So our next speaker is Joe Colandro.
He's an enterprise risk manager of a global financial services firm.
And he's a faculty member at the University of Connecticut,
where he designs and teaches MBA courses in value investing and risk management.
He has a new book coming out called Applied Value Investing.
And I'm holding it up right here.
Applied Value Investing, so we're going to fill this in later with the magic of media.
Joe, please join us. We're running about 10 minutes late, but we'll be sure and get you all.
Thank you all. Before I start, I would like to thank the Mises Institute as well as the sponsors of this great event for inviting me to speak today.
When I got here this morning, I was speaking with a friend of mine, Robert Blumen, who's
a pioneer in Austrian financial economics, and he asked me, you know, when are you speaking?
So I told him what my slot was, and I was somewhat complaining a little bit because
the speaker after me is Lew Rockwell.
It's like, I don't want comparisons with Lew Rockwell.
And Robert said to me in the insightful way that only he could say it, he goes, Joe, it
could be worse.
It could be a lot worse.
So by way of background, I traded currencies and commodities in the 1990s, and I did exceptionally
well for about four years.
At year five, I was caught in the Asian contagion, and my fortunes were reversed, if you will.
So examining the mistakes I made, and I made quite a few, led me to the study of Austrian
and Economics and Value Investing, which was fortunate in a sense, timing-wise.
Now I say it was fortunate because there were parallels with what I was seeing in the 1990s
in the new economy and what I was reading about from the new era in the 1920s.
And significantly, from an investment point of view, Austrian business cycle theory predicted
both the boom and bust waves of both business cycles, which is important from an investment
perspective.
So I started out writing memos for select friends of mine.
Those memos turned into working papers, some of which I actually presented at earlier Austrian
Scholars Conferences.
Working papers turned into journal articles, including in the Quarterly Journal of Austrian
Economics and some of those ended up in my book which was recently published.
Now the thesis of my talk today is that good economics facilitates good investing.
And I'd like to begin with something that Warren Buffett said about investment.
He indicated that investment students need only two well-taught courses.
The first is how to value a business and the second is how to think about market prices.
Now if I was coming up with courses, I would add two more of those, one of which is how
to think about money, but that's for another time.
Now with respect to the linkage between business valuation and market prices, I note that Mises
stated in his seminal 1920 article that quote, where there is no free market, there is no
No Pricing Mechanism, and Without a Pricing Mechanism, There is No Economic Calculation."
So there's a direct correlation between valuing a business and market pricing. So in other
words, good economics facilitates good investing. And by economics, for purposes of this talk,
I mean the science which studies human behavior as a relationship between ends and scarce
means which have alternative uses. And that of course is Lionel Robbins' famous definition.
Now what do I mean by investment? What's the definition for investment? And as Rothbard
indicated, quote, the capitalist entrepreneur buys factors or factor services in the present,
his product must be sold in the future. He's always on the lookout then for discrepancies
for areas where he can earn more than the market rate of interest, close quotes. So
price discrepancies. Well, how do investors do that? And according to Mises, open quotes,
the books in the balance sheets are the conscience of business. They are also the businessman's
Compass, close quotes. The books and the balance sheets, not just the books. And the
method that I found that facilitates the analysis of both the books and the balance sheets the
best is the modern gram and dot approach. And it proceeds over a unique value continuum
analytically. It begins with the balance sheet and net asset value, proceeds to the books
and earnings power value, and then potentially proceeds to franchise value competitive advantage
Research Analysis and then potentially Growth Value, which is the final and least tangible
aspect on the continuum.
Now value investing was founded by Benjamin Graham, the late great Benjamin Graham, in
the 1920s and 1930s.
He was heavily influenced by the New Era boom of the 1920s and the subsequent Buster or
Great Depression.
Now significantly, especially for purposes of this talk, he founded a price discrepancy
Based Strategy.
In its original formulation, it involved buying assets less than the liquidation value, which
resulted in a significant price discrepancy or what we call the margin of safety.
Now this concept of a margin of safety is the cornerstone of the approach and remains
so to this day, and it is what differentiates an investment from a speculation to Graham
and his students.
Now Graham's most famous student obviously is Warren Buffett, but there have been others
The difference between bottom-up analysis and top-down analysis is somewhat analogous to the difference between mindset analysis and top-down analysis.
