighthaveperformedateachpointintime,theportfolioswererebalancedmonthlytoequallyweightthethirtysecuritiesineachportfolio.

6.Thepurchase-andsale-pricesforasecuritywerethevolume-weightedaverageclosingpriceforthesecurityoverthefirsttentradingdaysofeachmonth.Thesimulations assumed a trading cost of $0.01 per share. The simulations alsoassumed a maximum participation of 10 percent of a target holding’s dailyvolumeovertheten-daytradingwindow.

7.Thesimulationperformancedoesnotreflectthedeductionofanyinvestmentadvisoryfees.

8. Simulated performance results have certain inherent limitations. Norepresentation is being made that any model or model mix will achieveperformance similar to that shown. Simulated performance and actual priorperformanceprovidenoguaranteeoffutureperformance.

$50MillionandGreater

YearlyReturns(1973to2017)

$10,000InvestedinS&P500,PureCharlie,MagicFormula,andAcquirer’sMultiple(1973to2017)Log

$50MillionandGreater,ThirtyStocks

$50MillionSampleStatistics(1973to2017)

$200MillionandGreater

YearlyReturns(1973to2017)

$10,000InvestedinS&P500,PureCharlie,MagicFormula,andAcquirer’sMultiple(1973to2017)Log

$200MillionandGreater,ThirtyStocks(1973to2017)

$200MillionSampleStatistics(1973to2017)

$1BillionandGreater

YearlyReturns(1973to2017)

$10,000InvestedinS&P500,PureCharlie,MagicFormula,andAcquirer’sMultiple(1973to2017)Log

$1BillionandGreater,ThirtyStocks

$1BillionSampleStatistics(1973to2017)

Notes1WarrenBuffett,“TheSuperinvestorsofGraham-and-Doddsville,”ColumbiaBusiness,May17,1984.2ShaunTully,“ThehottestinvestorinAmerica,”Fortune,May30,2007.3ShaunTully,“ThehottestinvestorinAmerica,”Fortune,May30,2007.4ShaunTully,“ThehottestinvestorinAmerica,”Fortune,May30,2007.5MichaelSteinhardt,“NoBull:MyLifeInandOutofMarkets,”Wiley,May2,2008.6RayDalio,“TheCulturePrinciple,”TheNewYorkTimesConferences,March7,2017.Availableathttps://www.youtube.com/watch?v=h2KHec3KNyQ7HowardsMarks,“TheMostImportantThingIlluminated:UncommonSensefortheThoughtfulInvestor,ColumbiaBusinessSchoolPublishing,April17,20128AndyRachleff,“DemystifyingVentureCapitalEconomics,Part1,”Wealthfront.June19,2014.Availableathttps://blog.wealthfront.com/venture-capital-economics/9CharlieRoseinterviewwithMichaelSteinhardt,CharlieRoseShow,PBS,December21,2001.Availableathttp://www.charlierose.com/view/interview/276610SethKlarman,SpeechtoColumbiaBusinessSchoolonOctober2,2008,ReproducedinOutstandingInvestorDigest22,nos.1-2(March17,2009):3.11BenjaminGraham,“StockMarketStudy.HearingsBeforeTheCommitteeonBankingandCurrency,UnitedStatesSenate,Eighty-FourthCongress,FirstSessiononFactorsAffectingtheBuyingandSellingofEquitySecurities.”(March3,1955)UnitedStatesGovernmentPrintingOffice.Washington.1955.Availableathttp://www4.gsb.columbia.edu/filemgr?file_id=131668.12JeremyGrantham,JeremyGrantham,Barron’s(c.2006),viaKatsenelson,TheLittleBookofSidewaysMarkets.13WarrenBuffett,“Mr.BuffettontheStockMarket,”Fortune,November11,1999.Availableathttp://archive.fortune.com/magazines/fortune/fortune_archive/1999/11/22/269071/index.htm.14SethKlarman,“MarginofSafety:Risk-AverseValueInvestingStrategiesfortheThoughtfulInvestor,”HarperColins,October1991.15WarrenBuffett.“Chairman’sLetter.”BerkshireHathaway,Inc.AnnualReport,1989.Availableathttp://www.berkshirehathaway.com/letters/1989.html16WarrenBuffett,“LettertoPartners,1961,”BuffettPartnership.Availableathttps://www.pragcap.com/warren-buffett-partnership-letters/17WarrenBuffett,“LettertoPartners,1961,”BuffettPartnership.Availableathttps://www.pragcap.com/warren-buffett-partnership-letters/18WarrenBuffett,“LettertoPartners,1961,”BuffettPartnership.Availableat