Microeconomics and Macroeconomics
Microeconomics pertains to individual action, supply, demand, pricing
things we can all get our arms around
whereas macroeconomics involves aggregate analysis
gets very murky, there's definitional problems and the like
Similarly, the difference between fundamental analysis
and portfolio analysis is somewhat similar
meaning fundamental analysis is concentrated on price discrepancies
looking for areas where there's a difference between
between Value and What You Can Buy the Assets for Today and Portfolio Analysis which is more concerned with top-down efficient frontiers and asset allocation strategies and significantly for the purposes of this talk portfolio analysis in many ways forms the basis of some of the risk models that did not perform very well in the credit crisis and to understand why I included a quote from Murray Rothbard which indicates quote it is certainly
It is not legitimate and necessary for economics and working out an analysis of reality to
isolate different segments for concentration as the analysis proceeds, but it is not legitimate
to falsify reality in this separation so that the final analysis does not present a correct
picture of the individual parts and their interrelations."
And I would indicate that one of the reasons why some of the quantitative models have collapsed
is because they did not present a correct picture of either the individual parts, meaning
and Individual Securities, or their interrelations, especially under conditions of stress.
Value investing begins with three core principles, and while these principles are associated
with the school, they don't necessarily need to be unique to the school, meaning they could
apply to any form of investment, and the first one is knowledge-based.
To begin my discussion, I'd like to paraphrase something that Frederic Hayek said in his
The recognition of the insupportable limits to his knowledge ought indeed to teach the student of investment a lesson of humility which should guard him against becoming an accomplice in men's failed striving to achieve quick and easy returns.
In other words, human knowledge is inherently limited, and in many cases, it's severely limited.
And as a result, from an investment perspective, you greatly increase the probability of success if you focus on what you know.
Benjamin Graham referred to this as the circle of competence and with respect to
the circle of competence Warren Buffett indicated that the size of that circle
is not important but knowing its boundaries is vital and that's important
because when you're doing a bottom-up evaluation you have to know which
adjustments you have the expertise to make yourself and which require the
services of an expert and I'll give you two examples of what I mean by that
There's a show on cable television called Pawn Stars, and it's a family-run pawn shop in Las Vegas run by a family of entrepreneurs who are very, very savvy.
But every now and then someone will come in the store with an item that's very specialized and they can't either assess its originality, if it's real, or price it, so they call in an expert.
And many value investors do the same type of thing.
I have an insurance background, so I wrote about Warren Buffett's Geico acquisition,
Jennery acquisition, and Pepsi Play for a billion sweepstakes.
So one of my students said, hey, you know, all right, you're real good when it comes
to that type of stuff, but could you do like retail?
Way, way out of my circle of competence.
So I took a crack at it and I followed the framework level by level.
I do not know Mr. Lampert.
I don't know how he values investments, but using this approach and using it conservatively,
I was able to come up with a value relatively close to what he paid for Sears.
So again, you may not have as an individual investor the means to go out and hire a professional
yourself, but you do know people and you do have resources you could tap as you conduct
your investment analysis.
Even if you're operating within a circle of competence, you could still be wrong.
As Mises indicates, quote, man does not always act correctly from the objective point of
view.
Either from ignorance of causal relations or because of an erroneous judgment of the given situation, in order to realize his ends, he acts differently from the way in which he would act if he had correct information."
In other words, as an investor, you could be wrong for any number of reasons, quantitative, qualitative, or behavioral.
And as a result, you should approach each adjustment very, very conservatively or each valuation very, very conservatively.
However, even if you do so, you could still be wrong.
As Rothbard has indicated, quote,
this world is a world of uncertainty.
We shall never be able to forecast the future course
of the world with precision.
Every action therefore involves risk.
This risk cannot be eliminated.
The man who keeps his cash balances suffers the risk
that his purchasing power may dwindle.
The man who invests suffers the risk of loss
and so forth, close quotes.
So how do successful investors manage or mitigate this risk?
Well, they discover discrepancies between present prices
and the anticipated prices of products lest the market rates of interest and are interested
and are eager to profit from them.
Value investors in general have operationalized this by the margin of safety concept and the
rule of thumb basis holds that the price you pay for an asset should be at least 30% less
than conservatively estimated value.
When you apply those principles in evaluation, absent of firm experiencing performance issues,
What you're going to see most of the time is the net asset value relatively reconciling
with the earnings power value and the reason for that is because most firms earn the rate
required by capital providers and as a result are valued at an amount consistent with the
reproduction value of their assets, no more, no less.
But every now and then you're going to come across a firm with earnings power significantly
greater than the net asset value and that will tip you off of the existence of a potential
Sustainable Competitive Advantage.
Value investors refer to that type of firm as a franchise and a number of my students
ask me, what is it, how do you start one, what are some of the characteristics of one?
And effectively, franchise begins with the entrepreneur and as Mises noted, quote, the
business of the entrepreneur is to select from the multitude of technologically feasible
methods those which are best fit to supply the public in the cheapest way with the things
is there asking for most urgently." Now, for the most part, entrepreneurs can't do that
themselves, so they start a firm or an enterprise. And as Mises also noted, open quotes, a profit-seeking
enterprise is supported by the voluntary patronage of the public. It cannot subsist if customers
do not pour in. Now, this concept of customers pouring in is very important because if a
The firm is able to do that, meaning voluntarily now, produce goods and services people want
to buy to the extent that they pour in to buy them.
They effectively evolve from what I call a base case firm or a firm showing a value profile
with assets equaling earnings to a franchise.
And Murray Rothbard describes how this evolution occurs, quote, the elemental physical nature
The structure of a good may be only one of its properties, in some cases a brand name.
The goodwill of a particular company or a more pleasant atmosphere in the store will
differentiate the product from its rivals in the view of many of its customers."
So let's kind of see what one of those looks like.
On the overhead is my valuation of Warren Buffett's 1995 acquisition of Geico.
Now I don't know Mr. Buffett.
I did work for one of his subsidiaries at one time, but I don't know how he values assets.
I don't know what valuation methodology he used, but I do know he was a student of Benjamin
Graham and he's a long-time proponent of the system.
And when he purchased Geico, he paid approximately $70 a share for it, which was about 26% price
premium over the stock price at the time, and it surprised many people.
So when I valued, when I valued Geico, I came to, my earnings power value came to $69 a
And with the benefit of hindsight, he made many multiples of that given the level of
profitability Geico has generated over the years.
It was a master stroke.
So the question you may ask now is, all right, well, he did it with Geico, what's the next
Geico?
I mean, what's the key driver of franchise value?
And in short, it's management.
And as Mises noted, quote, the profit motive is precisely the factor that forces the businessman
and to provide in the most efficient way those commodities the consumers most want to use."
So again, there's a very customer focus to a franchise, but as I indicated, entrepreneurs
and firms really can't do this themselves, so they have to have other people voluntarily
help them.
And as a result, one of the qualifications required for any higher position is precisely
the ability to judge people correctly.
He who fails in this regard jeopardizes his chances of success, and he's exactly right.
And as a result, the fourth course I would teach to investment students today, in addition
to how to think about market prices, how to value a business and how to think about money,
would be management, how to manage people.
There's been a lot written on this and some of it's better than others, but anecdotally
and in my opinion, successful managers have four core things in common.
The first is they have to have entrepreneurial insight and discipline.
Now they don't necessarily have to be entrepreneurs themselves, but they do have to have insight
Second, they have to know how to select, incentivize, develop and retain talent, third, they have
to effectively assign decision rights, and fourth, they have to be fanatical about profit
Profit and Loss
Now notice I said fanatical about profit and loss, I did not say fanatical about the stock
price.
If you can find somebody who can do this consistently over time, and they're very, very rare, you
will generate significant abnormal returns over time.
There's another way to generate significant abnormal returns over time and that has to
do not with a firm approach but with more of a kind of a macro approach.
Now I know what I said at the beginning of the talk that value investors in general are
bottom-up, not top-down focused, and that's true, but I note that even Ben Graham himself
once said that, quote, you should buy during periods of pessimism and low prices and sell
during periods of optimism and high prices.
I think it would be easier to do that if you understood the macroeconomic reasons driving
the pessimism and optimism, and I took it a step further.
I think you could use macro-based insights to screen for potential business opportunities
and one way of doing that is through the efficient use of Austrian business cycle theory.
Now there were a number of other speakers today who spoke about this so I'm not going
to define it.
I'm going to move right into my example.
Now the left chart on the overhead was created by George Soros, who's a favorite speculator
and one of my two favorite investors, Warren Buffett being the other.
And as I said, I have a trading background, someone with a trading background. The first
time I saw that chart, it just had the right kind of feel to it. And again, I rode the
Asian Contagion, I rode the good wave and I got clubbed in the bus, right? So from experience
too, it mirrored what I saw. But he didn't provide, you know, definite criteria for each
of the eight stages that are listed on the x-axis. So what I did is I used Austrian business
I used his technical model, as well as behavioral economics and Soros' reflexive theory, and I came up with criteria for each of the eight stages of the business cycle.
And I applied them to the new economy business cycle, and you see my application on the chart on the right.
Now, this isn't completely a retrospective analysis. I actually started this in stage five, and I was making calls.
I wasn't timing this market. That's impossible to do. George Soros can't do it. There's no reason why I would think I could do it.
And we can't do it. So I didn't even try. But you did say, okay, this is where we are now. This is what's going to happen.
Not quite sure when, but here's kind of how you should protect yourself.
And it started off with just verbal consultation with friends, started off to a memo, then a paper, and then another paper.
And I can't, due to time constraints here, go through each of the criteria, but I will go through one.
And I want you to focus on the left-hand side chart, stage three, the significant short-term top is what I call it.