https://www.pragcap.com/warren-buffett-partnership-letters/19WarrenBuffett,“LettertoPartners,1961,”BuffettPartnership.Availableathttps://www.pragcap.com/warren-buffett-partnership-letters/20AliceSchroeder,“TheSnowball:WarrenBuffettandtheBusinessofLife,”Bantam,September29,2008.21WarrenBuffett.“Chairman’sLetter.”BerkshireHathaway,Inc.AnnualReport,1985.Availableathttp://www.berkshirehathaway.com/letters/1985.html22JanetLowe,“DamnRight:BehindtheSceneswithBerkshireHathawayBillionaireCharlieMunger,”Wiley,May9,2003.23JanetLowe,“DamnRight:BehindtheSceneswithBerkshireHathawayBillionaireCharlieMunger,”Wiley,May9,2003.24JanetLowe,“DamnRight:BehindtheSceneswithBerkshireHathawayBillionaireCharlieMunger,”Wiley,May9,2003.25AliceSchroeder,“TheSnowball:WarrenBuffettandtheBusinessofLife,”Bantam,September29,2008.26AliceSchroeder,“TheSnowball:WarrenBuffettandtheBusinessofLife,”Bantam,September29,2008.27AliceSchroeder,“TheSnowball:WarrenBuffettandtheBusinessofLife,”Bantam,September29,2008.28AliceSchroeder,“TheSnowball:WarrenBuffettandtheBusinessofLife,”Bantam,September29,2008.29AliceSchroeder,“TheSnowball:WarrenBuffettandtheBusinessofLife,”Bantam,September29,2008.30AliceSchroeder,“TheSnowball:WarrenBuffettandtheBusinessofLife,”Bantam,September29,2008.31WarrenBuffett.“Chairman’sLetter.”BerkshireHathaway,Inc.AnnualReport,1989.Availableathttp://www.berkshirehathaway.com/letters/1989.html32WarrenBuffett.“Chairman’sLetter.”BerkshireHathaway,Inc.AnnualReport,2007.Availableathttp://www.berkshirehathaway.com/letters/2007.html.33WarrenBuffett.“Chairman’sLetter.”BerkshireHathaway,Inc.AnnualReport,1991.Availableathttp://www.berkshirehathaway.com/letters/1991.html.34WarrenBuffett.“Chairman’sLetter.”BerkshireHathaway,Inc.AnnualReport,1989.Availableathttp://www.berkshirehathaway.com/letters/1989.html35WarrenBuffett.“Chairman’sLetter.”BerkshireHathaway,Inc.AnnualReport,1988.Availableathttp://www.berkshirehathaway.com/letters/1988.html36BenjaminGrahamandDavidDodd.SecurityAnalysis:TheClassic1934Edition.McGrawHill1934.37WarrenBuffett.“Chairman’sLetter.”BerkshireHathaway,Inc.AnnualReport,1989.Availableathttp://www.berkshirehathaway.com/letters/1989.html38RogerLowenstein,“Buffett:TheMakingofanAmericanCapitalist,”RandomHouse.July24,2013.39JoelGreenblatt,“TheLittleBookThatBeatstheMarket(LittleBooks.BigProfits),”Wiley,April21,2008.40JoelGreenblatt,“TheLittleBookThatBeatstheMarket(LittleBooks.BigProfits),”Wiley,April21,