And that's a very important technical indicator because it means if you follow that over the life cycle of the boom and bust waves,
once the bust prices blow through that level of support, it effectively creates a speculative bubble.
So, specular bubbles don't pop. It's basically just a price structure that forms over the
boom and bust waves of a business cycle. So, what does that mean? Earlier this morning
Doug French quoted a famous economist from Chicago who said, I don't even know, I don't
know what bubbles are, I don't know what they mean. And I think what he meant by that is,
he's a mathematical economist. Mathematically, this is very difficult to do. I spent a year
You're trying to do it after I traded. Again, I had a lot of bad habits to unlearn. My numbing
math didn't make any sense, was completely wrong, and it was the wrong approach. And it's
the wrong approach because, as the Austrians tell us, economics is not a quantitative science,
it's a qualitative science. And you could make qualitative predictions and they're intellectually
valid but more importantly for those of us in this room, they're actionable. You can
Let me sum up my thoughts. Pricing and valuation, as I hope I've been able to convey, is predominantly
about people voluntarily buying and selling, and the resources allocated to produce goods
and services they want to buy and sell. Therefore, buying a security is like buying anything else.
You likely would not buy a compact disc based on a cross-section of different musical genres
As investors, we must know what we're buying, why, what we expect to get out of it, and
when, on every deal we make.
Value investing is a proven method of doing that over time.
There's also potential, value potential, buying into a privilege early, and I gave you an
example of business cycles, there's potentially a way to do that.
But you can also do it on a firm by firm basis.
I'm doing a paper right now on Warren Buffett's Burlington Northern Deal, and no, railroads
are not in my circle of competence, so I'm being very careful as to how I put this together.
Doug French reviewed an early draft of that paper for me, and you know, railroads have
a long history in the United States of governmental privileges, and one of the things that came
out of the research was they're very well positioned to benefit again under the Obama
administration, and if that does happen, it could greatly increase the value of this acquisition
over time.
Now, one cautionary note, if you're going to do this, I mean, if you're going to try to play a government privilege,
you should be very, very conservative and very, very careful, because it's very much a dual-edged sword,
as one very prominent investment bank is finding out right now.
It's just like a boom bust, if you ride it on the boom wave up, you could really be the beneficiary of significant abnormal returns,
but get out before it tops out and protect yourself, especially during a bust.
Now that said, as Murray Rothbard indicates, especially over the last 100 or so years,
there's a very long history of investors and businessmen seeking privileges, quote,
the steel manufacturer seeking a tariff, the bankers seeking taxes to repay their government
bonds, the rulers seeking a strong state from which to obtain subsidies, the bureaucrats wishing to
expand their empire are all professionals in statism. They are constantly at work trying to
to Preserve and Expand their Privileges.
One last word on playing a boom bust or playing a privilege.
Whenever you hear the word new, used to describe market phenomena, especially by a government
official, get ready for a bust.
And I mean directionally, not timing-wise.
We saw that in a new era boom of the 1920s, the new economy, the 1990s, and the recent
new paradigm credit boom that ended in such a disaster.
So, Austrian economics facilitates good investing. However, the converse is not necessarily true.
Good investing does not equate to good economics. An example of this will be after the recent
credit crisis. There were a number of very, very successful investors, many of whom clearly
should have known better, who were clamoring for more state intervention as a result of
and I spoke to a few of them and rather than getting in a shouting match or a debate all I reminded them of was what F.A. Hayek once said that the curious task of economics is to demonstrate to men how little they really know about what they imagine they can design and usually when I say that many of them said well who's Hayek so I explained who he was and what's Austrian economics and as a former educator that gave me the opening I needed to talk about for the reading.
Mises Institute offers a book called The Mystery of Banking by Murray Rothbard.
I strongly recommend it to every investment professional.
We live in a time right now where you're no longer able not to really understand banking
and what's going on in the banking community, and that book is a great primer on it.
I just bought my second copy because my first copy has notes written all over it.
I also recommend His America's Great Depression.
For those of you interested in value investing, there's two books in particular I want to
call your attention to.
The sixth edition of Security Analysis just came out last year.
Seth Klarman, who's probably the leading value investor today, served as the lead editor.
In my opinion, if you serve as the lead editor of Security Analysis, you lead the school.
But Seth also wrote a book in 1991 called Margin of Safety.
It's very, very difficult to find, especially priced reasonably.
But it set the stage for all modern work in the field and all authors, including me, that
came after him, worked to that book.
I want to say one more thing because I know there are young students in this room and
I know there are young analysts and young investors.
The field of Austrian finance and Austrian financial economics is really in its infancy
and you have a great opportunity to develop the field both intellectually and from a practical
perspective.
And over the coming years, I'm looking forward to celebrating your success, to reading your
papers and to moving or to advancing the school even further.