2008.41WarrenBuffett.“Chairman’sLetter.”BerkshireHathaway,Inc.AnnualReport,2014.Availableathttp://www.berkshirehathaway.com/letters/2014.html42WarrenBuffett.“Chairman’sLetter.”BerkshireHathaway,Inc.AnnualReport,1993.Availableathttp://www.berkshirehathaway.com/letters/1993.html43JamesMontier.“TheLittleNotethatBeatstheMarket.”DrKWMacroResearch,March9,2006.44TimLoughranandJayW.Wellman.“NewEvidenceontheRelationBetweentheEnterpriseMultipleandAverageStockReturns(September5,2010).”AvailableatSSRN:http://ssrn.com/abstract=1481279orhttp://dx.doi.org/10.2139/ssrn.1481279.45BenjaminGraham.“AConversationwithBenjaminGraham.”FinancialAnalystsJournal,Vol.32,No.5(1976),pp.20–23.46J.Greenblatt,R.Pzena,andB.Newberg.“Howthesmallinvestorcanbeatthemarket.”TheJournalofPortfolioManagement,Summer1981,48–52.47MichelleClayman.“InSearchofExcellence:TheInvestor’sVeiwpoint.”FinancialAnalystsJournal,May–June1987,54.SuggestedbyDamodaran,201248BarryB.BannisterandJesseCantor.“InSearchof“Un-Excellence”—AnEndorsementofValue-styleInvesting”StifelFinancialCorp.July16,2013.49MarkStevens,KingIcahn(NewYork:PenguinGroup,1993).50MarkStevens,KingIcahn(NewYork:PenguinGroup,1993).51MarkStevens,KingIcahn(NewYork:PenguinGroup,1993).52MarkStevens,KingIcahn(NewYork:PenguinGroup,1993).53RobertL.Chapman,LettertoJ.MichaelWilsondatedMarch30,2000,ExhibitAtoSchedule13D,March31,2000.Availableathttps://www.sec.gov/Archives/edgar/data/1017766/000101359400000097/000101359400-000097.txt54RobertL.Chapman,LettertoJ.MichaelWilsondatedMarch30,2000,ExhibitAtoSchedule13D.Availableathttps://www.sec.gov/Archives/edgar/data/1017766/000101359400000097/000101359400-000097.txt55RobertL.Chapman,ExhibitAtoSchedule13D,February7,2001.Availableathttps://www.sec.gov/Archives/edgar/data/1017766/000101359401000043/000101359401-000043.txt56DanielLoeb,“LettertoChiefExecutiveOfficer,”September8,2000.Availableathttps://www.sec.gov/Archives/edgar/data/1040273/000089914000000393/000089914000-000393-0003.txt57DanielLoeb,“LettertoChiefExecutiveOfficer,”September8,2000.Availableathttps://www.sec.gov/Archives/edgar/data/1040273/000089914000000393/000089914000-000393-0003.txt58DanielLoeb,“LettertoChiefExecutiveOfficer,”September8,2000.Availableathttps://www.sec.gov/Archives/edgar/data/1040273/000089914000000393/000089914000-000393-0003.txt59DavidEinhorn.“iPrefs:UnlockingValue.”GreenlightCapital,2013.Availableathttps://www.greenlightcapital.com/905284.pdf.60DavidEinhorn.“iPrefs:UnlockingValue.”GreenlightCapital,2013.Availableathttps://www.greenlightcapital.com/905284.pdf.61CarlIcahn,LettertoTimCook.Availableathttps://www.cnbc.com/2013/10/24/carl-icahns-letter-to-tim-cook.html62CarlCIcahn,Tweet,11:21AM,August14,2013.Availableat

https://twitter.com/Carl_C_Icahn/statuses/36735020699339980863DavidEinhorn.“iPrefs:UnlockingValue.”GreenlightCapital,2013.Availableathttps://www.greenlightcapital.com/905284.pdf.64CarlCIcahn,Tweet,11:12AM,11:13AM,August19,2014.Availableathttps://twitter.com/Carl_C_Icahn/status/501794143413493760,https://twitter.com/Carl_C_Icahn/status/501794076942172160,https://twitter.com/Carl_C_Icahn/status/50179387215944908965Author,Tweet,5:07PM,April24,2013.Availableathttps://twitter.com/Greenbackd/status/32721226171639808166Author,Tweet,7:19AM,April27,2016.Availableathttps://twitter.com/Greenbackd/status/72532853016746393667BenjaminGrahamandDavidDodd.SecurityAnalysis:TheClassic1934Edition.(NewYork:McGrawHill)1934.68MichaelA.Bishop.andJ.D.Trout.“50yearsofsuccessfulpredictivemodelingshouldbeenough:Lessonsforphilosophyofscience.”PhilosophyofScience69.S3(2002):S197–S208.69MichaelA.Bishop.andJ.D.Trout.“50yearsofsuccessfulpredictivemodelingshouldbeenough:Lessonsforphilosophyofscience.”PhilosophyofScience69.S3(2002):S197–S208.